UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


Washington,
      D.C. 20549





**FORM
      10-K**


[Mark
      One]





[
      x
      ]  **ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF**


**THE
      SECURITIES EXCHANGE ACT OF 1934**


For
      the
      Fiscal Year Ended March 31, 2006





OR


[ 
      ]  TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF


THE
      SECURITIES EXCHANGE ACT OF 1934


For
      the
      Transition Period from  to
      ______





Commission
      File Number: 0-6377





LASERCARD
      CORPORATION


(Exact
      name of registrant as specified in its charter)





Delaware
            
            77-0176309(State
                or other jurisdiction of
            
            (I.R.S.
                Employerincorporation
                or organization)
            
            Identification
                No.)





1875
                North Shoreline Boulevard, Mountain View, CA
            
            94043-1601(Address
                of principal executive offices)
            
            (Zip
                Code)





(650)
                  969-4428(Registrant's
                  telephone number, including area
                  code)


Securities
      registered pursuant to Section 12(b) of the Act:





None
            
            None(Title
                of each class
            
            (Name
                of each exchangeso
                registered)
            
            on
                which registered)





Securities
      registered pursuant to Section 12(g) of the Act:





Common
                Stock, $0.01 Par Value(Title
                of class)





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





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





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.  [x]  Yes   [  ] No





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





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





Large
                accelerated filer [  ]
            Accelerated
                filer [x]
            Non
                -accelerated filer [  ]

















Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the
      Act).  [  ]  Yes  [x]  No





Based
      on
      the last trade price of the Company's Common Stock on The Nasdaq Stock Market
      on
      the last business day of the registrant’s most recently completed second fiscal
      quarter (September 30, 2005), the aggregate market value of the voting stock
      held by non-affiliates of the registrant is approximately $99,624,000. Shares
      of
      common stock held by officers, directors and other persons who may be
“affiliates” of the Registrant have been excluded from this computation. This
      determination of affiliate status is not necessarily a conclusive determination
      for other purposes.





Indicate
      the number of outstanding shares of Common Stock, $.01 par value, at May
      31, 2006:  11,810,360








DOCUMENTS
      INCORPORATED BY REFERENCE: NONE


Exhibit
      Index is on page 91


Total
      number of pages is 98








2





PART
      I


Item
                1.
            Business
            4Forward-Looking
                Statements
            4General
                Development of Business
            5Financial
                Information about Segments
            6Narrative
                Description of Business
            7Item
                1A.
            Risk
                Factors
            17Item
                1B.
            Unresolved
                Staff Comments
            23Item
                2.
            Properties
            24Item
                3.
            Legal
                Proceedings
            24Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            24PART
                IIItem
                5.
            Market
                for Registrant's Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity Securities
            25Item
                6.
            Selected
                Financial Data
            26Item
                7.
            Management's
                Discussion and Analysis of Financial Condition and Results of Operations
            27Critical
                Accounting Policies
            27Results
                of Operations
            31Liquidity
                and Capital Resources
            38Item
                7A.
            Quantitative
                and Qualitative Disclosures about Market Risk
            41Item
                8.
            Financial
                Statements and Supplementary Data
            43Reports
                of Independent Registered Public Accounting Firms
            43Consolidated
                Financial Statements
            46Notes
                to Consolidated Financial Statements
            50Quarterly
                Financial Information (Unaudited)
            72Item
                9.
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            73Item
                9A.
            Controls
                and Procedures
            73Item
                9B.
            Other
                Information
            73PART
                IIIItem
                10.
            Directors
                and Executive Officers of the Registrant
            74Item
                11.
            Executive
                Compensation
            76Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            81Item
                13.
            Certain
                Relationships and Related Party Transactions
            83Item
                14.
            Principal
                Accountant Fees and Services
            84PART
                IVItem
                15.
            Exhibits
                and Financial Statement Schedules
            85Signatures
            
            90





3





PART
      I





ITEM
      1.
      BUSINESS





*FORWARD-LOOKING
      STATEMENTS* .
      All
      statements contained in this report that are not historical facts are
      forward-looking statements.  The forward-looking statements in this report
      are made pursuant to the safe harbor provisions of the Private Securities
      Litigation Reform Act of 1995.  They are not historical facts or guarantees
      of future performance or events. Rather, they are based on current expectations,
      estimates, beliefs, assumptions, and goals and objectives and are subject to
      uncertainties that are difficult to predict.  As a result, the Company’s
      actual results may differ materially from the statements made.  Often such
      statements can be identified by their use of words such as “may,” “will,”
“intends,” “plans,” “believes,” “anticipates,” “visualizes,” “expects,” and
“estimates.”  Forward-looking statements made in this report include
      statements as to the Company’s belief that the German subsidiaries will
      successfully complete the contract for a conventional non-optical card
      production facility during fiscal year 2007; the Company’s belief that the
      expired U.S. government contract will be replaced with a new contract or
      purchase order prior to delivery of those cards ordered prior to when the
      contract expired in November 2005; the Company’s beliefs as to current and
      potential market segments, customers, and applications for and deployment of
      the
      products of the Company; the advantages of, potential income from, and duties
      to
      be performed under the sale of a second-source card manufacturing license to
      Global Investments Group (GIG); future scheduled payments and contingent
      royalties under the GIG contract, GIG’s production capacity, and that the
      Company will sell equipment to GIG, provide GIG with installation support,
      and
      have on-site personnel; production quantities, delivery rates and expected
      delivery schedule, backlog, and revenue recognition for Company products for
      U.S. or foreign government programs; plans to increase card production capacity
      for anticipated increases in orders including $9 million in capital equipment
      and leasehold improvements during the next twelve months; plan to enhance CCD
      card manufacturing to encompass four key ID card technologies and belief that
      CCD factory assists the Company to take advantage of European growth
      opportunities and combined with CCD marketing will accelerate European
      acceptance of optical memory technology; our intent to find another photographic
      film supplier should Kodak cease supplying such film and to take advantage
      of
      any last-buy opportunity which Kodak may choose to provide; our intent to pursue
      patent infringers by litigation, arbitration, or negotiation; anticipated
      continued use of the Company’s products by the governments of the United States,
      Canada, a Middle Eastern country, India, Costa Rica and Italy; the need for,
      expected success of, and potential benefits from the Company’s research and
      engineering efforts and whether they can stimulate card sales growth; the
      effects of read/write drive prices and sales volume on gross profits or gross
      margins from read/write drive sales; expectations regarding revenues (overall
      and by segment and by customer), margins, SG&A and R&D expenses, state
      income taxes, capital resources, and capital expenditures and investments,
      and
      the Company’s deferred tax asset and related valuation allowance; expected card
      orders delivery volumes, estimates of optical card production capacity, expected
      card yields there from, the Company’s ability to expand production capacity, and
      the Company’s plans and expectations regarding the growth and associated capital
      costs of such capacity; expected schedule for personalization infrastructure
      installation in a Middle Eastern country; estimates that revenues and advance
      payments will be sufficient to generate cash from operating activities over
      the
      next 12 months despite expected quarterly fluctuations; expectations regarding
      market growth, product demand, and the continuation of current programs;
      expectation that international markets will be an important revenue source;
      potential expansion or implementation of government programs utilizing optical
      memory cards, including without limitation, those in Italy, India, and a Middle
      Eastern country, and the timing of the award of any prime contracts for such
      programs and the amount of card orders in such programs; and the Company's
      plans, objectives, and expected future economic performance including without
      limitation, its marketing objectives, EMEA strategy, long-term revenue growth
      objectives, and drive pricing strategy.





These
      forward-looking statements are based upon the Company’s assumptions about and
      assessment of the future, which may or may not prove true, and involve a number
      of risks and uncertainties including, but not limited to, whether there is
      a
      market for cards for homeland security in the U.S. and abroad, and if so whether
      such market will utilize optical memory cards as opposed to other technology;
      customer concentration and reliance on continued U.S. and Italian government
      business; risks associated with doing business in and with foreign countries;
      whether the Company will be successful in assisting GIG with factory startup
      and
      training; whether GIG will have the financial wherewithal to make the balance
      of
      its required payments to the Company and to operate the facility; whether the
      facility will efficiently produce high quality optical memory cards in volume
      and that meets our standards; lengthy sales cycles and changes in and dependence
      on government policy-making; reliance on value-added resellers and system
      integrators to generate sales, perform customer system integration, develop
      application software, integrate optical card systems with other technologies,
      test products, and work with governments to implement card programs;





4





risks
      and
      difficulties associated with development, manufacture, and deployment of optical
      cards, drives, and systems; the impact of litigation; the ability of the Company
      or its customers to initiate and develop new programs utilizing the Company's
      card products; risks and difficulties associated with development, manufacture,
      and deployment of optical cards, drives, and systems; potential manufacturing
      difficulties and complications associated with increasing manufacturing capacity
      of cards and drives, implementing new manufacturing processes, and outsourcing
      manufacturing; the Company’s ability to produce and sell read/write drives in
      volume; the unpredictability of customer demand for products and customer
      issuance and release of corresponding orders; government rights to withhold
      order releases, reduce the quantities released, and extend shipment dates;
      whether the Company receives a fixed shipment schedule, enabling the Company
      to
      recognize revenues on cards delivered to the vault instead of when cards later
      are shipped from the vault; the impact of technological advances, general
      economic trends, and competitive products; the impact of changes in the design
      of the cards; and the possibility that optical memory cards will not be
      purchased for the full implementation of card programs in Italy, a Middle
      Eastern country and India, or for DHS programs in the U.S., or will not be
      selected for other government programs in the U.S. and abroad; unanticipated
      delays in obtaining U.S. government approvals to extend or replace its expiring
      contract; the risks set forth in the section entitled “Risks ” and elsewhere in
      this report; and other risks detailed from time to time in the Company’s SEC
      filings. These forward-looking statements speak only as to the date of this
      report, and, except as required by law, the Company undertakes no obligation
      to
      publicly release updates or revisions to these statements whether as a result
      of
      new information, future events, or otherwise.





*Trademarks.* LaserCard ® and
      Drexon ® are the
      Company’s registered trademarks. OpticalSmart TM card,
      OpticalProximity TM card,
      LaserCard ® ConciergeCard TM ,
      OptiChip TM ,
      LaserPass TM ,
      Embedded HologramHD TM ,
      Optical
      IDLock TM ,
      and
      LaserBadge TM are
      the
      Company’s trademarks. The Company may also refer to trademarks of other
      corporations and organizations in this document.





GENERAL
      DEVELOPMENT OF BUSINESS





Headquartered
      in Mountain View, California, LaserCard Corporation, a Delaware corporation,
      (formerly known as Drexler Technology Corporation, until October 1, 2004) is
      primarily a holding company that performs all its operations through its two
      wholly owned subsidiaries. LaserCard Corporation, a California corporation,
      of
      Mountain View, manufactures LaserCard® optical memory cards and card related
      products, including chip-ready OpticalSmartTM cards, and Challenge Card Design
      Plastikkarten GmbH, acquired on March 31, 2004, with offices in Rastede and
      Ratingen, Germany, manufactures advanced-technology cards and markets cards,
      system solutions, and thermal card printers. The Company completed the merger
      of
      cards & more GmbH (also acquired on March 31, 2004) into Challenge Card
      Design Plastikkarten GmbH in January 2006. References to Challenge Card Design
      Plastikkarten GmbH in this document include the pre-merger activities of cards
      & more GmbH.





Challenge
      Card Design Plastikkarten GmbH (“CCD”) provides the Company with a strong card
      manufacturing base to serve the European, Middle Eastern, African, and Asian
      markets, supplementing the Company’s newly expanded manufacturing operations in
      California. While operating results of CCD since the acquisition are
      consolidated into the Company’s financial statements for fiscal years 2006 and
      2005, the historic operating results have not been included in the financial
      statements for fiscal year 2004 and prior periods. The consolidated balance
      sheets as of March 31, 2006 and March 31, 2005 reflect the
      acquisition.





LaserCard
      Corporation was incorporated under the laws of the State of California on
      July 23, 1968, and was reincorporated as a Delaware corporation on June 24,
      1987. The Company’s mailing address and executive offices are located at 1875
      North Shoreline Boulevard, Mountain View, California 94043, and the telephone
      number is (650) 969-4428. Throughout this report, the “Company,” “we,” and “us”
refer to LaserCard Corporation and subsidiaries, unless otherwise indicated.





The
      Company's annual report on Form 10-K, quarterly reports on Form 10-Q, current
      reports on Form 8-K, and all amendments to those reports can be obtained free
      of
      charge after such material is electronically filed with or furnished to the
      Securities and Exchange Commission (SEC). These documents are available as
      soon
      as reasonably practicable using the hypertext link to the SEC’s website via the
      Company's website, www.lasercard.com. They also may be obtained directly from
      the SEC's website, www.sec.gov/edgar/searchedgar/companysearch.html under CIK
      code 30140. In addition, these documents and the Company’s “Code of Ethics and
      Business Conduct for Employees, Officers, and Directors” are posted on the
      Company’s website.





5





The
      Company’s primary product is the LaserCard® optical memory card which is a
      credit-card sized, data storage card—invented, patented, developed, and
      manufactured by the Company. Along with its ability to record, update, and
      store
      up to 2.86 megabytes of user data, this unique card offers multiple
      data-security features, can be carried in a wallet, and is highly resistant
      to
      counterfeiting and data tampering. This makes the LaserCard® ideal for portable
      and secure data storage and for cardholder identification.





Current
      applications for the LaserCard® include identification cards for citizens,
      non-citizen permanent residents, foreign workers, and border crossing, as well
      as vehicle registration and driver’s licenses.





Major
      programs include:




o
            United
                States Permanent Resident Card (“Green
                Card”)


o
            United
                States Department of State Laser Visa Border Crossing Card
                (BCC)


o
            Government
                  of Canada “Maple Leaf” Permanent Resident
                  Card


o
            Italian
                  citizens’ ID card


o
            Italian
                  foreign resident card


o
            Costa
                  Rica residency card


o
            Middle
                  Eastern country national ID
                  card


o
            Vehicle
                registration in a few states in
                India




The
      Company sold a license, effective April 3, 2004, to Global Investments Group
      (GIG), based in Auckland, New Zealand, for card manufacturing in Slovenia. 
This agreement provides for payments to the Company of $14 million for a 20-year
      license and five-year training support package, followed by $15 million paid
      $1
      million annually for ongoing support for an additional 15 years. 
Additionally, the Company is to sell approximately $12 million worth of the
      required manufacturing equipment and installation support for the new facility
      to be built by GIG to provide a targeted initial manufacturing capacity of
      10
      million optical cards annually. As of March 31, 2006, the Company had acquired
      $5.9 million of this equipment classified as equipment held for resale on its
      consolidated balance sheet.  The Company has received $20.5 million of
      payments called for in the agreements, consisting of a partial payment for
      the
      equipment and training of $6.5 million and $14 million for the license fee
      and support. Another
      approximately $5.9 million is overdue with GIG most recently committing to
      complete the payment by the end of June. The Company has begun to investigate
      alternative courses of action should GIG fail to make such payment .
      For the
      $20.5 million the Company received, $18.5 million was recorded as advance
      payments from customer and $2 million for the licensing fee was recorded as
      deferred revenue, which were both classified as long term liabilities within
      the
      consolidated balance sheets.  In addition to the $41 million discussed
      above, GIG is to pay the Company royalties for each card produced under the
      license.  The territories covered by the license include most of the
      European Union and eastern European regions.  GIG has exclusive marketing
      rights in certain territories, with performance goals to maintain these
      rights.  The Company will assign a person on site during the license term
      to assist with quality, security and operational procedures, with the mutual
      goal that the facility and the cards made in the facility conform to the
      Company’s standards. The Company also retains rights to utilize up to 20% of the
      new facility capacity as backup and capacity buffer to augment its own card
      manufacturing facilities in Mountain View, California and at its German
      subsidiary. The granting of this license to GIG establishes a potential second
      source supplier of optical memory cards for existing and prospective customers
      who may request multiple sources for cards.





For
      a
      discussion of the risk factors related to the Company’s business operations, see
      the “Forward-Looking Statements” narrative at the beginning of this report, the
“Risk Factors” at the end of this section, and the “Management’s Discussion and
      Analysis of Results of Operations and Financial Condition” contained in Item
      7.





FINANCIAL
      INFORMATION ABOUT SEGMENTS





The
      Company’s three reportable segments are: (1) optical memory cards, (2) optical
      memory card drives, including read/write drives, maintenance, and related
      accessories (“optical card drives”), and (3) specialty cards and printers. The
      segments were determined based on the information used by the chief operating
      decision maker. The optical memory cards and optical card drives reportable
      segments are not strategic business units which offer unrelated products and
      services; rather these reportable segments utilize compatible technology and
      are
      marketed jointly. Specialty cards and printers is a strategic business unit
      offering at times unrelated products and at times related products with the
      other reportable segments. See “Segment Reporting” in Note 4 in Item 8,
“Financial Statements and Supplementary Data,” for additional industry segment
      information.





6








NARRATIVE
      DESCRIPTION OF BUSINESS





LaserCard
      Corporation develops, manufactures and sells optical memory cards, optical
      card
      drives, system software and card-related systems, and markets peripherals,
      specialty cards and card printers. The primary product of the Company is the
      LaserCard® optical memory card (OMC).





*LaserCard®;
      A Secure Counterfeit-resistant Credential*





The
      Company’s LaserCard® optical memory card is a secure, counterfeit-resistant
      credential whose current primary use is by national governments in
      identification applications.





Digital
      data is recorded in an irreversible process so that ID information on a
      legitimate card cannot be fraudulently altered for criminal purposes. Each
      implementation for secure ID is customized to the issuer’s own specifications.
      Key characteristics of the card’s memory and the issuing and inspection hardware
      are matched. To date, the Company’s users have concluded that the hurdle for
      would-be card counterfeiters is so high that such persons instead would seek
      some other vulnerability points in the issuance process.





Another
      security benefit of optical memory is its ability to create visible,
      high-resolution micro images and security patterns in the optical media itself
      at resolutions up to 12,000 dots per inch. These features, which cannot be
      accurately simulated, are used by inspectors and forensic specialists for both
      unaided and aided visual card authentication.





It
      is
      also possible to create a “laser-etched,” eye visible image in the media,
      irreversibly marking the digital recording media with the visible identity
      of
      the card holder - a unique security feature among all machine readable card
      technologies. This method of permanently “etching” a facial image in the media
      has been in use since 1997 and was originally used to verify or back-up the
      authenticity of the printed or laser engraved facial images on the card’s
      surfaces. Following recent development efforts, the resolution and contrast
      of
      this etched image has been significantly enhanced. The newly released Embedded
      HologramHDTM features a larger, high-definition photographic quality image, so
      the feature itself can be used for ID verification, while still serving the
      back-up function. The feature is essentially impossible to copy or reproduce
      and
      cannot be altered thus providing a very high level of counterfeit
      resistance.





Embedded
      HologramHD is a component of LaserCard’s unique document security package, known
      as Optical IDLockTM, a highly sophisticated layering and blending of overt,
      covert and forensic security and identity management features. These features
      collectively make each card uniquely counterfeit resistant, tamper evident
      and
      permanently locked to the identity of the cardholder. No other technology can
      deliver this level of security tied to the individual cardholder’s
      identity.





The
      Company's OpticalSmartTM Card offering combines the security and capacity of
      optical memory with the active transactional capability of IC chip. The chip
      can
      be any ISO 7816 series standard module and is embedded into the optical card
      base stock using traditional milling and embedding techniques.





Typical
      applications for the OpticalSmartTM Card include the provision of e-government
      services via the chip and while the optical memory acts as a visual and
      automatic card authentication feature, backs up the chip in case of failure
      or
      tampering, and stores an audit trail of events in the card's life for security
      and forensic purposes. In addition, the optical memory can store a suite of
      original biometric images (for example, face, fingerprints and irises) to
      provide a means of ID verification across other government and private sector
      applications. Given that optical memory can be used securely off-line, it is
      not
      necessary to have access to Public Key Infrastructure, an extremely costly
      and
      complex system, at every transaction point thus enhancing the over-all
      cost-effectiveness of optical memory.





The
      Company believes that the newly-introduced LaserPassTM is the most secure and
      flexible electronic ID solution available today. Combining the convenience
      and
      facilitation capabilities of RFID or contactless chip technology with the
      security and certain, automatic authentication of optical memory, the system
      can
      support a complete range of inspection and ID verification scenarios which
      can
      be set depending on perceived threat levels. For example, the combination of
      the
      technologies provides the following advantages:





7








·
            RFID
                provides convenient access within a facility after cardholder ID
                verification (one -to-one) with data stored on the optical
                memory


·
            RFID
                can be used in high traffic environments as a “read ahead” data base
                pointer allowing data to be retrieved and queued awaiting inspection


·
            Optical
                memory provides instant automatic card authentication, very rapid
                one-to-one biometric ID verification, and display of digital facial
                image
                and other ID data directly from the optical
                memory


·
            Optical
                memory provides an attending inspector with unparalleled surety in
                visually verifying card, cardholder and displayed
                data


·
            All
                RFID data is backed up on the optical
                media


·
            Optical
                memory can be used when the network is down or
                slow


·
            Optical
                memory can be used when the chip may have been compromised or there
                is
                suspicion about the cardholder’s match to the database image or tampering
                with the card’s printed personal
                data


·
            Optical
                memory acts as forensic evidence in criminal prosecutions for tampering
                or
                counterfeiting of either the chip’s data or card personalized
                data





*LaserCard
      Government Applications*





The
      predominant present application is secure identity in government programs,
      covering both immigration and border entry along with citizenship .
      The
      counterfeit-resistant cards are typically replaced every five or ten years.
      The
      following are examples of these government applications:





o
            The
                U.S. Permanent Resident Card (“Green Card”), made by the Company and
                issued by the Department of Homeland Security, evidences that a non-US
                citizen is approved to reside and be employed in the United
                States.





o
            The
                Laser Visa Border Crossing Card, made by the Company and issued by
                the
                United States Department of State, permits Mexican citizens to visit
                the
                United States (close to the U.S. border) for up to 30
                days.





o
            The
                Canadian “Maple Leaf” Permanent Resident Card, made by the Company, has
                been issued by the Government of Canada since mid-2002 to confirm
                Canadian
                permanent resident status.





o
            The
                electronic citizen ID card of Italy, identifies the holder as a citizen
                and confers upon the holder the rights and privileges to which a
                citizen
                is entitled.





o
            The
                Italian electronic non-citizen resident permit card for non-EU
                citizens.





o
            In
                a program for a Middle Eastern country, the LaserCard® is being issued as
                a national identification card. The Company has sold read/write drives,
                printers and application software for installation of the infrastructure
                required for card issuance, and to date has shipped about 500,000
                optical
                memory cards.





o
            A
                motor vehicle registration program in the States of Delhi and Gujarat,
                India, in which the OpticalSmartTM LaserCard® is used for storing the
                payment of road tax, vehicle registration, insurance, violations,
                and
                vehicle fitness. We have been informed that the two states have issued
                more than 600,000 such optical card-based registrations to date,
                and other
                Indian states have planned OpticalSmartTM card vehicle registration
                programs as well.


*Data
      Storage Capacity*





The
      gross
      data storage capacity of the standard LaserCard® is 4.1 megabytes on the 35mm
      optical stripe and 1.5 megabytes on the 16mm stripe. The LaserCard® itself is
      the size of a conventional credit card.





8








A
      portion
      of the LaserCard®’s total data capacity is used for an error detection and
      correction, or EDAC, algorithm. EDAC is routinely used in various data storage
      and transfer methods to compensate for data errors resulting from transmission
      errors, surface scratches above the recording material, or contamination such
      as
      dust or fingerprints. EDAC is automatically added to data written onto the
      LaserCard®, to achieve written data error rates of less than one in a
      trillion.





The
      resulting data storage capacities are 2.86 megabytes of “user” capacity for the
      standard 4.1 megabyte LaserCard® and 1.1 megabytes of “user” capacity for
      the 1.5 megabyte LaserCard®.





*Durability*





Since
      1993 more than 800,000 LaserCard® optical memory cards and approximately 2,000
      LaserCard® OMC drives have been installed by the U.S. Defense Logistics Agency
      for use in shipping goods all over the world, often in the most hazardous
      environments. Environmental testing done by the U.S. Army showed high durability
      with the optical memory card, and has subsequently been validated by the
      worldwide Army deployments where the card has demonstrated its ability to
      withstand some of the harshest conditions and still work reliably in this
      mission-critical application.





*International
      Standards for Optical Memory Cards*





Standardization
      of optical memory cards allows interchange of the digital information encoded
      on
      the cards and facilitates compatibility among optical memory card systems.
      The
      Company participates in optical card standards activities in the United States
      and internationally. Shown below is the current status of optical memory card
      standards under ISO/IEC (the International Organization for
      Standardization/International Electrotechnical Committee). The LaserCard®
optical memory card system, complies with all of the documents
      listed.





o
            ISO/IEC
                11693 describes the general characteristics of optical memory cards.
                This
                international standard was first published in
                1994.





o
            ISO/IEC
                11694-1 describes the physical characteristics of the card, such
                as
                height, width, thickness, etc. This international standard was first
                published in 1994.





o
            ISO/IEC
                11694-2 describes the dimensions and location of the accessible area—the
                area on the card where data writing/reading occurs. This international
                standard was first published in
                1995.





o
            ISO/IEC
                11694-3 describes the optical properties and characteristics of the
                card
                and provides the technical specifications which allow interchange.
                This
                international standard was published in
                1995.





o
            ISO/IEC
                11694-4 describes the logical data structure on the card and defines
                the
                method of writing and reading card data. This international standard
                was
                published in 1996.





In
      the
      United States, ANSI (the American National Standards Institute) has adopted
      all
      of the above ISO Standards as ANSI/ISO Standards.





Other
      standards defining the use of optical memory cards in certain application areas,
      such as driver’s license and interoperable ID documents, also
      exist.





9








*LaserCard®
      Manufacturing*





The
      Company’s LaserCard® optical memory card manufacturing operations are located in
      Mountain View, California, and Rastede, Germany. The Company produces optical
      memory cards using a roll-lamination process or a newer sheet-lamination
      process. The sheet-lamination process is currently more labor intensive than
      the
      roll-lamination process but allows the use of high security offset printing
      and
      other special features, resulting in a premium card. The Company has an annual
      production capacity of 10 million roll-process cards in conjunction with
      approximately 8 million sheet-process cards depending upon the optimum mix
      of
      features.





The
      March
      31, 2004 acquisition of Challenge Card Design Plastikkarten GmbH ** (“CCD”)
      of Rastede, Germany, provides the Company with a card manufacturing base to
      serve the European, Middle Eastern, African, and Asian markets, supplementing
      the Company’s card manufacturing operations in California. CCD has a
      manufacturing capacity of up to 20 million non-optical specialty cards per
      year.
      CCD also provides optical memory card manufacturing capacity for some interim
      steps of the sheet manufacturing process. The Company may enhance the existing
      CCD factory to manufacture finished optical card blanks in Germany if and when
      European customer orders justify such capacity expansion and such European
      expansion is determined to be cost effective. This would enable CCD to
      manufacture cards featuring four of the key ID card technologies (optical
      memory, contact IC chip, contactless RFID, and magnetic stripe) either singly
      or
      in combination, along with other high-security features.





*Raw
      Materials*





To
      maintain adequate raw material supplies for the manufacture of optical memory
      cards, the Company establishes ongoing relationships with principal qualified
      suppliers, and when commercially reasonable utilizes multiple suppliers, and
      obtains information about alternate suppliers. The Company maintains raw
      materials inventory levels that take into account current expected demand,
      order-to-delivery lead times, supplier production cycles, and minimum order
      quantities. If the Company is unable to buy raw materials in sufficient
      quantities and on a timely basis, it would not be able to deliver products
      to
      customers on time.





Most
      of
      the raw materials used in the manufacture of optical memory cards are available
      from one or more qualified suppliers. Such materials include plastic films
      used
      in optical memory card production, which are available from one supplier in
      the
      U.S. and from multiple foreign suppliers. Processing chemicals, inks, and
      bonding adhesives are obtained from various U.S. and foreign suppliers. However,
      certain photographic films are commercially available solely from Eastman Kodak
      Company, of the United States. No assurance can be given that Kodak will
      continue to supply such photographic films on a satisfactory basis and in
      sufficient quantities. If Kodak were to discontinue manufacturing the film
      from
      which our optical media is made, we would endeavor to establish an alternate
      supplier for such film, although the purchase price could increase and
      reliability and quality could decrease from a new supplier. No assurance can
      be
      given that there will be adequate demand to attract a second source. In
      addition, an alternate supplier could encounter technical issues in producing
      the film as there may be know-how and manufacturing expertise which Kodak has
      developed over the years which an alternate supplier may have difficulty to
      replicate. We have pre-purchased a long-term supply of the film used to produce
      mastering loops for prerecording cards. With regard to the film from which
      our
      optical media is made, we currently have an order which Kodak has accepted
      with
      deliveries scheduled through October 2006. If Kodak announced that it was no
      longer going to sell film, we would request that Kodak provide us with a
      last-buy opportunity which we would plan to take maximum advantage of, although
      no assurance can be given that Kodak would provide us with such an opportunity.
      We have film on hand plus on order that we believe would provide us with an
      adequate supply to meet anticipated demand until we could locate and begin
      volume purchases from a second source. In addition, the Company is researching
      other materials for use as its optical memory card media.





*LaserCard
      Read/Write Drives; Manufacturing and Parts/Components*





Optical
      memory cards are used in conjunction with a card read/write device (drive)
      that
      connects to a personal computer. The price, performance, and availability of
      read/write drives are factors in the commercialization of optical cards. The
      Company maintains read/write drive manufacturing operations in its Mountain
      View, California facilities. The Company continuously seeks design and
      procurement changes to improve performance and reduce the drive selling price
      although much higher volumes would be required to significantly reduce the
      price
      further.





10








To
      maintain adequacy of parts and components for the manufacture of read/write
      drives, the Company attempts to establish ongoing relationships with principal
      suppliers and obtains information about alternate suppliers. If the Company
      is
      unable to buy parts and components in sufficient quantities and on a timely
      basis, it would not be able to deliver products to customers on time. The
      Company purchases read/write drive parts for its anticipated read/write drive
      demand, taking into consideration the order-to-delivery lead times of vendors
      and the economic purchase order quantity for such parts. For read/write drives,
      the optical recording head for the current drive is a Company-specific part
      obtained from one supplier: Audio-Technica Corp., of Japan.





*Application
      Programming Interface (APIs) and Application Software*





*APIs* .
      As part
      of its read/write drive and system sales, LaserCard includes a comprehensive
      set
      of APIs in order for its customers to develop optical card applications. An
      API
      is a set of routines, protocols, and tools used by programmers for building
      software applications. LaserCard-related APIs control or facilitate the basic
      operations and read/write functions of optical memory card drives so that they
      can interface directly with personal computers. LaserCard develops
      LaserCard-related APIs such as device drivers, file system DLLs (dynamic link
      libraries), and custom software tools to enhance read/write drive integration.





*Custom
      Applications.* The
      Company also offers contract services for purchase by customers that require
      custom programming in the development and integration of their LaserCard®
applications. It also makes available for purchase by customers, software for
      demonstrating data storage, medical, and security concepts involving the
      LaserCard®, software-development tools for related peripherals, and a card
      issuance application software package.





*Application
      software.* End-user
      application software is an important factor in developing commercial markets
      for
      optical memory cards because it directs computers to do specific tasks related
      to the customer's end-user application for the LaserCard®. Typically, the
      Company’s value-added resellers (VARs) and/or their customers develop software
      for specific end-user applications. In this role, VARs may integrate optical
      card products into existing software products, write new application software
      for specific optical memory card programs, or license software from other VARs.
      Several VARs have written optical card software programs for applications.
      The
      Company markets the BadgeMaker card personalization and issuing applications
      used for card issuance and data management; and the LaserBadgeTM derivative of
      BadgeMaker, and a Biometric ID Verification System application.





API
      and
      application software sales have not been a significant portion of revenues
      thus
      far. To date, the Company’s software development has been completed concurrent
      with the establishment of technological feasibility and, accordingly, all
      software development costs have been charged to research and engineering expense
      in the accompanying statements of operations.





*LaserCard
      Biometric ID Verification System*





The
      Company has developed a LaserCard Biometric ID Verification System that can
      quickly confirm validity of optical memory card biometric ID cards sold to
      the
      U.S. Government, read and display digitally stored photographs and other digital
      data from the cards, and biometrically verify the cardholders’ live-scanned
      fingerprints with the fingerprint templates stored on the cards at time of
      card
      issuance.




The
      Company also is marketing the LaserCard Biometric ID Verification System as
      a
      "concept" package, meaning that software which performs the same functions
      (but
      not usable with U.S. government cards) is available in customized form to other
      customers for government, industrial, and commercial applications.





*Other
      Advanced-Technology Cards*





Acquired
      by the Company on March 31, 2004, Challenge Card Design Plastikkarten GmbH
      is a
      recognized leader in Europe as a provider of advanced contactless card
      solutions, primarily in the consumer, event, and access control sectors
      including gate systems for sporting events and student ID cards for German
      universities. CCD has the production capacity to manufacture up to 20 million
      advanced-technology specialty cards per year—including contact IC chip cards,
      contactless RFID cards, and magnetic stripe cards—and markets cards, thermal
      card printers, and system solutions worldwide under the cards & more brand.
      The CCD card manufacturing plant in Rastede provides significant capacity and
      product flexibility to the Company’s product line. With expertise in contactless
      IC technology and high resolution security printing, the European factory
      positions the Company to move into new market areas.





11








*Sales
      and Marketing*





The
      Company markets its OMC products, primarily through value-added resellers (VARs)
      of the Company in the United States and other countries. The Company makes
      available for sale optical memory cards, optical card read/write drives and
      software, and third-party peripherals to its VARs. VARs may add value in the
      form of services, application-specific software, personal computers, or other
      peripherals, and then resell these products as integrated systems. Sales to
      the
      United States government and foreign governments are made indirectly through
      VARs and licensees. For example, products are sold indirectly to ultimate use
      customers such as the U.S. Department of State, U.S. Department of Defense,
      U.S.
      Department of Homeland Security, and the government of Canada, through a VAR
      that is a government subcontractor.





Revenues
      by geographic region are shown in Note 4 of the “Notes to Consolidated Financial
      Statements” in Item 8, “Financial Statements and Supplementary Data.”
Substantially all foreign product sales have been made through VARs and
      licensees. The Company believes that international markets will be an important
      source of product sales and license revenue in the future.





LaserCard®
      sales and marketing operations are conducted through its offices in California,
      New York, Washington, D.C. area, and Germany. In addition, the LaserCard
      Corporation website (www.lasercard.com) supports worldwide marketing activities.
      The Company’s marketing and sales staff, general management, and technical
      personnel work closely with customers and provide pre-sales technical support
      to
      assist VARs and licensees.





*European
      Operations.* The
      Company’s German subsidiary, Challenge Card Design Plastikkarten GmbH (“CCD”)
      provides the marketing base for most of Europe, Middle East, and Africa (EMEA).
      CCD gives the Company an established position in the European Union in the
      advanced-technology card market. CCD is a recognized leader in Europe as a
      provider of advanced contactless card solutions, primarily in the consumer,
      event, and access control sectors under the cards & more brand. CCD heads
      the Company’s European marketing effort in coordination with LaserCard
      Corporation. The Company believes that the European marketing base, along with
      the optical card manufacturing capability in Germany, will accelerate European
      acceptance of the use of optical memory products in EU government and business
      solutions.





CCD
      serves and supports its existing customer base for advanced-technology specialty
      cards and thermal printers, while adding new resources to build the optical
      memory card business throughout the EMEA region. The Company intends to focus
      principally on biometric ID solutions for national and regional governments
      in
      this region, as well as promoting optical cards in commercial and industrial
      markets which can benefit from the large data capacity and robust security
      that
      optical cards offer.





*Marketing
      Objectives: The Company’s principal objectives are to:*





·
            Maintain,
                leverage and expand further the existing optical memory card user
                community of national and regional
                governments


·
            Broaden
                the optical memory-based range to address lower end applications
                characterized by higher price sensitivity


·
            Diversify
                optical memory products into, and effectively penetrate, industrial
                and
                commercial markets


·
            Expand
                hardware product offerings to address new markets and add value to
                the
                current offering


·
            Increase
                revenues by selling more application software and integrated solutions,
                such as data capture, personalization, quality assurance and kiosk
                systems


·
            Maintain
                and, where possible, increase market share for specialized cards
                and
                printer products





*Licensing*




The
      Company sold a license, effective April 3, 2004, to Global Investments Group
      (GIG), based in Auckland, New Zealand, for card manufacturing in Slovenia. 
This agreement provides for payments to the Company of $14 million for a 20-year
      license and five-year training support package, followed by $15 million paid
      $1
      million annually for ongoing support for an additional 15 years. 
Additionally, the Company is to sell approximately $12 million worth of the
      required manufacturing equipment and installation support for the new facility
      to be built by GIG to provide a





12





targeted
      initial manufacturing capacity of 10 million optical cards annually. As of
      March
      31, 2006, the Company had acquired $5.9 million of this equipment classified
      as
      equipment held for resale on its consolidated balance sheet.  The Company
      has received $20.5 million of payments called for in the agreements, consisting
      of a partial payment for the equipment and training of $6.5 million and
      $14 million for the license fee and support. Another approximately $5.9
      million is overdue with GIG most recently committing to complete the payment
      by
      the end of June. The Company has begun to investigate alternative courses of
      action should GIG fail to make such payment. For the $20.5 million the Company
      received, $18.5 million was recorded as advance payments from customer and
      $2
      million for the licensing fee was recorded as deferred revenue, which were
      both
      classified as long term liabilities within the consolidated balance
      sheets.  In addition to the $41 million discussed above, GIG is to pay the
      Company royalties for each card produced under the license.  The
      territories covered by the license include most of the European Union and
      eastern European regions.  GIG has exclusive marketing rights in certain
      territories, with performance goals to maintain these rights.  The Company
      will assign a person on site during the license term to assist with quality,
      security and operational procedures, with the mutual goal that the facility
      and
      the cards made in the facility conform to the Company’s standards.  The
      Company also retains rights to utilize up to 20% of the new facility capacity
      as
      backup and capacity buffer to augment its own card manufacturing facilities
      in
      Mountain View, California and at its German subsidiary. The granting of this
      license to GIG establishes a potential second source supplier of optical memory
      cards for existing and prospective customers who may request multiple sources
      for cards.





