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 May 31, 2008
  [_]
              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 0-22182
 
 PATRIOT
SCIENTIFIC CORPORATION
 (Exact
name of registrant as specified in its charter)
 
 Delaware
                (State
      or other jurisdiction of incorporation or organization)
              84-1070278
                (I.R.S.
      Employer Identification No.)
 
 6183
      Paseo Del Norte, Suite 180, Carlsbad, California
                (Address
      of principal executive offices)
              92011
                (Zip
      Code)
 
 (Registrant’s
telephone number, including area code): (760) 547-2700
 
 Securities
registered pursuant to Section 12(b) of the Act: NONE
 
 Securities
registered pursuant to Section 12(g) of the Act:
 
 Common
Stock, $.00001 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 [  ]  NO [X]
 
 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 [  ]  NO [X]
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X ]  NO [  ]
 
 Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§229.405 of this chapter) 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, a non-accelerated filer, or a smaller reporting
company.  See definitions of “large accelerated filer,” “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange
Act.  (Check one):
  Large
accelerated filer
[  ]         Accelerated
filer [X]       Non-accelerated filer
[  ]       Smaller reporting company
[  ]
  Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). YES [  ]  NO [X]
 
 Aggregate
market value of voting and non-voting common equity held by non-affiliates of
the registrant on November 30, 2007 was $238,797,982 based on a closing price of
$0.61 as reported on the OTC Electronic Bulletin Board system.
 
 On August
8, 2008, 387,448,755 shares of common stock, par value $.00001 per share (the
issuer’s only class of voting stock) were outstanding.
 
 DOCUMENTS
INCORPORATED BY REFERENCE
 
 Certain
information required to be disclosed in Part III of this report is
incorporated by reference from the registrant’s definitive Proxy Statement for
the 2008 annual meeting of shareholders, which will be held in October 2008 and
which proxy statement will be filed not later than 120 days after the end
of the fiscal year covered by this report.
  
 Table
of Contents
  PART
      I
              
              
              4ITEM
      1.
              Business
              4ITEM
      1A.
              Risk
      Factors
              8ITEM
      1B.
              Unresolved
      Staff Comments
              11ITEM
      2.
              Properties
              11ITEM
      3.
              Legal
      Proceedings
              11ITEM
      4.
              Submission
      of Matters to a Vote of Security Holders
              11PART
      II
              
              
              12ITEM
      5.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
              12ITEM
      6.
              Selected
      Financial Data
              14ITEM
      7.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
              15ITEM
      7A.
              Quantitative
      and Qualitative Disclosures About Market Risk
              23ITEM
      8.
              Financial
      Statements and Supplementary Data
              24ITEM
      9.
              Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
              24ITEM
      9A.
              Controls
      and Procedures
              24ITEM
      9B.
              Other
      Information
              29PART
      III
              
              
              29ITEM
      10.
              Directors,
      Executive Officers and Corporate Governance
              29ITEM
      11.
              Executive
      Compensation
              29ITEM
      12.
              Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
              29ITEM
      13.
              Certain
      Relationships and Related Transactions, and Director
      Independence
              29ITEM
      14.
              Principal
      Accounting Fees and Services
              29PART
      IV
              
              
              30ITEM
      15.
              EXHIBITS,
      AND FINANCIAL STATEMENT SCHEDULES
              30
 
 2
 CAUTIONARY
NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
 This
Annual Report on Form 10-K, including all documents incorporated by reference,
includes “forward-looking” statements within the meaning of Section 27A of
the Securities Act and Section 21E of the Exchange Act and the Private
Securities Litigation Reform Act of 1995, and we rely on the “safe harbor”
provisions in those laws. Therefore, we are including this statement for the
express purpose of availing ourselves of the protections of such safe harbor
with respect to all of such forward-looking statements. The forward-looking
statements in this report reflect our current views with respect to future
events and financial performance. These forward-looking statements are subject
to certain risks and uncertainties, including specifically: the uncertainty of
the effect of pending legislation, the uncertainty of patent and proprietary
rights, uncertainty as to royalty payments and indemnification risks, trading
risks of low-priced stocks and those other risks and uncertainties discussed
herein that could cause our actual results to differ materially from our
historical results or those we anticipate. In this report, the words
“anticipates,” “believes,” “expects,” “intends,” “future” and similar
expressions identify certain of the forward-looking statements. Readers are
cautioned not to place undue reliance on these forward-looking statements, which
speak only as of the date made. We undertake no obligation to publicly release
the result of any revision of these forward-looking statements to reflect events
or circumstances after the date they are made or to reflect the occurrence of
unanticipated events.
  