Also
      from
      time to time, the Company has offered nonexclusive, royalty bearing licenses
      for
      optical card read/write drive manufacture, for assembly of read/write drives
      from kits, for optical card finishing using Company-supplied materials, and
      for
      card manufacturing. In the past, the Company also offered card distribution
      licenses to create distributors, in selected regions of the world that can
      buy
      cards wholesale from the Company at prices lower than those charged to VARs.
      During the past five years, there have been no material purchases of optical
      memory cards by the licensees. The Company conducts its licensing efforts on
      a
      selective basis. The timing, number, type, and magnitude of future license
      sales, if any, cannot be predicted or inferred from past events. There is no
      assurance that any of the Company's licensing efforts will be successful.





There
      were no license revenues for fiscal years 2006, 2005, or 2004.





*Competition*





The
      Company’s primary competition is other card products. Competitive factors among
      the various card technologies include interoperability, per issued card system
      cost, standards compliance, installed base of compatible equipment, durability,
      environmental tolerance, card security, and potential for open competitive
      bidding. The Company believes its optical memory cards offer key technological
      and security advantages. The current price of optical card read/write drives
      is
      a competitive disadvantage to the Company in some markets because alternative
      technologies typically have lower priced drives. However, when the cost of
      drives and a large number of cards is factored together, the Company’s optical
      memory card technology can offer competitive pricing compared with its closest
      competitor, high capacity integrated circuit (IC) cards, especially when the
      very high cost of Public Key encryption and networks is factored into the cost
      of an IC card system. There are companies known to the Company, and there may
      be
      other companies unknown to the Company, which are working on optical memory
      and
      optical memory card products which could compete with the Company if
      commercialized.





Other
      card technologies that compete with optical memory cards include IC cards,
      2-dimensional bar code cards and symbology cards, optical CD or DVD-read only
      cards and recordable cards, holographic data storage cards, and RFID cards.
      The
      financial and marketing resources of some of the competing companies are greater
      than the Company’s resources. The Company believes that the LaserCard®'s storage
      capacity, read/write capability, price-performance ratio, rugged card
      construction and flexibility, optional technology add-ons, ability to store
      audit trails, and resistance to counterfeiting and tampering make the LaserCard®
optical memory card a viable choice for a variety of digital card applications.





In
      addition, centralized on-line databases combined with wide-area networks may
      limit the penetration of optical memory cards in certain applications, and
      are a
      form of competition.





*Smart
      Cards.* The
      LaserCard® competes primarily with cards that contain an IC microprocessor and
      memory. Known as "smart cards," or "chip cards," their prices and performance
      vary widely. The smart card uses a much lower





13





cost
      read/write unit than is currently used with an optical card, whereas a typical
      smart card containing a 64-kilobyte IC and a microprocessor is typically more
      than the cost of the Company’s 2.8 megabyte optical memory card. The IC card is
      more vulnerable to tampering and can be more easily damaged in everyday use,
      whereas the Company's card construction and the use of polycarbonate plastic
      make the LaserCard® more rugged. Companies
      that manufacture IC cards of various types and storage capacities include
      Gemplus, Axalto, Sharp, Orga Card Systems, Oberthur Card Systems, many of which
      are substantially larger and have more resources than the Company ****





*Contactless
      Chips.* Sometimes
      referred to as “RFID”, this technology has a predominant background in transit
      fare token applications and facility access. It has recently attracted a lot
      of
      attention for identity verification and border inspection applications and
      has
      been seen as competition to optical memory card in these markets.





Contactless
      chips exhibit the same characteristics as the contact chips used on smart cards
      - limited memory, volatile storage and a relative lack of durability. However,
      the technology has proven itself effective in certain markets, such as access
      control. One limitation of the typical contactless access control card is that
      there is no control on who is carrying the card. Thus, the system will grant
      access to anyone who finds or steals a genuine card.





The
      Company believes that there are often no absolutes in comparing one card
      technology with another. Rather, each technology will either stand on its own
      merits when viewed against specific application requirements or a hybrid
      combination of technologies will deliver the “best of all worlds” solution.
      Currently, only the Company offers a hybrid card embodying the optical memory
      technology of the LaserCard® with an embedded IC or RFID chip in the Company’s
      OpticalSmart TM card and
      LaserPass TM products, respectively.





*Other
      Card Products* .
      Read-only memory cards such as 2-dimensional bar code cards and symbology cards
      are lower priced and compete with the Company's read/write optical memory cards
      for certain markets, such as identification cards. However, the Company's cards
      have significantly higher storage capacity and offer unique security features
      to
      deter counterfeiting and data tampering. Two-dimensional bar codes on cards
      and
      other symbology cards store relatively small amounts of data compared to the
      LaserCard® and are not recordable/updatable after they are issued. Moreover,
      alternative technologies—such as IC chips, radio frequency (RF) circuitry, and
      bar codes/symbology—can be incorporated into the Company's optical memory cards,
      thereby adding additional performance features to the LaserCard®. Experimental
      card technologies probably are under development at other
      companies.





*Other
      Optical Memory Cards*  *and
      Equipment* .
      The
      Company previously licensed its card patents to two Japanese companies, Canon
      Inc. and Dai Nippon Printing, which the Company believes are not manufacturing
      or selling such cards at this time. In addition, as described in the “Licensing”
section, in April 2004, the Company sold a card-manufacturing license to Global
      Investments Group for the manufacture of optical memory cards in Slovenia.
      Under
      these royalty-bearing licenses, the licensees have the right to manufacture
      and
      sell optical memory cards in competition with the LaserCard®. The newly licensed
      Slovenian operation under the Global Investments Group license is not yet
      capable of manufacturing optical cards, but is expected to become a
      second-source for the Company’s cards over time. Global Investments Group could
      become a competitor in certain Western European countries; however, exclusivity
      provisions of the license preclude competition in certain markets. For example,
      the Company is prohibited from competing in certain Eastern European countries,
      and Global Investments Group is prohibited from competing outside European
      countries.





Recordable
      CD and DVD optical media are currently made in card shaped form factors that
      function with standard CD and DVD players. These cards have high-data capacity,
      storing hundreds of megabytes of data, and have high data transfer rates. The
      typical purchase price is less than $1.00 each for a blank card. The cards
      are
      typically 1.2-millimeter thick and therefore they do not meet the ISO Standards
      for either credit cards or ID-1 identification cards. These cards typically
      serve other markets such as advertising and promotional applications.





Other
      Matters





*Research
      and Engineering Expenses*





Research
      and engineering expenses were $2.3 million for fiscal year 2006; $3 million
      for
      fiscal year 2005; and $2.6 million for fiscal year 2004. The Company is
      continuing its efforts to develop new optical memory card features,





14





including
      the insertion of contactless chips with radio frequency (RF) capability, optical
      memory card media, optical memory card read/write drives, read-only drives
      (readers), OptiChip small form factor optical media,
      OpticalProximity TM systems,
      card personalization systems, and software products in an effort to strengthen
      its existing products and provide new products that can stimulate optical memory
      card sales growth. For example, the Company has developed an Optical/RFID and
      Optical/Proximity card and system (“LaserPassTM”) to compete in the rapidly
      growing RFID marketplace. The Company anticipates that these ongoing research
      and engineering efforts will result in new or enhanced card capabilities,
      production-model read-only drives, or drives with advanced security features
      and
      lower manufacturing costs; however, there is no assurance that such product
      development efforts will be successful. These factors are important for the
      Company’s existing and future optical memory card markets. Also see Item 7,
      "Management's Discussion and Analysis.”





*Patents
      and Trademarks*





*Optical
      Data Storage.* As of
      March 31, 2006, the Company owned approximately 29 U.S. patents relating to
      optical data storage (including optical storage media, optical cards, formats,
      equipment, systems, software, the utilization of optical storage media, and
      e-commerce technology), and other U.S. and foreign patent applications have
      been
      filed. Approximately 18 counterpart patents of certain U.S. patents are issued
      in various foreign countries. However, the Company owns certain U.S. patents
      as
      to which foreign counterparts have either not been filed or the examination
      process has been terminated without issuance of the foreign patents. From time
      to time, the Company elects to allow some of its U.S. or foreign patents to
      expire when maintenance fees become due, if the patents are deemed no longer
      relevant. In addition, the Company protects as trade secrets some refinements
      to
      the optical media and cards and know-how related to card production. Also,
      the
      Company’s know-how and experience in volume card production, system development
      and software capabilities, brand-name recognition within its card markets,
      and
      dominant-supplier status for optical-memory cards are of far greater importance
      than the Company’s patents. Therefore, at this time, the Company believes that
      its patent portfolio is helpful but is no longer materially meaningful for
      maintaining the LaserCard®’s market position.





The
      Company's U.S. patents have expiration dates ranging from 2006 to 2022, with
      the
      majority expiring during the first part of this period. Counterpart patents
      in
      foreign countries also expire during this period, usually about two to three
      years after the U.S. patent expires. ****





The
      Company cannot predict whether the expiration or invalidation of its patents
      would result in the introduction of competitive products which would affect
      its
      future revenues adversely. The Company presently intends to pursue any
      infringement of its patents either by litigation, arbitration, or negotiation.
      However, there can be no assurance that any of the Company's patents will be
      sufficiently broad in scope to afford protection from products with comparable
      characteristics that may be sold by competitors in the future. There also can
      be
      no assurance that the validity of any patents actually granted will not be
      challenged.





LaserCard®
      and Drexon® are federally registered trademarks of LaserCard Corporation. The
      Company believes that its LaserCard® brand name, trade name, and other
      trademarks are important assets in marketing optical memory card products.





*Employees*





As
      of
      March 31, 2006, the Company and its U.S. subsidiary employed 164 persons
      (including four executive officers). This workforce consisted of 112 persons
      in
      administration, marketing/sales, manufacturing, and research and engineering,
      plus 52 temporary personnel mainly engaged in manufacturing and the inspection
      of cards for quality assurance. In addition, the German subsidiary acquired
      by
      the Company on March 31, 2004 employed 97 people as of March 31, 2006. The
      German workforce consisted of 87 persons in administration, marketing/sales,
      manufacturing, and research and engineering, plus 10 temporary personnel mainly
      engaged in manufacturing and the inspection of cards for quality assurance.
      None
      of the Company's employees is represented by a labor union.





*Dependence
      on Government Subcontracts through Sole Contractors*





The
      largest purchaser of LaserCard products is a government prime contractor, Anteon
      International Corporation, a value-added reseller (VAR) of the Company. Anteon
      is the government contractor for LaserCard® product sales to





15





the
      U.S.
      Department of Homeland Security (DHS), U.S. Department of State (DOS), U.S.
      Department of Defense (DOD), and the government of Canada. Under government
      contracts with Anteon, the DHS purchases U.S. Permanent Resident Cards (Green
      Cards) and DOS Laser Visa Border Crossing Cards (BCCs); the DOD purchases
      Automated Manifest System cards; and the Canadian government purchases Permanent
      Resident Cards. Encompassing all of these programs, the Company’s product sales
      to Anteon represented 31% of total revenues for fiscal year 2006; 31% of total
      revenues for fiscal year 2005; and 72% of total revenues for fiscal year 2004.
      The proportion of revenues represented by Anteon decreased in fiscal year 2005
      as compared to fiscal year 2004, and is anticipated to decrease in the future
      as
      the Company generates increased revenues from other sources. Since the ultimate
      customers are national governments, the Company is not dependent upon any one
      specific contractor for continued revenues from these programs. Although not
      anticipated, if Anteon were to discontinue its participation as contractor,
      other qualified contractors could be utilized by those governments for
      purchasing our products, although the process of doing so could cause program
      delays.





Sales
      of
      DHS Green Cards and DOS Laser Visa BCCs represented approximately 24% of the
      Company’s revenue for fiscal year 2006; 21% of revenues for fiscal year 2005;
      and 44% of revenues for fiscal year 2004. The percentage declined during fiscal
      year 2005 as revenues from other sources increased and the Company included
      the
      results of the German acquisitions for the first time in fiscal year 2005.
      The
      Company is currently delivering on orders placed prior to the expiration of
      a
      U.S. government subcontract in November 2005. Backlog at March 31, 2006 for
      these programs, which is deliverable through August 2006, totaled $3.7 million.
      The Company expects that the U.S. government will issue a new contract or place
      a purchase order prior to the last shipment under orders on hand although no
      assurance can be given.





The
      Company’s revenues derived from sales to the government of Italy for its
      national ID card program, Carta d’Identità Elettronica (CIE), accounted for 18%
      of revenues for fiscal year 2006, 26% of revenues for fiscal year 2005, and
      22%
      of revenues for fiscal year 2004. Revenues on Italian Permesso di Soggiorno
      Elettronico (PSE) cards accounted for 13% of Company revenues in fiscal year
      2006. Card orders under these programs are placed with the Company through
      a
      value-added reseller, Laser Memory Card SPA of Italy. The Italian government
      successfully concluded the experimental phase of National ID CIE program using
      LaserCard® optical memory cards and enacted a law to replace paper ID documents
      with electronic documents starting January 2006. LaserCard®’s optical memory
      stripe is contained in CIE national ID cards and new PSE foreign worker cards.
      If these programs were to be discontinued or interrupted by the Italian
      government, the Company would lose one of its significant sources of optical
      memory card revenues.





*Backlog*





As
      of
      March 31, 2006, the backlog for LaserCard® optical memory cards totaled $8.3
      million scheduled for delivery in fiscal year 2007, compared with $0.9 million
      at March 31, 2005, and $4.1 million at March 31, 2004. In addition, backlog
      for
      a bundled order of optical memory cards, read/write drives, card printers,
      and
      software totaled $1.4 million at March 31, 2006. The Company has only a few
      customers who generally place orders for a several-month period so that
      variations in order placement from a single customer can materially affect
      backlog. As a result, the relative size of our backlog has not been a reliable
      indicator of future sales revenue trends.





The
      Company has no significant backlog for read/write drives.





In
      addition, the backlog for Challenge Card Design Plastikkarten GmbH as of March
      31, 2006 for specialty cards and printers totaled 0.8 million euros
      (approximately $1.0 million) compared with 1.2 million euros (approximately
      $1.6
      million) at March 31, 2005, and for a contract to develop a conventional
      non-optical card production facility totaled 0.7 million euros (approximately
      $0.8 million) at March 31, 2006 compared with 0.8 million euros (approximately
      $1 million) at March 31, 2005. Revenue on the contract for a conventional
      non-optical card production facility contract is being booked on a zero profit
      margin basis. Therefore, the total profit under this contract will be booked
      at
      completion probably during fiscal year 2008.





*Financial
      Information About Geographic Areas*





Financial
      information about geographic areas is described in Note 4 of the Notes to the
      Consolidated Financial Statements in Item 8, “Financial Statements and
      Supplementary Data.”





16





ITEM
      1A.  RISK
      FACTORS





OUR
      CURRENT AND FUTURE EXPECTED REVENUES ARE DERIVED FROM A SMALL NUMBER OF ULTIMATE
      CUSTOMERS SO THAT THE LOSS OF OR REDUCTIONS IN PURCHASES BY ANY ONE ULTIMATE
      CUSTOMER COULD MATERIALLY REDUCE OUR REVENUES AND LEAD TO LOSSES. During fiscal
      year 2006 and each of the previous two fiscal years, we have derived more than
      60% of our optical memory card and drive-related revenues from five programs
      ― two U.S. government programs and three
      foreign government programs. Due to the lengthy sales cycles, we believe that
      these programs, with perhaps the addition of one or two other foreign programs,
      will be the basis for a substantial majority of our revenues in the near-term.
      The loss of or reductions in purchases by any one customer due to program
      cutbacks, competition, or other reasons would materially reduce our revenue
      base. Annual or quarterly losses occur when there are material reductions,
      gaps
      or delays in card orders from our largest U.S. or foreign government programs
      or
      if such programs were to be reduced in scope, delayed, canceled, or not extended
      and not replaced by other card orders or other sources of income.





PRIOR
      TO
      THE QUARTER ENDED DECEMBER 31, 2005 WE INCURRED NET LOSSES DURING THE PREVIOUS
      ELEVEN QUARTERS AND MAY NOT BE ABLE TO GENERATE SUFFICIENT REVENUE IN THE FUTURE
      TO SUSTAIN PROFITABILITY. Although we generated $3.1 million of profit during
      the third and fourth quarters of fiscal year 2006, we incurred losses during
      the
      first two quarters of fiscal year 2006 aggregating $2.3 million, and we incurred
      a loss of $8.9 million in fiscal year 2005 and $12.4 million in fiscal year
      2004, and had an accumulated deficit of $26 million at March 31, 2006. There
      can
      be no assurance that we will generate enough card revenues in the near term
      to
      maintain profitability. We are relying upon our optical memory card technology
      to generate future product revenues, earnings, and cash flows. If alternative
      technologies emerge or if we are otherwise unable to compete, we may not be
      able
      to achieve or sustain profitability on a quarterly or annual basis. Annual
      or
      quarterly losses would also continue if increases in product revenues or license
      revenues do not keep pace with increased selling, general, administrative,
      research and engineering expenses and the depreciation and amortization expenses
      associated with capital expenditures.





OUR
      PROGRAM WITH ITALY, WHICH WE BELIEVE WILL BE OUR LARGEST CUSTOMER FOR THE NEXT
      FEW YEARS, MAY BE DELAYED OR CANCELLED FOR REASONS OUTSIDE OUR CONTROL WHICH
      WOULD CAUSE US TO HAVE LESS REVENUE THAN PLANNED AND WOULD LIKELY LEAD US TO
      INCUR OPERATING LOSSES. The Company believes that the Italian CIE and PSE card
      programs will be our largest customer for the next few years, comprising a
      significant portion of future revenues. Sales of cards and drives for the
      government of Italy for its CIE and PSE card programs represented 31% of total
      revenue for fiscal year 2006, 26% for fiscal year 2005, and 22% for fiscal
      year
      2004, while the current backlog for CIE and PSE cards amounts to about
      one-quarter of total optical memory card backlog. We are increasing capacity
      to
      meet the anticipated demand. However, there can be no assurance that demand
      will
      increase as anticipated by the Company. We would most likely incur losses if
      Phase 3 of this program, which is full implementation, was to be delayed,
      canceled, not extended, or not implemented at the level foreseen or if the
      government were to change its technology decision and no longer use optical
      memory cards. While during Phase 2, selected Italian cities have been issuing
      cards and testing the card issuing process, full implementation in Phase 3
      is
      dependent upon card issuance infrastructure developments being successfully
      undertaken and the national ID card system functioning as designed, of which
      there can be no assurance. Also,
      if
      Laser Memory Card SPA of Italy, our VAR customer for this program, were to
      discontinue participation in this program or discontinue operations,
      interruptions could occur in orders or shipments for this program until a
      replacement could be found.  Overcoming
      some of these issues may be difficult and complex and involve third parties,
      which could be time consuming and expensive and lead to delays for
      implementation of Phase 3.





OUR
      CONTRACT WITH THE U.S. GOVERNMENT, ONE OF OUR TWO LARGEST ULTIMATE CUSTOMERS,
      EXPIRED IN NOVEMBER 2005 AND IF NOT RENEWED COULD RESULT IN ORDER DELAYS WHICH
      WOULD LIKELY LEAD US TO INCUR OPERATING LOSSES. EVEN IF A NEW CONTRACT IS
      ISSUED, THE U.S. GOVERNMENT HAS THE RIGHT TO DELAY ITS ORDERS OR COULD CHANGE
      ITS TECHNOLOGY DECISIONS, WHICH WOULD RESULT IN ORDER DELAYS AND POSSIBLY IN
      OPERATING LOSSES. Our fiscal year 2006 revenues included sales of approximately
      $9.8 million of Green Cards and Laser Visa BCCs, and comprised 24% of our
      revenues. The Company expects these revenues to continue at approximately $9.5
      million annually ($7.5 million for Green Cards and $2.0 million for Laser Visa
      BCCs) if the government continues to use the Company’s cards in these programs,
      continues to personalize cards at that rate and continues to maintain an
      inventory level equal to six-months of usage. However, our U.S. government
      subcontract





17





expired
      in November 2005. While we have backlog as of March 31, 2006, for $3.7 million
      in optical memory cards deliverable through August 2006, further orders will
      require a new contract or a purchase order. Based on events to date, the Company
      believes that a follow-on contract or purchase order will be issued prior to
      the
      completion of deliveries from backlog; however, there is no assurance that
      a
      follow-on contract or purchase order will be issued by the U.S. government.
      Under U.S. government procurement regulations, even with a contract or purchase
      order in place, the government reserves certain rights, such as the right to
      withhold releases, to reduce the quantities released, extend delivery dates,
      reduce the rate at which cards are issued, and cancel all or part of its
      unfulfilled purchase orders. We would most likely incur losses if both of our
      largest U.S. government programs were to be delayed, canceled, or not extended
      or if the government were to change its technology decision and no longer use
      optical memory cards. The U.S. government acting through its prime contractor
      delayed orders for Green Cards during fiscal year 2004 due to a design change
      and again in the first part of fiscal year 2005 because of excess inventory,
      which resulted in a gap in production of several months, and which in turn
      significantly and adversely affected our operating results for the first half
      of
      fiscal year 2005. Any future excess inventory held by the U.S. government,
      delayed funding, slower than anticipated program volume, or any future changes
      to the design of the cards may result in future gaps in orders or production
      which may negatively impact our operating results. Our U.S.
      government card deliveries depend upon the issuance of corresponding order
      releases by the government to its prime contractor and then to us. If
      Anteon
      International Corporation, our VAR customer and the U.S. government prime
      contractor for this program, were to discontinue participation in this program
      or discontinue operations, interruptions could occur in orders or shipments
      for
      this program until a replacement could be found.





OUR
      PRODUCT REVENUES WILL NOT GROW IF WE DO NOT WIN NEW BUSINESS IN THE U.S. OR
      ABROAD AND IF THE ITALIAN NATIONAL ID PROGRAM IS NOT IMPLEMENTED AS ANTICIPATED.
      Even if our U.S. Government subcontract is renewed, we do not expect future
      growth from the U.S. Green Card and Laser Visa BCC programs as we expect their
      steady state revenue to average $9.5 million annually, about the same as
      purchased in fiscal year 2006. We expect our revenues from Italian CIE and
      PSE
      cards to be between $20 million and $30 million for fiscal year 2007, compared
      with about $12 million during fiscal year 2006. During full implementation,
      we
      expect our revenues from these programs to grow to reach approximately $40
      million per year. In order for us to achieve our overall revenue growth goal,
      we
      will need not only for these programs to continue and reach their anticipated
      levels, of which there can be no assurance, but we will also need to win new
      business in the U.S. and abroad. Emerging
      optical memory card programs or prospective applications include motor vehicle
      registration cards in a few states in India, foreign resident identification
      cards in Costa Rica, and national ID cards for a Middle Eastern country.  There
      can
      be no assurance that sizable orders will follow or even if ordered we will
      be
      successful in shipping products for any of these programs, nor can there be
      any
      assurance that we will be able to win any other new business in the U.S. or
      abroad which is necessary to grow our business to the level we desire.





SINCE
      THE
      SALES CYCLE FOR OUR PRODUCTS IS TYPICALLY LONG AND UNPREDICTABLE, WE HAVE
      DIFFICULTY PREDICTING WHEN NEW BUSINESS WILL CONTRIBUTE TO REVENUE GROWTH.
      Obtaining substantial orders usually involves a lengthy sales cycle, requiring
      marketing and technical time and expense with no guarantee that substantial
      orders will result. This long sales cycle results in uncertainties in predicting
      operating results, particularly on a quarterly basis. In addition, since our
      major marketing programs involve the U.S. government and various foreign
      governments and quasi-governmental organizations, additional uncertainties
      and
      extended sales cycles can result. Factors which increase the length of the
      sales
      cycle include government regulations, bidding procedures, budget cycles, and
      other government procurement procedures, as well as changes in governmental
      policy-making.





THE
      TIMING OF OUR U.S. GOVERNMENT REVENUES COULD BE EXTREMELY VOLATILE AND CANNOT
      BE
      PREDICTED BECAUSE WE REQUIRE A FIXED SHIPMENT SCHEDULE IN ORDER TO RECORD
      REVENUE WHEN WE DELIVER CARDS TO A VAULT, OTHERWISE WE RECOGNIZE REVENUE WHEN
      THE CARDS ARE SHIPPED OUT OF A VAULT OR WE RECEIVE A FIXED SHIPMENT SCHEDULE
      FROM THE GOVERNMENT. We recognize revenue from product sales when the following
      criteria are met: (a) persuasive evidence of an arrangement exists; (b) delivery
      has occurred; (c) the fee is fixed or determinable; and (d) collectibility
      is
      reasonably assured. Our U.S. government subcontract requires delivery of cards
      to a secure vault built on our premises. Deliveries are made into the vault
      on a
      production schedule specified by the government or one of its specified agents.
      When the cards are delivered to the vault, all title and risk of ownership
      are
      transferred to the government. At the time of delivery, the prime contractor
      is
      invoiced, with payment due within thirty days. The contract does not provide
      for
      any return provisions other than for warranty. We recognize revenue when the
      cards are





18





delivered
      into the vault because we have fulfilled our contractual obligations and the
      earnings process is complete. However, if we do not receive a shipment schedule
      for shipment from the vault, revenue is not recognized until the cards are
      shipped from the vault. In addition, revenue recognition for future deliveries
      into the vault would be affected if the U.S. government cancels the shipment
      schedule. As a result, our revenues may fluctuate from period to period if
      we do
      not continue to obtain shipment schedules under this subcontract or if the
      shipment schedules are cancelled. In this case, we would no longer recognize
      revenue when cards are delivered to the vault, but instead such revenue
      recognition would be delayed until the cards are shipped from the vault to
      the
      U.S. government.





WE
      COULD
      EXPERIENCE EQUIPMENT, RAW MATERIAL, QUALITY CONTROL, OR OTHER PRODUCTION
      PROBLEMS ESPECIALLY IN PERIODS OF INCREASING VOLUME. There can be no assurance
      that we will be able to meet our projected card manufacturing capacity if and
      when customer orders reach higher levels. We have made and intend to continue
      to
      make significant capital expenditures to expand our card manufacturing capacity.
      For example, we plan $9 million of capital expenditures during the next twelve
      months. However, since customer demand is difficult to predict, we may be unable
      to ramp up our production quickly enough to timely fill new customer orders.
      This could cause us to lose new business and possibly existing business. In
      addition, if we overestimate customer demand, we could incur significant costs
      from creating excess capacity which was the case during fiscal year 2005. We
      may
      experience manufacturing complications associated with increasing our
      manufacturing capacity of cards and drives, including the adequate production
      capacity for sheet-lamination process cards to meet order requirements and
      delivery schedules. We may also experience difficulties implementing new
      manufacturing processes, meeting customers’ quality or standards requirements,
      or outsourcing some of our manufacturing. The addition of fixed overhead costs
      increases our breakeven point and results in lower profit margins unless
      compensated for by increased product sales. When purchasing raw materials for
      our anticipated optical card demand, we take into consideration the
      order-to-delivery lead times of vendors and the economic purchase order quantity
      for such raw materials. If we over-estimate customer demand, excess raw material
      inventory can result.





IF
      WE ARE
      UNABLE TO BUY RAW MATERIALS IN SUFFICIENT QUANTITIES AND ON A TIMELY BASIS,
      WE
      WILL NOT BE ABLE TO DELIVER PRODUCTS TO CUSTOMERS ON TIME WHICH COULD CAUSE
      US
      TO LOSE CUSTOMERS, AND OUR REVENUES COULD DECLINE. We depend on sole source
      and
      limited source suppliers for optical card raw materials. Such materials include
      plastic films used in optical memory card production, which are available from
      one supplier in the U.S. and from multiple foreign suppliers. Processing
      chemicals, inks, and bonding adhesives are obtained from various U.S. and
      foreign suppliers. Certain photographic films are commercially available solely
      from Eastman Kodak Company, of the United States. No assurance can be given
      that
      Kodak will continue to supply such photographic films on a satisfactory basis
      and in sufficient quantities. If Kodak were to discontinue manufacturing the
      film from which our optical media is made, we would endeavor to establish an
      alternate supplier for such film, although the purchase price could increase
      and
      reliability and quality could decrease from a new supplier. No assurance can
      be
      given that there will be adequate demand to attract a second source. In
      addition, an alternate supplier could encounter technical issues in producing
      the film as there may be know-how and manufacturing expertise which Kodak has
      developed over the years which an alternate supplier may have difficulty to
      replicate. We have pre-purchased a long-term supply of the film used to produce
      mastering loops for prerecording cards. With regard to the film from which
      our
      optical media is made, we currently have an order which Kodak has accepted
      with
      deliveries scheduled through October 2006. If Kodak announced that it was no
      longer going to sell film, we would request that Kodak provide us with a
      last-buy opportunity which we would plan to take maximum advantage of, although
      no assurance can be given that Kodak would provide us with such an opportunity.
      We have film on hand plus on order that we believe would provide us with an
      adequate supply to meet anticipated demand until we could locate and begin
      volume purchases from a second source.





AN
      INTERRUPTION IN THE SUPPLY OF READ/WRITE DRIVE PARTS OR DIFFICULTIES ENCOUNTERED
      IN READ/WRITE DRIVE ASSEMBLY COULD CAUSE A DELAY IN DELIVERIES OF DRIVES AND
      OPTICAL MEMORY CARDS AND A POSSIBLE LOSS OF SALES, WHICH WOULD ADVERSELY AFFECT
      OUR OPERATING RESULTS. Several major components of our read/write drives are
      designed specifically for our read/write drive. For example, the optical
      recording head for the current drive is a part obtained from one supplier;
      and
      at current production volumes, it is not economical to have more than one
      supplier for this custom component. The ability to produce read/write drives
      in
      high-volume production, if required, will be dependent upon maintaining or
      developing sources of supply of components that meet our requirements for high
      volume, quality, and cost. In addition, we could encounter quality control
      or
      other production problems at high-volume production of read/write drives. We
      are
      also investing in research and engineering in an effort to develop new drive
      products.





19





IF
      WE ARE
      UNABLE TO DEVELOP UPGRADED READ/WRITE DRIVES THAT COST LESS TO MANUFACTURE
      AND
      ALSO A READ-ONLY DRIVE, WE COULD LOSE POTENTIAL NEW BUSINESS. The price of
      our
      read/write drive product line ranges from $1,800 to approximately $2,500
      depending on features and quantity purchased. We believe the price of our drives
      is competitive in applications requiring a large number of cards per each drive,
      because the relatively low cost for our cards offsets the high cost per drive
      when compared with our major competition, IC card systems. In addition, we
      have
      undertaken a product development program for a portable read-only drive that
      has
      been sampled in limited quantities at prices less than $1,000, which we believe
      would increase our prospects for winning future business. However, there can
      be
      no assurance that our development program will be successful, that volume
      production of any new design will occur in the near term, or that significantly
      lower manufacturing costs or increased sales will result.





WE
      MAY
      NOT BE ABLE TO ADAPT OUR TECHNOLOGY AND PRODUCTS TO COMMERCIAL APPLICATIONS
      WHICH GENERATE MATERIAL AMOUNTS OF REVENUE AND PROFIT. THIS WOULD LIMIT THE
      FUTURE GROWTH OF OUR BUSINESS TO THE GOVERNMENT SECTOR AND THE LACK OF
      DIVERSIFICATION EXPOSES US TO ENHANCED RISK OF COMPETITION. We are seeking
      commercial applications for our optical memory products in order to lessen
      our
      dependence upon the government sector. Our efforts to develop
      OpticalProximity TM access
      cards are one example. We may be unsuccessful in these efforts in which case
      we
      would not obtain the diversity of revenues we are seeking for the future. If
      the
      use of our technology remains limited to secure ID card applications for
      government use, then we are more susceptible to other technologies and products
      making in-roads or to political pressures or changing laws.





IF
      WE ARE
      UNABLE TO ADAPT TO TECHNOLOGICAL CHANGES IN THE DATA CARD INDUSTRY AND IN THE
      INFORMATION TECHNOLOGY INDUSTRY GENERALLY, WE MAY NOT BE ABLE TO EFFECTIVELY
      COMPETE FOR FUTURE BUSINESS. The information technology industry is
      characterized by rapidly changing technology and continuing product evolution.
      The future success and growth of our business will require the ability to
      maintain and enhance the technological capabilities of the LaserCard® product
      line. There can be no assurance that the Company’s products currently sold or
      under development will remain competitive or provide sustained revenue growth.





SEVERAL
      OF OUR FOREIGN PROGRAMS INVOLVE OUR CARDS AS PART OF A SOLUTION WHICH INCLUDES
      TECHNOLOGIES OF THIRD PARTIES. SOME TIMES THESE THIRD PARTY TECHNOLOGIESARE
      INTEGRATED WITH OUR CARDS BY OUR SYSTEMS INTEGRATOR CUSTOMER OR SUBCONTRACTOR.
      WE THEREFORE HAVE VARYING DEGREES OF CONTROL OVER THE OVERALL SYSTEM WHICH
      COULD
      LEAD TO TECHNICAL AND COMPATIBILITY ISSUES WHICH ARE DIFFICULT, EXPENSIVE,
      AND
      TIME CONSUMING TO SOLVE. THIS COULD CAUSE OUR ULTIMATE CUSTOMERS, GENERALLY
      GOVERNMENTS, TO FIND FAULT IN OPTICAL CARDS AND SWITCH TO OTHER SOLUTIONS EVEN
      THOUGH OUR OPTICAL TECHNOLOGY IS NOT THE ROOT CAUSE. In certain of our current
      foreign programs such as Italy, India, and a Middle Eastern country, and
      possibly in future other programs, various third party technologies such as
      contact or contactless chips will be added to our cards. The embedding or
      addition of other technologies to the LaserCard® optical memory card, especially
      when contracted to independent third parties, could potentially lead to
      technical, compatibility and other issues. In such circumstances, it may be
      difficult to determine whether a fault originated with the Company’s technology
      or that of a co-supplier or the person embedding or adding the third party
      technology to our cards.  If such faults occur, they could be difficult,
      expensive, and time-consuming to resolve.  Such difficulties could lead to
      our ultimate customers, the foreign governments, switching to other technologies
      even though optical technology is not the root cause.  The resulting loss
      of customers would adversely affect our revenues.





IF
      WE
      FAIL TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, COMPETITORS MAY BE ABLE TO
      USE
      OUR TECHNOLOGIES, WHICH COULD WEAKEN OUR COMPETITIVE POSITION, REDUCE REVENUES,
      OR INCREASE COSTS. We use a combination of patent, trademark, and trade secret
      laws, confidentiality procedures, and licensing arrangements to establish and
      protect our proprietary rights. Our existing and future patents may not be
      sufficiently broad to protect our proprietary technologies. Despite our efforts
      to protect proprietary rights, we cannot be certain that the steps we have
      taken
      will prevent the misappropriation or unauthorized use of our technologies,
      particularly in foreign countries where the laws may not protect proprietary
      rights as fully as U.S. law. Any patents we may obtain may not be adequate
      to
      protect our proprietary rights. Our competitors may





20





independently
      develop similar technology, duplicate our products, or design around any of
      our
      issued patents or other intellectual property rights. Litigation may be
      necessary to enforce our intellectual property rights or to determine the
      validity or scope of the proprietary rights of others. This litigation could
      result in substantial costs and diversion of resources and may not ultimately
      be
      successful. We cannot predict whether the expiration or invalidation of our
      patents would result in the introduction of competitive products that would
      affect our future revenues adversely. However, since our technology is now
      in
      the commercial stage, our know-how and experience in volume card production,
      system development and software capabilities, brand-name recognition within
      our
      card markets, and dominant-supplier status for optical memory cards are of
      far
      greater importance than our patents. At this time, we believe that our existing
      patent portfolio is helpful but is no longer essential for maintaining the
      LaserCard®'s market position.





THE
      MARKETS FOR OUR PRODUCTS ARE COMPETITIVE, AND IF WE ARE UNABLE TO COMPETE
      SUCCESSFULLY, REVENUES COULD DECLINE OR FAIL TO GROW. Our optical memory cards
      may compete with optical memory cards that can be manufactured and sold by
      three
      of our licensees (although none is currently doing so) and with other types
      of
      portable data storage cards and technologies used for the storage and transfer
      of digital information. These may include contact or contactless integrated
      circuit (IC) chip cards; 2-dimensional bar code cards and symbology cards;
      thick, rigid CD or DVD-read only cards or recordable cards; radio frequency,
      or
      RFID cards; and small, digital devices such as data-storage keys, tokens, and
      small cards and tags. The financial and marketing resources of some of the
      competing companies are greater than our resources. Competitive product factors
      include system/card portability, interoperability, price-performance ratio
      of
      cards and associated equipment, durability, environmental tolerance, and card
      security. Although we believe our cards offer key technological and security
      advantages for certain applications, the current price of optical card
      read/write drives is a competitive disadvantage in some of our targeted markets.
      However, we believe the price of our drives is competitive in applications
      requiring a large number of cards per each drive, because the relatively low
      cost for our cards offsets the high cost per drive when compared with our major
      competition, IC card systems. In countries where the telecommunications
      infrastructure is extensive and low cost, centralized databases and wide-area
      networks may limit the penetration of optical memory cards. These trends toward
      Internet, intranet, and remote wireless networks will in some cases preclude
      potential applications for our cards.





THE
      PRICE
      OF OUR COMMON STOCK IS SUBJECT TO SIGNIFICANT VOLATILITY. The price of our
      common stock is subject to significant volatility, which may be due to
      fluctuations in revenues, earnings, liquidity, press coverage, financial market
      interest, low trading volume, and stock market conditions, as well as changes
      in
      technology and customer demand and preferences. As a result, our stock price
      might be low at the time a stockholder wants to sell the stock. Also, since
      we
      have a relatively low number of shares outstanding (approximately 11 million
      shares) there will be more volatility in our stock if one or two major holders,
      for example, large institutional holders, attempt to sell a large number of
      shares in the open market. There also is a large short position in our stock,
      which can create volatility when borrowed shares are sold short and later if
      shares are purchased to cover the short position. Furthermore, our trading
      volume is often small, meaning that a few trades may have disproportionate
      influence on our stock price. In addition, someone seeking to liquidate a
      sizeable position in our stock may have difficulty doing so except over an
      extended period or privately at a discount. Thus, if one or more stockholders
      were to sell or attempt to sell a large number of its shares within a short
      period of time, such sale or attempt could cause our stock price to decline.
      There can be no guarantee that stockholders will be able to sell the shares
      that
      they acquired at a price per share equal to the price they paid for the stock.





WE
      ARE
      SUBJECT TO RISKS ASSOCIATED WITH CHANGES IN FOREIGN CURRENCY EXCHANGE RATES.
      Part of the manufacturing process of the LaserCard products that we sell in
      Italy takes place in our operations in Germany. Also, some of the raw materials
      we use to manufacture optical memory cards are sourced in Europe. These costs
      are denominated in euros, the currency used in much of Europe. However, when
      we
      sell our finished products the prices that we charge are denominated in United
      States dollars. Accordingly, we are subject to exposure if the exchange rate
      for
      euros increases in relation to the United States dollar. During fiscal year
      2005, we experienced a $0.2 million loss on foreign currency exchange. The
      losses on foreign currency exchange for both fiscal years 2006 and 2004 were
      immaterial. As of March 31, 2006, we had not entered into a forward exchange
      contract to hedge against or potentially minimize the foreign currency exchange
      risk related to transactions other than those related to intercompany and
      external payables and receivables.





21








WE
      SOLD A
      SECOND-SOURCE CARD MANUFACTURING LICENSE TO GLOBAL INVESTMENTS GROUP (GIG),
      UNDER WHICH WE WILL PROVIDE CERTAIN FACTORY SET-UP AND TRAINING SERVICES. IF
      WE
      ARE NOT SUCCESSFUL OR IF GIG IS UNABLE TO FINANCE THIS OPERATION, THE
      SECOND-SOURCE SUPPLY OF OPTICAL CARDS WILL NOT MATERIALIZE. IF WE AND GIG ARE
      SUCCESSFUL, THE SECOND-SOURCE WILL COMPETE WITH US FOR BUSINESS. If GIG is
      not
      successful, but current and potential customers require a second source of
      optical memory cards (which is a common business practice) they could decide
      to
      use alternate technology cards, such as chip cards, that have multiple-source
      suppliers. We are obligated to deliver approximately $12 million worth of the
      required manufacturing equipment and installation support to GIG for its
      to-be-built new card manufacturing facility in Slovenia, to provide a targeted
      initial manufacturing capacity of 10 million optical cards annually. If GIG
      is
      successful, this will supply a second source for optical memory cards. We will
      also be assigning personnel to be on site during the license term to assist
      with
      quality, security, and operational procedures, with a mutual goal that the
      facility and the cards made in Slovenia conform to our standards. If cards
      are
      not produced in conformance with our quality standards, the reputation and
      marketability of optical memory card technology could be damaged. If the factory
      does not become operational and produce quality cards in high volume, or if
      GIG
      is unable to raise sufficient capital to build, equip and operate this facility,
      we would not obtain the hoped-for benefits--including ongoing royalties, sales
      of raw materials to GIG, expansion of the European market, and a bona fide
      second source for optical memory cards. In these regards, GIG currently is
      overdue in paying us approximately $5.9 million under our Agreement with GIG
      most recently committing to complete the payment by the end of June. The Company
      has begun to investigate alternative courses of action should GIG fail to make
      such payment. GIG also has not identified a site for the facility, several
      dates
      originally proposed by GIG for doing so having passed. On the other hand, if
      and
      when the factory is successfully manufacturing the cards in high volume, it
      will
      compete against us for business in certain territories, which could reduce
      our
      potential card revenues if the market does not expand. Revenue will be
      recognized over the remaining term of the agreement beginning when the equipment
      has been accepted and training completed, which date is dependent on GIG
      providing a facility in Slovenia. The Company could incur greater expenses
      than
      it anticipates for the purchase and installation of the required manufacturing
      equipment thereby reducing cash and anticipated profits.





WE
      MAY
      NOT BE ABLE TO ATTRACT, RETAIN OR INTEGRATE KEY PERSONNEL, WHICH MAY PREVENT
      US
      FROM SUCCEEDING. We may not be able to retain our key personnel or attract
      other
      qualified personnel in the future. Our success will depend upon the continued
      service of key management personnel. The loss of services of any of the key
      members of our management team, including our chief executive officer, chief
      operating officer, the managing directors of our German operations, vice
      president of business development or our vice president of finance and
      treasurer, or our failure to attract and retain other key personnel could
      disrupt operations and have a negative effect on employee productivity and
      morale, thus decreasing production and harming our financial results. In
      addition, the competition to attract, retain and motivate qualified personnel
      is
      intense.





OUR
      CALIFORNIA FACILITIES ARE LOCATED IN AN EARTHQUAKE ZONE AND THESE OPERATIONS
      COULD BE INTERRUPTED IN THE EVENT OF AN EARTHQUAKE, FIRE, OR OTHER DISASTER.
      Our
      card manufacturing, corporate headquarters, and drive assembly operations,
      administrative, and product development activities are located near major
      earthquake fault lines. In the event of a major earthquake, we could experience
      business interruptions, destruction of facilities and/or loss of life, all
      of
      which could materially adversely affect us. Likewise, fires, floods, or other
      events could similarly disrupt our operations and interrupt our
      business.





FOREIGN
      GOVERNMENT INTERVENTION COULD ADVERSELY AFFECT RESULTS OF OPERATIONS. Economic,
      political and other risks associated with foreign operations could adversely
      affect our international sales.  We sell our products worldwide and
      therefore, our business could be subject to risks due to changes in a country’s
      or region’s political or economic conditions.  Differing tax laws and
      changes in those laws may also affect future results of our
      operations.





PANDEMICS
      THROUGHOUT THE WORLD COULD ADVERSELY AFFECT OUR BUSINESS. The occurrence of
      a
      pandemic such as the Bird Flu coupled with the lack of government readiness
      and
      support in those countries where we do business could temporarily impede our
      revenue growth.





ACTS
      OF
      TERRORISM OR WAR MAY ADVERSELY AFFECT OUR BUSINESS. Acts of terrorism, acts
      of
      war, and other events may cause damage or disruption to our properties,
      business, employees, suppliers, distributors,





22





resellers,
      and customers, which could have an adverse effect on our business, financial
      condition, and operating results. Such events may also result in an economic
      slowdown in the United States or elsewhere, which could adversely affect our
      business, financial condition, and operating results.





WE
      ARE
      PLANNING TO IMPLEMENT ENTERPRISE RESOURCE PLANNING (“ERP”) SOFTWARE DURING
      CALENDAR 2006 TO PROVIDE US THE INFORMATION WE NEED TO BETTER MANAGE AND PLAN
      OUR BUSINESS AND ENHANCE OUR FINANCIAL REPORTING. IF THIS IMPLEMENTATION IS
      UNSUCCESSFUL OR DELAYED, IT COULD ADVERSELY IMPACT RATHER THAN ENHANCE OUR
      ABILITY TO MANAGE AND GROW OUR BUSINESS. Our
      ability to successfully implement our business plan and comply with regulations
      requires an effective planning and management process. We expect that we will
      need to continue to improve existing, and implement new, operational and
      financial systems, procedures and controls to manage our business effectively
      in
      the future, especially as we integrate our German subsidiary’s management and
      accounting information system. We are planning to implement ERP software during
      calendar 2006 to provide us the information we need to better manage and plan
      our business and enhance our financial reporting. ****** Such
      implementations are costly and require personnel time and attention in order
      to
      succeed and can be delayed and problematic. Any delay in the implementation
      of,
      or disruption in the transition to, new or enhanced systems, procedures or
      controls, could harm our ability to accurately forecast sales demand, manage
      our
      supply chain and record and report financial and management information on
      a
      timely and accurate basis.





AS
      A
      RESULT OF OUR REQUIRED ANNUAL EVALUATION OF OUR INTERNAL CONTROLS OVER FINANCIAL
      REPORTING, WE MAY IDENTIFY INTERNAL CONTROL WEAKNESSES NEEDING REMEDIATION,
      WHICH COULD HARM OUR REPUTATION. We
      have
      completed the first and second annual evaluation of our internal controls over
      financial reporting as required by Section 404 of the Sarbanes-Oxley Act of
      2002 for the fiscal years ended March 31, 2005 and 2006. Although our
      assessment, testing and evaluation resulted in our conclusion that as of both
      March 31, 2006 and 2005, our internal controls over financial reporting were
      effective, we cannot predict the outcome of our testing in future periods.
      B ecause
      of
      the inherent limitation of disclosure controls, no evaluation of such controls
      can provide absolute assurance that all control issues and instances of fraud,
      if any, within the Company have been detected. If
      our
      internal controls are found to be ineffective in future periods, our reputation
      could be harmed. We may incur additional expenses and commitment of management’s
      time in connection with further evaluations, either of which could materially
      increase our operating expenses and accordingly reduce our net income.





BEGINNING
      WITH OUR FISCAL YEAR 2007, WE WILL BE REQUIRED TO RECORD COMPENSATION EXPENSE
      FOR STOCK OPTIONS. AS A RESULT OF THE RESULTING SIGNIFICANT EXPENSES, IT WILL
      BE
      MORE DIFFICULT FOR US TO CONTINUE TO BE PROFITABLE AND ANY PROFITABILITY WE
      ACHIEVE WILL BE REDUCED SIGNIFICANTLY. In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued
      Financial Accounting Standard 123R that requires the fair value of all
      equity-based awards granted to employees be recognized in the statement of
      operations as compensation expense, for fiscal years beginning after December
      15, 2005, rather than just to disclose such expense in a footnote as we have
      done in the previous years. Given our outstanding options and our current
      intention to continue to grant options in the future as an incentive and
      retention tool for our employees, the adoption of this accounting standard
      will
      reduce our profitability as measured by generally accepted accounting principles
      (GAAP) which may adversely affect our stock price. Such adoption could lead
      us
      to supplement our GAAP reports with non-GAAP measures in order to provide
      analysts with the same metrics we use to measure our business. Such adoption
      could also lead us to reduce or otherwise alter our use of stock options which
      we believe help align our employees’ long-term interests with increasing our
      enterprise value. This could, in turn, hurt our ability to recruit employees
      and
      retain existing employees and directors.





ITEM
      1B.  UNRESOLVED
      STAFF COMMENTS





Not
      applicable.





23








ITEM
      2.  PROPERTIES





*Mountain
      View, Ca*





As
      of
      March 31, 2006, approximately 70,000 square feet of floor space are leased
      by
      the Company on a long-term basis for card manufacturing, read/write drive
      production, administration, sales, and research and engineering, in two
      buildings located in Mountain View, California. These facilities have a current
      total annualized rental of approximately $885,000 on leases that expire in
      October 2013 and in March 2014. One 27,000-square foot building is used for
      optical memory card production and one 43,000 square-foot building is used
      for
      optical card production, read/write drive production, administration, sales,
      and
      research and engineering.





*Germany*





The
      Company leases a portion of a building in Ratingen, Germany, and a building
      in
      Rastede, Germany totaling approximately 15,000 square feet, for optical and
      specialty card manufacturing, distribution, administration and sales, for a
      total annualized rental of 239,000 euros on leases that expire on dates from
      February 2009 to August 2009. Also, the Company owns land and a building in
      Rastede, Germany that is used in production of specialty cards and research
      and
      engineering.





*Other*





The
      Company also leases small marketing offices in New York and in the Washington
      DC
      area.





Management
      believes these leased and owned facilities to be satisfactory for its present
      operations. Upon expiration of the leases, management believes that these or
      other suitable buildings will be able to be leased on a reasonable basis.





ITEM
      3.  LEGAL
      PROCEEDINGS





From
      time
      to time we are a party to litigation matters and pending or threatened claims
      and assessments that are normal in the course of our operations. While we
      believe that the ultimate outcome of these matters will not have a material
      adverse effect on the Company’s financial position, results of operations or
      cash flows, the outcome of these matters is not determinable and negative
      outcomes may adversely affect our financial position, liquidity, or results
      of
      operations.





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





None.








24





PART
      II





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





The
      Company's only class of common stock, $0.01 par value, is traded on The Nasdaq
      Stock Market® under the symbol LCRD and is quoted in *The
      Wall Street Journal* and
      other newspapers. Stock price information and other data also can be obtained
      on
      the Internet directly from Nasdaq at: www.nasdaq.com.  The
      table
      below sets forth the high and low trade prices for the Company's common stock
      (rounded to two decimal points) as reported by Nasdaq during the fiscal periods
      indicated.




QUARTERLY
      STOCK PRICES





Fiscal
                  year 2006
              
              Fiscal
                  year 2005High
                  Trade
              
              Low
                  Trade
              
              High
                  Trade
              
              Low
                  TradeFirst
                  Quarter
              
              $
              6.80
              
              $
              4.56
              
              $
              21.37
              
              $
              11.40Second
                  Quarter
              
              
              10.45
              
              
              5.77
              
              
              13.48
              
              
              6.49Third
                  Quarter
              
              
              15.25
              
              
              6.97
              
              
              11.75
              
              
              7.86Fourth
                  Quarter
              
              
              22.75
              
              
              12.71
              
              
              11.89
              
              
              4.77





As
      of
      March 31, 2006, there were approximately 761 holders of record of the Company's
      common stock. The total number of stockholders is believed by the Company to
      be
      several thousand higher since many holders’ shares are listed under their
      brokerage firms’ names.





The
      Company has never paid cash dividends on its common stock. The Company
      anticipates that for the foreseeable future, it will retain any earnings for
      use
      and reinvestment in its business.





The
      Company did not repurchase any of its outstanding shares or other securities
      during its fourth quarter ended March 31, 2006.





For
      information regarding securities authorized for issuance under equity
      compensation plans, see Part III, Item 12 below on page 81.








25





ITEM
      6.  SELECTED
      FINANCIAL DATA





The
      following selected consolidated financial information as of and for each of
      the
      five years in the period ended March 31 is derived from the consolidated
      financial statements of the Company. This financial data should be read in
      conjunction with the consolidated financial statements and "Management's
      Discussion and Analysis of Financial Condition and Results of Operations"
      appearing in Item 7 of this report.





LASERCARD
      CORPORATION AND SUBSIDIARIES


FIVE-YEAR
      SUMMARY OF CONSOLIDATED FINANCIAL INFORMATION


Fiscal
      Years Ended March 31, 2002 - 2006


(In
      thousands, except per share amounts)








OPERATIONS
                DATA
            
            2006(1)
            
            2005(1)
            
            2004
            
            2003
            
            2002Revenues
            
            $
            39,857
            
            $
            28,544
            
            $
            16,963
            
            $
            26,331
            
            $
            20,889Cost
                of product sales
            
            
            24,804
            
            
            22,637
            
            
            13,157
            
            
            13,906
            
            
            10,652Selling,
                general, and administrative expenses
            
            
            11,949
            
            
            11,891
            
            
            6,700
            
            
            6,202
            
            
            5,165Research
                and engineering expenses
            
            
            2,338
            
            
            3,018
            
            
            2,620
            
            
            2,818
            
            
            3,045Interest
                and other income, net
            
            
            471
            
            
            240
            
            
            176
            
            
            397
            
            
            386Income
                (loss) before income taxes
            
            
            1,237
            
            
            (8,762
            )
            
            (5,338
            )
            
            3,802
            
            
            2,413Income
                tax (benefit) provision
            
            
            443
            
            
            139
            
            
            7,089
            
            
            1,520
            
            
            (2,786
            )Net
                income (loss)
            
            $
            794
            
            $
            (8,901
            )
            $
            (12,427
            )
            $
            2,282
            
            $
            5,199Net
                income (loss) per share:Basic
            
            $
            0.07
            
            $
            (0.78
            )
            $
            (1.15
            )
            $
            0.22
            
            $
            0.52Diluted
            
            $
            0.07
            
            $
            (0.78
            )
            $
            (1.15
            )
            $
            0.21
            
            $
            0.50Weighted
                average number of common and common equivalent shares:Basic
            
            
            11,415
            
            
            11,362
            
            
            10,761
            
            
            10,356
            
            
            9,961Diluted
            
            
            11,587
            
            
            11,362
            
            
            10,761
            
            
            10,842
            
            
            10,468BALANCE
                SHEET DATACurrent
                assets
            
            $
            39,574
            
            $
            21,310
            
            $
            23,294
            
            $
            21,192
            
            $
            28,118Current
                liabilities
            
            
            9,228
            
            
            6,764
            
            
            11,271
            
            
            3,620
            
            
            7,501Total
                assets
            
            
            62,335
            
            
            48,768
            
            
            49,835
            
            
            40,463
            
            
            40,713Long-term
                liabilities
            
            
            21,090
            
            
            15,326
            
            
            2,878
            
            
            —
            
            
            —Stockholders'
                equity
            
            
            32,017
            
            
            26,678
            
            
            35,686
            
            
            36,843
            
            
            32,337





(1)
            Only
                fiscal years 2006 and 2005 operations data includes results of our
                German
                subsidiary acquired on March 31,
                2004.





26





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





The
      following discussion and analysis of the Company's financial condition and
      results of operations should be read in conjunction with the audited
      consolidated financial statements and related notes included elsewhere in this
      Form 10-K Report for the year ended March 31, 2006.





*Forward-Looking
      Statements* .
      For a
      discussion of the risk factors related to the Company’s business operations,
      please refer to the “Forward-Looking Statements” section starting at page 4 of
      this report and the section entitled “Risk Factors” starting at page 17 of this
      report.





CRITICAL
      ACCOUNTING POLICIES





Our
      discussion and analysis of financial condition and results of operations are
      based upon our audited consolidated financial statements, which have been
      prepared in accordance with U.S. generally accepted accounting principles.
      Note
      2 to the Consolidated Financial Statements describes the significant accounting
      policies and methods used in the preparation of the Consolidated Financial
      Statements. The preparation of these financial statements requires us to make
      estimates and judgments that affect the reported amounts of assets, liabilities,
      revenues and expenses. On an ongoing basis, we evaluate our estimates, including
      those related to our revenues, inventories, stock-based compensation,
      warranties, and income taxes. We base our estimates on historical experience
      and
      on various other assumptions that are believed to be reasonable under the
      circumstances, the results of which form the basis for making judgments about
      the carrying values of assets and liabilities that are not readily apparent
      from
      other sources.





We
      consider the accounting policies described below to be our critical accounting
      policies. Our critical accounting policies are those that both (1) are most
      important to the portrayal of the financial condition and results of operations
      and (2) require management’s most difficult, subjective, or complex judgments,
      often requiring estimates about matters that are inherently uncertain. These
      critical accounting policies reflect our significant judgments, assumptions,
      and
      estimates used in the preparation of the Consolidated Financial Statements.
      Our
      management has discussed the development and selection of these critical
      accounting policies and estimates with the Audit Committee of our Board of
      Directors and the Audit Committee has reviewed our disclosures relating to
      them
      in this report





*Revenue
      Recognition* .
      Product
      sales primarily consist of optical cards, optical card drives and specialty
      cards and card printers. The Company recognizes revenue from product sales
      when
      the following criteria are met: (1) persuasive evidence of an arrangement
      exists; (2) delivery has occurred; (3) the fee is fixed or determinable; and
      (4)
      collectibility is reasonably assured. The Company recognizes revenue on product
      sales at the time of shipment when shipping terms are F.O.B. shipping point,
      orders are placed pursuant to a pre-existing sales arrangement and there are
      no
      post-shipment obligations other than warehousing under a U.S. government
      subcontract or customer acceptance criteria. Where appropriate, provision is
      made at the time of shipment for estimated warranty costs and estimated returns,
      and such provision is included in accrued liabilities in the Company’s
      consolidated balance sheet. The total amount of provision charged to warranty
      expense and product returns was $747,000, $518,000 and $56,000 for fiscal years
      2006, 2005 and 2004, respectively. Actual warranty costs and returns activity
      was $176,000, $493,000 and $17,000 for fiscal years 2006, 2005 and 2004,
      respectively.





The
      Company’s U.S. government subcontract requires delivery into a secure vault
      located on Company premises. Shipments are made from the vault on a shipment
      schedule provided by the prime contractor, which is subject to revision, but
      generally not subject to cancellation, at the option of the prime contractor.
      At
      the time the cards are delivered into the vault, title to the cards is
      transferred to the government and all risks of ownership are transferred as
      well. The prime contractor is invoiced, with payment due within thirty days,
      and
      the contract does not contain any return (other than for warranty) or
      cancellation provisions. Pursuant to the provisions of SEC Staff Accounting
      Bulletin No. 104 (SAB 104), revenue is recognized on delivery into the vault
      as
      the Company has fulfilled its contractual obligations and the earnings process
      is complete. If the Company does not receive a shipment schedule for shipment
      of
      cards from the vault, revenue is deferred and recognized upon shipment from
      the
      vault. In addition, revenue recognition for future deliveries into the vault
      would be affected if the U.S. government cancels the shipment schedule through
      the prime contractor. As a result, the Company’s revenues may fluctuate from
      period to period if the Company does not continue to obtain shipment schedules
      under this subcontract or if the shipment schedules are cancelled.





27





Emerging
      Issues Task Force No. 00-21, "Revenue Arrangements with Multiple Deliverables,"
      (EITF 00-21) provides criteria governing how to identify whether goods or
      services that are to be delivered separately in a bundled sales arrangement
      should be accounted for separately. Deliverables are accounted for separately
      if
      they meet all of the following criteria: a) the delivered items have stand-alone
      value to the customer; b) the fair value of any undelivered items can be
      reliably determined; and c) if the arrangement includes a general right of
      return, delivery of the undelivered items is probable and substantially
      controlled by the seller. In situations where the deliverables fall within
      higher-level literature as defined by EITF 00-21, the Company applies the
      guidance in that higher-level literature. Deliverables that do not meet these
      criteria are combined with one or more other deliverables. The Company adopted
      EITF 00-21 for any new arrangements entered into after July 1, 2003 and now
      assesses all revenue arrangements against the criteria set forth in EITF 00-21.





The
      Company applies the provisions of Statement of Position (“SOP”) No. 81-1,
      "Accounting for Performance of Construction-Type and Certain Production-Type
      Contracts" (SOP No. 81-1) in applicable contracts. Revenues on time and
      materials contracts are recognized as services are rendered at contract labor
      rates plus material and other direct costs incurred. Revenues on fixed price
      contracts are recognized on the percentage of completion method based on the
      ratio of total costs incurred to date compared to estimated total costs to
      complete the contract. Estimates of costs to complete include material, direct
      labor, overhead and allowable general and administrative expenses. In
      circumstances where estimates of costs to complete a project cannot be
      reasonably estimated, but it is assured that a loss will not be incurred, the
      percentage-of-completion method based on a zero profit margin, rather than
      the
      completed-contract method, is used until more precise estimates can be made.
      The
      full amount of an estimated loss is charged to operations in the period it
      is
      determined that a loss will be realized from the performance of a contract.





For
      the
      fiscal years ended March 31, 2006 and 2005, the Company recognized approximately
      $77,000 and $127,000, respectively, of revenues based on a zero profit margin
      related to a long-term contract. The Company had no revenues generated from
      this
      type of contract for the year ended March 31, 2004.





At
      the
      beginning of the fourth quarter of fiscal year 2006, the Company entered into
      a
      contract with a Middle Eastern country to provide them with a full system
      integration of our optical memory cards for use in that country’s personalized
      national ID program which includes optical memory cards, hardware, and software.
      The contract calls for multiple deliverables, installation, and certain client
      acceptance criteria, as defined in the agreement. In applying the guidance
      within EITF 00-21, the Company determined the deliverables are not to be
      accounted for as separate units, but rather as a bundled arrangement as the
      fair
      value of the undelivered items cannot be readily determined. Therefore, revenue
      recognition on this new contract and the associated contract costs were and
      will
      be deferred until the predominant undelivered element, the overview of card
      personalization, is delivered and accepted, commencing with the installation
      and
      client acceptance of the card personalization system. Total contract
      revenue will be recognized ratably based on actual cards personalized and
      accepted. As of March 31, 2006, no revenue has been recognized under this
      contract, and costs incurred under the contract of $1 million were recorded
      as
      deferred contract costs under the current assets on the accompanying
      consolidated balance sheet.





License
      revenue, which may consist of up-front license fees and royalty payments, is
      recognized as revenue when earned. There were no costs or license revenue
      recorded in fiscal years 2006, 2005 and 2004.





The
      Company entered into an agreement with Global Investments Group (GIG), effective
      April 3, 2004, for the manufacturing of optical memory cards. In accordance
      with
      EITF 00-21, the card manufacturing license, sale and installation of equipment,
      training, and ongoing support have been accounted for as one unit of accounting,
      since the Company is unable to determine evidence of the fair value of any
      of
      the undelivered items. Accordingly, revenues for the arrangement have been
      deferred and will be recognized based on the predominant undelivered item,
      which
      is the ongoing annual support of the manufacturing equipment over the remainder
      of the 20-year license period. Pursuant to FTB 90-1, “Accounting for Separately
      Priced Extended Warranty and Product Maintenance Contracts” revenue will be
      recognized ratably over the remaining term of the agreement beginning when
      the
      equipment is accepted and training has been completed, which date is dependent
      on GIG providing a facility in Slovenia. The Company also defers direct and
      incremental expenses associated with building the card manufacturing equipment
      and with the delivery of other services for which revenue has been deferred,
      and
      the Company will recognize these expenses as the Company recognizes the related
      revenue.





28








The
      Company applies the provisions of Statement of Position No. 97-2, “Software
      Revenue Recognition,” as amended by Statement of Position 98-9, “Modification of
      SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions” to
      all transactions involving the sale of software products. Revenue from the
      license of the Company’s software products is recognized when persuasive
      evidence of an arrangement exists, the software product has been delivered,
      the
      fee is fixed or determinable, and collectibility is probable, and, if
      applicable, upon acceptance when acceptance criteria are specified or upon
      expiration of the acceptance period. Software revenue was immaterial for the
      fiscal years 2006, 2005 and 2004, respectively.





*Accounting
      for Income Taxes.* As part
      of the process of preparing its consolidated financial statements, the Company
      is required to estimate income taxes in each of the jurisdictions in which
      it
      operates. This process involves estimating the actual current tax exposure
      together with assessing temporary differences resulting from differing treatment
      of items, such as deferred revenue, for tax and accounting purposes. These
      differences result in deferred tax assets and liabilities, which are included
      within the consolidated balance sheets. The Company must then assess the
      likelihood that the deferred tax assets will be recovered from future taxable
      income and to the extent that management believes recovery is not likely, the
      Company must establish a valuation allowance. To the extent that a valuation
      allowance is established or increased in a period, the Company includes an
      expense within the tax provision in the statements of operations.





Significant
      management judgment is required in determining the provision for income taxes
      and, in particular, any valuation allowance recorded against the Company’s
      deferred tax assets. The Company determined in fiscal year 2004 that due to
      the
      Company’s recent cumulative tax loss history for the previous three-year period,
      income statement loss history over the previous five quarters, and the
      difficulty in forecasting the timing of future revenue as evidenced by the
      deviations in achieved revenues from expected revenues during the previous
      few
      quarters and taking into account the newness of certain customer relationships,
      that it was necessary to increase the valuation allowance under SFAS No. 109
      to
      the full amount of the deferred tax asset. As a result, the Company determined
      that a full valuation allowance was required to net against its deferred tax
      assets in fiscal year 2004 and increased the existing allowance by $2.4 million
      to $14.8 million. In addition, the Company increased its valuation allowance
      against its deferred tax asset in the amount of $0.9 million during fiscal
      year
      2006 and $3.7 million during fiscal year 2005.





The
      fiscal year 2004 acquisition of Challenge Card Design GmbH resulted in a
      deferred tax liability of $568,000 at March 31, 2006 and $641,000 at March
      31,
      2005.





The
      Company's methodology for determining the realizability of its deferred tax
      assets involves estimates of future taxable income; the estimated impact of
      future stock option deductions; and the expiration dates and amounts of net
      operating loss carryforwards. These estimates are based on near-term projections
      and assumptions which management believes to be reasonable. For recent prior
      periods through second quarter fiscal year 2004, the Company had been estimating
      future taxable income from its core business, which assumed on-going business
      under the U.S. government subcontract for Permanent Resident Cards (Green Cards)
      and Laser Visa Border Crossing Cards and the Canadian government’s Permanent
      Resident Card program, as well as estimated operating expenses to support that
      level of business, as offset by the estimated impact of future stock option
      deductions. Starting with the third quarter of fiscal year 2004, the Company
      estimated future taxable income based upon its expectations for the current
      and
      next three years because this past core business has not proven to be as stable
      as the Company had believed it to be and because this past core business is
      expected to represent an increasingly smaller part of the business. This is
      because the Company expected revenues from these U.S. programs to stabilize
      at
      revenue levels lower than had been expected in the past and because the Company
      expects new foreign business, which has fluctuated considerably quarter to
      quarter, to comprise a larger portion of the core business. The Company has
      had
      difficulty in the past, and expects to have continued difficulty in the future,
      in reliably forecasting its foreign business and the revenue to be received
      from
      it. This, in combination with the anticipated three-year cumulative tax loss
      for
      the period ended March 31, 2004, resulted in the Company basing its estimates
      of
      future income for these purposes to booked orders only. As circumstances change,
      the Company may in the future be able to revert back to estimating future
      revenue based upon its forecast revenues rather than only using booked orders,
      although the Company cannot say when this will occur.





In
      concluding that a valuation allowance was required at the end of fiscal year
      2004 and is still required at the end of fiscal year 2006, the Company
      considered both the positive and negative evidence regarding its ability to
      generate sufficient future taxable income to realize its deferred tax assets.
      Positive evidence included having achieved profitability for financial reporting
      purposes from fiscal year 1999 through fiscal year 2003. Other positive evidence





29





included
      (1) the level of sales and business experienced under the contract with the
      Canadian government’s Permanent Resident Card program; (2) prospects in Italy
      and a Middle Eastern country for national identification card programs; (3)
      the
      heightened interest in border security initiatives following the events of
      September 11, 2001; and (4) expected future orders. Negative evidence included
      (1) the Company’s reliance on a limited number of customers for a substantial
      portion of its business; (2) the uncertainty in timing of anticipated orders
      from customers; (3) the impact of future stock option deductions on taxable
      income; (4) recent experience of net operating loss carryforwards expiring
      unused through fiscal year 2004; (5) the financial statement loss for the fourth
      quarter of fiscal year 2003 through the first two quarters of fiscal year 2006;
      and (6) the prior three years’ cumulative tax net operating losses. In weighing
      the positive and negative evidence above, the Company considered the “more
      likely than not” criteria pursuant to SFAS No. 109 as well as the following
      risks: “dependence on VARs and on a limited number of customers,” “lengthy sales
      cycles,” “technological change,” and “competition”. As
      described above, the Company concluded that the negative evidence outweighed
      the
      positive evidence and as a result increased the valuation allowance to be equal
      to the full amount of the deferred tax asset as of March 31, 2005 and again
      at
      March 31, 2006.





In
      the
      event that actual results differ from these estimates or that these estimates
      are adjusted in future periods, the Company may need to adjust the amount of
      the
      valuation allowance based on future determinations of whether it is more likely
      than not that some or all of its deferred tax assets will be realized. A
      decrease in the valuation allowance would be recorded as an income tax benefit
      or a reduction of income tax expense or a credit to stockholders’ equity. The
      Company’s net operating losses available to reduce future taxable income expire
      on various dates from fiscal year 2008 through fiscal year 2024. To the extent
      that the Company generates taxable income in jurisdictions where the deferred
      tax asset relates to net operating losses that have been offset by a full
      valuation allowance, the utilization of these net operating losses would result
      in the reversal of the related valuation allowance.





*Inventories.* The
      Company values its inventory at the lower of the actual cost to purchase and/or
      manufacture the inventory or the current estimated market value of the inventory
      less cost to sell. Management regularly reviews inventory quantities on hand
      and
      records a provision for excess and obsolete inventory based primarily on
      forecasts of product demand. Demand for optical card drives can fluctuate
      significantly. In order to obtain favorable pricing, purchases of certain
      read/write drive parts are made in quantities that exceed the booked orders.
      The
      Company purchases drive parts for its anticipated demand and takes into
      consideration the order-to-delivery lead times of vendors and the economic
      purchase order quantity for such parts. In addition, the Company keeps a supply
      of card raw materials it deems necessary for anticipated demand.




Management’s
      analysis of the carrying value of card and read/write drive inventory is
      performed on a quarterly basis. With respect to inventory carrying values,
      the
      Company follows the principles articulated in Accounting Research Bulletin
      No.
      43, Chapter 4, “Inventory Pricing,” paragraphs 5 through 7 and 10 and other
      authoritative guidance (e.g. SAB 100) as it relates to determining the
      appropriate cost basis of inventory and determining whether firm, noncancelable
      purchase commitments should be accrued as a loss if forecasted demand is not
      sufficient to utilize all such committed inventory purchases. As part of the
      Company’s quarterly excess/obsolete inventory analysis, management also
      determines whether lower of cost or market adjustments (i.e., where selling
      prices less certain costs are not sufficient to recover inventory carrying
      values) are warranted; during fiscal year 2006 and fiscal year 2005, the Company
      did not record any significant lower of cost or market adjustments other than
      for read/write drives in fiscal year 2005 in the amount of about $205,000 which
      is included as part of cost of product sales in the Company’s consolidated
      statements of operations. During fiscal year 2004, the Company did not record
      any significant lower of cost or market adjustment. In those instances where
      the
      Company has recorded charges for excess and obsolete inventory, management
      ensures that such new cost basis is reflected in the statement of operations
      if
      that inventory is subsequently sold. The Company’s inventory reserves are based
      upon the lower of cost or market for slow moving or obsolete items. As a result,
      the Company believes a 10% increase or decrease of sales would not have a
      material impact on such reserves. The
      Company is currently evaluating SFAS No. 151 “Inventory Costs -
      Amendment of ARB No. 43, Chapter 4”, and does not expect the adoption will have
      a material impact on its results of operations or financial
      condition.





*Value
      of long-lived assets, including intangibles.* Our
      balance sheet carries a variety of long-lived assets including property and
      equipment, identifiable intangible assets, and goodwill. We undertake the
“Impairment” review on an annual basis for assets such as goodwill and other
      non-amortizing intangible assets in accordance with Financial Accounting
      Standard No. 142 (“FAS 142”), Goodwill and Other Intangible  Assets. Our
      review is based, in part, upon current estimated market values and our
      projections of anticipated future cash flows.





30








In
      accordance with Financial Accounting Standard No. 144, for other long-lived
      assets, we periodically review the impairment of those assets. An impairment
      loss is recognized if the carrying amount of an intangible asset is not
      recoverable and its carrying amount exceeds its fair value. After an impairment
      loss is recognized, the adjusted carrying amount of the intangible asset becomes
      its new accounting basis. As it is prohibited, we do not reverse previously
      recognized impairment loss.





We
      completed the annual impairment tests of goodwill for fiscal year 2006 and
      the
      review of other long-lived assets and concluded that there were no impairments.
      While we believe that our estimates of current value are reasonable, different
      assumptions regarding items such as future cash flows and the volatility
      inherent in markets we serve could affect our evaluations and result in
      impairment charges against the carrying value of those assets. If events or
      circumstances indicate that our estimates are no longer reasonable, the assets
      will be tested for impairment in accordance with FAS 142 and FAS 144.





*Stock-based
      compensation.* We
      have
      elected to continue to follow Accounting Principles Board opinion No. 25 (“APB
      25”), “ *Accounting
      for Stock Issued to Employees,”* to
      account for employee stock options because the alternative fair value method
      of
      accounting prescribed by Statement of Financial Accounting Standards No. 123
      (“SFS 123”), “ *Accounting
      for Stock-Based Compensation,”* requires
      the use of option valuation models that were not developed for use in valuing
      employee stock options. Under APB 25, no compensation expense is recognized
      when
      the exercise price of our employee stock options equals the market price of
      the
      underlying stock on the date of grant. Had we elected to follow SFAS 123 and
      to
      apply the fair value method to stock=based employee compensation, we would
      have
      recorded an additional $1.2 million in expense for the year ended March 31,
      2006.





In
      December 2004, the Financial Accounting Standards Board (FASB) issued their
      final standard on accounting for share-based payments in FASB Standard No.
      123R
      (revised 2004), *Share-based
      Payment* (FAS
      123R). This statement replaces FASB Statement 123, *Accounting
      for Stock-Based Compensation,* and
      superseded Accounting Principles Board (APB) Opinion No. 25, *Accounting
      for Stock Issued to Employees.* The
      statement is effective for all interim and annual periods beginning after
      December 15, 2005 and requires companies to measure and recognize compensation
      expense for all stock-based payments at fair value. Stock-based payments include
      stock option grants under our stock plans. The adoption of FAS 123R could
      materially impact our results of operations.