 3
 PART
I
 
 ITEM
1                 BUSINESS
 
 The
Company
 
 Patriot
Scientific Corporation (“Patriot Scientific”, “Patriot” or “the Company”) has
developed a number of innovative technologies throughout its 20-year history. We
are primarily an intellectual-property licensing company with several patents
(described below) covering the design of microprocessor chips. Chips with our
patented technology are used throughout the world in products ranging from
computers and cameras to printers, automotive and industrial
devices.
 
 Our
current business strategy is to commercialize our patented microprocessor
technologies through broad and open licensing and to litigate against those who
may be infringing on our patents. With the proceeds generated by these licensing
efforts, we are undertaking to make investments in technologies, and
acquisitions of companies, operating in the electronics technology market
sector. Our business address is 6183 Paseo del Norte, Suite 180, Carlsbad,
California 92011; our main telephone number is (760) 547-2700. Our internet
website page is located at http://www.ptsc.com. All of our reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of
1934, as amended (the “Exchange Act”), are available free of charge on our
internet website.
 
 Incorporation
History. Patriot Scientific Corporation was organized under Delaware law
on March 24, 1992, and is the successor by merger to Patriot Financial
Corporation, a Colorado corporation, incorporated on June 10, 1987. In June
2005, we entered into a joint venture agreement with Technology Properties
Limited, Inc. (“TPL”) to form Phoenix Digital Solutions, LLC (“PDS”). During
February 2007, we acquired the preferred stock of Scripps Secured Data, Inc.
(“SSDI”), a Carlsbad company that develops and manufactures network-security
hardware to government, military, and other high-security
facilities.  During May 2008, we acquired a 15% share in Talis Data
Systems, LLC (“Talis”), a Delaware LLC that produces multi-domain computer
networking hardware.  In August 2008, we increased our investment in
Talis to 37.4%.
 
 Our
Technology
 
 General Background.
Throughout our history, Patriot Scientific has developed a number of innovative
technologies for a variety of industries. We’re best known for our
microprocessors, including the ShBoom, Ignite, and PSC-1000 families of chips,
and for the Moore Microprocessor Patent (MMP) portfolio of intellectual property
surrounding them. These chips and their underlying innovations were created
through a combination of in-house development and acquired
technology.
 
 Industry Background.
The global semiconductor (or silicon “chip”) market has many segments and
categories. The best-known - and most profitable - of these is the
microprocessor segment. Microprocessor chips are the “brains” of nearly every
electronic and electrical device throughout the world. Although microprocessors
are often closely associated with personal computers, PCs account for only 2% of
the microprocessor chips made and sold every year. The vast majority of
microprocessors are used in everyday items like automobiles, digital cameras,
cell phones, video game players, data networks, industrial flow-control valves,
sensors, medical devices, weapons, home appliances, robots, security systems,
televisions, and much more. These “embedded microprocessors” (so called because
they’re embedded into another product) are far more ubiquitous than the chips
inside personal computers. It is this huge and growing market that Patriot
Scientific’s technology serves.
 
 Patent Description.
Over the years we’ve developed a number of innovative technologies that have
been embodied in our own products and, through licensing, into other companies’
products. Many of these patented technologies are available under the MMP
portfolio. The MMP portfolio includes several U.S. patents as well as their
European and Japanese counterparts. Some highlights of the patent portfolio
are:
  ●
              US
      5,809,336. The ’336 patent covers an early and seminal approach to making
      microprocessor chips go faster. It allows the “core” of the microprocessor
      to run at a different speed (usually faster) than the rest of the chip.
      There are many advantages to this, including higher performance, lower
      power consumption, and simpler
manufacturing.
  ●
              US
      5,784,584. The ’584 patent covers an important method for a microprocessor
      chip to fetch multiple instructions at once. Like speed reading,
      multiple-instruction fetch allows a chip to get more done in less time - a
      valuable technique.
  4
 ●
              US
      6,598,148. The ’148 patent describes on-chip oscillators (clocks) and
      covers multi-core and multi-processor implementations - important factors
      in today’s high-end microprocessor
chips.
 
 Our
Partners and Affiliates
 
 Phoenix Digital
Solutions. On June 7, 2005, we entered into a Master Agreement (the
“Master Agreement”) with TPL, and Charles H. Moore, an individual (“Moore”
and together with us and TPL, the “Parties”). We, TPL and Moore were parties to
certain lawsuits filed by us alleging infringement (the “Infringement
Litigation”) of our Microprocessor Patents and a lawsuit also filed by us
alleging claims for declaratory judgment for determination and correction of
inventorship of the Microprocessor Patents (the “Inventorship Litigation”). The
transactions described in the Master Agreement and related agreements (the
“Transactions”) included the settlement or dismissal of the Inventorship
Litigation.
 