*Warranties.* We have
      estimated reserves for product returns under warranty. We estimate our reserves
      by utilizing historical information for existing products.





Significant
      judgment is inherent in the selection of assumptions and the interpretation
      of
      historical experience as well as the identification of external and internal
      factors affecting the estimates of our reserves for product returns. We believe
      that the assumptions used to estimate these product sales reserves are the
      most
      reasonably likely assumptions considering known facts and circumstances.
      However, our product return activity could differ significantly from our
      estimates. If actual product returns are significantly different from our
      estimates, such differences would be accounted for in the period in which they
      become known.





RESULTS
      OF OPERATIONS





Overview





Headquartered
      in Mountain View, California, LaserCard Corporation manufactures LaserCard®
optical memory cards and card related products, including chip-ready
      OpticalSmartTM cards. In addition, the Company operates a wholly owned German
      subsidiary acquired on March 31, 2004, Challenge Card Design Plastikkarten
      GmbH
      (“CCD”), with offices in Rastede and Ratingen, Germany, which manufactures
      advanced-technology cards provides manufacturing capacity for certain steps
      of
      optical memory card production, and markets cards, system solutions, and thermal
      card printers. The Company completed the merger of cards & more GmbH (also
      acquired on March 31, 2004) into Challenge Card Design Plastikkarten GmbH in
      January 2006.





In
      addition to using its own marketing staff in California, New York, Washington
      D.C. area, and Germany, the Company utilizes value added reseller (VAR)
      companies and card distribution licensees, who generally have





31





knowledge
      in specific markets, for the development of markets and applications for
      LaserCard products. Product sales to VARs and licensees consist primarily of
      the
      Company's optical memory cards and optical card read/write drives. The Company
      also offers for sale, its customized software applications and add-on
      peripherals made by other companies (such as equipment for adding a digitized
      photo, fingerprint, or signature to the cards). These peripherals have not
      generated significant revenue for the Company but have demonstrated various
      system options. The VARs/licensees may add application software, personal
      computers, and other peripherals, and then resell these products as integrated
      solutions. The Company is continuing its efforts to recruit new VARs and
      eliminate nonproductive VARs.





Major
      near term growth potential for LaserCard® optical memory cards is in
      government-sponsored identification programs in several countries. Since
      governmental card programs typically rely on policy-making, which in turn is
      subject to technical requirements, budget approvals, and political
      considerations, there is no assurance that these programs will be implemented
      as
      expected or that they will include optical cards. Objectives for long-term
      revenue growth include: (1) broaden the “Optical Memory” (“OM”) products range
      to address lower-end applications characterized by higher price sensitivity,
      (2)
      diversify OM products into, and effectively penetrate, industrial and commercial
      markets, (3) expand hardware product offering to address new markets and add
      value to current offerings, and (4) increase OM product revenues by selling
      more
      application software and integrated solutions.





The
      table
      below presents condensed consolidated revenues, excluding inter-company
      transactions, recorded by the U.S. and German operations (in
      thousands):




Fiscal
                  Year2006
              
              2005
              
              2004U.S.
                  operations
              
              $
              29,419
              
              $
              18,561
              
              $
              16,963German
                  operations
              
              $
              10,438
              
              $
              9,983
              
              
              —





Revenues
      recorded by the U.S. operations are generally to a small number of government
      customers located throughout the world.  Revenues recorded by the German
      operations are mainly for a relatively large number of commercial
      customers.





Historically,
      the largest purchaser of LaserCard products has been a U.S. Government
      contractor, Anteon International Corporation (Anteon), a value-added reseller
      (VAR) of the Company. Anteon is the U.S. Government contractor for LaserCard
      product sales to the U.S. Department of Homeland Security (DHS), U.S. Department
      of State (DOS), U.S. Department of Defense (DOD), and the government of Canada.
      Under government contracts with Anteon, the DHS purchases Green Cards and DOS
      Laser Visa BCCs; the DOD purchases Automated Manifest System cards; and the
      Canadian government purchases Permanent Resident Cards. Encompassing all of
      these programs, the Company’s product sales to Anteon represented 31%, 31% and
      72% of the total revenues for fiscal year 2006, 2005 and 2004. Another
      unaffiliated VAR, Laser Memory Card SPA of Italy, accounted for 31%, 26% and
      22%
      of the Company’s total revenues for fiscal year 2006, 2005, and 2004 mainly for
      secure ID card programs in Italy.





Revenues
      for the major government programs are shown below as a percentage of total
      revenues:





Fiscal
                Year2006
            
            2005
            
            2004United
                States Green Cards and Laser Visa BCCs
            
            
            24%
            
            
            21%
            
            
            44%Canadian
                Permanent Resident Cards
            
            
            5%
            
            
            6%
            
            
            25%Italian
                Carta d’Identità Elettronica (CIE) Cards
            
            
            18%
            
            
            26%
            
            
            22%Italian
                Permesso di Soggiorno Elettronico (PSE) Cards
            
            
            13%
            
            
            —
            
            
            —





For
      the
      government of Italy, the Company has received orders for CIE cards (Carta
      d’Identità Elettronica) and PSE cards (Permesso di Soggiorno Elettronico). As
      card
      issuance infrastructure is more fully developed and the national ID card system
      functions as designed, CIE and PSE card orders could ramp toward their full
      implementation level and could potentially result in annual revenues of $40
      million when these two national ID programs are fully implemented. Backlog
      for
      these programs totaled $2.5 million at March 31, 2006 and is deliverable through
      June 2006. The Company believes that card revenue for these programs will amount
      to $20 million to $30 million in its fiscal year ending March 31, 2007 although
      no significant incremental shipments beyond the backlog are expected during
      the
      quarter ending June 30, 2006.





32








U.S.
      Laser Visa Border Crossing Cards (BCCs) and Green Cards for the U.S. Department
      of Homeland Security (DHS) are an important part of the Company’s revenue base.
      For these programs, the Company recorded card revenues of $9.8 million for
      fiscal year 2006, $5.8 million for fiscal year 2005 and $4.8 million for fiscal
      year 2004. The Company is currently delivering on orders placed prior to the
      expiration of a U.S. government subcontract in November 2005. Backlog at March
      31, 2006 for these programs, which is deliverable through August 2006, totaled
      $3.7 million. The Company expects to receive a purchase order or a new
      subcontract prior to the last shipment under orders on hand although no
      assurance can be given.





For
      fiscal year 2006, shipments under a subcontract for Canada’s Permanent Resident
      Cards totaled $2 million. The backlog at March 31, 2006 was $1.9 million
      deliverable through June 2007. The delivery rate is subject to increase or
      decrease by customer request.





For
      the
      fiscal year 2006, the Company recorded revenue of $1.7 million for the national
      ID card program in a Middle Eastern country, with all of the shipments made
      during the first six months of the fiscal year. In January 2006, the Company
      entered into a separate $11 million contract , for both the supply of secure
      national ID cards for the same Middle Eastern government national ID card
      program and the supply, installation and support of associated card
      personalization equipment, consumables and software. Deliveries are expected
      over approximately a one-year period as the prime contractor elects to place
      a
      series of up to ten purchase orders. The cards are being issued to adult
      citizens for national identity purposes and feature the latest advancements
      in
      identity theft protection provided by Optical IDLock TM, a
      combination of the highly-secure LaserCard® optical memory technology and
      Embedded HologramHDTM, the new high-definition “photographic quality” etched
      image.  This subcontract is the first time that LaserCard Corporation has
      assumed responsibility for both supplying and installing personalization
      hardware, the oversight of the card personalization process, and the quality
      of
      the fully personalized cards, including the printing of cardholder information
      and encoding of data and the Embedded HologramHD. Revenue will be recognized
      as
      cards are issued after personalization, but only after the entire infrastructure
      called for in the contract has been installed and accepted. The Company
      anticipates that this will be accomplished during the first six months of fiscal
      year 2007. The contract’s first release valued at $1.4 million was shipped prior
      to the end of fiscal year 2006 and is included in backlog until revenue is
      recorded. Revenue has not been recorded on this release and the cost of the
      items is included in deferred contract costs on the Company’s consolidated
      balance sheets.





Effective
      April 3, 2004, the Company sold a second-source card-manufacturing license,
      including equipment, training, and support, to the Global Investments Group,
      based in Auckland, New Zealand, for card manufacturing in Slovenia and began
      receiving cash payments. Revenue on this arrangement will begin recognized
      over
      the remaining term of the agreement beginning when the equipment has been
      accepted and the training has been completed, which date is dependent on GIG
      providing a facility in Slovenia as discussed below under “ *License
      Fees and Other Revenues”.*





The
      Company plans to invest up to $9 million in additional capital equipment and
      leasehold improvement expenditures at its facilities when forecasts justify
      the
      investment. These expenditures could occur throughout the next twelve months,
      as
      more fully discussed under “Liquidity and Capital Resources.”





Revenues





For
      the
      fiscal year ended March 31, 2006 the Company’s total revenues were $39.9 million
      compared with $28.5 million for fiscal year 2005 and $17 million for fiscal
      year
      2004.





*Product
      Revenues.* The
      Company’s total revenues consisted of sales in its three segments of (1) optical
      memory cards, (2) optical card drives, drive accessories, and maintenance,
      and
      (3) specialty cards and card printers, as well as in other miscellaneous items.
      Product revenues were $39.9 million for fiscal year 2006; $28.5 million for
      fiscal year 2005; and $17 million for fiscal year 2004. There were no license
      revenues earned in fiscal years 2006, 2005, and 2004.





33








The
      following table presents product revenue by segment (in thousands, except for
      percentages):





Fiscal
                  Year
              
              Change
              
              Change2006
              
              2005
              
              2004
              
              2006
                  vs 2005
              
              2005
                  vs 2004Optical
                  memory cards
              
              $
              28,200
              
              $
              17,364
              
              $
              13,379
              
              $
              10,836
              
              $
              3,985%
                  of total revenues
              
              
              71
              %
              
              61
              %
              
              79
              %Optical
                  card drives
              
              
              985
              
              
              933
              
              
              3,448
              
              
              52
              
              
              (2,515
              )%
                  of total revenues
              
              
              2
              %
              
              3
              %
              
              20
              %Specialty
                  cards and card printers
              
              
              10,672
              
              
              10,235
              
              
              —
              
              
              437
              
              
              10,235%
                  of total revenues
              
              
              27
              %
              
              36
              %
              
              —Other
              
              
              —
              
              
              12
              
              
              136
              
              
              (12
              )
              
              (124
              )%
                  of total revenues
              
              
              —
              
              
              —
              
              
              1
              %Total
                  revenues
              
              $
              39,857
              
              $
              28,544
              
              $
              16,963
              
              $
              11,313
              
              $
              11,581





The
      following table presents optical memory card revenue by major program (in
      thousands):





Fiscal
                  Year
              
              Change
              
              Change2006
              
              2005
              
              2004
              
              2006
                  vs 2005
              
              2005
                  vs 2004U.S.
                  Green Cards & Laser Visas
              
              $
              9,752
              
              $
              5,763
              
              $
              4,800
              
              $
              3,989
              
              $
              963Italian
                  National ID Card Programs
              
              
              12,191
              
              
              7,227
              
              
              3,479
              
              
              4,964
              
              
              3,748Canadian
                  Permanent Resident Cards
              
              
              1,964
              
              
              1,807
              
              
              4,156
              
              
              157
              
              
              (2,349
              )National
                  ID Cards in a Middle Eastern country
              
              
              1,477
              
              
              621
              
              
              109
              
              
              856
              
              
              512Vehicle
                  Registration in India
              
              
              1,272
              
              
              458
              
              
              27
              
              
              814
              
              
              431All
                  other programs
              
              
              1,544
              
              
              1,488
              
              
              808
              
              
              56
              
              
              680Total
                  optical memory card revenues
              
              $
              28,200
              
              $
              17,364
              
              $
              13,379
              
              $
              10,836
              
              $
              3,985





Optical
      memory card revenue increased 62% for fiscal year 2006 as compared with fiscal
      year 2005 due mainly to increases in card unit volume in the U.S. and Italian
      programs as well as increases in the other programs. Optical memory card revenue
      increased 30% for fiscal year 2005 as compared with fiscal year 2004 due mainly
      to an increase in card unit volume in the Italian program as well as increases
      in other programs except for a decrease in volume for Canadian “Maple leaf”
Permanent Resident cards. The Company anticipates annual growth rates averaging
      50% in this segment over the next several years including the 62% growth in
      fiscal year 2006, driven by growth in current programs augmented by the addition
      of new programs.





There
      was
      no significant change in optical card drive revenue for fiscal year 2006 as
      compared with fiscal year 2005. The $2.5 million decrease in fiscal year 2005
      as
      compared with fiscal year 2004 was due to the unusually large order for 1,000
      drives for the U.S. Department of Homeland Security shipped during fiscal year
      2004. The Company does not anticipate that it will derive significant profits
      on
      future drive sales as prices are set near the manufacturing cost in order to
      promote optical memory card sales.





Specialty
      cards and printers revenue of $10.7 million in fiscal year 2006 was mostly
      unchanged from the $10.2 million recorded in fiscal year 2005, the first year
      the Company operated in this segment. The Company anticipates growth of less
      than 10% in this segment in fiscal year 2007.







*License
      Fees and Other Revenues* .  There
      were no license revenues during fiscal year 2006, fiscal year 2005 or fiscal
      year 2004. The Company sold a license, effective April 3, 2004, to Global
      Investments Group (GIG), based in Auckland, New Zealand, for card manufacturing
      in Slovenia.  This agreement provides for payments to the Company of $14
      million for a 20-year license and five-year training support package, followed
      by $15 million paid $1 million annually for ongoing support for an additional
      15
      years.  Additionally, the Company is to sell approximately





34





$12
      million worth of the required manufacturing equipment and installation support
      for the new facility to be built by GIG to provide a targeted initial
      manufacturing capacity of 10 million optical cards annually. As of March 31,
      2006, the Company had acquired $5.9 million of this equipment classified as
      equipment held for resale on its consolidated balance sheet.  The Company
      has received $20.5 million of payments called for in the agreements, consisting
      of a partial payment for the equipment and training of $6.5 million and
      $14 million for the license fee and support. Another approximately $5.9
      million is overdue with GIG most recently committing to complete the payment
      by
      the end of June. The Company has begun to investigate alternative courses of
      action should GIG fail to make such payment.  For
      the
      $20.5 million the Company received, $18.5 million was recorded as advance
      payments from customer and $2 million for the licensing fee was recorded as
      deferred revenue, which were both classified as long term liabilities within
      the
      consolidated balance sheets.  In addition to the $41 million discussed
      above, GIG is to pay the Company royalties for each card produced under the
      license.  The territories covered by the license include most of the
      European Union and eastern European regions.  GIG has exclusive marketing
      rights in certain territories, with performance goals to maintain these
      rights.  The Company will assign a person on site during the license term
      to assist with quality, security and operational procedures, with the mutual
      goal that the facility and the cards made in the facility conform to the
      Company’s standards.  The Company also retains rights to utilize up to 20%
      of the new facility capacity as backup and capacity buffer to augment its own
      card manufacturing facilities in Mountain View, California and at its German
      subsidiary. The granting of this license to GIG establishes a potential second
      source supplier of optical memory cards for existing and prospective customers
      who may request multiple sources for cards.  The agreement contains various
      elements including a card manufacturing license, sale and installation of
      equipment, training, and ongoing support, and contingent payments for the sale
      of materials, and royalty payments for cards manufactured. In accordance with
      EITF 00-21, the card manufacturing license, sale and installation of equipment,
      training, and ongoing support have been accounted for as one unit of accounting,
      since the Company is unable to determine evidence of the fair value of any
      of
      the undelivered items. Accordingly, revenues for the arrangement have been
      deferred and will be recognized based on the predominant undelivered item,
      which
      is the ongoing annual support of the manufacturing equipment over the remainder
      of the 20-year license period beginning when the equipment is accepted and
      training has been completed, which date is dependent on GIG providing a facility
      in Slovenia. Pursuant to FTB 90-1, “Accounting for Separately Priced Extended
      Warranty and Product Maintenance Contracts” this revenue will be recognized
      ratably over the remaining term of the agreement. The Company also defers direct
      and incremental expenses associated with building the card manufacturing
      equipment and with the delivery of other services for which revenue has been
      deferred, and the Company will recognize these expenses as the Company
      recognizes the related revenue.





Backlog





As
      of
      March 31, 2006, the backlog for LaserCard® optical memory cards totaled $8.3
      million scheduled for delivery in fiscal year 2007, compared with $0.9 million
      at March 31, 2005, and $4.1 million at March 31, 2004. In addition, backlog
      for
      a bundled order of optical memory cards, read/write drives, card printers,
      and
      software totaled $1.4 million at March 31, 2006. The Company has only a few
      customers who generally place orders for a several-month period so that
      variations in order placement from a single customer can materially affect
      backlog. As a result, the relative size of the Company’s backlog has not been a
      reliable indicator of future sales revenue trends.





The
      Company has no significant backlog for read/write drives.





In
      addition, the backlog for Challenge Card Design Plastikkarten GmbH as of March
      31, 2006 for specialty cards and printers totaled 0.8 million euros
      (approximately $1.0 million) compared with 1.2 million euros (approximately
      $1.6
      million) at March 31, 2005, and for a contract to develop a conventional
      non-optical card production facility totaled 0.7 million euros (approximately
      $0.8 million) at March 31, 2006 compared with 0.8 million euros (approximately
      $1 million) at March 31, 2005. In circumstances where estimates of costs to
      complete a project cannot be reasonably estimated, but it is assured that a
      loss
      will not be incurred, the percentage-of-completion method based on a zero profit
      margin, rather than the completed-contract method, is used until more precise
      estimates can be made. Therefore, revenue on the contract for a conventional
      non-optical card production facility contract is being booked on a zero profit
      margin basis and the total profit under this contract will be booked at
      completion; probably during fiscal year 2008.








35





Gross
      Margin





The
      following table represents gross margin in absolute amount and percentage by
      segment (in thousands, except for percentages):




Fiscal
                  Year
              
              Change
              
              Change2006
              
              2005
              
              2004
              
              2006
                  vs 2005
              
              2005
                  vs 2004Optical
                  memory cards
              
              $
              13,107
              
              $
              4,561
              
              $
              3,414
              
              $
              8,546
              
              $
              1,147%
                  of optical memory card revenues
              
              
              46
              %
              
              26
              %
              
              26
              %Optical
                  card drives
              
              
              (754
              )
              
              (1,154
              )
              
              409
              
              
              400
              
              
              (1,563
              )%
                  of optical card drive revenues
              
              
              —
              
              
              —
              
              
              12
              %Specialty
                  cards and card printers
              
              
              2,700
              
              
              2,512
              
              
              —
              
              
              188
              
              
              2,512%
                  of specialty cards and card printers revenues
              
              
              25
              %
              
              25
              %
              
              —Other
              
              
              —
              
              
              (12
              )
              
              (17
              )
              
              12
              
              
              5%
                  of other revenues
              
              
              NM
              
              
              NM
              
              
              NMTotal
                  gross margin
              
              $
              15,053
              
              $
              5,907
              
              $
              3,806
              
              $
              9,146
              
              $
              2,101%
                  of total revenues
              
              
              38
              %
              
              21
              %
              
              22
              %





*Optical
      Memory Cards.* Optical
      memory card gross margin can vary significantly based upon changes in average
      selling price, production and sales volumes, mix of card types, production
      efficiency and yields, and changes in fixed costs. Unit volume affects gross
      margin due to the absorption of fixed manufacturing costs. The increase in
      optical memory card gross margin to 46% of revenue for fiscal year 2006 as
      compared with 26% of revenue for fiscal year 2005 is mainly due to the 49%
      increase in production unit volume and 64% increase in sales unit volume with
      minimal increase in fixed costs. This was also augmented by increases in
      production efficiency and yields. The 30% sales unit volume increase for fiscal
      year 2005 as compared with fiscal year 2004 did not result in an increase in
      gross margin due largely to the increase in fixed costs to increase card
      manufacturing capacity for anticipated orders of cards made with the newly
      introduced sheet-lamination process.





*Optical
      Card Drives.* Except
      for the large read/write drive order from the U.S. government in the third
      quarter of fiscal year 2004, read/write drive gross profits have been negative,
      inclusive of fixed overhead costs, due to low sales volume and the Company’s
      policy to price drives close to manufacturing cost to promote card sales. The
      Company anticipates that read/write drive negative gross margins will continue
      in the future unless sales volume is sufficient to cover fixed costs. The
      Company believes sales volume will increase during fiscal year 2007 resulting
      in
      a positive gross margin of about 10%. During fiscal year 2005, the Company
      incurred approximately $0.3 million in costs to convert model 780 to model
      Q-600
      drives. The negative gross profit decreased from year to year because there
      was
      no similar cost in fiscal year 2006.





*Specialty
      cards and card printers.* The
      gross margin on specialty cards and card printers was 25% in both fiscal year
      2006 and 2005. Fiscal year 2005 was the first year the Company operated in
      this
      segment. Historically, the quarterly gross margin has ranged from 21% to
      31%.





**Operating
      expenses**





The
      following table presents operating expenses (in thousands):






**Fiscal
                Year****2006**
            
            **2005**
            
            **2004**Selling,
                general and administrative expenses
            
            $
            11,949
            
            $
            11,891
            
            $
            6,700Research
                and engineering expenses
            
            $
            2,338
            
            $
            3,018
            
            $
            2,620





*Selling,
      General, and Administrative Expenses (SG&A).* SG&A
      expenses were essentially flat in fiscal year 2006 as compared with fiscal
      year
      2005 even as the Company’s revenues increased almost 40%. Fiscal year 2006
      SG&A expenses increased due to a $0.7 million management bonus accrual, and
      decreased in almost every other spending category. In addition, the $0.2 million
      on exchange rate fluctuations on debt incurred in fiscal year 2005 was not
      repeated in fiscal year 2006. The $5.2 million increase for fiscal year 2005
      as
      compared with fiscal year 2004 includes $2.8 million from the acquired German
      companies, $1 million for additional costs for legal, accounting, auditing,
      and
      the cost of compliance with assessing internal control over financial reporting
      mandated by Section 404 of the





36





Sarbanes-Oxley
      Act of 2002, $0.4 million for increased marketing, selling, and customer service
      expenditures, $0.2 million on exchange rate fluctuations on debt that has
      subsequently been extinguished, $0.3 million for occupancy costs, $0.2 million
      for increases in investor relations expenditures, and $0.3 million in other
      miscellaneous expenses. The Company believes that SG&A expenses for fiscal
      year 2007 will be higher than fiscal year 2006 levels, mainly due to increases
      in marketing and selling expenses and the implementation costs for a new
      enterprise resource planning (ERP) system.





*Research
      and Engineering Expenses (R&E)* .
      The
      Company is continuing its efforts to develop new optical memory card features
      and structures, including various sheet-lamination card structures, the
      insertion of contactless chips with radio frequency (RF) capability,
      OptiChipTM ,
      OVD
      (optically variable device) products, and associated media development; enhanced
      optical memory card read/write drives and read-only drives (readers); and new
      software products in an effort to provide new products that can stimulate
      optical memory card sales growth. For example, the Company recently has
      developed a prototype of a LaserCard® handheld reader that is being evaluated by
      value-added resellers. The Company anticipates that these ongoing research
      and
      engineering efforts will result in new or enhanced card capabilities,
      production-model read-only drives, or drives with advanced security features
      and
      lower manufacturing costs; however, there is no assurance that such product
      development efforts will be successful. These features are important for the
      Company’s existing and future optical memory card markets. The decrease in
      R&E spending for fiscal year 2006 as compared with fiscal year 2005 was
      primarily due to the completion of major spending for the first prototype
      LaserCard® portable reader, coupled with being between phases of the new card
      media development project and the completion of card material and other
      projects. The increase in R&E spending for fiscal year 2005 compared with
      fiscal year 2004 was mainly due to R&E expenditures by the acquired German
      entity. Increases in R&E expenses are anticipated for fiscal year 2007 for
      development of production-model read-only drives, optical memory card media
      development, and other card and hardware related programs.





*Other
      Income, Net* .
      Total
      net other income for fiscal year 2006 was $471,000 including $583,000 of
      interest income, partially offset by interest expense of $80,000 and $32,000
      for
      other miscellaneous expenses net of other miscellaneous income. Total net other
      income for fiscal year 2005 was $240,000 of interest income. Total net other
      income for fiscal year 2004 was $176,000, consisting of $269,000 of interest
      income, offset by $93,000 of expense recorded to mark-to-market the fair value
      of common stock options and warrants issued in December 2003. The increase
      in
      interest income for fiscal year 2006 compared with fiscal year 2005 was
      primarily due to income from invested funds. The decrease in interest income
      for
      fiscal year 2005 compared with fiscal year 2004 was primarily due to the
      reduction in invested funds.




*Income
      Taxes.* The
      Company recorded an income tax expense of $443,000 for fiscal year 2006,
      $139,000 for fiscal year 2005, and $7.1 million for fiscal year 2004. The
      Company’s income tax expense for fiscal year 2006 was primarily due to federal
      and state alternative minimum taxes. ** The
      Company’s income tax expense for fiscal year 2005 was mainly due to federal
      alternative minimum tax. The payments from GIG received during fiscal years
      2006
      and 2005 are recorded as income on the federal tax return even though they
      are
      not recorded as income under U.S. generally accepted accounting principles.
      This
      income has been offset by net operating loss carryforwards generated in previous
      years. However, alternative minimum taxes are due on this income. The Company’s
      income tax expense for fiscal year 2004 was due to increasing the valuation
      allowance to be equal to the remaining balance of the Company’s deferred tax
      asset. The fiscal year 2004 income tax expense was not a cash item and did
      not
      mean that the Company owed income taxes, but rather that it no longer could
      demonstrate that in the future it would likely be able to utilize the tax
      benefits of previously generated net operating losses. The
      methodology for determining the realizability of its deferred tax asset is
      a
      critical accounting policy as described under the heading "Critical Accounting
      Policies" under Item 7. In summary, this methodology considers positive and
      negative evidence regarding the Company's ability to generate sufficient future
      taxable income to realize its deferred tax assets. Due to the Company's
      cumulative tax loss history for the three-year period ending March 31, 2004,
      income statement loss history over the five quarters ended March 31, 2004,
      and
      the difficulty in forecasting the timing of future revenue which could lead
      to
      positive income on its financial statements and taxable income as evidenced
      by
      the deviations in achieved revenues from expected revenues and taking into
      account the newness of certain customer relationships, the Company determined
      it
      was necessary to increase the valuation allowance under SFAS No. 109 to the
      full
      amount of the deferred tax asset because its estimated future revenue taking
      into account only booked orders would not generate sufficient taxable income
      to
      realize any of its deferred tax assets. If the Company has taxable income in
      the
      future, any unexpired net operating loss income tax carry-forward amounts will
      be utilized to reduce otherwise required income tax payments, and future tax
      expense, up to the full amount of the net deferred tax asset which is currently $19.5
      million. In future years, unless the valuation allowance is reduced, should
      the
      Company be profitable for income tax purposes, the Company will utilize its
      available net operating loss carryforwards to reduce the income tax it would
      otherwise owe, meaning that its federal effective tax rate will be zero except
      for alternative minimum taxes.





37








LIQUIDITY
      AND CAPITAL RESOURCES





The
      following table summarizes cash, cash equivalents and investments as of March
      31, (in thousands):




2006
              
              2005Cash,
                  cash equivalents and short-term investments
              
              $
              23,471
              
              $
              10,115Cash,
                  cash equivalents, short-term and long-term investments
              
              $
              23,471
              
              $
              16,415





Cash,
      cash equivalents, and investments increased during fiscal year 2006 primarily
      due to the $5 million generated by operating activities and the proceeds from
      the exercise of employee stock options in the amount of $4.4 million, offset
      by
      the purchase of property and equipment of $2.3 million.





The
      following table displays the sources and uses of cash by activity (in
      thousands):





Fiscal
                  Year2006
              
              2005
              
              2004Net
                  cash provided by (used in) operating activities
              
              $
              5,048
              
              $
              2,955
              
              $
              (2
              )Net
                  cash provided by (used in) investing activities
              
              $
              (11,318
              )
              $
              2,523
              
              $
              (10,544
              )Net
                  cash provided by (used in) financing activities
              
              $
              4,432
              
              $
              (3,896
              )
              $
              11,080





Cash
      provided by operations of $5 million in fiscal 2006 primarily consists of $3.7
      million received from GIG, net of equipment purchased for this contract, plus
      $4.3 million from net income, plus non-cash charges for depreciation, excess
      and
      obsolete inventory, warranty reserves, stock-based compensation, and tax
      benefits related to the stock options. Additionally, advance payments received
      from customers totaled $6.1 million, offset by changes in accounts receivable,
      inventories, deferred contract costs, equipment held for resale, accounts
      payable and accrued liabilities of $5.6 million.





Net
      cash
      used in investing activities of $11.3 million during fiscal 2006 consisted
      of an
      increase in investments of $8.9 million and capital expenditures of
      approximately $2.4 million.





Net
      cash
      provided by financing activities during fiscal 2006 was $4.4 million, which
      consisted of net proceeds from the sale of common stock under the Company’s
      stock plans.





The
      Company believes that the estimated level of revenues and customer advance
      payments over the next 12 months will be sufficient to generate cash from
      operating activities over the same period. However, quarterly fluctuations
      are
      expected. Operating cash flows could be negatively impacted to a significant
      degree if either of the Company’s largest U.S. government programs were to be
      delayed, reduced, canceled, or not extended; if the Italian CIE card program
      does not grow as planned internally; and if these programs are not replaced
      by
      other card orders or other sources of income, or if increases in product
      revenues or licenses do not keep pace with increased marketing and R&E and
      capital expenditures.





The
      Company has not established a line of credit and has no current plans to do
      so.
      The Company may negotiate a line of credit if and when it becomes appropriate,
      although no assurance can be made that such financing would be available on
      favorable terms or at all, if needed.





As
      a
      result of the $0.8 million net income recorded for fiscal year 2006, the
      Company’s accumulated deficit decreased from $27.1 million to $26.4 million.
      Stockholders’ equity increased to $32.0 million from $26.7 million as a result
      of the net income and issuance of common stock.





Net
      cash
      used in investing activities was $11.3 million for fiscal year 2006 compared
      with cash provided by investing activities of $2.5 million for fiscal year
      2005
      and cash used in investing activities of $10.5 million for fiscal year 2004.
      Purchases of property and equipment accounted for $2.3 million for fiscal year
      2006, $3.3 million in fiscal year 2005, and $4 million in fiscal year 2004.
      The
      purchase of the two German companies, Challenge Card Design Plastikkarten GmbH
      and cards & more GmbH during fiscal year 2004 accounted for $3.1 million of
      cash used in investing activities. The balance of the changes was mainly due
      to
      the maturities and purchases of investments.





38








The
      Company considers all highly liquid investments, consisting primarily of
      commercial paper, discount notes, and U.S. government bonds, with original
      or
      remaining maturities of three months or less at the date of purchase, to be
      cash
      equivalents. All investments with original or remaining maturities of more
      than
      three months but not more than one year at the date of purchase are classified
      as short-term. Investments with original or remaining maturities of more than
      one year at the date of purchase are classified as long-term. The Company
      determines the length of its investments after considering its cash requirements
      and yields available for the type of investment considered by the Company.
      Management also determines the appropriate classification of debt and equity
      securities at the time of purchase and reevaluates the classification of
      investments as of each balance sheet date. As of March 31, 2006 the Company
      had
      $21.4 million classified as short-term investments and had no long-term
      investment, compared with $6.2 million classified as short-term investments
      and
      $6.3 million classified as long-term investments at March 31, 2005. All auction
      rate securities are accounted for as available-for-sale and all other
      interest-bearing securities are accounted for as held-to-maturity.





The
      Company made capital equipment and leasehold improvement purchases of
      approximately $2.3 million during fiscal year 2006 compared with approximately
      $3.3 million during fiscal year 2005 and $4 million during fiscal year 2004.
      The
      Company's current card capacity, assuming optimal card type mix, is estimated
      at
      approximately 16 million cards per year. The Company plans to purchase
      additional production equipment in a series of steps when deemed appropriate
      by
      the Company. The Company is also increasing production capacity for cards with
      new structures used by the programs in Canada, Italy, and a Middle Eastern
      country. In addition to investment used for expansion, the Company plans to
      make
      additional capital expenditures which are expected to yield cost savings,
      quality improvements, and other purposes. The Company plans to use cash on
      hand
      and cash generated from operations to fund capital expenditures of approximately
      $9 million for equipment and leasehold improvements for card production,
      read/write drive tooling and assembly, and general support items as customer
      orders justify the investment. These expenditures could occur throughout the
      next twelve months.





On
      March
      31, 2004, the Company completed its acquisition of two related German card
      companies, Challenge Card Design Plastikkarten GmbH of Rastede, Germany, and
      cards & more GmbH of Ratingen, Germany (collectively, the Acquired German
      Entities), including their sales operations in the United States and Korea.
      The
      Company purchased the shares of the Acquired German Entities from their five
      shareholders (the Shareholders) and purchased assets of the United States sales
      operation from a partnership comprised of the Shareholders. In the acquisition
      transaction, the Company agreed to assume 0.5 million euros of debt and to
      pay
      approximately 4.8 million euros in cash, consisting of approximately 2.3 million
      euros payable at closing and the remaining approximately 2.5 million euros
      payable in five equal annual installments for the business and certain assets.
      Subsequently, in January 2005, the Company determined that it would be in its
      best interest to eliminate this debt and pay the net present value of this
      debt
      to the selling shareholders. The acquisition agreement specified that the
      purchase price be adjusted based upon other assets purchased and additional
      liabilities assumed. This resulted in a reduction in the purchase price of
      approximately 0.4 million euros as of March 31, 2004. The present value of
      the
      net total purchase price is $5.5 million. This purchase price was determined
      by
      negotiation between the Company and the Shareholders, taking into account such
      matters as the value of the tangible assets and the going concern value of
      the
      business operations of the Acquired German Entities. Four of the Shareholders
      entered into new employment agreements with the Acquired German Entities while
      the fifth Shareholder, who is resident in the U.S., entered into an employment
      agreement with registrant. In addition to salaries, these employment agreements
      provide for commission based upon the future results of operations of the
      Acquired German Entities, which could be as much as 3.8 million euros over
      a
      four year period. The Company used a portion of its available cash to fund
      the
      acquisition. The Shareholders had no previous material relationship with the
      Company or its affiliate or subsidiaries, although the Company did substantial
      business with the Acquired German Entities in recent years. One of the Acquired
      German Entities owns a plant in Rastede, Germany together with associated
      equipment that manufactures plastic cards featuring contactless IC chip
      technology and high resolution printing. The Company intends to continue to
      use
      the facility and equipment to produce such cards as well as to enhance the
      facility to produce LaserCard® optical memory cards in Germany.  This
      will
      enable that company to manufacture cards featuring four of the key ID card
      technologies (optical memory, contact IC chip, contactless RFID, and magnetic
      stripe) either singly or in combination, along with other high-security
      features.





39








Net
      cash
      provided by financing activities was $4.4 million in fiscal year 2006 versus
      $3.9 million used in financing activities in fiscal year 2005 and $11.1 million
      provided by financing activities for fiscal year 2004. Proceeds on sales of
      common stock through the Company’s stock-option and stock-purchase plans were $
      4.4 million for fiscal year 2006, $0.3 million for fiscal year 2005; and $1.7
      million for fiscal year 2004. During fiscal year 2005 the Company used cash
      in
      the amount of $3.6 million to retire debt attributable to the acquisition of
      Challenge Card Design GmbH and cards & more GmbH on March 31, 2004. Fiscal
      year 2004 financing activities consisted of proceeds from the equity private
      placement described in the following paragraph.





The
      Company received net proceeds of $9.4 million (net of fees and expenses) from
      the issuance and sale in December 2003 of 791,172 shares of common stock,
      options to purchase 122,292 shares of common stock, and warrants to purchase
      174,057 shares of common stock for an aggregate purchase price of $10.1 million
      in a private placement. The purchase price of the common stock was $12.76 per
      share, which was a 15% discount from the five-day average price as of December
      23, 2003. The options have an exercise price of $16.51 per share and a
      nine-month life. The warrants have an exercise price of $17.26 per share and
      a
      life of five years. The options and warrants were valued at $245,000 and
      $984,000, respectively, based on a Black-Scholes calculation as of December
      23,
      2003 and pursuant to the provisions of EITF
      Issue No. 00-19, “Accounting
      for Derivative Financial Instruments Indexed to, and Potentially Settled in,
      a
      Company's Own Stock,” (EITF 00-19) were recorded at those values in long-term
      liabilities. The balance of the net proceeds was accounted for as additional
      paid in capital. Under EITF 00-19, the Company marks-to-market the fair value
      of
      the options and warrants at the end of each accounting period. At the end of
      the
      fiscal year 2004 third quarter, this resulted in options and warrants valued
      at
      $195,000 and $916,000, respectively. The decrease in valuation of the options
      and warrants between December 23, 2003 and the quarter end of $118,000 was
      recorded as other income in the accompanying Condensed Consolidated Statement
      of
      Operations and resulted from a decrease in the Company’s stock price. On
      February 6, 2004, the Company and the investors entered into an amendment to
      their original agreement that resulted in the reclassification of the options
      and warrants to equity. The amendment clarified that the options and warrants
      granted in the financing may be exercised at a time when a registration
      statement covering the resale of the underlying shares is not effective or
      available and that in such instance the Company would deliver to the investors
      shares of common stock whose resale is not currently registered. On the
      effective date of the amendment, the options and warrants were reclassified
      to
      equity as additional paid-in-capital. As a result of the increase in value
      of
      the options and warrants from the previous quarter end to the amendment date,
      due to increases in the Company’s stock price, the Company recognized an expense
      of $211,000, which is included in other expense in the Condensed Consolidated
      Statement of Operations in the fourth quarter of fiscal year 2004.