 Pursuant
to the Master Agreement we agreed with TPL and Moore as follows:
  ●
              We
      entered into a patent license agreement (the “Intel License”) with Intel
      Corporation (“Intel”) pursuant to which we licensed certain rights in the
      Microprocessor Patents to Intel.
  ●
              We
      entered into an Escrow Agreement along with TPL pursuant to which the
      proceeds arising from the Intel License were allocated for the benefit of
      us and TPL. Pursuant to the Escrow Agreement, the proceeds were allocable
      equally to PTSC and TPL.  Accordingly, when the initial
      capitalization obligations of PTSC and those of TPL with regard to PDS
      (defined below) were satisfied, and when our payment obligations and those
      of TPL with regard to the Rights Holders (defined below) were made, we
      received $6,672,349, and the remaining proceeds were allocated to or for
      the benefit of TPL.
  ●
              We
      caused certain of our respective interests in the Microprocessor Patents
      to be licensed to PDS a limited liability company owned 50% by us and 50%
      by TPL.
 
 ●
              PDS
      engaged TPL to commercialize the Microprocessor Patents pursuant to a
      Commercialization Agreement among PDS, TPL and us (the “Commercialization
      Agreement”).
 
 ●
              We
      paid $1,327,651 and TPL paid $1,000,000 to certain holders of rights in
      the Microprocessor Patents (“Rights Holders”) in exchange for the release
      of such Rights Holders to the
Transactions.
  ●
              We
      agreed with TPL and Moore to settle or cause to be dismissed all
      litigation pursuant to a stipulated final judgment, including the
      Inventorship Litigation.
 
 ●
              We
      issued warrants to TPL to acquire shares of our common stock. 1,400,000
      warrants were exercisable upon issue; 700,000 warrants were exercisable
      when our common stock traded at $0.50 per share; an additional 700,000
      warrants were exercisable when our common stock traded at $0.75 per share;
      and an additional 700,000 warrants were exercisable when our common stock
      traded at $1.00 per share. As of the date of this filing, all of the
      common stock trading prices have been met, causing TPL to be fully vested
      in all 3,500,000 of the above
warrants.
  ●
              We
      agreed with TPL and Moore to indemnify each other for, among other things,
      any inaccuracy or misrepresentation to any representation or warranty
      contained in the Master Agreement, any breach of the Master Agreement,
      certain liabilities relating to the respective interests of each of us in
      the Microprocessor Patents and the Transactions, and certain tax
      liabilities.
 
 Pursuant
to the Commercialization Agreement, PDS granted to TPL the exclusive right to
grant licenses and sub-licenses of the Microprocessor Patents and to pursue
claims against violators of the Microprocessor Patents, in each case, on behalf
of PDS, us, TPL and Moore, and TPL agreed to use reasonable best efforts to
commercialize the Microprocessor Patents in accordance with a mutually agreed
business plan. Pursuant to the Commercialization Agreement, PDS agreed to
reimburse TPL’s expenses incurred in connection with the commercialization of
the Microprocessor Patents. All proceeds generated by TPL in connection with the
commercialization of the Microprocessor Patents will be paid directly to
PDS.  From inception of the Commercialization Agreement to May 31,
2008 license revenues to PDS totaled $230,161,956.
 
 5
 Pursuant
to the Master Agreement, we and TPL have entered into the Limited Liability
Company Operating Agreement of PDS (“LLC Agreement”). We and TPL each own 50% of
the membership interests of PDS, and each have the right to appoint one member
of the three (3) member management committee. The two (2) appointees
are required to select a mutually acceptable third member of the management
committee. Pursuant to the LLC Agreement, we and TPL must each contribute to the
working capital of PDS (in addition to the Microprocessor Patent licenses
described above), and are obligated to make future contributions in equal
amounts in order to maintain a working capital fund. The LLC Agreement provides
that PDS shall indemnify its members, managers, officers and employees to the
fullest extent permitted by applicable law, for any liabilities incurred as a
result of their involvement with PDS, if the person seeking indemnification
acted in good faith and in a manner reasonably believed to be in the best
interest of PDS.
 
 Scripps Secured Data,
Inc. On March 27, 2007 we entered into a revolving line of credit with
SSDI, a company that manufactures products that protect information and data
transmitted over secured networks. Previously, we maintained an unconsolidated
equity investment in SSDI. We determined that the line of credit transaction
caused us to become the primary beneficiary under the Financial Accounting
Standards Board’s (“FASB”) guidance in Interpretation No. 46 as amended
(“FIN46(R)”), Consolidation of
Variable Interest Entities. Under FIN46(R) we are required to consolidate
variable interest entities for which we are deemed to be the primary
beneficiary.
 
 SSDI is
an operating segment of our business. Refer to footnote 16 of our consolidated
financial statements for disclosures about this operating segment.
 