On
      January 23, 2004, the Company filed an S-3 Registration Statement with the
      Securities and Exchange Commission covering the resale of the common stock
      issued and issuable in such financing. The Securities and Exchange Commission
      declared the registration statement effective on April 28, 2004. The Company
      is
      subject to certain indemnity provisions included in the stock purchase agreement
      entered into as part of the financing associated with this registration. Morgan
      Keegan & Company, Inc. acted as the Company's exclusive placement agent for
      this transaction. The Company used approximately $3 million of the net proceeds
      from this private placement in connection with the purchase of CCD and
      C&M.





During
      fiscal year 2005, the Company commenced a share repurchase program under which
      up to 350,000 shares of common stock could be purchased by the Company from
      time
      to time in Nasdaq Stock Market transactions in an aggregate amount not exceeding
      $3 million. During the second quarter of fiscal year 2005, the Company used
      cash of $655,000 for this purpose and has since terminated this program without
      further activity.





There
      were no debt financing activities for fiscal year 2006. The Company acquired
      bank debt in the amount of $1.4 million in the fiscal year 2004 acquisition
      of
      Challenge Card Design Plastikkarten GmbH and cards & more GmbH, of Germany.
      The Company extinguished this debt during fiscal year 2005. In addition, the
      Company incurred debt with a net present value of future payments on this
      acquisition of $2.2 million on this transaction as of March 31, 2004. The
      Company extinguished this debt during fiscal year 2005.








40





The
      following table provides a summary of the effect on liquidity and cash flows
      from the Company’s contractual obligations as of March 31, 2006 (in
      thousands):





Fiscal
                Year2007
            
            2008
            
            2009
            
            2010
            
            2011
            
            2012
                andThereafter
            
            TotalContractual
                obligations:
              Non-cancelable
                operating leases
            
            $
            1,164
            
            $
            1,054
            
            $
            998
            
            $
            1,382
            
            $
            1,415
            
            $
            4,196
            
            $
            10,209Non-cancelable
                purchase orders
            
            
            1,734
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,734Total
            
            $
            2,898
            
            $
            1,054
            
            $
            998
            
            $
            1,382
            
            $
            1,415
            
            $
            4,196
            
            $
            11,943





OFF-BALANCE
      SHEET ARRANGEMENTS





The
      Company has no off-balance sheet arrangement that has or is reasonably likely
      to
      have a current or future effect on our financial condition, changes in financial
      condition, revenues or expenses, results of operations, liquidity, capital
      expenditures, or capital resources that is material to investors.





ITEM
      7A.  QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS





*Interest
      Rate Risk.* The
      Company invests its cash, beyond that needed for daily operations, in high
      quality debt securities. In doing so, the Company seeks primarily to preserve
      the value and liquidity of its capital and, secondarily, to safely earn income
      from these investments. To accomplish these goals, the Company invests only
      in
      debt securities issued by (a) the U.S. Treasury and U.S. government agencies,
      state agencies and corporations and (b) debt instruments that meet the following
      criteria:





o
            Commercial
                paper rated A1/P1 or debt instruments rated AAA, as rated by the
                major
                rating services


o
            Can
                readily be sold for cash





Investments
      in both fixed rate and floating rate interest earning instruments carry a degree
      of interest rate risk. Fixed rate securities may have their fair market value
      adversely impacted because of a rise in interest rates, while floating rate
      securities may produce less income than expected if interest rates fall. Due
      in
      part to these factors, the Company’s future investment income may fall short of
      expectations because of changes in interest rates or we may suffer losses in
      principal if forced to sell securities that have seen a decline in market value
      because of changes in interest rates.





There
      were no material changes during the fourth quarter of fiscal year 2006 in the
      Company's exposure to market risk for changes in interest rates.




The
      following summarizes short-term investments at fair value, weighted average
      yields and expected maturity dates as of March 31, 2006 (in
      thousands):





Fiscal
                Year2007Auction
                rate securities
            
            $
            15,050Weighted
                Average Yield
            
            
            4.74
            %U.S.
                Government and Agency Obligations
            
            
            6,264Weighted
                Average Yield
            
            
            2.67
            %Total
                Investments
            
            $
            21,314





There
      were no long-term investments as of March 31, 2006.





41








*Foreign
      Currency Exchange Rate Risk.* The
      Company’s U.S. Operations sell products in various international markets. To
      date an immaterial amount of sales have been denominated in euros. In addition,
      some raw material purchases and purchased services are denominated in euros.
      As
      of March 31, 2006, the outstanding balance of a debt relating to the acquisition
      of Challenge Card Design Plastikkarten GmbH (“CCD”) was immaterial. Accordingly,
      the exchange rate risk related to this debt is minimal. Since acquisition,
      cash
      provided by/used in CCD’s operating activities has been immaterial.





The
      Company uses short-term foreign exchange forward contracts to mitigate foreign
      currency risk associated primarily with inter-company payables, account, and
      loan receivables (denominated in Euros) to its German subsidiaries.  Our
      foreign exchange forward contracts are not designated for accounting purposes
      as
      hedging instruments under SFAS No. 133, “Accounting for Derivative Instruments
      and Hedging Activities,” as amended.  Accordingly, any gains or losses
      resulting from changes in the fair value of the forward contract are reported
      in
      selling, general and administrative expenses.  The gains and losses on
      these forward contracts generally offset gains and losses associated with the
      underlying foreign currency denominated inter-company payable, account, and
      loan
      receivables.  At March 31, 2006, we had a foreign exchange forward contract
      with a maturity of less than 30 days to purchase 1.9 million euros. The
      fair value of the forward contract was not material at March 31,
      2006.





42





ITEM
      8. FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA




REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To
      the
      Board of Directors and Stockholders of


LaserCard
      Corporation





We
      have
      audited management’s assessment, included in the accompanying Management Report
      on Internal Controls Over Financial Reporting included in Item 9A, that
      LaserCard Corporation and its subsidiaries maintained effective internal control
      over financial reporting as of March 31, 2006, based on criteria established
      in *Internal
      Control—Integrated Framework* issued
      by
      the Committee of Sponsoring Organizations of the Treadway Commission (the COSO
      criteria). The Company’s management is responsible for maintaining effective
      internal control over financial reporting and for its assessment of the
      effectiveness of internal control over financial reporting. Our responsibility
      is to express an opinion on management’s assessment and an opinion on the
      effectiveness of the Company’s internal control over financial reporting based
      on our audit.





We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether effective
      internal control over financial reporting was maintained in all material
      respects. Our audit included obtaining an understanding of internal control
      over
      financial reporting, evaluating management’s assessment, testing and evaluating
      the design and operating effectiveness of internal control, and performing
      such
      other procedures as we considered necessary in the circumstances. We believe
      that our audit provides a reasonable basis for our opinion.





A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company’s internal control over
      financial reporting includes those policies and procedures that (1) pertain
      to the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company;
      (2) provide reasonable assurance that transactions are recorded as
      necessary to permit preparation of financial statements in accordance with
      generally accepted accounting principles, and that receipts and expenditures
      of
      the company are being made only in accordance with authorizations of management
      and directors of the company; and (3) provide reasonable assurance
      regarding prevention or timely detection of unauthorized acquisition, use,
      or
      disposition of the company’s assets that could have a material effect on the
      financial statements.





Because
      of the inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of the
      effectiveness to future periods are subject to the risk that the controls may
      become inadequate because of changes in conditions, or that the degree of
      compliance with the policies or procedures may deteriorate.





In
      our
      opinion, management’s assessment that the Company maintained effective internal
      control over financial reporting as of March 31, 2006, is fairly stated, in
      all
      material respects, based on the COSO criteria. Also, in our opinion, the Company
      maintained, in all material respects, effective internal control over financial
      reporting as of March 31, 2006, based on the COSO criteria.





We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets of LaserCard
      Corporation and its subsidiaries at March 31, 2006 and 2005, and the related
      consolidated statements of operations, stockholders’ equity and comprehensive
      income (loss), and cash flows for the years then ended and our report dated
      May
      15, 2006, expressed an unqualified opinion thereon.











/s/
      Odenberg Ullakko Muranishi & Co. LLP


San
      Francisco, California


May
      15,
      2006








43








REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM











The
      Board
      of Directors and Stockholders of


LaserCard
      Corporation





We
      have
      audited the accompanying consolidated balance sheets of LaserCard Corporation
      and its subsidiaries as of March 31, 2006 and 2005, and the related consolidated
      statements of operations, stockholders' equity and comprehensive income (loss),
      and cash flows for the years then ended. These financial statements are the
      responsibility of the Company's management. Our responsibility is to express
      an
      opinion on these financial statements based on our audits.





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





In
      our
      opinion, the consolidated financial statements audited by us  present
      fairly, in all material respects, the consolidated financial position of
      LaserCard Corporation and its subsidiaries at March 31, 2006 and 2005, and
      the
      consolidated results of their operations and their cash flows for the years
      then
      ended , in
      conformity with U.S. generally accepted accounting principles.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of LaserCard Corporation
      and
      its subsidiaries' internal control over financial reporting as of March 31,
      2006, based on criteria established in Internal Control—Integrated Framework
      issued by the Committee of Sponsoring Organizations of the Treadway Commission
      and our report dated May 15, 2006, expressed an unqualified opinion
      thereon.








/s/
      Odenberg Ullakko Muranishi & Co. LLP


San
      Francisco, California


May
      15,
      2006





44








REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM











The
      Board
      of Directors and Stockholders


LaserCard
      Corporation:





We
      have
      audited the accompanying consolidated statements of operations, stockholders’
equity and comprehensive income (loss), and cash flows of LaserCard Corporation
      (formerly Drexler Technology Corporation) and subsidiaries for the year ended
      March 31, 2004. These consolidated financial statements are the responsibility
      of the Company's management. Our responsibility is to express an opinion on
      these consolidated financial statements based on our audit.





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





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the results of operations and cash flows of LaserCard
      Corporation and subsidiaries for the year ended March 31, 2004, in conformity
      with accounting principles generally accepted in the United States of
      America.








/s/
      KPMG
      LLP


Mountain
      View, California


June
      9,
      2004, except for note 2.(8.) which


is
      as of
      June 14 , 2006.








45





LASERCARD
      CORPORATION AND SUBSIDIARIES


CONSOLIDATED
      BALANCE SHEETS


March
      31,
      2006 and 2005


(In
      thousands, except share and per share amounts)





2006
            
            2005ASSETSCurrent
                assets:Cash
                and cash equivalents
            
            $
            2,121
            
            $
            3,965Short-term
                investments
            
            
            21,350
            
            
            6,150Accounts
                receivable, net of allowances of $142 at March 31, 2006 and $56 at
                March
                31, 2005
            
            
            4,920
            
            
            1,934Inventories,
                net of reserves of $503 at March 31, 2006 and $648 at March 31,
                2005
            
            
            8,874
            
            
            7,909Deferred
                contract cost
            
            
            1,041
            
            
            —Prepaid
                and other current assets
            
            
            1,268
            
            
            1,352Total
                current assets
            
            
            39,574
            
            
            21,310Property
                and equipment, net
            
            
            12,306
            
            
            12,532Long-term
                investments
            
            
            —
            
            
            6,300Equipment
                held for resale
            
            
            5,877
            
            
            4,061Patents
                and other intangibles, net
            
            
            889
            
            
            923Goodwill
            
            
            3,321
            
            
            3,321Note
                receivable
            
            
            205
            
            
            220Other
                non-current assets
            
            
            163
            
            
            101Total
                assets
            
            $
            62,335
            
            $
            48,768LIABILITIES
                AND STOCKHOLDERS' EQUITYCurrent
                liabilities:Accounts
                payable
            
            $
            3,311
            
            $
            2,105Accrued
                liabilities
            
            
            3,118
            
            
            2,312Deferred
                tax liabilities
            
            
            568
            
            
            641Advance
                payments from customers
            
            
            1,772
            
            
            1,167Deferred
                revenue
            
            
            459
            
            
            539Total
                current liabilities
            
            
            9,228
            
            
            6,764Advance
                payments from customer
            
            
            18,500
            
            
            13,000Deferred
                revenue
            
            
            2,000
            
            
            2,000Deferred
                rent
            
            
            590
            
            
            326Total
                liabilities
            
            
            30,318
            
            
            22,090Commitments
                and contingencies (Note 7)Stockholders'
                equity:Preferred
                stock, $0.01 par value:Authorized—2,000,000
                sharesIssued—none
            
            
            —
            
            
            —Common
                stock, $0.01 par value:Authorized—30,000,000
                sharesIssued
                and outstanding—11,734,255 shares at March 31, 2006 and 11,436,794 shares
                at March 31, 2005
            
            
            117
            
            
            114Additional
                paid-in capital
            
            
            58,255
            
            
            54,155Accumulated
                deficit
            
            
            (26,351
            )
            
            (27,145
            )Accumulated
                other comprehensive income (loss)
            
            
            (4
            )
            
            209Treasury
                stock at cost — 0 shares at March 31, 2006 and 91,630 shares at March 31,
                2005
            
            
            —
            
            
            (655
            )Total
                stockholders' equity
            
            
            32,017
            
            
            26,678Total
                liabilities and stockholders’ equity
            
            $
            62,335
            
            $
            48,768





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








46








LASERCARD
      CORPORATION AND SUBSIDIARIES


CONSOLIDATED
      STATEMENTS OF OPERATIONS


Fiscal
      Years Ended March 31, 2006, 2005, and 2004


(In
      thousands, except per share amounts)








2006
            
            2005
            
            2004Total
                revenues
            
            $
            39,857
            
            $
            28,544
            
            $
            16,963Cost
                of product sales
            
            
            24,804
            
            
            22,637
            
            
            13,157Gross
                profit
            
            
            15,053
            
            
            5,907
            
            
            3,806Operating
                expenses:Selling,
                general and administrative expenses
            
            
            11,949
            
            
            11,891
            
            
            6,700Research
                and engineering expenses
            
            
            2,338
            
            
            3,018
            
            
            2,620Total
                operating expenses
            
            
            14,287
            
            
            14,909
            
            
            9,320Operating
                income (loss)
            
            
            766
            
            
            (9,002
            )
            
            (5,514
            )Other
                income, net
            
            
            471
            
            
            240
            
            
            176Income
                (loss) before income taxes
            
            
            1,237
            
            
            (8,762
            )
            
            (5,338
            )Income
                tax expense
            
            
            443
            
            
            139
            
            
            7,089Net
                income (loss)
            
            $
            794
            
            $
            (8,901
            )
            $
            (12,427
            )Net
                income (loss) per share:Basic
            
            $
            0.07
            
            $
            (0.78
            )
            $
            (1.15
            )Diluted
            
            $
            0.07
            
            $
            (0.78
            )
            $
            (1.15
            )Weighted-average
                  shares used incomputing
                  net income (loss) per share:Basic
            
            
            11,415
            
            
            11,362
            
            
            10,761Diluted
            
            
            11,587
            
            
            11,362
            
            
            10,761





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





47











LASERCARD
                  CORPORATION AND SUBSIDIARIESCONSOLIDATED
                  STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
                  (LOSS)Fiscal
                  Years Ended March 31, 2004, 2005, and 2006(In
                  thousands)Common
                  Stock
              
              
              
              Additional
                  Paid-in
              
              Accumulated
                Income
              
              Accumulated
                  Other Comprehensive
              
              Treasury
                  Stock
              
              
              
              Total
                  Stockholders'
              
              ComprehensiveShares
              
              Amount
              
              Capital
              
              (Deficit)
              
              Income
                  (loss)
              
              Shares
              
              Amount
              
              Equity
              
              Income
                  (loss)Balance,
                  March 31, 2003
              
              
              10,443
              
              $
              104
              
              $
              42,556
              
              $
              (5,817
              )
              $
              —
              
              
              —
              
              $
              —
              
              $
              36,843Shares,
                  warrants, and options sold in private placement, net of $706 in
                  issuance
                  costs and $93 for change in fair value of common stock warrants
                  and
                  options
              
              
              791
              
              
              8
              
              
              9,474
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              9,482Shares
                  issued under stock option and stock purchase plans
              
              
              166
              
              
              2
              
              
              1,689
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,691Compensation
                  related to stock plan activity
              
              
              —
              
              
              —
              
              
              97
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              97Comprehensive
                  loss:Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              (12,427
              )
              
              —
              
              
              —
              
              
              —
              
              
              (12,427
              )
              $
              (12,427
              )Balance,
                  March 31, 2004
              
              
              11,400
              
              $
              114
              
              $
              53,816
              
              $
              (18,244
              )
              
              —
              
              
              —
              
              
              —
              
              $
              35,686Purchase
                  of treasury stock
              
              
              ―
              
              
              ―
              
              
              ―
              
              
              —
              
              
              —
              
              
              (92
              )
              
              (655
              )
              
              (655
              )Shares
                  issued under stock option and stock purchase plans
              
              
              37
              
              
              —
              
              
              252
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              252Compensation
                  related to stock plan activity
              
              
              —
              
              
              —
              
              
              87
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              87Comprehensive
                  loss:Foreign
                  currency translation adjustments
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              209
              
              
              —
              
              
              —
              
              
              209
              
              $
              209Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              (8,901
              )
              
              —
              
              
              —
              
              
              —
              
              
              (8,901
              )
              
              (8,901
              )Total
                  comprehensive loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              (8,692
              )Balance,
                  March 31, 2005
              
              
              11,437
              
              $
              114
              
              $
              54,155
              
              $
              (27,145
              )
              $
              209
              
              
              (92
              )
              $
              (655
              )
              $
              26,678Shares
                  issued under stock option and stock purchase plans and related
                  income tax
                  benefits
              
              
              297
              
              
              3
              
              
              3,977
              
              
              —
              
              
              —
              
              
              92
              
              
              655
              
              
              4,635Compensation
                  related to stock plan activity
              
              
              ―
              
              
              ―
              
              
              123
              
              
              ―
              
              
              ―
              
              
              ―
              
              
              ―
              
              
              123Comprehensive
                  loss:Foreign
                  currency translation adjustments
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (213
              )
              
              —
              
              
              —
              
              
              (213
              )
              $
              (213
              )Net
                  income
              
              
              —
              
              
              —
              
              
              —
              
              
              794
              
              
              —
              
              
              —
              
              
              —
              
              
              794
              
              
              794Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              581Balance,
                  March 31, 2006
              
              
              11,734
              
              $
              117
              
              $
              58,255
              
              $
              (26,351
              )
              $
              (4
              )
              
              —
              
              $
              —
              
              $
              32,017The
                  accompanying notes are an integral part of these consolidated financial
                  statements.











48





LASERCARD
                  CORPORATION AND SUBSIDIARIESCONSOLIDATED
                  STATEMENTS OF CASH FLOWSFiscal
                  Years Ended March 31, 2006, 2005, and 2004(In
                  thousands)2006
              
              2005
              
              2004Cash
                  flows from operating activities:Net
                  income (loss)
              
              $
              794
              
              $
              (8,901
              )
              $
              (12,427
              )Adjustments
                  to reconcile net income (loss) to net cashprovided
                  by (used in) operating activities:Depreciation
                  and amortization
              
              
              2,515
              
              
              2,640
              
              
              2,123Loss
                  on disposal of equipment
              
              
              21
              
              
              10
              
              
              -Provision
                  for doubtful accounts receivable
              
              
              34
              
              
              3
              
              
              1Provision
                  for excess and obsolete inventory
              
              
              194
              
              
              335
              
              
              97Provision
                  for product return reserve
              
              
              78
              
              
              62
              
              
              -Provision
                  for warranty reserve
              
              
              516
              
              
              -
              
              
              -Decrease
                  in deferred income tax assets
              
              
              -
              
              
              -
              
              
              7,086Stock-based
                  compensation
              
              
              130
              
              
              111
              
              
              97Tax
                  benefit relating to the exercise of stock options
              
              
              196
              
              
              -
              
              
              -Loss
                    associated with increase in fair value of common stockwarrants
                    and options
              
              
              -
              
              
              -
              
              
              93Changes
                    in operating assets and liabilities, net of assets acquired andand
                    liabilities assumed in business combination:Decrease
                  (increase) in accounts receivable
              
              
              (3,216
              )
              
              559
              
              
              346Increase
                  in inventories
              
              
              (1,238
              )
              
              (1,361
              )
              
              (1,476
              )Decrease
                  (increase) in deferred contract costs
              
              
              (1,041
              )
              
              -
              
              
              -Decrease
                  (increase) in prepaid and other current assets
              
              
              47
              
              
              (61
              )
              
              63Increase
                  in equipment held for resale
              
              
              (1,816
              )
              
              (1,641
              )
              
              -Increase
                  in other non-current assets
              
              
              (62
              )
              
              -
              
              
              -Increase
                  (decrease) in accounts payable and accrued liabilities
              
              
              1,587
              
              
              (1,751
              )
              
              2,305Decrease
                  in deferred income tax liabilities
              
              
              (30
              )
              
              -
              
              
              -Increase
                  (decrease) in deferred revenue
              
              
              (46
              )
              
              2,413
              
              
              106Increase
                  in deferred rent
              
              
              265
              
              
              -
              
              
              -Increase
                  in advance payments from customers
              
              
              6,120
              
              
              10,537
              
              
              1,584Net
                  cash provided by (used in) operating activities
              
              
              5,048
              
              
              2,955
              
              
              (2
              )Cash
                  flows from investing activities:Purchases
                  of property and equipment
              
              
              (2,314
              )
              
              (3,325
              )
              
              (3,996
              )Proceeds
                  from sale of equipment
              
              
              -
              
              
              2
              
              
              -Acquisition
                  of patents and other intangibles
              
              
              (104
              )
              
              (117
              )
              
              (93
              )Payment
                  of note receivable
              
              
              -
              
              
              (214
              )
              
              -Purchases
                  of investments
              
              
              (27,200
              )
              
              (3,451
              )
              
              (25,415
              )Proceeds
                  from maturities of investments
              
              
              18,300
              
              
              9,628
              
              
              22,049Purchase
                  of Challenge Card Design and cards & more, net of $12 cash
                  acquired
              
              
              -
              
              
              -
              
              
              (3,089
              )Net
                  cash provided by (used in) investing activities:
              
              
              (11,318
              )
              
              2,523
              
              
              (10,544
              )Cash
                  flows from financing activities:Proceeds
                  from sale of common stock through stock plans
              
              
              4,432
              
              
              339
              
              
              1,691Repayment
                  of bank loan
              
              
              -
              
              
              (745
              )
              
              -Decrease
                  in short-term and long-term debt
              
              
              -
              
              
              (2,835
              )
              
              -Cash
                    used to purchase common stock through an open marketrepurchase
                    program
              
              
              -
              
              
              (655
              )
              
              -Net
                    proceeds from sale of common stock, options andwarrants
                    through private placement
              
              
              -
              
              
              -
              
              
              9,389Net
                  cash provided by (used in) financing activities
              
              
              4,432
              
              
              (3,896
              )
              
              11,080Effect
                  of exchange rate changes on cash
              
              
              (6
              )
              
              95
              
              
              -Net
                  increase (decrease) in cash and cash equivalents
              
              
              (1,844
              )
              
              1,677
              
              
              534Cash
                  and cash equivalents:Beginning
                  of period
              
              
              3,965
              
              
              2,288
              
              
              1,754End
                  of period
              
              $
              2,121
              
              $
              3,965
              
              $
              2,288Supplemental
                  disclosures - cash payments for:Income
                  taxes
              
              $
              233
              
              $
              82
              
              $
              -Interest
                  expense
              
              $
              80
              
              $
              128
              
              $
              -The
                  accompanying notes are an integral part of these consolidated financial
                  statements.





49








LASERCARD
      CORPORATION AND SUBSIDIARIES


NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS








**1.**
            **Organization
                and Operations**





LaserCard
      Corporation, a Delaware Corporation, and its wholly owned subsidiaries,
      LaserCard Corporation, a California Corporation, and Challenge Card Design
      Plastikkarten GmbH (collectively the “Company”) develop, manufacture and
      integrate LaserCard Ò optical
      memory cards, optical card drives, peripherals and specialty cards and printers.
      Challenge Card Design Plastikkarten GmbH and cards & more GmbH were acquired
      by LaserCard Corporation on March 31, 2004. cards & more GmbH was merged
      into Challenge Card Design Plastikkarten GmbH (“CCD”) in fiscal year 2006. The
      Company's customers for optical memory card related products are mainly
      value-added reseller (VAR) companies worldwide, that develop commercial
      applications for LaserCard products. Target markets for these products include
      government and commercial applications for portable, recordable, secure,
      identification cards and other unitary-record cards. Current applications
      include United States Permanent Resident Card (“Green Card”) and Laser Visa
      Border Crossing Cards, U.S. military cargo manifests, Canadian Permanent
      Resident Cards, Italian national ID cards, biometric IDs and other wallet-card
      applications. Challenge Card Design Plastikkarten GmbH supplies other
      advanced-technology cards for various applications, card printers and systems
      integration for gate-keeping and ticketing.





The
      Company is subject to certain risks including, but not limited to, competition
      from substitute products and larger companies and dependence on certain
      suppliers and customers.





**2.**
            **Summary
                of Significant Accounting
                Policies**





(1.)*Principles
      of
      Consolidation and Basis of Presentation.* The
      accompanying consolidated financial statements have been prepared on the accrual
      basis of accounting in accordance with U. S. generally accepted accounting
      principles. The consolidated financial statements include the accounts of
      LaserCard Corporation and its wholly owned subsidiaries. All significant
      intercompany accounts and transactions have been eliminated in
      consolidation.





(2.)*Use
      of
      Estimates* .
      The
      preparation of consolidated financial statements in conformity with U. S.
      generally accepted accounting principles requires management to make estimates
      and assumptions that affect the reported amounts of assets and liabilities
      and
      disclosure of contingent assets and liabilities at the date of the financial
      statements and the reported amounts of revenues and expenses during the
      reporting period. Actual results could differ from those estimates.





(3.)*Fiscal
      Period* .
      For
      purposes of presentation, the Company labels its annual accounting period end
      as
      March 31 and its quarterly accounting period ends as June 30, September 30
      and December 31. The Company, in fact, operates and reports based on quarterly
      periods ending on the Friday closest to month end. Fiscal year 2006 ended on
      March 31, 2006, fiscal year 2005 ended on April 1, 2005 and fiscal year 2004
      ended on April 2, 2004.




(4.)*Foreign
      Currency Transactions* . The
      functional currency of the Company's foreign subsidiaries is generally the
      local
      currency. The financial statements of these subsidiaries are translated to
      United States dollars using period-end rates of exchange for assets and
      liabilities and average rates of exchange for the year for revenues and
      expenses. Translation gains (losses) are recorded in accumulated other
      comprehensive income as a component of stockholders' equity. Net gains and
      losses resulting from foreign exchange transactions are included in selling,
      general and administrative expenses and were not significant during the periods
      presented .





(5.)*Derivative
      Financial Instruments.* The
      Company uses short-term foreign exchange forward contracts to mitigate foreign
      currency risk associated primarily with inter-company payables, account, and
      loan receivables (denominated in Euros) to its German subsidiaries.  Our
      foreign exchange forward contracts are not designated for accounting purposes
      as
      hedging instruments under SFAS No. 133, “Accounting for Derivative Instruments
      and Hedging Activities,” as amended.  Accordingly, any gains or losses
      resulting from changes in the fair value of the forward contract are reported
      in
      selling, general and administrative expenses.  The gains and losses on
      these forward contracts generally offset gains and losses associated with the
      underlying foreign currency denominated inter-company payable, account, and
      loan
      receivables.  At March 31, 2006, we had a foreign exchange forward contract
      with a maturity of less than 30 days to purchase 1.9 million euros. The
      fair value of the forward contract was not material at March 31,
      2006.





50








(6.)*Concentrations
      of
      Risk.* Financial instruments that potentially subject the Company to significant
      concentrations of credit risk consist principally of cash, cash equivalents,
      short-term investments, long-term investments and accounts receivable. The
      Company places its cash, cash equivalents, short-term and long-term investments
      in high-credit quality financial institutions. The Company is exposed to credit
      risk in the event of default by these institutions to the extent of the amount
      recorded on the consolidated balance sheet. As of March 31, 2006, the
      Company has invested in short-term and long-term investments
      including auction
      rate securities, discount notes and U.S. government bonds .
      Accounts receivable are derived from revenue earned from customers primarily
      located in the United States, Italy and Germany. The Company performs ongoing
      credit evaluations of its customers’ financial condition and generally does not
      require collateral. The Company maintains reserves for potential credit losses
      and historically, such losses have been immaterial.





(7.)*Major
      Customers.* One
      customer accounted for 31% of revenues for fiscal year 2006, 31% of revenues
      for
      fiscal year 2005, and 72% of revenues for fiscal year 2004. Another customer
      accounted for 31% of revenues for fiscal year 2006, 26% of revenues for fiscal
      year 2005, and 22% of revenues for fiscal year 2004. The revenue from these
      customers was attributable to both the optical memory card and the optical
      card
      drive segments. No other customer accounted for more than 10% of revenues during
      the periods.





Two
      customers accounted for 48% and 14% respectively of accounts receivable at
      March
      31, 2006. One customer accounted for 27% of accounts receivable at March 31,
      2005.





(8.)*Cash
      and Cash
      Equivalents, Short-term Investments and Long-term Investments* .
      The
      Company considers all highly liquid investments, consisting primarily of
      commercial paper, discount notes and U.S. government bonds, with maturities
      of
      three months or less at the date of purchase, to be cash equivalents. Cash
      and
      cash equivalents at March 31, 2006 and March 31, 2005 were $2.1 million and
      $4
      million, respectively. As of March 31, 2006 and 2005, the Company held auction
      rate securities which have been accounted for as available-for-sale and
      classified as short-term investments. The fair values of the auction rate
      securities, based on quoted market prices, were substantially equal to
      their carrying costs due to the frequency of the reset dates. Short-term
      investments also include investments with maturities at date of purchase of
      more
      than three months and investments with remaining maturities of less than one
      year. All investments with maturities at date of purchase greater than one
      year
      are classified as long-term investments. Management determines the appropriate
      classification of debt securities at the time of purchase and reevaluates the
      classification of investments as of each balance sheet date.





All
      short-term investments, except for auction rate securities which are recorded
      at
      fair value, and long-term investments are classified as held to maturity and
      are
      stated in the consolidated balance sheet at amortized cost. As such investments
      are classified as held to maturity, no unrealized gains or losses are recorded.
      The carrying amounts of individual held to maturity securities are reviewed
      at
      the consolidated balance sheet date for potential impairment. As of March 31,
      2006 and 2005, the Company has determined that an impairment which was “other
      than temporary” has not occurred. The carrying amounts of short-term and
      long-term investments at March 31 are (in thousands):





2006
            
            2005Short-term
                investments (up to one year):U.S.
                government and agency obligations
            
            $
            6,300
            
            $
            1,000Auction
                rate securities
            
            
            15,050
            
            
            5,150Total
                short-term investments
            
            
            21,350
            
            
            6,150Long-term
                investments (one to two years):U.S.
                government and agency obligations
            
            
            —
            
            
            6,300Total
                long-term investments
            
            
            —
            
            
            6,300Total
                investments
            
            $
            21,350
            
            $
            12,450








51








The
      company has revised the amounts of its previously reported purchases of
      investments and proceeds from the sale of investments under cash flows from
      investing activities in the accompanying March 31, 2004 Consolidated Statement
      of Cash Flows to include activity related to its auction rate securities
      transactions. Previously, the Company presented its auction rate note securities
      transaction activity under cash flows from investing activities on a net
      basis.





(9.)*Fair
      Value of
      Financial Instruments* .
      The
      carrying amounts of the Company’s financial instruments including cash and cash
      equivalents, short-term investments, accounts receivable, accounts payable
      and
      accrued liabilities, approximate their fair values due to their short
      maturities. The Company had no long-term investments at March 31, 2006.





(10.)       
      *Accounts Receivable.* Accounts
      receivable are net of reserves for doubtful accounts and product return reserves
      of $142,000 and $56,000 as of March 31, 2006 and March 31, 2005, respectively.
      We maintain allowances for doubtful accounts and product return reserves for
      anticipated losses resulting from the inability of our customers to make
      required payments and in-process product returns. We generally compute our
      allowances based on specifically identifying accounts that are past due that
      are
      likely not collectible. Interest receivable is accrued from investments in
      auction rate securities and other interest-bearing securities. Other receivables
      comprise of value added tax refunds and miscellaneous items. The components
      of
      accounts receivable at March 31 are (in thousands):





2006
              
              2005Trade
                  receivables
              
              $
              4,897
              
              $
              1,817Bad
                  debt reserve
              
              
              (64
              )
              
              (32
              )Reserve
                  for sales returns
              
              
              (78
              )
              
              (24
              )Interest
                  receivable
              
              
              93
              
              
              89Receivable-other
              
              
              72
              
              
              84Total
                  receivables
              
              $
              4,920
              
              $
              1,934





(11.) *Inventories* .
      Inventories are stated at the lower of cost or market,
      with cost determined on a first-in, first-out basis and
      market based on the lower of cost or estimated realizable value less cost
      to sell. The components of inventories as of March 31 are (in
      thousands):




2006
              
              2005Raw
                  materials
              
              $
              5,662
              
              $
              4,891Work-in-process
              
              
              1,453
              
              
              739Finished
                  goods
              
              
              1,759
              
              
              2,279Total
                  Inventories
              
              $
              8,874
              
              $
              7,909




The
      Company establishes lower of cost or market reserves, aged inventory reserves
      and obsolescence reserves. Inventory reserves are generally recorded when
      management determines that an item is not readily saleable. Inventory reserves
      are not relieved until the related inventory has been sold or scrapped. The
      Company recorded charges to write down inventory of $194,000 for fiscal year
      2006, $381,000 for fiscal year 2005 and $97,000 for fiscal year
      2004.





52








(12.) *Equipment held for resale.* Equipment
      held for resale primarily consists of parts, labor costs and other costs
      incurred to build equipment under a contract with Global Investments Group.
      Direct incremental costs associated with the purchase or construction of these
      items are deferred until revenue is recorded. The components of equipment held
      for resale as of March 31 are (in thousands):





2006
              
              2005Parts
              
              $
              5,187
              
              $
              3,812Labor
                  costs
              
              
              591
              
              
              212Other
              
              
              99
              
              
              37Total
                  equipment held for resale
              
              $
              5,877
              
              $
              4,061





(13.) *Property and Equipment, Net* .
      The
      components of property and equipment as of March 31 are (in
      thousands):





2006
              
              2005Building
                  and land
              
              $
              803
              
              $
              856Equipment
                  and furniture
              
              
              22,464
              
              
              23,267Construction
                    in progress, includingpurchased
                    equipment
              
              
              802
              
              
              1,409Leasehold
                  improvements
              
              
              4,409
              
              
              4,50528,478
              
              
              30,037Less:
                  accumulated depreciation
              
              
              (16,172
              )
              
              (17,505
              )Total
                  property and equipment, net
              
              $
              12,306
              
              $
              12,532




Property
      and equipment, including tooling, are recorded at cost. Depreciation is provided
      over the estimated useful lives which is four to seven years for equipment
      and
      furniture using the straight-line method and twenty-five years for the building
      using the straight-line method. Leasehold improvements are amortized over the
      shorter of the life of the asset or the life of the lease using the
      straight-line method. Depreciation and leasehold amortization expense for fiscal
      years 2006, 2005 and 2004 was $2.4 million, $2.5 million and $1.9 million,
      respectively. Maintenance and minor repairs and replacements are expensed when
      incurred. Disposition or retirement of property and equipment related gains
      and
      losses are charged to other income/expenses.





(14.) *Goodwill, Patents, and Other Intangible Assets.* Goodwill
      represents the excess of the purchase price over the fair value of identifiable
      net tangible and intangible assets acquired in a business combination. In
      accordance with SFAS No. 142, “Goodwill, Patents, and Other Intangible Assets,”
the Company does not amortize goodwill. Instead, the Company evaluates goodwill
      for impairment annually in the fourth quarter and whenever events or changes
      in
      circumstances indicate that it is more likely than not that an impairment loss
      has been incurred. Goodwill is assigned to reporting units, which are operating
      segments as defined by our current segment reporting structure. As of March
      31,
      2006, the Company has one reporting unit that contains goodwill.
      Acquisition-related intangible assets other than goodwill include backlog,
      which
      was amortized on a straight-line basis over its estimated useful life of six
      months; and brand, which has an indefinite useful life. Legal expenses incurred
      in connection with patents are capitalized and amortized over the estimated
      remaining useful lives of the patents of six to seven years.