 Talis Data Systems,
LLC.  On May 16, 2008 we acquired a 15.09% share in Talis, a
company that produces multi-domain computer and network security products for
sale to government, military, and enterprise customers. Talis develops and
markets PCs incorporating its Datagent security device, a patented, hardware
based data security solution that avoids the vulnerability of software–based
approaches.
 
 On August
1, 2008, we increased our investment in Talis to 37.4% as a result of purchasing
additional shares offered by Talis, as well as acquiring shares from minority
shareholders which included the acquisition of all Talis shares previously held
by SSDI. The acquisition of Talis shares previously owned by SSDI was made for
$100,000 in cash and a reduction on their outstanding line of credit of
$219,000.
 
 Licenses,
Patents, Trade Secrets and Other Proprietary Rights
 
 We rely
on a combination of patents, copyright and trademark laws, trade secrets,
software security measures, license agreements and nondisclosure agreements to
protect our proprietary technologies. Our policy is to seek the issuance of
patents that we consider important to our business to protect inventions and
technology that support our microprocessor technology.
 
 We have
seven U.S. patents issued dating back to 1989 on our microprocessor technology
(the “Microprocessor Patents”). We have one microprocessor technology patent
issued in five European countries and one patent issued in Japan. We may file
additional applications under international treaties depending on an evaluation
of the costs and anticipated benefits that may be obtained by expanding possible
patent coverage. In addition, we have one U.S. patent issued on
ground-penetrating radar technology and one U.S. patent issued on one of the
communications products.
 
 In
addition to such factors as innovation, technological expertise and experienced
personnel, we believe that a strong patent position is becoming increasingly
important to compete effectively in the semiconductor industry. It may become
necessary or desirable in the future for us to obtain patent and technology
licenses from other companies relating to certain technology that may be
employed in future products or processes. To date, we have not received notices
of claimed infringement of patents based on our existing processes or products
but, due to the nature of the industry, we may receive such claims in the
future.
 
 We have
one U.S. patent on our ground-penetrating radar technology. No foreign
application has been made. There are a large number of patents owned by others
in the radar field generally and in the field of ground-penetrating radar
specifically. Accordingly, although we are not aware of any possible
infringement and have not received any notices of claimed infringement, we may
receive such claims in the future.
 
 6
 In
November, 2004, we filed a patent application for “Remote Power Charging of
Electronic Devices” with assignment to Patriot Scientific
Corporation.
 
 There can
be no assurance that any patents will be issued from pending or future
applications or that any patents that are issued will provide meaningful
protection or other commercial advantages to us. Although we intend to protect
our rights vigorously, there can be no assurance that these measures will be
successful.
 
 We
generally require all of our employees and consultants, including our
management, to sign a non-disclosure and invention assignment agreement upon
employment with us.
 
 Marketing
and Distribution
 
 We do not
currently actively market the microprocessor chips in our Ignite product line,
although we continue to sell a limited number of chips from our remaining
inventory. All of our sales for fiscal years ended May 31, 2008, 2007 and
2006 were to domestic customers.
 
 All of
our operating assets are located within the United States. While sales to
certain geographic areas generally vary from year to year, we do not expect that
changes in the geographic composition of sales will materially affect our
operations.
 
 Business
Development
 
 We are in
the process of evaluating investments in technologies, and acquisitions of
companies, operating in the technology market sector. In March 2008 we hired a
Vice-President of Business Development to work as part of the senior management
team to identify investment and acquisition candidates.  In this area
we are utilizing a multi-faceted approach, with a focus on i) selective
expansion of our IP portfolio, ii) pursuit of strategic minority investments in
certain early-stage revenue or technology ventures that represent a technology
or capability of interest to us, and iii) full M&A
transactions.
 
 Dependence
Upon Single Customers
 
 Ten
percent (10%) or more of our consolidated product sales were derived from
shipments to the following customers for the fiscal years ended May 31 as
follows:
  2008
              
              
              2007
              
              
              2006Space
      and Naval Warfare Systems
              
              
              -----
              
              
              
              -----
              
              
              
              $262,500Anixter
              
              
              $1,354,494
              
              
              
              $461,494
              
              
              
              -----Graybar
      Electric Company, Inc.
              
              
              $889,724
              
              
              
              -----
              
              
              
              -----Victory
      Global Solutions
              
              
              $370,301
              
              
              
              -----
              
              
              
              -----
 
 We had no
backlog orders as of May 31, 2008, 2007 or 2006.
 
 Most of
our net income for the years ended May 31, 2008, 2007 and 2006, was attributable
to our equity in the earnings of our unconsolidated affiliate, PDS.
 
 Government
Regulation and Environmental Compliance
 
 We
believe our products are not subject to governmental regulation by any federal,
state or local agencies that would materially affect the manufacture, sale or
use of our products, other than occupational health and safety laws and labor
laws which are generally applicable to most companies. We do not know what sort
of regulations of this type may be imposed in the future, but we do not
anticipate any unusual difficulties in complying with governmental regulations
which may be adopted in the future.
 