53








Definite
      life intangible assets capitalized and accumulated amortization as of
      March 31 are as follows (in thousands):





2006
            
            2005Patent
                expenditures
            
            $
            3,399
            
            $
            3,290Technology
                transfer expenditures
            
            
            545
            
            
            545Other
            
            
            —
            
            
            10Total
                patent and other intangible expenditures
            
            
            3,944
            
            
            3,845Patent
                accumulated amortization
            
            
            (3,034
            )
            
            (2,923
            )Technology
                transfer accumulated amortization
            
            
            (511
            )
            
            (483
            )Other
            
            
            —
            
            
            (6
            )Accumulated
                amortization
            
            
            (3,545
            )
            
            (3,412
            )Amortizable
                patents and other intangibles, net
            
            $
            399
            
            $
            433








The
      weighted average remaining amortization periods as of March 31 are as
      follows:





2006
            
            2005Patents
            3.3
                years
            
            4.0
                yearsTechnology
                transfer
            1.3
                years
            
            2.2
                yearsTotal
            3.0
                years
            
            3.7
                years


Amortization
      expense on intangible assets for fiscal years 2006, 2005 and 2004 was $139,000,
      $172,000 and $201,000 respectively. The estimated amortization expense for
      each
      of the next five years on patents and other intangible assets with definite
      lives as of March 31, 2006 is as follows (in thousands):





Fiscal
                Year2007
            
            $
            1272008
            
            
            902009
            
            
            692010
            
            
            512011
            
            
            35





Intangible
      assets with indefinite lives as of March 31 are as follows (in
      thousands):





2006
            
            2005Brand
            
            $
            490
            
            $
            490Goodwill
            
            
            3,321
            
            
            3,321Total
            
            $
            3,811
            
            $
            3,811





(15.)*Assessment of Impairment of Tangible and Intangible Long-Lived
      Assets* .
      In
      accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of
      Long-Lived Assets,” the Company assesses the impairment of long-lived assets
      whenever events or changes in circumstances indicate that their carrying value
      may not be recoverable from the estimated future cash flows expected to result
      from their use and eventual disposition. The Company’s long-lived assets subject
      to this evaluation include property and equipment and amortizable intangible
      assets. If the Company’s estimate of future undiscounted net cash flows is
      insufficient to recover the carrying value of the assets, the Company will
      record an impairment loss in the amount by which the carrying value of the
      assets exceeds the fair value. If assets are determined to be recoverable but
      the useful lives are shorter than originally estimated, the Company depreciates
      or amortizes the net book value of the asset over the newly determined remaining
      useful lives. As of March 31, 2006, the fair value of long-lived assets exceeds
      the book value. Therefore, no impairment loss has been recognized.





54











(16.)*Accrued Liabilities.* The
      components of accrued liabilities as of March 31 are (in
      thousands):





2006
            
            2005Accrued
                payroll and fringe benefits
            
            $
            1,218
            
            $
            408Accrued
                compensated absences
            
            
            622
            
            
            579Warranty
                reserves
            
            
            648
            
            
            132Other
                accrued liabilities
            
            
            630
            
            
            1,193Total
                accrued liabilities
            
            $
            3,118
            
            $
            2,312





(17.)      
      *Software Development Costs* .
      Development costs incurred in the research and development of new software
      products are expensed as incurred until technological feasibility in the form
      of
      a working model has been established. To date, the Company’s software
      development has been completed concurrent with the establishment of
      technological feasibility and, accordingly, all software development costs
      have
      been charged to research and engineering expenses in the accompanying
      consolidated statements of operations.





(18.)*Pre-production Design and Development Costs.* Costs
      incurred in the pre-production phase of contracts are expensed as incurred
      and
      included in cost of goods sold.





(19.) *Advance Payments from Customers* .
      The
      Company routinely receives advance payments on orders placed by its customers.
      The advance payments are recorded as a liability on the consolidated balance
      sheet until the related orders are shipped.





(20.)      
      *Revenue Recognition* .
      Product
      sales primarily consist of optical card sales, sales of optical card read/write
      drives and sales of specialty cards and card printers. The Company recognizes
      revenue from product sales when the following criteria are met: (1) persuasive
      evidence of an arrangement exists; (2) delivery has occurred; (3) the fee is
      fixed or determinable; and (4) collectibility is reasonably assured. The Company
      recognizes revenue on product sales at the time of shipment when shipping terms
      are F.O.B. shipping point, orders are placed pursuant to a pre-existing sales
      arrangement and there are no post-shipment obligations other than warehousing
      under a U.S. government subcontract or customer acceptance criteria. Where
      appropriate, provision is made at the time of shipment for estimated warranty
      costs and estimated returns. The total amount of provision charged to warranty
      expense and product returns was $747,000, $518,000 and $56,000 for fiscal years
      2006, 2005 and 2004, respectively. Actual warranty costs and returns activity
      was $176,000, $493,000 and $17,000 for fiscal years 2006, 2005 and 2004,
      respectively.





The
      Company’s U.S. government subcontract requires delivery into a secure vault
      located on Company premises. Shipments are made from the vault on a shipment
      schedule provided by the prime contractor, which is subject to revision, but
      generally not subject to cancellation, at the option of the prime contractor.
      At
      the time the cards are delivered into the vault, title to the cards is
      transferred to the government and all risks of ownership are transferred as
      well. The prime contractor is invoiced, with payment due within thirty days
      and
      the contract does not contain any return (other than for warranty) or
      cancellation provisions. Pursuant to the provisions of SEC Staff Accounting
      Bulletin No. 104 (“SAB 104”), revenue is recognized on delivery into the vault
      as the Company has fulfilled its contractual obligations and the earnings
      process is complete. If the Company does not receive a shipment schedule for
      shipment of cards from the vault, revenue is deferred and recognized upon
      shipment from the vault. In addition, revenue recognition for future deliveries
      into the vault would be affected if the U.S. government cancels the shipment
      schedule. As a result, the Company’s revenues may fluctuate from period to
      period if the Company does not continue to obtain shipment schedules under
      this
      subcontract or if the shipment schedules are cancelled.




The
      Company applies the provisions of the Emerging Issues Task Force Issue No.
      00-21, "Revenue Arrangements with Multiple Deliverables," (“EITF 00-21”) to
      revenue arrangements with multiple deliverables. EITF 00-21 provides criteria
      governing how to identify whether goods or services that are to be delivered
      separately in a bundled sales arrangement should be accounted for separately.
      Deliverables are accounted for separately if they meet all of the following
      criteria: a) the delivered items have stand-alone value to the customer; b)
      the
      fair value of any undelivered items can be reliably determined; and c) if the
      arrangement includes a general right of return, delivery of the undelivered
      items is probable and substantially controlled by the seller. In situations
      where the deliverables fall within higher-level literature as defined by EITF
      00-21, the Company applies the guidance in that higher-level literature.
      Deliverables that do not meet these criteria are combined with one or more
      other
      deliverables.





55











The
      Company applies the provisions of Statement of Position 81-1, "Accounting for
      Performance of Construction-Type and Certain Production-Type Contracts" (“SOP
      81-1”) in applicable contracts. Revenues on time and materials contracts are
      recognized as services are rendered at contract labor rates plus material and
      other direct costs incurred. Revenues on fixed price contracts are recognized
      on
      the percentage of completion method based on the ratio of total costs incurred
      to date compared to estimated total costs to complete the contract. Estimates
      of
      costs to complete include material, direct labor, overhead and allowable general
      and administrative expenses. In circumstances where estimates of costs to
      complete a project cannot be reasonably estimated, but it is assured that a
      loss
      will not be incurred, the percentage-of-completion method based on a zero profit
      margin, rather than the completed-contract method, is used until more precise
      estimates can be made. The full amount of an estimated loss is charged to
      operations in the period it is determined that a loss will be realized from
      the
      performance of a contract. The Company recognized approximately $77,000 and
      $127,000 of revenues for the fiscal year ended March 31, 2006 and March 31,
      2005, respectively, based on a zero profit margin related to a long-term
      contract. The Company had no revenues generated from this type of contract
      for
      the year ended March 31, 2004.





At
      the
      beginning of the fourth quarter of fiscal year 2006, the Company entered into
      a
      contract with a Middle Eastern country to provide them with a full system
      integration of our optical memory cards for use in that country’s personalized
      national ID program which includes optical memory cards, hardware, and software.
      The contract calls for multiple deliverables, installation, and certain client
      acceptance criteria, as defined in the agreement. In applying the guidance
      within EITF 00-21, the Company determined the deliverables are not to be
      accounted for as separate units, but rather as a bundled arrangement as the
      fair
      value of the undelivered items cannot be readily determined. Therefore, revenue
      recognition on this new contract and the associated contract costs were and
      will
      be deferred until the predominant undelivered element, the overview of card
      personalization, is delivered and accepted, commencing with the installation
      and
      client acceptance of the card personalization system. Total contract
      revenue will be recognized ratably based on actual cards personalized and
      accepted. As of March 31, 2006, no revenue has been recognized under this
      contract, and costs incurred under the contract of $1 million were recorded
      as
      deferred contract costs under the current assets on the accompanying
      consolidated balance sheet. The components of the deferred contract costs
      consist of the following (in thousands):




2006Material,
                  labor, and overhead
              
              $
              820Other
                  expenses
              
              
              221Total
                  deferred contract costs
              
              $
              1,041




The
      Company applies the provisions of Statement of Position (“SOP”) No. 97-2,
“Software Revenue Recognition,” as amended by Statement of Position 98-9,
“Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain
      Transactions” to all transactions involving the sale of software products.
      Revenue from the license of the Company’s software products is recognized when
      persuasive evidence of an arrangement exists, the software product has been
      delivered, the fee is fixed or determinable and collectibility is probable,
      and,
      if applicable, upon acceptance when acceptance criteria are specified or upon
      expiration of the acceptance period. Software revenue was immaterial for fiscal
      years 2006, 2005 and 2004.





License
      revenue, which may consist of up-front license fees and long-term royalty
      payments, is recognized as revenue when earned. There were no license costs
      or
      revenues recorded for fiscal years 2006, 2005 and 2004.





The
      Company entered into an agreement with Global Investments Group (GIG), effective
      April 3, 2004, for the manufacturing of optical memory cards. In accordance
      with
      EITF 00-21, the card manufacturing license, sale and installation of equipment,
      training, and ongoing support have been accounted for as one unit of accounting,
      since the Company is unable to determine evidence of the fair value of any
      of
      the undelivered items. Accordingly, revenues for the arrangement have been
      deferred and will be recognized based on the predominant undelivered item,
      which
      is the ongoing annual support of the manufacturing equipment over the remainder
      of the 20-year license period. Pursuant to FTB 90-1, “Accounting for Separately
      Priced Extended Warranty and Product Maintenance Contracts” revenue will be
      recognized ratably over the remaining term of the agreement beginning when
      the
      equipment is accepted and training has been completed, which date is dependent
      on GIG providing a facility in Slovenia. The Company also defers direct and
      incremental expenses associated with building the card manufacturing equipment
      and with the delivery of other services for which revenue has been deferred,
      and
      the Company will recognize these expenses as the Company recognizes the related
      revenue.





56











The
      Company sold a license, effective April 3, 2004, to Global Investments Group
      (GIG), based in Auckland, New Zealand, for card manufacturing in Slovenia. 
This agreement provides for payments to the Company of $14 million for a 20-year
      license and five-year training support package, followed by $15 million paid
      $1
      million annually for ongoing support for an additional 15 years. 
Additionally, the Company is to sell approximately $12 million worth of the
      required manufacturing equipment and installation support for the new facility
      to be built by GIG to provide a targeted initial manufacturing capacity of
      10
      million optical cards annually. As of March 31, 2006, the Company had acquired
      $5.9 million of this equipment classified as equipment held for resale on its
      consolidated balance sheet.  The Company has received $20.5 million of
      payments called for in the agreements, consisting of a partial payment for
      the
      equipment and training of $6.5 million and $14 million for the license fee
      and support. Another approximately $5.9 million is overdue with GIG most
      recently committing to complete the payment by the end of June. The Company
      has
      begun to investigate alternative courses of action should GIG fail to make
      such
      payment. For the $20.5 million the Company received, $18.5 million was recorded
      as advance payments from customer and $2 million for the licensing fee was
      recorded as deferred revenue, which were both classified as long-term
      liabilities within the consolidated balance sheets.  In addition to the $41
      million discussed above, GIG is to pay the Company royalties for each card
      produced under the license.  The territories covered by the license include
      most of the European Union and eastern European regions.  GIG has exclusive
      marketing rights in certain territories, with performance goals to maintain
      these rights.  The Company will assign a person on site during the license
      term to assist with quality, security and operational procedures, with the
      mutual goal that the facility and the cards made in the facility conform to
      the
      Company’s standards.  The Company also retains rights to utilize up to 20%
      of the new facility capacity as backup and capacity buffer to augment its own
      card manufacturing facilities in Mountain View, California and at its German
      subsidiary. The granting of this license to GIG establishes a potential second
      source supplier of optical memory cards for existing and prospective customers
      who may request multiple sources for cards.  The agreement contains various
      elements including a card manufacturing license, sale and installation of
      equipment, training, and ongoing support, and contingent payments for the sale
      of materials, and royalty payments for cards manufactured. In accordance with
      EITF 00-21, the card manufacturing license, sale and installation of equipment,
      training, and ongoing support have been accounted for as one unit of accounting,
      since the Company is unable to determine evidence of the fair value of any
      of
      the undelivered items. Accordingly, revenues for the arrangement have been
      deferred and will be recognized based on the predominant undelivered item,
      which
      is the ongoing annual support of the manufacturing equipment over the remainder
      of the 20-year license period beginning when the equipment is accepted and
      training has been completed, which date is dependent on GIG providing a facility
      in Slovenia. Pursuant to FTB 90-1, “Accounting for Separately Priced Extended
      Warranty and Product Maintenance Contracts” this revenue will be recognized
      ratably over the remaining term of the agreement. The Company also defers direct
      and incremental expenses associated with building the card manufacturing
      equipment and with the delivery of other services for which revenue has been
      deferred, and the Company will recognize these expenses as the Company
      recognizes the related revenue.





(21.)      
      *Research and Engineering Expenses* .
      Costs
      related to research, design and development of products are charged to research
      and engineering expense as incurred. Research and engineering costs include
      salaries, contractor fees, building and utility costs, and
      depreciation.





(22.)      
      *Shipping and Handling Costs* .  Shipping
      and handling costs are recorded in cost of product sales.







(23.)    *Advertising Costs.* Advertising costs consist of development and placement costs of the Company’s
      advertising campaigns and are charged to expense when incurred. Advertising
      expense was approximately $183,000 for fiscal year 2006 and $189,000 for fiscal
      year 2005. No advertising costs were incurred in fiscal year 2004.





(24.)      
      *Stock-based Compensation* .
      The
      Company accounts for its stock-based compensation plans using the intrinsic
      value method prescribed in Accounting Principles Board Opinion No. 25,
“Accounting for Stock Issued to Employees.” Compensation cost for stock options,
      if any, is measured by the excess of the quoted market price of the Company’s
      stock at the date of grant over the amount an employee must pay to acquire
      the
      stock. SFAS No. 123, “Accounting for Stock-Based Compensation,” established
      accounting and disclosure requirements using a fair-value based method of
      accounting for stock-based employee compensation plans. The following table
      illustrates the effect on net income (loss) and income (loss) per share as
      if
      the Company had applied the fair value recognition provisions of SFAS No. 123
      (in thousands except per share amounts):





57











Fiscal
                Year2006
            
            2005
            
            2004Net
                income (loss), as reported
            
            $
            794
            
            $
            (8,901
            )
            $
            (12,427
            )Add:
                Stock-based employee compensation expense included in reported net
                income
                (loss), net of related tax effects
            
            
            105
            
            
            111
            
            
            97Deduct:
                total stock-based employee compensation determined under fair-value
                based
                method for all awards, net of related tax effects
            
            
            (1,317
            )
            
            (1,842
            )
            
            (1,925
            )Pro
                forma net loss
            
            $
            (418
            )
            $
            (10,632
            )
            $
            (14,255
            )Basic
                net income (loss) per common share:As
                reported
            
            $
            0.07
            
            $
            (0.78
            )
            $
            (1.15
            )Pro
                forma
            
            $
            (0.04
            )
            $
            (0.94
            )
            $
            (1.32
            )Diluted
                net income (loss) per common share:As
                reported
            
            $
            0.07
            
            $
            (0.78
            )
            $
            (1.15
            )Pro
                forma
            
            $
            (0.04
            )
            $
            (0.94
            )
            $
            (1.32
            )Shares
                used in computing basic and diluted pro forma net income (loss) per
                share:Basic
            
            
            11,415
            
            
            11,362
            
            
            10,761Diluted
            
            
            11,587
            
            
            11,362
            
            
            10,761





The
      Company computed the fair value of each option grant on the date of grant using
      the Black-Scholes option valuation model with the following
      assumptions:





Fiscal
                Year2006
            
            2005
            
            2004Risk-free
                interest rate
            
            
            3.81%
                to 4.68%
            
            
            3.65%
                to 4.08%
            
            
            2.74%
                to 3.85%Average
                expected life of option
            
            
            5
                to 6 years
            
            
            5
                to 8 years
            
            
            5
                to 8 yearsDividend
                yield
            
            
            0%
            
            
            0%
            
            
            0%Volatility
                of common stock
            
            
            54%
            
            
            55%
            
            
            48%
                to 50%Weighted
                average fair value of option grants
            
            $
            3.91
            
            $
            5.38
            
            $
            8.35








58








(25.)  *Comprehensive Income (Loss)* .
      Under
      SFAS No. 130, “Reporting Comprehensive Income,” comprehensive income (loss) is
      defined as the changes in equity of an enterprise except for those resulting
      from stockholders’ transactions. For the fiscal years ended March 31, 2006,
      2005 and 2004, comprehensive income (loss) is as follows (in
      thousands):





Fiscal
                Year2006
            
            2005
            
            2004Net
                income (loss)
            
            $
            794
            
            $
            (8,901
            )
            $
            (12,427
            )Net
                change in cumulative foreign currency translation
                adjustments
            
            
            (213
            )
            
            209
            
            
            —Other
                comprehensive income (loss)
            
            $
            581
            
            $
            (8,692
            )
            $
            (12,427
            )




(26.)   *Recent Accounting Pronouncements.*  On
      June
      1, 2005, the Financial Accounting Standards Board (FASB) issued Statement No.
      154, “ Accounting
      Changes and Error Corrections” (FAS
      154), a replacement of APB No. 20, “ Accounting
      Changes and FASB
      Statement No. 3, Reporting
      Accounting Changes in Interim Financial Statements .”
FAS
      154 applies to all voluntary changes in accounting principles and changes the
      requirements for accounting for and reporting of a change in accounting
      principle. This statement establishes, that unless impracticable, retrospective
      application is the required method for reporting a change in accounting
      principle in the absence of explicit transition requirements specific to the
      newly adopted accounting principle. It also requires the reporting of an error
      correction which involves adjustments to previously issued financial statements
      similar to those generally applicable to reporting an accounting change
      retrospectively. FAS 154 is effective for accounting changes and corrections
      of
      errors made in fiscal years beginning after December 15, 2005. The Company
      does
      not expect the adoption of FAS 154 will
      have
      a material impact on its results of operations or financial condition.





In
      March
      2005, the Financial Accounting Standards Board (“FASB”) issued Interpretation
      No. 47, “Accounting for Conditional Asset Retirement Obligations.”
Interpretation No. 47 clarifies that an entity must record a liability for
      a “conditional” asset retirement obligation if the fair value of the obligation
      can be reasonably estimated. Interpretation No. 47 also clarifies when an
      entity would have sufficient information to reasonably estimate the fair value
      of an asset retirement obligation. Interpretation No. 47 is effective no
      later than the end of the fiscal year ending after December 15, 2005. The
      Company’s adoption in the fourth quarter of fiscal year 2006 did not have a
      material impact on its results of operations or financial condition.





On
      October 22, 2004, the American Jobs Creation Act of 2004 (the “Act”) was signed
      into law. The Act contains numerous changes to U.S. tax law, both temporary
      and
      permanent in nature, including a potential tax deduction with respect to certain
      qualified domestic manufacturing activities, changes in the carryback and carryforward utilization periods for
      foreign tax credits and a
      dividend received deduction with respect to accumulated income earned abroad.
      The new law could potentially have an impact on the Company’s effective tax
      rate, future taxable income and cash and tax planning strategies, amongst other
      affects. In December 2004, the FASB issued Staff Position No. 109-1 (“ FSP 109-1 ”),
      “Application of FASB Statement No. 109, Accounting for Income Taxes, to the
      Tax
      Deduction on Qualified Production Activities Provided by the American Jobs
      Creation Act of 2004” and Staff Position No. 109-2 (“ FSP 109-2”),
“Accounting and Disclosure Guidance for the Foreign Earnings Repatriation
      Provision within the American Jobs Creation Act of 2004.” FSP 109-1 clarifies that the manufacturer’s tax deduction provided for under the Act
      should be accounted for as a special deduction in accordance with SFAS No.
      109
      and not as a tax rate reduction. FSP 109-2
      provides accounting and disclosure guidance for the repatriation of certain
      foreign earnings to a U.S. taxpayer as provided for in the Act. Currently,
      there are no material foreign earnings to consider. Accordingly, the Company
      has
      not adjusted its income tax expense or deferred tax liability to reflect the
      tax
      impact of any repatriation of non-U.S. earnings it may make.




In
      December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” to revise
      SFAS No. 123, “Accounting for Stock-Based Compensation” and supersede APB
      Opinion No. 25, “Accounting for Stock Issued to Employees” and its related
      implementation guidance. It requires companies to recognize their compensation
      costs related to share-based payment transactions in financial statements.
      These
      costs are to be measured based on the fair value of the equity or liability
      instruments issued. The Company will apply
      SFAS No. 123R in the first quarter of the





59







fiscal
      year ending March 31, 2007 .
      Based
      on options outstanding as of March 31, 2006, the Company expects the adoption
      of
      SFAS No. 123R to result in a pre-tax expense of approximately $2 million for
      fiscal year 2007. This amount will vary depending on the number of option shares
      granted, the price of the stock at the time of option grant, and other variables
      used in the Black-Scholes model.




In
      December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary
      Assets — an Amendment of APB Opinion No. 29,” which eliminates the
      exception for nonmonetary exchanges of similar productive assets and replaces
      it
      with a general exception for exchanges of nonmonetary assets that do not have
      commercial substance. A nonmonetary exchange has commercial substance if the
      future cash flows of the entity are expected to change significantly as a result
      of the exchange. SFAS No. 153 will be effective for nonmonetary asset
      exchanges occurring in fiscal periods beginning after June 15, 2005. The
      Company is currently evaluating SFAS No. 153 and does not expect the
      adoption will have a material impact on its results of operations or financial
      condition.




In
      November 2004, the FASB issued SFAS No. 151, “Inventory Costs —
an Amendment of ARB No. 43, Chapter 4,” which clarifies the accounting
      for abnormal amounts of idle facility expense, freight, handling costs and
      wasted material (spoilage) be recognized as current period charges. In addition,
      SFAS No. 151 requires that allocation of fixed production overheads to
      the costs of conversion be based on the normal capacity of the production
      facilities. SFAS No. 151 will be effective for inventory costs
      incurred in fiscal years beginning after June 15, 2005. The Company
      continues to evaluate the impact of SFAS No. 151 to its overall result of
      operations or financial condition. Management expects no material impact from
      this new pronouncement on the results of our operations or financial condition.




(27.)    *Indemnification* .
      The
      Company’s major sales agreements provide remedies to customers, such as defense,
      settlement, or payment of judgment for intellectual property claims related
      to
      the use of the Company’s products. The Company also has indemnified various
      vendors for certain potential claims. The Company has also entered into
      indemnification agreements with its directors and officers and the Company’s
      bylaws contain similar indemnification obligations. To date, there have been
      no
      claims made under such indemnifications and as a result the associated estimated
      fair value of the liability is not material. The Company is required to
      indemnify the investors in the Company's December 2003 financing from any third
      party claim based upon any untrue statement or alleged untrue statement of
      a
      material fact contained in the Registration Statement covering the resale of
      the
      shares purchased by such investors, or any failure by the Company to fulfill
      any
      undertaking included in the Registration Statement.





**3.**
            **Net
                Income (Loss) per Share**





Basic
      net
      income (loss) per share is computed by dividing net income (loss) by the
      weighted average number of shares of common stock outstanding. Diluted net
      income (loss) per share is computed by dividing net income (loss) by the
      weighted average number of shares of common stock and common stock equivalents
      outstanding. Common stock equivalents consist of stock options and warrants
      using the treasury stock method.





60








The
      reconciliation of the denominators of the basic and diluted net income (loss)
      per share computation for the fiscal years ended March 31, 2006, 2005 and
      2004 is shown in the following table (in thousands, except per share
      data):





Fiscal
                Year2006
            
            2005
            
            2004Net
                income (loss)
            
            $
            794
            
            $
            (8,901
            )
            $
            (12,427
            )Basic
                net income (loss) per share:Weighted
                average common shares outstanding
            
            
            11,415
            
            
            11,362
            
            
            10,761Basic
                net income (loss) per share
            
            $
            0.07
            
            $
            (0.78
            )
            $
            (1.15
            )Diluted
                net income (loss) per share:Weighted
                average common shares outstanding
            
            
            11,415
            
            
            11,362
            
            
            10,761Weighted
                average common shares from stock option grants
            
            
            172
            
            
            —
            
            
            —Weighted
                average common shares and common stock equivalents
                outstanding
            
            
            11,587
            
            
            11,362
            
            
            10,761Diluted
                net income (loss) per share
            
            $
            0.07
            
            $
            (0.78
            )
            $
            (1.15
            )





Stock
      options having an exercise price greater than the average market value for
      profitable periods are excluded from the calculation of diluted net income
      per
      share, as their effect would be antidilutive. Therefore, stock options to
      purchase 1,554,000 shares were excluded from the calculation of diluted net
      income per share for the fiscal year ended March 31, 2006. As the effect of
      common stock equivalents would be antidilutive since the Company incurred a
      loss
      in fiscal years ended March 31, 2005 and 2004, all stock options and warrants
      were excluded from the calculation of diluted net loss per share for those
      fiscal years.





**4.**
            **Segments**





*Segment
      Reporting.*





The
      Company operates in three reportable segments: (1) optical memory cards, (2)
      optical memory card drives, including read/write drives, maintenance and related
      accessories (“optical card drives”) and (3) specialty cards and card printers.
      The segments were determined based on the information used by the chief
      operating decision maker. The optical memory cards and optical card drives
      reportable segments are not strategic business units which offer unrelated
      products and services; rather these reportable segments utilize compatible
      technology and are marketed jointly. Specialty cards and printers, which was
      acquired on March 31, 2004, is a strategic business unit offering at times
      unrelated products and at times related products with the other reportable
      segments.





The
      accounting policies used to derive reportable segment results are the same
      as
      those described in the "Summary of Significant Accounting Policies." Resources
      are allocated to the optical memory card and optical card drive segments in
      a
      manner that optimizes optical memory card revenues and to the specialty card
      and
      printers segment in a manner that optimizes consolidated income as determined
      by
      the chief operating decision maker. Segment revenues are comprised of sales
      to
      external customers. Segment gross profit (loss) includes all segment revenues
      less the related cost of sales. Accounts receivable, cash, deferred income
      taxes, prepaid expenses, fixed assets and inventory are not separately reported
      by segment to the chief operating decision maker. Therefore, the amount of
      assets by segment is not meaningful. There are no inter-segment sales or
      transfers. All of the Company’s long-lived assets are attributable to the United
      States except for $5.5 million in fiscal year 2006 and $5.6 million in fiscal
      year 2005 that are attributable to the operations in Germany.





The
      Company's chief operating decision maker is currently the Company's Chief
      Executive Officer. The chief operating decision maker reviews financial
      information presented on a consolidated basis that is accompanied by
      disaggregated information about revenues and gross profit (loss) by segment.





61











The
      table
      below presents information for optical memory cards, optical card drives and
      specialty cards and card printers for the fiscal years ended March 31,
      2006, 2005 and 2004 (in thousands):





Fiscal
                Year Ended March 31, 2006Optical
              Memory
              Cards
            
            Optical
              Card
              Drives
            
            Specialty
              Cards
                &
              Card
              Printers
            
            Segment
              TotalRevenues
            
            $
            28,200
            
            $
            985
            
            $
            10,672
            
            $
            39,857Cost
                of product sales
            
            
            15,093
            
            
            1,739
            
            
            7,972
            
            
            24,804Gross
                profit (loss)
            
            
            13,107
            
            
            (754
            )
            
            2,700
            
            
            15,053Depreciation
                andamortization
                expense
            
            
            1,517
            
            
            137
            
            
            292
            
            
            1,946








Fiscal
                Year Ended March 31, 2005Optical
              Memory
              Cards
            
            Optical
              Card
              Drives
            
            Specialty
              Cards
                & Card
              Printers
            
            Segment
              TotalRevenues
            
            $
            17,364
            
            $
            933
            
            $
            10,235
            
            $
            28,532Cost
                of product sales
            
            
            12,803
            
            
            2,087
            
            
            7,723
            
            
            22,613Gross
                profit (loss)
            
            
            4,561
            
            
            (1,154
            )
            
            2,512
            
            
            5,919Depreciation
                andamortization
                expense
            
            
            1,505
            
            
            159
            
            
            266
            
            
            1,930








Fiscal
                Year Ended March 31, 2004Optical
              Memory
              Cards
            
            Optical
              Card
              Drives
            
            Segment
              TotalRevenues
            
            $
            13,379
            
            $
            3,448
            
            $
            16,827Cost
                of product sales
            
            
            9,965
            
            
            3,039
            
            
            13,004Gross
                profit
            
            
            3,414
            
            
            409
            
            
            3,823Depreciation
                andamortization
                expense
            
            
            1,207
            
            
            179
            
            
            1,386








62








The
      following is a reconciliation of segment results to amounts included in the
      Company’s consolidated financial statements for the fiscal years ended
      March 31, 2006, 2005 and 2004 (in thousands):





Fiscal
                Year Ended March 31, 2006Segment
              Total
            
            Other(a)
            
            TotalRevenues
            
            $
            39,857
            
            $
            —
            
            $
            39,857Cost
                of product sales
            
            
            24,804
            
            
            —
            
            
            24,804Gross
                profit
            
            
            15,053
            
            
            —
            
            
            15,053Depreciation
                andamortization
                expense
            
            
            1,946
            
            
            569
            
            
            2,515





Fiscal
                Year Ended March 31, 2005Segment
              Total
            
            Other(a)
            
            TotalRevenues
            
            $
            28,532
            
            $
            12
            
            $
            28,544Cost
                of product sales
            
            
            22,613
            
            
            24
            
            
            22,637Gross
                profit (loss)
            
            
            5,919
            
            
            (12
            )
            
            5,907Depreciation
                andamortization
                expense
            
            
            1,930
            
            
            710
            
            
            2,640





Fiscal
                Year Ended March 31, 2004Segment
              Total
            
            Other(a)
            
            TotalRevenues
            
            $
            16,827
            
            $
            136
            
            $
            16,963Cost
                of product sales
            
            
            13,004
            
            
            153
            
            
            13,157Gross
                profit (loss)
            
            
            3,823
            
            
            (17
            )
            
            3,806Depreciation
                andamortization
                expense
            
            
            1,386
            
            
            737
            
            
            2,123






(a)
            Other
                depreciation and amortization expense represents amounts charged
                to
                selling, general and administrative and research and
                engineering.








63








*Sales
      by Geographic Region.* Sales
      by
      geographic region are generally determined based upon the ship-to address on
      the
      invoice. Revenues by geographic region are as follows (in thousands):





Fiscal
                Year2006
            
            2005
            
            2004United
                States
            
            $
            11,011
            
            $
            7,900
            
            $
            8,461Italy
            
            
            12,547
            
            
            7,617
            
            
            3,720Germany
            
            
            5,123
            
            
            4,820
            
            
            7Europe,
                other
            
            
            4,568
            
            
            4,411
            
            
            49Canada
            
            
            2,068
            
            
            1,902
            
            
            4,177Middle
                East and Africa
            
            
            3,499
            
            
            1,397
            
            
            478Asia
            
            
            405
            
            
            280
            
            
            39Rest
                of world
            
            
            636
            
            
            217
            
            
            32$
            39,857
            
            $
            28,544
            
            $
            16,963





In
      fiscal
      years 2006 and 2005, sales to customers outside the United States in the amount
      of $18.5 million and $10.9 million respectively were denominated in U.S. dollars
      and $10.4 million and $9.7 million respectively were denominated in euros.
      In
      fiscal year 2004, sales to customers outside the United States were denominated
      in U.S. dollars.





**5.**
            **Related-Party
                Transactions**





Since
      October 21, 2001, the Company contracted with Wexler & Walker Public Policy
      Associates, a unit of Hill and Knowlton, Inc., (“Wexler”) to be lobbyists on
      behalf of the Company. The Chairman of Wexler is Robert S. Walker, a brother
      of
      Walter F. Walker, member of the Company’s Board of Directors. In October 2002,
      the agreement was extended for the period October 1, 2002 through September
      2003
      or until terminated upon seven days’ notice. The extended agreement provides for
      a monthly retainer of $10,000 and a purchase order dated November 12, 2004
      valid
      through April 29, 2005 with the same terms and conditions of the previous
      agreement. In addition, there is another purchase order dated February 25,
      2005
      in the total of $35,000 to cover the consulting services for the period from
      January 2005 to April 2005. The purchase order was extended from May 2005
      through July 2006 in the aggregate amount of $125,000. The Company paid Wexler
      $142,082 during fiscal year 2006, $206,000 during fiscal year 2005, and $151,000
      during fiscal year 2004. As of March 31, 2006, $10,012 was due to Wexler and
      is
      included as part of current liabilities in the accompanying consolidated balance
      sheets.





**6.**
            **Common
                Stock**





*2004
      Equity Incentive Compensation Plan (the “2004 Plan”):* In
      October 2004, the Company’s shareholders approved 2004 Equity Incentive
      Compensation Plan, which replaced the existing 1994 Stock Option Plan. The
      2004
      Plan provides for the grant of restricted share awards, options, stock units
      and
      stock appreciation rights, any of which may or may not require the satisfaction
      of performance objectives, with respect to shares of our common stock to
      directors, officers, employees and consultants of the Company and its
      subsidiaries. The 2004 Plan is administered by the Compensation Committee of
      the
      Board of Directors, which has complete discretion to select the participants
      and
      to establish the terms and conditions of each award, subject to the provisions
      of the 2004 Plan. Options granted under the 2004 Plan may be “incentive stock
      options” as defined in Section 422 of the Internal Revenue Code of 1986, as
      amended, or the Code or nonqualified options. A total of 2,365,432 shares of
      Common Stock were reserved for issuance under the 2004 Plan as of March 31,
      2006. If any award granted under the 2004 Plan is forfeited or expires for
      any
      reason, then the shares subject to that award will once again be available
      for
      additional awards. If any outstanding option under the 1994 Plan expires or
      terminates for any reason without having been exercised in full, then the
      unpurchased shares subject to that option will be available for additional
      awards under the 2004 Plan. Under the 2004 Plan, the exercise price of incentive
      stock options may not be less than 100% of the fair market value of the Common
      Stock as of the date of grant (110% of the fair market value if the grant is
      to
      an employee who owns more than 10% of the total combined voting power of all
      classes of the Company’s capital stock). The Code currently limits to $100,000
      the aggregate value of Common Stock for which incentive stock options may become
      exercisable in any





64





calendar
      year under the 2004 Plan or any other option plan adopted by the Company.
      Nonstatutory stock options may be granted under the 2004 Plan at an exercise
      price of not less than 100% of the fair market value of the Common Stock on
      the
      date of grant. There is no limitation on the amount of common stock to which
      nonstatutory grants may first become exercisable in any calendar year. Repricing
      a stock option or stock appreciation right is not permitted without shareholder
      approval. Subject to the limitations contained in the 2004 Plan, the Committee
      sets the terms of each option grant. Any options that were not exercisable
      on
      the date of termination of employment immediately terminate at that time.
      Options granted under the 2004 Plan may not be exercised more than 10 years
      after the date of grant (five years after the date of grant if the grant is
      an
      incentive stock option to an employee who owns more than 10% of the total
      combined voting power of all classes of the Company’s capital stock). The Board
      of Directors specifies the term of options and the vesting schedule for exercise
      of options. No options were granted to consultants during fiscal years 2006,
      2005, or 2004. As of March 31, 2006, 421,759 shares were available for future
      issuance under the 2004 Plan.





In
      addition, as of March 31, 2006, 120,000 shares of stock have been reserved
      outside of the Company’s Stock Option Plan, for stock options issued under
      Nasdaq Rule No. 4350(i)(1)(A), in connection with the CCD-C&M acquisition.
      As an inducement to join the Company, each of six key employees of the acquired
      companies were granted non-statutory stock options on March 31, 2004 with a
      term
      of five years to purchase 20,000 common shares.





The
      following table lists stock option activity from March 31, 2003 through
      March 31, 2006:





Options
            
            
            
            WeightedAvailable
            
            Outstanding
            
            Averagefor
                Grant
            
            Options
            
            Exercise
                PriceBalance
                March 31, 2003
            
            
            218,804
            
            
            2,059,798
            
            $
                13.25Granted
            
            
            (35,000
            )
            
            155,000
            
            $
                14.43Exercised
            
            
            —
            
            
            (145,147
            )
            $
                10.34Expired
            
            
            40,592
            
            
            (40,592
            )
            $
                15.12Balance
                March 31, 2004
            
            
            224,396
            
            
            2,029,059
            
            $
                13.51Authorized
            
            
            300,000
            
            
            —Granted
            
            
            (69,000
            )
            
            69,000
            
            $ 
                 9.52Exercised
            
            
            —
            
            
            (10,300
            )
            $
                10.68Expired
            
            
            20,475
            
            
            (20,475
            )
            $
                15.47Balance
                March 31, 2005
            
            
            475,871
            
            
            2,067,284
            
            $
                13.37Authorized
            
            
            315,000
            
            
            —Granted
            
            
            (468,800
            )
            
            468,800
            
            $  
                7.18Exercised
            
            
            —
            
            
            (372,723
            )
            $
                12.02Expired
            
            
            99,688
            
            
            (99,688
            )
            $
                12.07Balance
                March 31, 2006
            
            
            421,759
            
            
            2,063,673
            
            $
                12.27





The
      following table summarizes information about stock options outstanding at March
      31, 2006:











Options
                Outstanding
            
            Options
                ExercisableRange
                of
              Exercise
                Prices
            
            Number
              Outstanding
                at
              March
                31, 2006
            
            Weighted-Average
              Remaining
              Contractual
                Life
            
            Weighted-
              Average
              Exercise
                Price
            
            Number
              Exercisable
              at
                March 31, 2006
            
            Weighted-
              Average
              Exercise
                Price$
                6.04 - $7.05
            
            
            395,567
            
            
            9.1
                years
            
            $6.06
            
            
            5,467
            
            $7.05$
                7.50 - $10.91
            
            
            235,867
            
            
            3.9
                years
            
            $9.90
            
            
            220,867
            
            $9.99$10.99
                - $12.69
            
            
            397,168
            
            
            2.4
                years
            
            $11.72
            
            
            385,918
            
            $11.74$13.06
                - $15.34
            
            
            623,821
            
            
            5.1
                years
            
            $13.94
            
            
            497,611
            
            $13.93$16.30
                - $22.75
            
            
            411,250
            
            
            5.7
                years
            
            $17.60
            
            
            337,750
            
            $17.43Totals
            
            
            2,063,673
            
            
            
            
            
            
            
            
            1,447,613





65








*Employee
      Stock Purchase Plan* .
      The
      Company has an Employee Stock Purchase Plan (Stock Purchase Plan), under which
      61,517 shares are reserved as of March 31, 2006 for future purchases by
      employees. Under the Stock Purchase Plan, eligible employees may designate
      from
      2% to 6% of their compensation to be withheld for the purchase of shares of
      common stock at 67% of a trailing average price. The differential between fair
      market value and the average price of the shares sold under the Stock Purchase
      Plan is charged to operations as a compensation expense and is taxed to the
      employee as income. Under the Stock Purchase Plan, employees purchased 25,961
      shares for fiscal year 2006, 26,730 shares for fiscal year 2005 and 20,253
      shares for fiscal year 2004. The weighted average purchase price per share
      was
      $6.53 for fiscal year 2006, $5.89 for fiscal year 2005 and $9.38 for fiscal
      year
      2004. The weighted average market price per share for shares purchased was
      $11.26 for fiscal year 2006, $9.13 for fiscal year 2005 and $14.19 for fiscal
      year 2004.




*Other
      Employee Benefit Plan:*




*401(k)
      Plan* .
      The
      401(k) Plan provides participating employees with an opportunity to accumulate
      funds for retirement. The Company’s contribution to this Plan will not exceed
      the lesser of: (a) 25% of the maximum employee contribution allowed by IRS,
      (b)
      25% of an employee’s contribution, or (c) 1.5% of an employee’s eligible
      earnings. The company contributed $73,000, $59,000, and $28,000 for fiscal
      years
      2006, 2005, and 2004, respectively.





**7.**
            **Commitments
                and Contingencies**





*Lease.* The
      Company occupies its buildings under various operating leases. Rent expense
      relating to these buildings was approximately $1.5 million for fiscal year
      2006,
      approximately $1.5 million for fiscal year 2005 and approximately $1.1 million
      for fiscal year 2004. As of March 31, 2006, future minimum rental payments
      relating to these leases are (in thousands):





Fiscal
                Year2007
            
            $
            1,1642008
            
            
            1,0542009
            
            
            9982010
            
            
            1,3822011
            
            
            1,415Thereafter
            
            
            4,196Total
            
            $
            10,209





By
      mutual
      agreement with the lessor, on November 1, 2003, a lease on a 27,000-square-foot
      building was modified and extended through October 2013. The original lease
      had
      a remaining term through May 2006 with lease payments totaling $2.1 million.
      The
      modified lease calls for payments totaling $1.3 million over the same period.
      Rent expense is recorded at the average of the rent payments over the term
      of
      the lease. At the time the renegotiated lease was signed, there was $139,000
      of
      deferred rent associated with the original lease. This amount is being amortized
      on a straight-line basis over the ten-year term of the modified
      lease.





*Purchase
      Commitment* . The
      Company purchases services, software, manufacturing equipment and facilities
      from a variety of vendors. As
      of
      March 31, 2006, the Company has non-cancelable purchase orders of $1.7 million
      for raw materials which will be delivered over 12 months.





*Product
      Warranties.* The
      Company estimates its warranty costs based on historical warranty claim
      experience and applies this estimate to the revenue stream for products under
      warranty. The Company’s product warranty claims are settled through the returns
      of defective products and the shipment of replacement products. Warranty returns
      were included in the allowance for sales returns, based on historical returns,
      prior to fiscal year 2006. The warranty returns were immaterial for fiscal
      years
      2005 and 2004. For the current fiscal year, the Company has reclassified
      warranty returns as a part of other accrued liabilities. Warranty reserve is
      reviewed quarterly to verify that it properly reflects the remaining obligations
      based on the anticipated returns over the balance of the obligation period.
      Adjustments are made when actual return claim experience differs from estimates.
      As of March 31, 2006 and 2005, the warranty reserves were $648,000 and $132,000,
      respectively and are included as part of other accrued liabilities in the
      consolidated balance sheets.





66











In
      the
      normal course of business, the Company is subject to various claims and
      assertions. In the opinion of management, the ultimate disposition of such
      claims and assertions will not have a material adverse impact on the financial
      position of the Company.





**8.**
            **Income
                Taxes**





The
      provision for income taxes for fiscal year 2006, 2005 and 2004 consists of
      the following (in thousands):





Fiscal
                Year2006
            
            2005
            
            2004Current:Federal
            
            $
            139
            
            $
            109
            
            $
            —State
            
            
            261
            
            
            3
            
            
            3Foreign
            
            
            72
            
            
            27
            
            
            —472
            
            
            139
            
            
            3Deferred:Federal
            
            
            —
            
            
            —
            
            
            6,552State
            
            
            —
            
            
            —
            
            
            534Foreign
            
            
            (29
            )
            
            —
            
            
            —(29
            )
            
            —
            
            
            7,086Income
                tax expense
            
            $
            443
            
            $
            139
            
            $
            7,089








The
      Company’s effective tax rate differs from the statutory rate as follows:





Fiscal
                Year2006
            
            2005
            
            2004Tax
                reconciliation:Federal
                statutory rate
            
            
            34%
            
            
            (34%
            )
            
            (34%
            )State
                tax, net of federal benefit
            
            
            (3%
            )
            
            (6%
            )
            
            —Foreign
                provision differential
            
            
            (2%
            )
            
            2%
            
            
            —Alternative
                minimum tax
            
            
            3%
            
            
            2%
            
            
            —Change
                in valuation allowance
            
            
            7%
            
            
            38%
            
            
            166%Other
            
            
            (3%
            )
            
            —
            
            
            —36%
            
            
            2%
            
            
            132%








The
      major
      components of the net deferred tax asset/(liability) as of March 31 are as
      follows (in thousands):





Fiscal
                Year2006
            
            2005Deferred
                tax asset:Net
                operating loss carryforwards:Federal
            
            $
            7,513
            
            $
            9,255Tax
                credits
            
            
            803
            
            
            738Advance
                payments from customers and deferred revenue
            
            
            8,230
            
            
            6,031Reserves
                and accruals not currently deductible for tax purposes
            
            
            1,022
            
            
            862Depreciation
            
            
            803
            
            
            759Other
            
            
            1,102
            
            
            906Total
                deferred tax asset
            
            
            19,473
            
            
            18,551Valuation
                allowance
            
            
            (19,328
            )
            
            (18,426
            )Net
                deferred tax asset
            
            
            145
            
            
            125Deferred
                tax liability:German
                operations
            
            
            (568
            )
            
            (641
            )Capitalized
                patent costs
            
            
            (145
            )
            
            (125
            )Total
                deferred tax liability
            
            
            (713
            )
            
            (766
            )Net
                deferred tax liability
            
            $
            (568
            )
            $
            (641
            )








67








The
      fiscal year 2004 acquisition of Challenge Card Design GmbH resulted in a
      deferred tax liability of $568,000 at March 31, 2006 and $641,000 at March
      31,
      2005.





As
      part
      of the process of preparing its consolidated financial statements, the Company
      is required to estimate income taxes in each of the jurisdictions in which
      it
      operates. This process involves estimating the actual current tax exposure
      together with assessing temporary differences resulting from differing treatment
      of items, such as deferred revenue, for tax and accounting purposes. These
      differences result in deferred tax assets and liabilities, which are included
      within the consolidated balance sheets. The Company must then assess the
      likelihood that the deferred tax assets will be recovered from future taxable
      income and to the extent that management believes recovery is not likely, the
      Company must establish a valuation allowance. To the extent that a valuation
      allowance is established or increased in a period, the Company includes an
      expense within the tax provision in the statements of operations.





Significant
      management judgment is required in determining the provision for income taxes
      and, in particular, any valuation allowance recorded against the Company’s
      deferred tax assets. The Company determined in fiscal year 2004 that due to
      the
      Company’s recent cumulative tax loss history for the previous three-year period,
      income statement loss history over the previous five quarters, and the
      difficulty in forecasting the timing of future revenue as evidenced by the
      deviations in achieved revenues from expected revenues during the previous
      few
      quarters and taking into account the newness of certain customer relationships,
      that it was necessary to increase the valuation allowance under SFAS No. 109
      to
      the full amount of the deferred tax asset. As a result, the Company determined
      that a full valuation allowance was required to net against its deferred tax
      assets in fiscal year 2004 and increased the existing allowance by $2.4 million
      to $14.8 million. In addition, the Company increased its valuation allowance
      against its deferred tax asset in the amount of $0.9 million during fiscal
      year
      2006 and $3.7 million during fiscal year 2005.





The
      Company's federal net operating loss carryforwards as of March 31, 2006 of
      $22.1
      million will expire at various dates from 2008 through 2024, if not utilized.
      The tax effect of this amount is reflected above as federal net operating loss
      carryforwards totaling $7.5 million. Of this amount, $6.3 million, representing
      tax benefits relating to stock-based compensation programs, will be credited
      to
      stockholders’ equity to the extent the Company concludes that it is more likely
      than not that this amount will be realized. Federal tax credits in the amount
      of
      $539,000 for alternative minimum taxes have no expiration. Federal tax credits
      in the amount of $238,000 will expire on various dates from 2013 through 2025,
      if not utilized. California tax credits in the amount of $26,000 have no
      expiration date.





The
      Company's methodology for determining the realizability of its deferred tax
      assets involves estimates of future taxable income; the estimated impact of
      future stock option deductions; and the expiration dates and amounts of net
      operating loss carryforwards. These estimates are based on near-term projections
      and assumptions which management believes to be reasonable. For recent prior
      periods through second quarter fiscal year 2004, the Company had been estimating
      future taxable income from its core business, which assumed on-going business
      under the U.S. government subcontract for Permanent Resident Cards (Green Cards)
      and Laser Visa Border Crossing Cards and the Canadian government’s Permanent
      Resident Card program, as well as estimated operating expenses to support that
      level of business, as offset by the estimated impact of future stock option
      deductions. Starting with the third quarter of fiscal year 2004, the Company
      estimated future taxable income based upon its expectations for the current
      and
      next three years because this past core business has not proven to be as stable
      as the Company had believed it to be and because this past core business is
      expected to represent an increasingly smaller part of the business. This is
      because the Company expected revenues from these U.S. programs to stabilize
      at
      revenue levels lower than had been expected in the past and because the Company
      expects new foreign business, which has fluctuated considerably quarter to
      quarter, to comprise a larger portion of the core business. The Company has
      had
      difficulty in the past, and expects to have continued difficulty in the future,
      in reliably forecasting its foreign business and the revenue to be received
      from
      it. This, in combination with the anticipated three-year cumulative tax loss
      for
      the period ended March 31, 2004, resulted in the Company basing its estimates
      of
      future income for these purposes to booked orders only. As circumstances change,
      the Company may in the future be able to revert back to estimating future
      revenue based upon its forecast revenues rather than only using booked orders,
      although the Company cannot say when this will occur.





In
      concluding that a valuation allowance was required at the end of fiscal year
      2004 and is still required at the end of fiscal year 2006, the Company
      considered both the positive and negative evidence regarding its ability to
      generate sufficient future taxable income to realize its deferred tax assets.
      Positive evidence included having achieved profitability for financial reporting
      purposes from fiscal year 1999 through fiscal year 2003. Other positive evidence





68





included
      (1) the level of sales and business experienced under the contract with the
      Canadian government’s Permanent Resident Card program; (2) prospects in Italy
      and a Middle Eastern country for national identification card programs; (3)
      the
      heightened interest in border security initiatives following the events of
      September 11, 2001; and (4) expected future orders. Negative evidence included
      (1) the Company’s reliance on a limited number of customers for a substantial
      portion of its business; (2) the uncertainty in timing of anticipated orders
      from customers; (3) the impact of future stock option deductions on taxable
      income; (4) recent experience of net operating loss carryforwards expiring
      unused through fiscal year 2004; (5) the financial statement loss for the fourth
      quarter of fiscal year 2003 through the first two quarters of fiscal year 2006;
      and (6) the prior three years’ cumulative tax net operating losses. In weighing
      the positive and negative evidence above, the Company considered the “more
      likely than not” criteria pursuant to SFAS No. 109 as well as the following
      risks: “dependence on VARs and on a limited number of customers,” “lengthy sales
      cycles,” “technological change,” and “competition”. As
      described above, the Company concluded that the negative evidence outweighed
      the
      positive evidence and as a result increased the valuation allowance to be equal
      to the full amount of the deferred tax asset as of March 31, 2005 and again
      at
      March 31, 2006.





In
      the
      event that actual results differ from these estimates or that these estimates
      are adjusted in future periods, the Company may need to adjust the amount of
      the
      valuation allowance based on future determinations of whether it is more likely
      than not that some or all of its deferred tax assets will be realized. A
      decrease in the valuation allowance would be recorded as an income tax benefit
      or a reduction of income tax expense or a credit to stockholders’ equity. The
      Company’s net operating losses available to reduce future taxable income expire
      on various dates from fiscal year 2008 through fiscal year 2024. To the extent
      that the Company generates taxable income in jurisdictions where the deferred
      tax asset relates to net operating losses that have been offset by a full
      valuation allowance, the utilization of these net operating losses would result
      in the reversal of the related valuation allowance.





**9.**
            **Issuance
                of Stock, Options and
                Warrants**





In
      December 2003,
      the Company issued and sold 791,172 shares of common stock, options to purchase
      122,292 shares of common stock and warrants to purchase 174,057 shares of common
      stock for an aggregate purchase price of $10.1 million in a private placement.
      The Company received net proceeds of $9.4 million (net of fees and expenses).
      The purchase price of the common stock was $12.76 per share, which was at a
      15%
      discount from the five-day average price as of December 23, 2003. The options
      had an exercise price of $16.51 per share and a nine-month life. The warrants
      have an exercise price of $17.26 per share and a life of five years. The options
      and warrants were valued at $245,000 and $984,000, respectively, based on a
      Black-Scholes calculation as of December 23, 2003 and pursuant to the provisions
      of EITF
      Issue No. 00-19, “Accounting
      for Derivative Financial Instruments Indexed to, and Potentially Settled in,
      a
      Company's Own Stock,” (EITF 00-19) were recorded at those values in short-term
      and long-term liabilities. The balance of the net proceeds was accounted for
      as
      additional paid-in capital. Under EITF 00-19, the Company marks-to-market the
      fair value of the options and warrants at the end of each accounting period.
      At
      December 31, 2003, this resulted in options and warrants valued at $195,000
      and
      $916,000, respectively. The decrease in the valuation of the options and
      warrants, between December 23, 2003 and December 31, 2003, of $118,000 was
      recorded as other income in the accompanying consolidated statements of
      operations and resulted from a decrease in the Company’s stock price. On
      February 6, 2004, the Company and the investors entered into an amendment to
      their original agreement that resulted in the reclassification of the options
      and warrants to equity. The amendment clarified that the options and warrants
      granted in the financing may be exercised at a time when a registration
      statement covering the resale of the underlying shares is not effective or
      available and that in such instance the Company would deliver to the investors
      shares of common stock whose resale is not currently registered. On the
      effective date of the amendment, the option and warrant value was reclassified
      to equity as additional paid-in capital. As a result of the increase in the
      value of the options and warrants from December 31, 2003 to the amendment date
      due to increases in the Company’s stock price, the Company recognized an expense
      of $211,000 which is included in other expense in the consolidated statements
      of
      operations for the fourth quarter of fiscal year 2004. The Company is subject
      to
      certain indemnity provisions included in the stock purchase agreement entered
      into as part of the financing in connection with its registration of the resale
      of the common stock issued and issuable in the financing. Morgan Keegan &
Company, Inc. acted as the Company's placement agent for this transaction and
      was granted warrants to purchase 15,824 shares of common stock. The option
      to
      purchase 122,292 shares of common stock expired on September 30,
      2004.





69








**10.**
            **Stock
                Repurchases**





On
      August
      2, 2004, the Company’s Board of Directors approved a 350,000 share repurchase
      program pursuant to which the Company could make open market or privately
      negotiated repurchase transactions for up to an aggregate of $3 million for
      a
      four-month period beginning August 2, 2004 and ending December 1, 2004. During
      fiscal year 2005, the Company repurchased 91,630 shares of common stock in
      the
      open market amounting to $655,000 at an average price of $7.15 per
      share.





**11.**
            **Acquisition**





On
      March
      31, 2004, the Company completed its acquisition of 100% of two related German
      card companies, Challenge Card Design Plastikkarten GmbH of Rastede, Germany
      and
      cards & more GmbH of Ratingen, Germany (collectively, the Acquired German
      Entities), including their sales operations in the USA and Korea. The Company
      purchased the shares of the Acquired German Entities from their five
      shareholders (the Shareholders) and purchased the intangible assets of the
      USA
      sales operation from a partnership comprised of the Shareholders. In the
      acquisition transaction, the Company agreed to assume approximately 0.5 million
      euros of debt and to pay approximately 4.75 million euros in cash, consisting
      of
      approximately 2.25 million euros payable at closing and the remaining
      approximately 2.5 million euros payable to the shareholders of the Acquired
      German Entities in five equal annual installments for the business and certain
      assets. The acquisition agreement specified that the purchase price be adjusted
      based upon other assets purchased and additional liabilities assumed. This
      resulted in a reduction in the purchase price of approximately 0.4 million
      euros
      as of March 31, 2004. This purchase price was determined by negotiation between
      the Company and the Shareholders, taking into account such matters as the value
      of the tangible assets and the going concern value of the business operations
      of
      the Acquired German Entities. Four of the Shareholders entered into new
      employment agreements with the Acquired German Entities while the fifth
      Shareholder, who is resident in the U.S., entered into an employment agreement
      with registrant. In addition to salaries, these employment agreements provide
      for commission based upon the results of operations of the Acquired German
      Entities which could be as much as 3.75 million euros over the next four years.
      The Company used a portion of its available cash to fund the acquisition. The
      Shareholders had no previous material relationship with the Company or its
      affiliate or subsidiaries, although the Company did substantial business with
      the Acquired German Entities during recent years. One of the Acquired German
      Entities owns a plant in Rastede, Germany together with associated equipment
      which it has used to manufacture plastic cards featuring contactless IC chip
      technology and high resolution printing. The Company intends to continue to
      use
      the facility and equipment to produce such cards as well as to enhance the
      facility to produce LaserCard® optical memory cards.





On
      January 6, 2005, a $2.2 million (1.6 million euros) payment was made to the
      former shareholders (currently Managing Directors) of the Acquired German
      Entities to settle in large part a loan related to the acquisition. As of March
      31, 2005, the outstanding balance of $203,000 (150,000 euros) was maintained
      by
      the Company in case the known contingent claim or other unknown claims develop
      into actual claims. The payment was approved on December 2, 2004 by the
      Company’s Board of Directors.





The
      primary reasons for the acquisition were to provide the Company with (1) a
      strong card manufacturing base to serve the European, Middle Eastern, African
      and Asian markets; (2) additional production capacity of up to 20 million
      advanced-technology cards per year; (3) an expanded product line; namely,
      contact IC chip cards, contactless RFID cards, magnetic stripe cards and color
      thermal printers for printing on cards; and (4) future cooperation in developing
      and marketing advanced, secure optical card solutions.





Goodwill
      is derived when the purchase price is greater than the value of the tangible
      and
      intangible assets acquired less the liabilities assumed. Factors that
      contributed to a purchase price that resulted in goodwill were (1) the assembled
      workforce, in particular the managing directors of the acquired companies;
      (2)
      the proximity of the managing directors to the target customer base; and (3)
      the
      ability of the managing directors to use their skills and specific know-how
      to
      enhance the Company's product offerings in the advanced technology card
      marketplace. Goodwill resulting from the purchase price allocation in the amount
      of $3.3 million was recorded as a result of the acquisition. Goodwill is not
      expected to be deductible for income tax purposes.





70








An
      intangible asset for backlog in the amount of $29,000 was recorded as a result
      of the acquisition. This was amortized as the backlog was shipped, which period
      was six months. There were no other amortizable intangible assets recorded.





The
      results of operations of the acquired entities from the acquisition date to
      fiscal year 2004 year-end have not been included in the Company's 2004 operating
      results, as the acquisition occurred at the end of the Company's fiscal year
      and
      the acquired entities' results during this period were not material. The cost
      of
      the acquired entities totaled $5.3 million, comprised of $3.1 million paid
      up-front plus future payments specified in the purchase agreement with a net
      present value of $2.2 million.





The
      total
      purchase price of $5.3 million has been allocated to the net assets acquired
      based on estimated fair values as follows (in thousands):





Current
                assets
            
            $
            4,577Property
                and equipment
            
            
            2,094Goodwill
                and other intangibles
            
            
            3,840Total
                assets acquired
            
            
            10,511Current
                liabilities
            
            
            (4,891
            )Long-term
                debt
            
            
            (369
            )Total
                liabilities assumed
            
            
            (5,260
            )Net
                assets acquired
            
            $
            5,251Cash
                paid
            
            $
            3,101Future
                payments accrued
            
            
            2,150Total
                purchase price
            
            $
            5,251





*Pro-Forma
      Financial Information* .
      Pro-forma financial information for the impact of the acquisition on the
      Company’s consolidated results of operations has not been presented as the
      Acquired German Entities were foreign entities who did not prepare financial
      statements in accordance with United States Generally Accepted Accounting
      Principles (U.S. GAAP). Reported revenues, excluding sales to the Company,
      for
      fiscal year 2004 for the entities on a local GAAP basis was $10.4 million
      (unaudited). On a local GAAP basis, which management believes does not
      materially differ from U.S. GAAP, results of operations of the acquired entities
      would not be material to the Company’s consolidated results of
      operations.











71





LASERCARD
      CORPORATION AND SUBSIDIARIES


SELECTED
      QUARTERLY FINANCIAL DATA (UNAUDITED)


(In
      thousands, except per share amounts)








1st
                Quarter
            
            2nd
                Quarter
            
            3rd
                Quarter
            
            4th
                QuarterFiscal
                year 2006:Total
                revenues
            
            $
            6,994
            
            $
            8,699
            
            $
            10,077
            
            $
            14,087Cost
                of product sales
            
            
            5,154
            
            
            6,206
            
            
            5,890
            
            
            7,554Gross
                Profit
            
            
            1,840
            
            
            2,493
            
            
            4,187
            
            
            6,533Net
                income (loss)
            
            
            (1,694
            )
            
            (564
            )
            
            1,154
            
            
            1,898Net
                income (loss) per share:Basic
            
            $
            (0.15
            )
            $
            (0.05
            )
            $
            0.10
            
            $
            0.16Diluted
            
            $
            (0.15
            )
            $
            (0.05
            )
            $
            0.10
            
            $
            0.15Weighted
                average number of common and common equivalent shares:Basic
            
            
            11,345
            
            
            11,355
            
            
            11,375
            
            
            11,584Diluted
            
            
            11,345
            
            
            11,355
            
            
            11,577
            
            
            12,251Fiscal
                year 2005:Total
                revenues
            
            $
            8,710
            
            $
            7,773
            
            $
            6,282
            
            $
            5,779Cost
                of product sales
            
            
            6,366
            
            
            5,842
            
            
            5,477
            
            
            4,952Gross
                Profit
            
            
            2,344
            
            
            1,931
            
            
            805
            
            
            827Net
                loss
            
            
            (1,544
            )
            
            (1,521
            )
            
            (2,841
            )
            
            (2,995
            )Net
                loss per share:Basic
                and Diluted
            
            $
            (0.14
            )
            $
            (0.13
            )
            $
            (0.25
            )
            $
            (0.26
            )Weighted
                average number of common and common equivalent shares:Basic
                and Diluted
            
            
            11,407
            
            
            11,368
            
            
            11,314
            
            
            11,340











72








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





There
      have been no disagreements with our accountant on accounting and financial
      disclosure.





ITEM
              9A.
            CONTROLS
                AND PROCEDURES





(a)  *Evaluation
      of Disclosure Controls and Procedures* .
      We
      maintain disclosure controls and procedures that are designed to ensure that
      information required to be disclosed by us in reports that we file or submit
      under the Securities Exchange Act of 1934 is recorded, processed, summarized,
      and reported within the time periods specified in Securities and Exchange
      Commission rules and forms, and that such information is accumulated and
      communicated to our management, including our Chief Executive Officer and Chief
      Financial Officer, as appropriate, to allow timely decisions regarding required
      disclosure. In designing and evaluating our disclosure controls and procedures,
      management recognized that disclosure controls and procedures, no matter how
      well conceived and operated, can provide only reasonable, not absolute,
      assurance that the objectives of the disclosure controls and procedures are
      met.  Our disclosure controls and procedures have been designed to meet,
      and management believes that they meet, reasonable assurance standards. 
Additionally, in designing disclosure controls and procedures, our management
      necessarily was required to apply its judgment in evaluating the cost-benefit
      relationship of possible disclosure controls and procedures. The design of
      any
      disclosure controls and procedures also is based in part upon certain
      assumptions about the likelihood of future events, and there can be no assurance
      that any design will succeed in achieving its stated goals under all potential
      future conditions.





Based
      on
      their evaluation as of the end of the period covered by this Form 10-K, our
      Chief Executive Officer and Chief Financial Officer have concluded that, subject
      to the limitations noted above, as of such dates, our disclosure controls and
      procedures were effective at the reasonable assurance level.





(b) *Management’s
      Annual Report on Internal Control Over Financial Reporting.* Our
      management is responsible for establishing and maintaining adequate internal
      control over our financial reporting, which is designed to provide reasonable
      assurance regarding the reliability of our financial reporting and the
      preparation of financial statements for external purposes in accordance with
      U.S. generally accepted accounting principles. Internal control over financial
      reporting includes those policies and procedures that: (i) pertain to the
      maintenance of records that, in reasonable detail, accurately and fairly reflect
      the transactions and dispositions of our assets; (ii) provide reasonable
      assurance that transactions are recorded as necessary to permit preparation
      of
      financial statements in accordance with U.S. generally accepted accounting
      principles, and that receipts and expenditures of the Company are being made
      only in accordance with authorizations of our management and directors; and
      (iii) provide reasonable assurance regarding prevention or timely detection
      of unauthorized acquisition, use or disposition of our assets that could have
      a
      material effect on the financial statements. Management assessed the
      effectiveness of our internal control over financial reporting as of March
      31,
      2006. In making this assessment, management used the criteria set forth by
      the
      Committee of Sponsoring Organizations of the Treadway Commission in *Internal
      Control-Integrated Framework.* Based
      on
      the assessment using those criteria, management concluded that, as of March
      31,
      2006, our internal control over financial reporting is effective.





(c)  *Attestation
      Report of the Registered Public Accounting Firm.* Our
      independent registered public accountants, Odenberg Ullakko Muranishi &
Co., LLP, audited the consolidated financial statements included in this Annual
      Report on Form 10-K and have issued an audit report on management’s
      assessment of our internal control over financial reporting as well as on the
      effectiveness of our internal control over financial reporting. Each of the
      reports on the audit of internal control over financial reporting and the report
      on the audit of the consolidated financial statements appear elsewhere in this
      Annual Report on Form 10-K




(d) *Changes
      in Internal Control over Financial Reporting.* There
      were no significant changes in the Company’s internal control over financial
      reporting that occurred during the fourth quarter of fiscal year
      2006 ** that
      have
      materially affected, or are reasonably likely to materially affect, the
      Company’s internal control over financial reporting.





ITEM
              9B.
            OTHER
                INFORMATION





None.





73


PART
      III





ITEM
              10.
            DIRECTORS
                AND EXECUTIVE OFFICERS OF THE REGISTRANT





**A.**
              **Directors
                  and Executive
                  Officers**





The
      current members of the board of directors and executive officers of the Company
      are as follows:





Officer
                orDirectorName
            
            Age
            
            Since
            
            Position
                with Registrant and, If Different, Principal OccupationRichard
                M. Haddock
            
            54
            
            1997
            
            Director
                (since 2001) and Chief Executive Officer (since November 2004) and
                President (since September 2005).
                Previously Co-Chief Executive Officer from August 2003 through November
                2004 and President and Chief Operating Officer from1997
                through November 2003.Christopher
                J. Dyball
            
            55
            
            1992
            
            Director
                (since 2001) and Chief Operating Officer (since November 2004).
                Formerly President from November 2004 through September 2005, Co-Chief
                Executive Officer from August 2003 through November 2004 and Executive
                Vice Presidentfrom 1992 through November 2003.Steven
                G. Larson
            
            56
            
            1987
            
            Vice
                President of Finance, Treasurer and Assistant Secretary of LaserCard
                Corporation.Stephen
                D. Price-Francis
            
            59
            
            2004
            
            Vice
                President of Business Development (since November 2004) of LaserCard
                Corporation. Previously Director of Business Development since 1999.
                Member of the Board of Directors, North American Security Products
                Organization; Past president, Advanced Card Technology Association
                of
                Canada (ACT Canada).Arthur
                H. Hausman
            
            82
            
            1981
            
            Director.
                Private investor. Retired Chairman, President and ChiefExecutive Officer of Ampex Corporation (manufacturer of professionalaudio-video
                systems, data/memory products and magnetic tape). Director of CalAmp
                Corp.
                (since 1987) (direct broadcast satellite product).Donald
                E. Mattson
            
            73
            
            2005
            
            Director.
                Private investor. Retired Senior Vice President and Chief Operating
                Officer of InVision Technologies, an explosives detection systems
                manufacturer, until its acquisition by GE.Dan
                Maydan
            
            70
            
            1998
            
            Director.
                President Emeritus (since April 2003),Board
                of Trustees of PAMF (Palo Alto Medical Foundation) since 2003, Board
                of
                Directors of Infinera (a private, optical communication systems company)
                since 2001, Board of Directors of Ponte Solutions (a private, Semi
                Conductor Company) since 2004, formerly
                Director and President of Applied Materials, Inc. (semiconductor
                manufacturing equipment). Director of Electronics for Imaging, Inc.
                (software). Member of the National Academy of
                Engineering.Albert
                J. Moyer
            
            62
            
            2005
            
            Director.
                Private investor. RetiredExecutive
                Vice President and Chief Financial Officer of QAD Inc. (a
                publicly held software company and subsequently served as consultant
                to
                QAD). Previously Director of QAD, Inc. from 2000 - 2005, Collectors’
                Universe (collectibles markets), Inc. (since 2003), CalAmp Corp.
                (direct
                broadcast satellite products) (since 2004) and Virco Manufacturing
                Corp.
                (a leading supplier of education furniture) (since
                2004).Walter
                F. Walker
            
            51
            
            1999
            
            Director. 
                President, CEO and Director (since 2001) of The Basketball Club of
                Seattle, LLC, which owns the Seattle Sonics & Storm Basketball teams
                (NBA and WNBA basketball); formerly President (since 1994) of Seattle
                SuperSonics NBA basketball team. Previously, was President (in 1994)
                of
                Walker Capital, Inc. (money management firm) and Vice President (from
                1987
                to 1994) of Goldman Sachs & Co. (investment banking firm). Director of
                Advanced Digital Information Corporation (archival and backup data-storage
                peripherals). Member of the Institute of Chartered Financial Analysts
                (CFAs).




It
      is
      anticipated that each of the remaining directors and executive officers will
      continue in his position, although there is no understanding or arrangement
      to
      that effect. Each director holds office until the next annual meeting of
      stockholders and until such director's successor is elected and qualified.
      However, any of the above directors or executive officers could resign and
      any
      of the officers could be replaced or removed by the Board of Directors at any
      time. There are no family relationships among any directors or executive
      officers of the Company.





74








**B.**
            **Section
                16(a) Beneficial Ownership Reporting
                Compliance**





Section
      16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's
      directors, executive officers and beneficial owners of more than 10% of the
      Company's common stock to file with the Securities and Exchange Commission
      (SEC)
      initial reports of ownership and reports of changes in ownership of common
      stock
      and other equity securities of the Company. The Company typically files these
      reports on behalf of its directors and officers, based on information provided
      by them. The Company believes, based on its review of Forms 3, 4, 5, if any,
      and
      periodic written representations from reporting persons, that all other
      officers, directors and holders of more than 10% of the Company's common stock
      complied with all Section 16(a) filing requirements for the 2006 fiscal year.
      The Company’s website at www.lasercard.com contains copies of the fiscal year
      2006 and subsequent filings of Forms 3, 4 and 5 related to beneficial ownership
      by the Company’s directors and executive officers and the SEC’s EDGAR database
      website at
      www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=30140&owner=only
      contains this information as soon as it is posted by the SEC.





**C.**
            **Audit
                Committee**





The
      members of the Audit Committee of the Board of Directors are four non-employee
      directors, Albert J. Moyer, Arthur H. Hausman, Walter F. Walker, and Donald
      E.
      Mattson each of whom has been determined to be independent in accordance with
      the rules of The Nasdaq Stock Market and the Securities and Exchange Commission.
      Messr. Moyer is an “audit committee financial expert” as defined by the
      Securities and Exchange Commission.





**D.**
            **Code
                of Ethics**





The
      Company has adopted a code of ethics that applies to all Company employees.
      A
      copy of this code of ethics is accessible free of charge on the Company’s
      Internet website for investor relations (www.lasercard.com). Information
      contained on the Company’s website is not part of this report.












75





ITEM
              11.
            EXECUTIVE
                COMPENSATION





**A.**
            **Compensation
                of Executive Officers**





The
      Summary Compensation table below discloses the total compensation awarded to,
      earned by, or paid to each of the four persons who have served as the Company's
      executive officers for the three fiscal years ended March 31, 2006, for services
      rendered in all capacities to the Company and its subsidiaries.





SUMMARY
      COMPENSATION TABLE







Annual
                Compensation
            
            Long-Term
                CompensationName
                and Principal Position
            
            Fiscal
              Year
            
            Salary
                ($)
            
            Bonus
                ($)
            
            Securities
                Underlying
              Option
                Grants (#)
            
            All
                Other
              Compensation(1)Richard
                M. Haddock
            
            2006
            
            $
            332,690
            
            $
            241,713
            
            
            75,000
            
            $
            4,583President
                & Chief Executive Officer
            
            2005
            
            
            363,352
            
            
            —
            
            
            —
            
            
            3,423(since
                November 30, 2004)
            
            2004
            
            
            318,176
            
            
            —
            
            
            —
            
            
            —Christopher
                J. Dyball
            
            2006
            
            $
            323,821
            
            $
            182,918
            
            
            65,000
            
            $
            4,542Chief
                Operating Officer
            
            2005
            
            
            364,475
            
            
            —
            
            
            —
            
            
            3,423(since
                November 30, 2004)
            
            2004
            
            
            314,408
            
            
            —
            
            
            —
            
            
            —Steven
                G. Larson
            
            2006
            
            $
            256,598
            
            $
            137,842
            
            
            45,000
            
            $
            3,857Vice
                President of Finance
            
            2005
            
            
            265,453
            
            
            —
            
            
            —
            
            
            3,293and
                Treasurer
            
            2004
            
            
            250,150
            
            
            —
            
            
            —
            
            
            —Steven
                D. Price-Francis
            
            2006
            
            $
            163,998
            
            $
            96,685
            
            
            35,000
            
            $
            2,443Vice
                President of
            
            2005
            
            
            46,444
            
            
            —
            
            
            —
            
            
            697Business
                Development (2)


_____________________





(1)
            Represents
                the Company’s matching contribution on behalf of these individuals in the
                Company’s 401(k) Plan.





(2)
            Stephen
                D. Price-Francis was named Vice President, Business Development of
                LaserCard Corporation on December 2, 2004. His compensation shown
                is since
                that date.





*Stock
      Option Grants to Executive Officers*





The
      stock
      option table below discloses the total stock options granted to the Company's
      four executive officers under the Company's Stock Option Plan during the fiscal
      year ended March 31, 2006.





STOCK
      OPTION GRANTS TO EXECUTIVE OFFICERS





Individual
                  GrantsNumber
                  of
              
              Percent
                  of TotalSecurities
              
              Options
                  Granted to
              
              
              
              
              
              Potential
                  Realizable Value at AssumedUnderlying
                  Options
              
              Employees
                  in Fiscal
              
              Exercise
                  or Base
              
              
              
              Annual
                  Rates of Stock PriceName
              Granted
              
              Year
              
              Price/Share
              
              Expiration
                  Date
              
              Appreciation
                  for Option Term5%
              
              10%Richard
                  Haddock
              75,000
              
              16.0%
              
              $
                  6.045
              
              5/24/2015
              
              $
                  285,125
              
              $
                  722,563Christopher
                  Dyball
              65,000
              
              13.9%
              
              $
                  6.045
              
              5/24/2015
              
              $
                  247,109
              
              $
                  626,221Steven
                  Larson
              45,000
              
              9.6%
              
              $
                  6.045
              
              5/24/2015
              
              $
                  171,075
              
              $
                  433,538Stephen
                  Price-Francis
              35,000
              
              7.5%
              
              $
                  6.045
              
              5/24/2015
              
              $
                  133,058
              
              $
                  337,196








76








*Aggregated
      Option Exercises and Options Held by Executive Officers*





The
      following table sets forth the value of options exercised by the Company's
      executive officers during the fiscal year ended March 31, 2006 and remaining
      options held at fiscal year end.