 We have
not incurred any material costs associated with compliance with environmental
laws and do not anticipate such laws will have any material effect on our future
business.
 
 
 7
 Research
and Development
 
 We did
not incur research and development expenditures for our fiscal years ended May
31, 2008 and 2007. We incurred research and development expenditures of $225,565
for our fiscal year ended May 31, 2006. The majority of these expenditures
have been devoted to our microprocessor technology. As our primary business
strategy has been to enforce our intellectual property patents through
licensing, we are not currently making expenditures relating to research and
development, although future research and development costs may be incurred as a
result of our merger and acquisition activities.
 
 Employees
 
 We
currently have eighteen employees, five of which are Patriot Scientific
Corporation employees. All Patriot employees are full time and are employed in
general and administrative activities. We also engage additional consultants and
part-time persons, as needed.
 
 Our
future success depends in significant part upon the continued services of our
key technical and senior management personnel. The competition for highly
qualified personnel is intense, and there can be no assurance that we will be
able to retain our key managerial and technical employees or that we will be
able to attract and retain additional highly qualified technical and managerial
personnel in the future. None of our employees are represented by a labor union,
and we consider our relations with our employees to be good. None of our
employees are covered by key man life insurance policies.
 
 ITEM
1A.                      RISK FACTORS
 
 We urge
you to carefully consider the following discussion of risks as well as other
information contained in this Form 10-K. We believe the following to be our most
significant risk factors as of the date this report is being filed. The risks
and uncertainties described below are not the only ones we face.
 
 We
Have Reported Substantial Income In 2008, 2007 and 2006 Which May Not Be
Indicative Of Our Future Income
 
 During
fiscal 2008, 2007 and 2006, we entered into license agreements, directly and
through our joint venture with TPL. Because of the uncertain nature of the
negotiations that lead to license revenues, pending litigation with companies
which we allege have infringed on our patent portfolio, the possibility of
legislative action regarding patent rights, petitions with the U. S. Patent and
Trademark Office to re-examine certain of our patents, and the possible effect
of new judicial interpretation of patent laws, we cannot predict the amount of
future revenues from such agreements, or whether there will be future revenues
from license agreements at all.
 
 We
Are Dependent Upon A Joint Venture In Which We Are A Passive Partner For
Substantially All Of Our Income
 
 In June
of 2005, we entered into a joint venture with TPL, pursuant to which TPL is
responsible for the licensing and enforcement of our microprocessor patent
portfolio. This joint venture has been the source of virtually all of our income
since June of 2005. Therefore, in light of the absence of significant revenue
from other sources, we should be regarded as entirely dependent on the success
or failure of the licensing and prosecution efforts of TPL on behalf of the
joint venture. Sales of our microprocessor products and data security products
have resulted in limited revenues. Our microprocessor product lines are no
longer being actively marketed, and only generate limited and sporadic
sales.
 
 We
May Not Be Successful In Identifying Acquisition Candidates And If We Undertake
Acquisitions, They Could Increase Our Costs Or Liabilities And Impair Our
Revenue And Operating Results.
  One of
our strategies is to pursue growth through acquisitions. We may not be able to
identify suitable acquisition candidates at prices that we consider appropriate.
If we do identify an appropriate acquisition candidate, we may not be able to
successfully negotiate the terms of the acquisition or finance the acquisition
on terms that are satisfactory to us. Negotiations of potential acquisitions and
the integration of acquired business operations could disrupt our business
by diverting management attention from day-to-day operations. Acquisitions of
businesses or other material operations may require debt or equity financing,
resulting in leverage or dilution of ownership. We may encounter increased
competition for acquisitions, which may increase the price of our
acquisitions.
  8
 Integration
of acquisitions requires significant management time and financial resources.
Any failure to properly integrate and manage businesses we acquire could
seriously harm our operating results. In addition, acquired companies
may not perform as well as we expect, and we may fail to realize
anticipated benefits. In connection with acquisitions, we may issue common stock
that would dilute our current stockholders’ ownership and incur debt and other
costs which may cause our quarterly operating results to vary significantly. The
dilution of our current stockholders’ ownership may be exacerbated if our per
share stock price is depressed and common stock is issued in connection with
acquisitions.
  If we are
unable to successfully integrate companies we may acquire, our revenue and
operating results could suffer. The integration of such businesses into our
operations may result in unforeseen operating difficulties, may absorb
significant management attention and may require significant financial resources
that would otherwise be available for other business purposes. These
difficulties of integration may require us to coordinate geographically
dispersed organizations, integrate personnel with disparate business backgrounds
and reconcile different corporate cultures. In addition, we may not be
successful in achieving anticipated synergies from these
acquisitions.  We may experience increased attrition, including, but
not limited to, key employees of the acquired companies, during and following
the integration of acquired companies that could reduce our future
revenue.
  In
addition, we may need to record write-downs from future impairments of
identified intangible assets and goodwill, which could reduce our future
reported earnings. Acquired companies may have liabilities or adverse operating
issues that we fail to discover through due diligence prior to the acquisition.
In particular, to the extent that prior owners of any acquired businesses or
properties failed to comply with or otherwise violated applicable laws or
regulations, or failed to fulfill their contractual obligations to their
customers or clients, we, as the successor owner, may be financially responsible
for these violations and failures and may suffer reputational harm or otherwise
be adversely affected. The discovery of any material liabilities associated with
our acquisitions could cause us to incur additional expenses and cause a
reduction in our operating profits.
 