AGGREGATED
      OPTION EXERCISES IN LAST FISCAL YEAR


AND
      FISCAL YEAR-END OPTION VALUES





Shares
                Acquired
                  on
                Exercise
              
              Value
                  Realized
              
              Number
                  of Securities Underlying Unexercised Options at Fiscal Year-End
                  (#)
              
              Value
                  of Unexercised In-the-Money Options at Fiscal Year-End
                  ($)(2)Name
              
              (#)
              
              ($)(1)
              
              Exercisable
              
              Unexercisable
              
              Exercisable
              
              UnexercisableRichard
                  Haddock
              
              
              5,000
              
              $
              25,550
              
              
              228,500
              
              
              87,500
              
              $
              1,990,840
              
              $
              1,290,500Christopher
                  Dyball
              
              
              —
              
              
              —
              
              
              235,200
              
              
              77,500
              
              $
              2,094,576
              
              $
              1,126,400Steven
                  Larson
              
              
              10,190
              
              $
              88,602
              
              
              150,727
              
              
              53,750
              
              $
              1,278,916
              
              $
              780,275Stephen
                  Price-Francis
              
              
              —
              
              
              —
              
              
              22,462
              
              
              36,688
              
              $
              227,361
              
              $
              586,959




______________________





(1)
            Market
                value of underlying securities (based on the fair market value of
                the
                Company's common stock on The Nasdaq Stock Market) at the time of
                their
                exercise, minus the exercise price.




(2)
            Market
                value of securities underlying in-the-money options at fiscal year
                end
                (based on $22.455 per share, the average market price of the Company's
                common stock on The Nasdaq Stock Market on the last day of the Company’s
                fiscal year) minus the exercise
                price.





**B.**
            **Compensation
                of Directors**





During
      fiscal year 2006, each non-employee director received an annual fee of $21,000
      for serving as a director, the standard fee in effect since October 1, 2005.
      The
      Chairman of the Board received an additional $19,000.





The
      Chairman of each committee is paid an additional $10,000, $5,000, and $2,000
      per
      year for serving on the Board, Compensation, and Nominating and Corporate
      Governance Committees, respectively. Audit Committee members are paid an
      additional $5,000 per year. All retainer fees were prorated over 12 months.





The
      Company also pays each member no more than $7,500, $2,000, and $1,000 per year
      for meeting attendance on the Audit, Compensation, and Nominating and Corporate
      Governance Committees, respectively. Fees for meeting attendance were paid
      per
      meeting. Reasonable out-of-pocket expenses incurred by directors for performing
      services for the Company were also reimbursed.





The
      Company's 2004 Equity Incentive Compensation Plan provides for the automatic
      grant of an option to purchase 15,000 shares of the Company's common stock
      on
      the date any person first becomes a director. These grants to newly elected
      directors have become exercisable in cumulative increments of one-fourth (1/4)
      each at the end of 12 months, 24 months, 36 months and 48 months from the date
      of grant. The 2004 Equity Incentive Compensation Plan further provides that
      on
      the date of the Company's annual meeting, each non-employee director who has
      been a director of the Company for the preceding six-month period and who is
      re-elected at the annual meeting, is automatically granted an option to purchase
      6,000 shares of the Company's common stock. The option share grants to the
      re-elected directors are exercisable in full at the time of grant. The exercise
      price for options granted to newly elected directors and re-elected directors
      is
      the fair market value of the Company's common stock on the date of
      grant.





**C.**
            **Employment
                Contracts, Termination of Employment and Change-in-Control
                Arrangements**





None
      of
      the Company's executive officers has employment or severance arrangements with
      the Company. Under the terms of the Stock Option Plan, the Board of Directors
      and/or Stock Option Committee retains discretion, subject to certain limits,
      to
      modify the terms of outstanding options. In the event of a merger or sale of
      assets or like event, the Board of Directors is empowered to make appropriate
      adjustments to options under the Stock Option Plan. The Board of Directors
      has
      adopted guidelines specifying the following as adjustments that it would
      consider appropriate upon the occurrence of such an event:





77











o
            permitting
                optionees no less than 30 days to exercise the vested portion of
                their
                options;





o
            having
                the successor corporation either (a) issue to optionees replacement
                options for the unvested portions of options, or else (b) pay deferred
                compensation on the spread between the value of Company stock upon
                the
                occurrence of such event and the option exercise price at the time
                such
                unvested portion would have vested;
                and





o
            providing
                for vesting of 100% of the unvested portion for optionees employed
                by the
                Company for at least two years prior to such event if their employment
                is
                terminated within one year of such event by the successor corporation
                other than by resignation or for acts of moral
                turpitude.





**D.**
            **Compensation
                Committee Interlocks and Insider
                Participation**





During
      fiscal year 2006, none of the Company’s executive officers served on the board
      of directors of any entities whose directors or officers serve on the Company’s
      Compensation Committee. During fiscal year 2006, Mr. Hausman, Dr. Maydan and
      Mr.
      Moyer served as members of the Compensation Committee, which is currently
      composed entirely of three outside directors who are not officers or employees
      of the Company. As presently established, the Compensation Committee approves
      the salary of executive officers, including the Chief Executive Officer and
      certain other employees.




**E.**
            **Compensation
                Committee Report on Fiscal 2006 Executive Compensation**




*Notwithstanding
      anything to the contrary set forth in any of the Company’s previous filings
      under the Securities Act of 1933 or the Securities Exchange Act of 1934, that
      might incorporate future filings, including this Form 10-K, in whole or in
      part,
      the following Compensation Committee Report shall not be incorporated by
      reference into any such filings, nor shall it be deemed to be soliciting
      material or deemed filed with the Securities and Exchange Commission under
      the
      Securities Act of 1933 or under the Securities Exchange Act of 1934.*




*Committee
      Independence* .
      The
      Board of Directors has established Compensation Committee which is composed
      entirely of outside directors who are not officers or employees of the Company
      and who are independent. The Committee reports to the Board of Directors on
      its
      activities. The current members of the Committee are Arthur H. Hausman
      (Chairman), Dan Maydan, and Albert J. Moyer. Under
      its
      charter adopted by the Board of Directors, the Committee is responsible, on
      behalf of the Board, for reviewing and approving compensation programs,
      policies, and plans designed to motivate personnel to achieve Company
      objectives. One of the key responsibilities of the Committee is to recommend
      to
      the independent directors for their approval the compensation of the Chief
      Executive Officer (the “CEO”), taking into account his evaluation by the Board
      of Directors. Other responsibilities include: review and approve recommendations
      from the CEO for the compensation of officers, other senior managers, and key
      employees; review and approve recommendations regarding stock option grants
      for
      specific employees as provided under existing Company plans; and review and
      approve the concept and design of management incentive plans and programs for
      Company officers, other senior managers, and key employees. An additional
      responsibility of the Committee is to review and approve recommendations
      regarding changes in compensation of non-employee directors.




*Compensation
      Philosophy* .
      The
      Company's compensation practices are intended to provide total compensation
      opportunities that are competitive with the pay practices of similar,
      high-technology companies. The goal of these compensation practices is to enable
      the Company to attract, retain and motivate superior performing officers and
      employees and to align compensation with the Company’s business objectives and
      performance. This is accomplished through a combination of base salary, cash
      bonuses and stock options. The Company believes that its compensation philosophy
      closely aligns employee interests with those of its stockholders and provides
      incentives for management to strive to i ncrease
      shareholder value and contribute to the long-term success of the
      Company .




*Base
      Salary.* The
      annual base salaries paid to the Company's four executive officers were
      decreased during fiscal 2006 as the Company instituted the bonus plan described
      below designed to be a meaningful element of executive officer compensation
      if
      the performance of the Company and individual officer merited. The Compensation
      Committee annually reviews and recommends to the independent directors the
      base
      salary level for the CEO, based on industry practice, competitive factors,
      prior
      experience, technical and administrative ability, position and responsibility,
      corporate performance, individual contribution, recommendations of executive
      management, in-depth knowledge of the Company and its technology and similar
      factors. The
      Committee annually discusses with the CEO his similar analysis of the base
      salary of the other executive officers in deciding whether to approve the CEO’s
      recommendation of the salaries of the other executive officers. Consistent
      with
      the Company’s current size, the Committee believes current executive salaries
      are comparable to the average salaries offered by competitive companies.





78











*Bonus
      Compensation.* In the
      past, cash bonuses were occasionally awarded to executive officers and
      management employees based upon criteria such as pre-tax, pre-bonus Company
      earnings and licensing revenues, with various adjustments. No bonuses were
      awarded to executive officers for fiscal 2003, 2004 and 2005. In fiscal 2006, the
      Company established a bonus plan that provides for bonuses to be awarded to
      executive officers and key employees based on specific goals achieved by the
      Company and the level of contribution to achievement of the goals by the
      executive officers and key employees. The Company’s performance objectives
      include operating, strategic and financial goals considered critical to the
      Company’s short and long term goals. The bonus plan is designed such that
      bonuses when combined with salaries create total compensation which is
      comparable to the average compensation of successful companies against which
      the
      Company competes in hiring and retaining key employees.





*Stock
      Option Grants.* Stock
      options are granted to a broad range of the Company's employees, including
      executive officers and outside directors receive automatic option grants. These
      awards are made to recruit, retain and motivate the employees and outside
      directors and to align their personal financial interests with those of the
      Company’s shareholders. Eligible employees are generally granted options upon
      commencement of employment and are considered for additional options
      periodically thereafter. In recommending stock options the Committee considers
      individual performance, overall contribution to the Company, retention, the
      number of unvested stock options and the total number of stock options to be
      granted. Options are generally granted with an exercise price equal to the
      market price of the Common Stock on the date of grant and generally vest over
      a
      four-year period. This approach is designed to focus key employees on
      sustainable growth of the Company and the creation of shareholder value over
      the
      long term. During fiscal 2004 and 2005 no options were granted to the executive
      officers. The decision was made in fiscal 2006 that option grants should be
      a
      major component of the compensation package of executive officers. Therefore,
      in
      fiscal 2006, the Company granted options which were larger than it would
      otherwise have granted had the executive officers possessed substantial unvested
      options from prior grants.





*CEO
      Compensation.*  The
      Committee uses the same procedures described above in recommending to the
      independent directors regarding the annual salary, bonus, and stock option
      awards for the CEO. The Committee determines the CEO’s compensation based on
      objective data synthesized to competitive ranges following a statistical
      analysis and subjective policies and practices, including assessment of the
      CEO’s achievements, and a review of compensation paid to CEOs of competitive
      companies. The Committee believes that the CEO’s salary and bonus plan reflects
      the CEO’s achievements and is comparable to the cash compensation offered to
      CEOs of competitive companies. The Committee believes the CEO’s option award,
      considered in combination with the number of unvested options held, reflects
      his
      performance and overall contribution to the Company, and the need to have
      unvested options for retention purposes, and is comparable to the equity
      compensation paid to CEOs of competitive companies.





*Conclusion.*  As
      a
      significant portion of the Company’s compensation program is linked to Company
      performance, the Committee believes that compensation is closely tied to
      increases in long-term shareholder value.





*Compliance
      with Internal Revenue Code Section 162(m)* .
      The
      provisions of Section 162(m) of the Internal Revenue Code do not currently
      affect any of the Company's executive officers. Section 162(m) imposes a $1
      million annual limit on the amount of compensation deductible by the Company
      with respect to each executive officer employed as of the last day of the
      applicable year. While the Company will consider deductibility under Section
      162(m) with respect to future compensation arrangements with executive officers,
      deductibility would not be the sole factor used in ascertaining appropriate
      levels or modes of compensation. Since corporate objectives may not always
      be
      consistent with the requirements for full deductibility, it is conceivable
      that
      the Company may enter into compensation arrangements in the future under which
      payments would not be deductible under Section 162(m).




**Compensation
      Committee**


Arthur
      H.
      Hausman (Chairman)


Dan
      Maydan


Albert
      J.
      Moyer








79








**F.**
            **Stock
                Performance Graph**





In
      the
      following stock performance graph, the cumulative total return on investment
      for
      the Company’s common stock over the past five fiscal years is compared with the
      Russell 2000 Stock Index (“Russell 2000”) and the University of Chicago Center
      for Research in Security Prices (CRSP) Total Return Index for the Nasdaq
      Stock Market Electronic Components industry group (“Nasdaq Electronic
      Components”). The Russell 2000 is a benchmark index for small capitalization
      stocks. The Nasdaq Electronic Components index is used because the majority
      of
      the Company’s revenues currently are derived from the sale of optical recording
      media (optical memory cards). The chart assumes that the value of the investment
      in the Company and each index was $100 on March 31, 2001, and that any
      dividends were reinvested.











The
      stock
      performance graph was plotted using the following data:





Fiscal
                  Year Ended March 31,2001
              
              2002
              
              2003
              
              2004
              
              2005
              
              2006LaserCard
                  Corporation
              
              $
              100.00
              
              $
              180.79
              
              $
              116.56
              
              $
              107.07
              
              $
              40.03
              
              $
              180.87Russell
                  2000
              
              
              100.00
              
              
              113.98
              
              
              83.25
              
              
              136.39
              
              
              143.77
              
              
              180.93CRSP
                  Nasdaq Electronic Components
              
              
              100.00
              
              
              108.62
              
              
              56.50
              
              
              95.49
              
              
              79.70
              
              
              87.97











80








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





The
      table
      below, based upon information supplied by the principal stockholders, shows
      the
      name, address, number of shares held, nature of ownership and percentage of
      shares held as of March 31, 2006 by the persons or entities known to the Company
      to own beneficially more than 5% of the outstanding common stock. Applicable
      percentages are based on 11,734,255 shares outstanding on March 31,
      2006.





BENEFICIAL
      OWNERSHIP BY PRINCIPAL STOCKHOLDERS





Name
                  and Address of Beneficial Owner
              
              Common
                Shares
                  (1)
              
              Percent
                  ofClass
                  (2)American
                  Century Investment Management
                4500
                  Main St., 4th Floor, Kansas City, MO  64111
              
              
              646,399
              
              
              5.5%


_____________________





(1)
            The
                stockholder named in this table has sole voting and investment power
                with
                respect to the shares indicated as beneficially owned, subject to
                community property laws, where applicable, and the information contained
                in the footnotes to this table.




(2)
            For
                purposes of computing the percentage of outstanding shares held by
                each
                person or group of persons named above on a given date, shares which
                such
                person or group has the right to acquire within 60 days after such
                date
                are deemed to be outstanding, but are not deemed to be outstanding
                for the
                purposes of computing the percentage ownership of any other
                person.





The
      following table contains information as of March 31, 2006, respecting the number
      of shares and percentage of the Company's common stock beneficially owned by
      each of the Company's seven directors, by each executive officer of the Company,
      and by all executive officers and directors as a group. The address of each
      beneficial owner listed in the table is c/o LaserCard Corporation, 1875 North
      Shoreline Boulevard, Mountain View, California 94043. Applicable percentages
      are
      based on 11,734,255 shares outstanding on March 31, 2006.





STOCK
      OWNERSHIP BY DIRECTORS AND EXECUTIVE OFFICERS





Name
            
            
            Common
                Shares (1)
            
            Percent
                of Class (2)Christopher
                J. Dyball
            
            
            268,099
                (3)
            
            
            2.2%Richard
                M. Haddock
            
            
            272,713
                (4)
            
            
            2.3%Arthur
                H. Hausman
            
            
            74,392
                (5)
            
            
            0.6%Steven
                G. Larson
            
            
            173,784
                (6)
            
            
            1.5%Donald
                E. Mattson
            
            
            9,750
                (7)
            
            
            0.1%Dan
                Maydan
            
            
            33,000
                (8)
            
            
            0.3%Albert
                J. Moyer
            
            
            9,750
                (9)
            
            
            0.1%Stephen
                Price-Francis
            
            
            33,353
                (10
            )
            
            0.3%Walter
                F. Walker
            
            
            121,539
                (11
            )
            
            1.0%All
                executive officers and directors as a group
            
            
            996,380
                (12
            )
            
            7.9%


_____________________





(1)
            To
                the Company’s knowledge, the persons named in the table have sole voting
                and investment power with respect to all shares of common stock shown
                as
                beneficially owned by them, subject to community property laws, where
                applicable, and the information contained in the footnotes to this
                table.




(2)
            For
                purposes of computing the percentage of outstanding shares held by
                each
                person or group of persons named above on a given date, shares which
                such
                person or group has the right to acquire within 60 days after such
                date
                are deemed to be outstanding, but are not deemed to be outstanding
                for the
                purposes of computing the percentage ownership of any other
                person.







81










(3)
            Includes
                251,450 shares purchasable by exercise of option within 60
                days.




(4)
            Includes
                247,250 shares purchasable by exercise of option within 60
                days.




(5)
            Includes
                54,000 shares purchasable by exercise of option within 60
                days.




(6)
            Includes
                161,977 shares purchasable by exercise of option within 60
                days.




(7)
            Includes
                9,750 shares purchasable by exercise of option within 60
                days.




(8)
            Includes
                33,000 shares purchasable by exercise of option within 60
                days.




(9)
            Includes
                9,750 shares purchasable by exercise of option within 60
                days.




(10)
            Includes
                31,212 shares purchasable by exercise of options within 60
                days.




(11)
            Includes
                49,000 shares purchasable by exercise of option within 60 days. Does
                not
                include 1,000 shares owned by Mr. Walker's wife, as to which shares
                Mr. Walker disclaims any beneficial
                ownership.




(12)
            Includes
                847,389 shares purchasable by exercise of option within 60
                days.










82








EQUITY
      COMPENSATION PLAN INFORMATION





The
      table
      below shows information as of March 31, 2006, with respect to equity
      compensation plans under which equity securities of the Company are authorized
      for issuance. The Company’s equity compensation plans, consisting of the
      Company’s prior Stock Option Plan, 2004 Equity Incentive Compensation Plan, and
      Employee Stock Purchase Plan, are approved by security holders.





Plan
                Category
            
            Number
                of Securities to Be
              Issued
                upon Exercise of
              Outstanding
                Options,
              Warrants
                and Rights
            
            Weighted-Average
              Exercise
                Price of
              Outstanding
                Options,
              Warrants
                and Rights
            
            Number
                of Securities Remaining
              Available
                for Future Issuance under
              Equity
                Compensation Plans (Excluding
              Securities
                Reflected in Column (a))(a)
            
            (b)
            
            (c)Equity
                compensation plans approved by security holders
            
            1,943,673
            
            $12.20
            
            483,276
                (1)Equity
                compensation plans not approved by security holders (Nasdaq
                exemption Rule No. 4350(i)(1)(A))
            
            135,824
                (2)
            
            $13.81
            
            —


_____________________





(1)
            Includes
                61,517 shares reserved as of March 31, 2006 for future purchases
                by
                employees through payroll deductions under the Company’s Employee Stock
                Purchase Plan, which is available to all regular employees who work
                a
                minimum of 30 hours per week and who have completed six months of
                employment with the Company and 421,759 shares under the 2004 Equity
                Incentive Compensation Plan.





(2)
            Includes
                options to purchase 120,000 shares of common stock granted to six
                key
                employees of the acquired German subsidiaries and warrants to purchase
                15,824 shares of common stock granted to the placement agent in our
                December 2003 private placement.  See Notes 6 and
                9 of Notes to Financial Statements for a
                description
                of our equity compensation plans that do not require the approval of and have not been
                approved by our shareholders.  Excludes warrants outstanding as of
                March 31, 2006, to purchase 158,233 shares of common stock issued
                to
                investors in our December2003
                private placement.





ITEM
      13.  CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS





Since
      October 21, 2001, the Company contracted with Wexler & Walker Public Policy
      Associates, a unit of Hill and Knowlton, Inc., (“Wexler”) to be lobbyists on
      behalf of the Company. The Chairman of Wexler is Robert S. Walker, a brother
      of
      director Walter F. Walker. In October 2002, the agreement was extended for
      the
      period October 1, 2002 through September 2003 or until terminated upon seven
      days’ notice. The extended agreement provides for a monthly retainer of $10,000
      and there currently is a purchase order dated November 12, 2004 valid through
      April 29, 2005 with the same terms and conditions of the previous agreement.
      In
      addition, there is another purchase order dated February 25, 2005 in the total
      of $35,000 to cover the consulting services for the period from January 2005
      to
      April 2005. The purchase order was extended from May 2005 through July 2006
      in
      the aggregate amount of $125,000. The Company paid Wexler $142,082 during fiscal
      year 2006, $206,000 during fiscal year 2005, and $151,000 during fiscal year
      2004. As of March 31, 2006, $10,012 was due to Wexler.





83








ITEM
      14.  PRINCIPAL
      ACCOUNTANT FEES AND SERVICES





**Audit
      and Non-Audit Fees**





The
      following table shows the aggregate fees billed to the Company by its previous
      independent accountants, KPMG LLP (“KPMG”) and by its current independent
      accountants, Odenberg Ullakko Muranishi & Co. LLP (“OUM”), for services
      related to fiscal years 2006 and 2005.




2006
              
              2005Description
                  of Fees
              
              OUM
              
              KPMG
              
              OUMAudit
                  Fees
              
              $
              376,250
              
              $
              147,532
              
              $
              398,532Audit-Related
              
              
              9,068
              
              
              66,471
              
              
              —Tax
                  Fees
              
              
              —
              
              
              5,725
              
              
              —All
                  Other Fees
              
              
              —
              
              
              —
              
              
              —





·
            Audit
                Fees:  Includes fees associated with the annual audit of financial
                statements and internal control over financial reporting in compliance
                with regulatory requirements under the Sarbanes-Oxley Act of 2002,
                review
                of our quarterly reports on Form 10-Q, annual report on Form 10-K
                and
                periodic reports on Form 8-K, consents issued in connection with
                the our
                Form S-8 and S-3 filings, assistance and review with other documents
                we
                filed with the SEC.





·
            Audit-Related
                Fees: Audit-related services principally include employee benefit
                plan
                audits and due diligence services.





·
            Tax
                Fees: Includes fees for tax compliance (tax return preparation
                assistance), general tax planning, tax-related services on acquisition,
                and international tax consulting.





·
            All
                Other Fees: The Company was not billed by OUM or KPMG for other
                services.





All
      audit
      and non-audit fees were approved by the Audit Committee. The Company’s policy on
      auditor independence does not permit the employment of its independent auditor
      for material non-audit related services, except for the following: services
      which are incidental and directly related to audit activities, tax related
      activities and tax planning on behalf of the Company. The
      Audit
      Committee considered whether the provision of services other than the audit
      services is compatible with maintaining the auditors’ independence.





**Pre-Approval
      Policies and Procedures**





It
      is the
      Company’s policy that all non-audit services to be performed by the Company’s
      independent auditor be approved in advance by the Audit Committee. The Company’s
      policy on auditor independence requires that, prior to engaging the independent
      auditor in any non-audit related activity other than that specifically
      authorized by the Company’s policy on auditor independence, Company management
      report to the Audit Committee the nature of the proposed activity, including
      the
      reasons why (i) it is necessary or beneficial to the Company to use the
      independent auditor to engage in such activity, and (ii) the steps being taken
      to ensure that the engagement of the independent auditor in such activity will
      not, among other things, violate applicable laws or regulations of the United
      States and applicable states, or the rules and regulations of the Nasdaq Stock
      Market, on which the Company’s securities are listed. In order for the Company
      to engage the independent auditor in the proposed activity, the Company must
      obtain Audit Committee approval.








84








PART
      IV





ITEM
      15.  EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES





**(a)**
            **List
                of Documents Filed as Part of this Report**





1.
            The
                consolidated financial statements of the Company, filed herewith
                under
                Item 8, as follows:




Description
              Page
                Number(1)Reports
                  of Independent Registered Public Accounting Firms
              43(2)Consolidated
                  Balance Sheets at March 31, 2006 and March 31, 2005
              46(3)Consolidated
                  Statements of Operations for Fiscal Years 2006, 2005 and
                  2004
              47(4)Consolidated
                  Statements of Stockholders' Equity and Comprehensive Income (Loss)
                  for
                  Fiscal Years 2006, 2005 and 2004
              48(5)Consolidated
                  Statements of Cash Flows for Fiscal Years 2006, 2005 and
                  2004
              49(6)Notes
                  to Consolidated Financial Statements
              50








2.
            Financial
                Statement Schedules:




The
      schedule supporting the Company's Consolidated Financial Statements, filed
      herewith under Item 14(d), as follows:




Schedule
                Number
              Description
              Page
                Number―
              Report
                  of Independent Registered Public Accounting Firms on Financial
                  Statement
                  Schedule
              87II
              Valuation
                  and Qualifying Accounts
              89







Schedules
      not listed above are not applicable or not required, or the information required
      to be set forth therein is included in the consolidated financial statements
      or
      the notes thereto.





3.  Exhibits:
 
 The
        Exhibits to this Report, filed herewith under Item 14(c) or incorporated
        by
        reference from other documents previously filed with the Securities and Exchange
        Commission, as follows:
 
 Exhibit
                Number
              Description
              Filed
                  Herewith or Incorporated
                Herein
                  by Reference to3.1
              Amended
                  and Restated Certificate of Incorporation
              Exhibit
                  3.1 to Report on Form 10-K for the fiscal year ended March 31,
                  20053.2
              Amended
                  and Restated By-Laws
              Exhibit
                  3.2 to Report on Form 10-K for the fiscal year ended March 31,
                  200510.1
              Building
                  lease agreement with Renault & Handley Employees Investment Co. for
                  2644-2648 Bayshore Pkwy., Mountain View, CA
              Exhibit
                  10.1 to Report on Form 10-Q for period ended December 31,
                  2003





85








10.2
            Building
                Lease Agreement with Shoreline Park LLC for 1395 Charleston Road,
                Mountain
                View, CA (mailing address 1875 North Shoreline Boulevard, Mountain
                View,
                CA)
            Exhibit
                10.2 to Report on Form 10-K for fiscal year ended March 31,
                200410.3*
            Amended
                and Restated Stock Option Plan
            Exhibit
                10.4.1 to Report on Form 10-Q for period ended September 30,
                200210.7
            Stock
                and Warrant Purchase Agreement (as amended)
            Exhibit
                99.2 to Report on Form 10-Q for period ended December 31,
                200310.8
            Optical
                Card Manufacturing License Agreement with Global Investments Group
                (portions omitted pursuant to a request for confidential
                treatment)
            Exhibit
                10.8 to Report on Form 10-K for fiscal year ended March 31,
                200416.1
            Letter
                re Change in Certifying Accountants
            Exhibit
                16 to Report on Form 8-K dated
              April
                8, 200216.2
            Letter
                re Change in Certifying Accountants
            Exhibit
                16.1 to Report on Form 8-K dated
              August
                29, 200316.3
            Letter
                re Change in Certifying Accountants
            Exhibit
                16.1 to Report on Form 8-K dated
              December
                14, 200421
            Subsidiaries
                of the Registrant
            Filed
                herewith as page 9223.1
            Consent
                of Independent Registered Public Accounting Firm (OUM)
            Filed
                herewith as page 9323.2
            Consent
                of Independent Registered Public Accounting Firm (KPMG)
            Filed
                herewith as page 9424
            Power
                of attorney
            Filed
                herewith as page 9031.1
            Rule
                13a-14(a)/15d-14(a) Certification of Richard M. Haddock, principal
                executive officer
            Filed
                herewith as page 9531.2
            Rule
                13a-14(a)/15d-14(a) Certification of Steven G. Larson, principal
                financial
                officer
            Filed
                herewith as page 9632.1
            Section
                1350 Certification of Richard M. Haddock, chief executive
                officers
            Filed
                herewith as page 9732.2
            Section
                1350 Certification of Steven G. Larson, chief financial
                officer
            Filed
                herewith as page 98


___________________


*Indicates
      management contract or compensatory plan or arrangement.





**(b)**
            **Exhibits**


Exhibits
      21, 23.1, 23.2, 24, 31.1, 31.2, 32.1 and 32.2 are filed herewith.





**(c)**
            **Financial
                Statement Schedule**


Schedule
      II to the Company's consolidated financial statements is on page
      89.





86








REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


ON
      FINANCIAL STATEMENT SCHEDULE








The
      Board
      of Directors and Stockholders


LaserCard
      Corporation:





The
      audit
      referred to in our report dated May 15, 2006, included the related
      financial statement schedule as of March 31, 2006 and 2005, included
      in this Annual Report on Form 10-K. The financial statement schedule is the
      responsibility of the Company’s management. Our responsibility is to express an
      opinion on the financial statement schedule based on our audits. In our opinion,
      such financial statement schedule, when considered in relation to the
      consolidated financial statements taken as a whole, presents fairly in all
      material respects the information set forth therein.








/s/Odenberg
      Ullakko Muranishi & Co. LLP


San
      Francisco, California


May
      15,
      2006













87








REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


ON
      FINANCIAL STATEMENT SCHEDULE























The
      Board
      of Directors and Stockholders


LaserCard
      Corporation:





The
      audit
      referred to in our report dated June 9, 2004, except for note 2.(8.) which
      is as
      of June 14, 2006, included the related financial statement schedule as of March
      31, 2004, included in this Annual Report on Form 10-K. The financial
      statement schedule is the responsibility of the Company's management. Our
      responsibility is to express an opinion on the financial statement schedule
      based on our audit. In our opinion, such financial statement schedule, when
      considered in relation to the consolidated financial statements taken as a
      whole, presents fairly in all material respects the information set forth
      therein.











/s/
      KPMG
      LLP


Mountain
      View, California


June
      14,
      2006

















88





SCHEDULE
      II





LASERCARD
                  CORPORATION AND SUBSIDIARIESVALUATION
                  AND QUALIFYING ACCOUNTSFor
                  the Fiscal Years Ended March 31, 2004, 2005 and 2006(In
                  thousands)
  Description
              
              Balance
                  at
                Beginningof
                Period
              
              Additions(Deletions)Charged(Credited)
                to
                  Profit & Loss
              
              Additions
                Charged
                  to
                Other
                  Accounts
              
              
              Deductions/
                Write-off
              
              Balance
                  at
                Endof
                PeriodFiscal
                  year 2004:Product
                  return reserve
              
              $
              90
              
              $
              -
              
              $
              -
              
              
              $
              4
              
              $
              86Bad
                  debt reserve
              
              $
              -
              
              $
              -
              
              $
              210
              (1)
              
              $
              -
              
              $
              210Inventory
                  reserves
              
              $
              1,263
              
              $
              97
              
              $
              -
              
              
              $
              377
              
              $
              983Warranty
                  reserve
              
              $
              3
              
              $
              56
              
              $
              -
              
              
              $
              13
              
              $
              46Deferred
                  tax asset valuation allowance
              
              $
              5,254
              
              $
              8,940
              
              $
              557
              (2)
              
              $
              -
              
              $
              14,751Fiscal
                  year 2005:Product
                  return reserve
              
              $
              86
              
              $
              311
              
              $
              -
              
              
              $
              373
              
              $
              24Bad
                  debt reserve
              
              $
              210
              
              $
              22
              
              $
              -
              
              
              $
              200
              
              $
              32Inventory
                  reserves
              
              $
              983
              
              $
              381
              
              $
              -
              
              
              $
              716
              
              $
              648Warranty
                  reserve
              
              $
              46
              
              $
              207
              
              $
              -
              
              
              $
              120
              
              $
              132Deferred
                  tax asset valuation allowance
              
              $
              14,751
              
              $
              3,675
              
              $
              -
              
              
              $
              -
              
              $
              18,426Fiscal
                  2006:Product
                  return reserve
              
              $
              24
              
              $
              78
              
              $
              -
              
              
              $
              24
              
              $
              78Bad
                  debt reserve
              
              $
              32
              
              $
              34
              
              $
              (2
              )
                  (3)
              
              $
              -
              
              $
              64Inventory
                  reserves
              
              $
              648
              
              $
              274
              
              $
              -
              
              
              $
              418
              
              $
              503Warranty
                  reserve
              
              $
              132
              
              $
              669
              
              $
              (1
              )
                  (3)
              
              $
              152
              
              $
              648Deferred
                  tax asset valuation allowance
              
              $
              18,426
              
              $
              901
              
              $
              -
              
              
              $
              -
              
              $
              19,327








Notes:(1)
              This
                  represents the amount of bad debt reserve recorded against the
                  accounts
                  receivable of the acquired entities at the date of
                  acquisition.(2)
              This
                  amount relates to stock option deductions to be credited to additional
                  paid-in capital when realized.(3)
              Due
                  to foreign exchange rate
                  translation.


89





SIGNATURES





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





Dated:
      June 13, 2006





LASERCARD
      CORPORATION





By: /s/Richard
      M. Haddock


Richard
      M. Haddock, Chief Executive Officer





KNOW
      ALL
      PERSONS BY THESE PRESENTS, that each person whose signature appears below
      constitutes and appoints Richard M. Haddock and Steven G. Larson and each of
      them, acting individually, as his attorney-in-fact, each with full power of
      substitution and resubstitution, for him and in his name, place and stead,
      in
      any and all capacities, to sign any and all amendments to this Report on Form
      10-K, and to file the same, with all exhibits thereto, and other documents
      in
      connection therewith, with the Securities and Exchange Commission, granting
      unto
      said attorneys-in-fact and agents, and each of them, full power and authority
      to
      do and perform each and every act and thing requisite and necessary to be done
      in connection therewith and about the premises, as fully to all intents and
      purposes as he might or could do in person, hereby ratifying and confirming
      all
      that said attorneys-in-fact and agents, or any of them, or their or his
      substitute or substitutes, may lawfully do or cause to be done by virtue hereof.





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





Signature
            Title
            Date/s/
                Richard M. Haddock
            President
                and Chief Executive Officer
            June
                13, 2006Richard
                M. Haddock
            (Principal
                Executive Officer) Director/s/
                Steven G. Larson
            Vice
                President of Finance and Treasurer
            June
                13, 2006Steven
                G. Larson
            (Principal
                Financial Officer andPrincipal
                Accounting Officer)/s/
                Christopher J. Dyball
            Chief
                Operating Officer
            June
                13, 2006Christopher
                J. Dyball
            Director/s/
                Arthur H. Hausman
            Director
            June
                13, 2006Arthur
                H. Hausman/s/
                Donald E. Mattson
            Director
            June
                13, 2006Donald
                E. Mattson/s/
                Dan Maydan
            Director
            June
                13, 2006Dan
                Maydan/s/
                Albert J. Moyer
            Director
            June
                13, 2006Albert
                J. Moyer/s
                /Walter F. Walker
            Director
            June
                13, 2006Walter
                F. Walker





90






INDEX
        TO
        EXHIBITS
 [ITEM
        14(c)]
  ExhibitNumber
              Description3.1
              Amended
                  and Restated Certificate of Incorporation; Exhibit 3.1 to Report
                  on Form
                  10-K for the fiscal year ended March 31, 20053.2
              Amended
                  and Restated By-Laws; Exhibit 3.2 to Report on Form 10-K for the
                  fiscal
                  year ended March 31, 200510.1
              Building
                  lease agreement with Renault & Handley Employees Investment Co. for
                  2644-2648 Bayshore Parkway, Mountain View, CA; previously filed
                  as Exhibit
                  10.1 to Report on Form 10-Q for period ending December 31, 2003
                  and
                  incorporated herein by reference10.2
              Building
                  lease agreement with Shoreline Park LLC for 1395 Charleston Road,
                  Mountain
                  View, CA (mailing address 1875 North Shoreline Boulevard, Mountain
                  View,
                  CA) filed as Exhibit 10.2 to Report on Form 10-K for fiscal year
                  ended
                  March 31, 2004 and incorporated herein by reference10.3
              Amended
                  and Restated Stock Option Plan; previously filed as Exhibit 10.4.1
                  to
                  Report on Form 10-Q for period ended September 30, 2002 and
                  incorporated herein by reference10.7
              Stock
                  and Warrant Purchase Agreement (as amended); previously filed as
                  Exhibit
                  99.2 to Report on Form 10-Q for period ended December 31,
                  200310.8
              Optical
                  Card Manufacturing License Agreement with Global Investments Group
                  (portions omitted pursuant to a request for confidential treatment);
                  filed
                  as Exhibit as Exhibit 10.8 to Report on Form 10-K for fiscal year
                  ended
                  March 31, 2004 and incorporated herein by reference.16.1
              Letter
                  re Change in Certifying Accountant; previously filed as Exhibit
                  16 to
                  Current Report on Form 8-K dated April 8, 200216.2
              Letter
                  re Change in Certifying Accountant; previously filed as Exhibit
                  16.1 to
                  Current Report on Form 8-K dated August 29, 200316.3
              Letter
                  re Change in Certifying Accountant; previously filed as Exhibit
                  16.1 to
                  Current Report on Form 8-K dated December 14, 200421
              Subsidiaries
                  of the Registrant; filed herewith as page 9223.1
              Consent
                  of Independent Registered Public Accounting Firm (OUM); filed herewith
                  as
                  page 9323.2
              Consent
                  of Independent Registered Public Accounting Firm (KPMG); filed
                  herewith as
                  page 9424
              Power
                  of Attorney; filed herewith as page 9031.1
              Rule
                  13a-14(a)/15d-14(a) Certification of Richard M. Haddock, principal
                  executive officer; filed herewith as page 9531.2
              Rule
                  13a-14(a)/15d-14(a) Certification of Steven G. Larson, principal
                  financial
                  officer; filed herewith as page 9632.1
              Section
                  1350 Certification of Richard M. Haddock, chief executive officer
                  and
                  president; filed herewith as page 9732.2
              Section
                  1350 Certification of Steven G. Larson, chief financial officer;
                  filed
                  herewith as page 98












91