 Changes
In Our Relationships With Companies In Which We Hold Less Than A Majority
Interest Could Change The Way We Account For Such Interests In The
Future.
 
 We hold a
minority interest in SSDI to which we provide financing. Under the applicable
provisions of accounting principles generally accepted in the United States of
America, including FIN 46(R), we currently consolidate the financial statements
and results of operations of this company into our consolidated financial
statements and results of operations, and record the equity interest that we do
not own as a minority interest. For our other investments (PDS and Talis)
accounted for under the equity method, we record as part of other income or
expense our share of the increase or decrease in the equity of these companies
in which we have invested. It is possible that, in the future, our relationships
and/or our interests in or with this consolidated entity and equity method
investees could change. Such potential future changes could result in
deconsolidation or consolidation of such entities, as the case may be, which
could result in changes in our reported results.
 
 A
Successful Challenge To Our Intellectual Property Rights Would Have A
Significant And Adverse Effect On Us
 
 A
successful challenge to our ownership of our technology or the proprietary
nature of our intellectual property would materially damage our business
prospects. We rely on a combination of patents, trademarks, copyrights, trade
secret laws, confidentiality procedures and licensing arrangements to protect
our intellectual property rights. We currently have seven U.S. patents, one
European patent, and one Japanese patent issued. Any issued patent may be
challenged and invalidated. Patents may not be issued for any of our pending
applications. Any claims allowed from existing or pending patents may not be of
sufficient scope or strength to provide significant protection for our products.
Patents may not be issued in all countries where our products can be sold so as
to provide meaningful protection or any commercial advantage to us. Our
competitors may also be able to design around our patents.
 
 Vigorous
protection and pursuit of intellectual property rights or positions characterize
the fiercely competitive semiconductor industry, which has resulted in
significant and often protracted and expensive litigation. Therefore, our
competitors and others may assert that our technologies or products infringe on
their patents or proprietary rights. Persons we believe are infringing our
patents are likely to vigorously defend their actions and assert that our
patents are invalid. Problems with patents or other rights could result in
significant costs, limit future license revenue, and impair or hinder our
acquisition strategy. If infringement claims against us are deemed valid or if
our infringement claims are successfully opposed, we may not be able to obtain
appropriate licenses on acceptable terms or at all. Litigation could be costly
and time-consuming but may be necessary to protect our future patent and/or
technology license positions or to defend against infringement
claims.  Parties have petitioned the U. S. Patent and Trademark Office
to re-examine certain of our patents. An adverse decision in litigation or in
the re-examination process would have a very significant and adverse effect on
our business.
  On
December 18, 2007 we announced that a resolution was reached in two patent
infringement lawsuits in the U.S. District Courts in the Eastern District of
Texas and the Northern District of California.  There are no
assurances that the resolution will favorably impact, or that it will not
impair, our ability to assert our technology rights in the future.
 
 9
 During
the quarter ended February 29, 2008, we were named as co-defendants in three
separate lawsuits regarding the MMP Portfolio.  See footnote 15 to our
consolidated financial statements and Part I, Item 3. Legal Proceedings in this
Report on Form 10-K.
 
 If A Large Number Of Our Shares Are
Sold All At Once Or In Blocks, The Market Price Of Our Shares Would
Most Likely
Decline
 
 Shareholders
who acquired common stock through the exercise of warrants are not restricted in
the price at which they can sell their shares. Shares sold at a price below the
current market price at which the common stock is trading may cause the market
price to decline.
 
 A
Significant Portion Of Our Investments Are Currently Illiquid Which May Impact
Our Acquisition Strategy And/Or Operating Results
 
 Our
long-term investment in marketable securities balance consists of auction rate
securities with a par value of $12.9 million, which at present are highly
illiquid. In the event we need immediate access to these funds, we will not be
able to sell these investments at par value. These instruments are expected to
remain illiquid until a future auction of these investments is successful,
buyers are found outside of the auction process, or they are redeemed by the
issuing agencies. We have partially offset the consequences of this illiquidity
by securing a line of credit collateralized by the auction rates securities. In
the event these securities are deemed to be permanently impaired, we will be
required to take a charge to operations in recognition of this
impairment.
 
 The
Market For Our Stock Is Subject To Rules Relating To Low-Priced Stock (“Penny
Stock”) Which May Limit Our Ability To Raise Capital
 
 Our
common stock is currently listed for trading in the National Association of
Securities Dealers (“NASD”) Over-The-Counter Bulletin (“OTC”) Board Market and
is subject to the “penny stock rules” adopted pursuant to Section 15(g) of the
Exchange Act. In general, the penny stock rules apply to non-NASDAQ or
non-national stock exchange companies whose common stock trades at less than
$5.00 per share or which have tangible net worth of less than $5,000,000
($2,000,000 if the company has been operating for three or more years). Such
rules require, among other things, that brokers who trade “penny stock” on
behalf of persons other than “established customers” complete certain
documentation, make suitability inquiries of investors and provide investors
with certain information concerning trading in the security, including a risk
disclosure document, quote information, broker’s commission information and
rights and remedies available to investors in penny stocks. Many brokers have
decided not to trade “penny stock” because of the requirements of the penny
stock rules, and as a result, the number of broker-dealers willing to act as
market makers in such securities is limited. The “penny stock rules,” therefore,
may have an adverse impact on the market for our common stock and may affect our
ability to raise additional capital if we decide to do so.
 
 Our
Share Price Could Decline As A Result Of Short Sales
 
 When an
investor sells stock that he does not own, it is known as a short sale. The
seller, anticipating that the price of the stock will go down, intends to buy
stock to cover his sale at a later date. If the price of the stock goes down,
the seller will profit to the extent of the difference between the price at
which he originally sold it less his later purchase price. Short sales enable
the seller to profit in a down market. Short sales could place significant
downward pressure on the price of our common stock. Penny stocks which do not
trade on an exchange, such as our common stock, are particularly susceptible to
short sales.
 
 Our
Future Success Depends In Significant Part Upon The Continued Services Of Our
Key Senior Management
 
 Our
future success depends in significant part upon the continued services of our
key senior management personnel. The competition for highly qualified personnel
is intense, and we may not be able to retain our key managerial employees or
attract and retain additional highly qualified technical and managerial
personnel in the future. None of our employees are represented by a labor union,
and we consider our relations with our employees to be good. None of our
employees are covered by key man life insurance policies.
 
 10
 ITEM
1B.         UNRESOLVED STAFF
COMMENTS
 
 None.
 
 ITEM
2.            PROPERTIES
 
 We have
one 3,289 square foot office located at 6183 Paseo Del Norte, Suite 180,
Carlsbad, California. The facility is leased under a non-cancelable lease
through February 2009. The current floor space provides adequate and
suitable facilities for all of our corporate functions.
 
 SSDI has
one 3,364 square foot office located at 2386 Faraday Avenue, Suite 200,
Carlsbad, California. The facility is subleased from an unrelated party with a
month-to-month option until no later than December 2008.
 
 SSDI
maintains one 16,500 square foot warehouse facility in Anaheim, California. The
warehouse is leased under a cancelable lease until November 2009.
 
 SSDI
subleases office space in San Diego, CA under a lease agreement expiring in
August 2008.
 
 ITEM
3.            LEGAL
PROCEEDINGS
 
 Patent
Litigation
 
 On
February 8, 2008, the Company, TPL and Alliacense Ltd. were named as defendants
in three separate lawsuits filed in the United States District Court for the
Northern District of California by Asustek Computer, Inc., HTC Corporation, and
Acer, Inc., and affiliated entities of each of them. On February 13, 2008, the
Asustekclaims were
amended to include claims against MCM Portfolio, LLC (Alliacense and MCM
Portfolio are TPL-related entities), which do not involve the
Company.
 
 The Asustekcase seeks
declaratory relief that its products do not infringe enforceable claims of our
'336, '584 and '749 patents.  The Asustek case also seeks a
similar declaration with respect to two patents owned by TPL that are not a part
of the MMP Portfolio, and as such the Company is not engaged in this aspect of
the litigation and defense.  The Acer case seeks declaratory
relief that its products do not infringe enforceable claims of our '336, '584
and '749 patents.  The HTC case similarly seeks
declaratory relief that its products do not infringe enforceable claims of those
three patents and our '148 patent.
 
 On April
25, 2008, the Company and TPL filed five patent infringement lawsuits in the
Eastern District of Texas against HTC, Acer and Asustek.  These suits
allege infringement by HTC and Acer with respect to our '336 '749 '584 and '148
patents; and by Asustek with respect to our '336, '749 and '584
patents.  On June 4, 2008, the Company and TPL filed patent
infringement lawsuits against those parties in the Eastern District of Texas
with respect to our '890 patent of the MMP Portfolio.  Motions to
dismiss or transfer the Northern District of California actions to the Eastern
District of Texas are currently pending with hearings set for August 29, 2008 in
the Acer case and September 19, 2008 for the HTC and Asustek
cases.  At that point we expect to learn where the T-3 (“Acer, Asustek
and HTC”) litigation will proceed.  Responsive pleadings in those
cases are due at varying times in mid-August and early September
2008.  Similar to the actions in the Northern District of California,
the Asustek action in
the Eastern District of Texas is inclusive of matters with respect to two
patents owned by TPL that are not a part of the MMP Portfolio, and as such we
are not engaged in this aspect of the litigation and defense.
  ITEM
4.            SUBMISSION OF MATTERS TO A VOTE OF
SECURITY HOLDERS
 
 None.
 
 11
  PART
II
 
 ITEM
5.        MARKET FOR REGISTRANT’S COMMON EQUITY,
RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
SECURITIES
 
 Our
common stock is traded in the over-the-counter market and is quoted on the NASD
OTC Bulletin Board system maintained by the National Association of Securities
Dealers, Inc. under the symbol PTSC.  Prices reported represent prices
between dealers, do not include markups, markdowns or commissions and do not
necessarily represent actual transactions. The market for our shares has been
sporadic and at times very limited.
 
 The
following table sets forth the high and low closing bid quotations for our
common stock for the fiscal years ended May 31, 2008 and 2007.
  BID QUOTATIONSHIGH
              LOWFiscal
      Year Ended May 31, 2008First
      Quarter
              $0.59
              $0.45Second
      Quarter
              $0.62
              $0.38Third
      Quarter
              $0.80
              $0.36Fourth
      Quarter
              $0.59
              $0.27Fiscal
      Year Ended May 31, 2007First
      Quarter
              $1.37
              $0.79Second
      Quarter
              $1.18
              $0.61Third
      Quarter
              $0.77
              $0.46Fourth
      Quarter
              $0.70
              $0.45
 
 On August
8, 2008 the closing price of our stock was $0.28 and we had approximately 601
shareholders of record. Because most of our common stock is held by brokers and
other institutions on behalf of stockholders, we are unable to estimate the
total number of beneficial owners represented by these record
holders.
 
 Dividend
Policy
 
 During
the fiscal year ended May 31, 2006, we paid a $0.02 per common share dividend on
March 22, 2006 and paid a $0.04 per common share dividend on April 24,
2006. During the fiscal year ended May 31, 2007 we paid a $0.02 per common share
dividend on April 9, 2007.  We paid no dividends during the fiscal
year ended May 31, 2008. On February 22, 2007, our Board of Directors adopted a
semi-annual dividend payment policy, subject to determination by our Board of
Directors in light of our financial condition, other possible applications of
our available resources, and relevant business considerations.
 
 Equity
Compensation Plan Information
 
 Our
stockholders previously approved each of the Company’s 1992, 1996, 2001, 2003
and 2006 Stock Option Plans. The following table sets forth certain information
concerning aggregate stock options authorized for issuance under our 1996, 2001,
2003 and 2006 Stock Option Plans as of May 31, 2008. For a narrative
description of the material features of the plans, refer to footnote 13 of our
consolidated financial statements.
 
 On March
11, 2008, we amended our 2006 Stock Option Plan to increase the total number of
shares of our common stock issuable under the plan from 5,000,000 to
7,000,000.  Shareholders will be asked to ratify the amendment to the
plan at our next annual meeting.
 
 12
  Shares of
common stock issuable on the exercise of warrants have not been approved by our
stockholders. This item has been segregated in the table below under the item
“Equity compensation plan not approved by security holders”.
 
 Plan Category
              
              Number
      of securities
                to
      be issued
                upon
      exercise of outstanding
                options and
      warrants
              
              
              Weighted-average
                exercise price of
      outstanding
                options and
      warrants
              
              
              Number of
      securities remaining available for future issuance under equity
      compensation plansEquity
      compensation plans approved by security holders
              
              
              8,195,000
              
              
              $
              0.44
              
              
              
              3,352,404Equity
      compensation plan not approved by security holders
              
              
              300,000
              
              
              $
              0.57
              
              
              
              —Total
              
              
              8,495,000
              
              
              
              
              
              
              
              3,352,404
 
 Recent
Sale of Unregistered Securities
 
 Unless
otherwise noted, the issuance noted below is considered exempt from registration
by reason on Section 4(2) of the Securities Act of 1933, as
amended.
 
 The
exercise listed below was performed on a cashless basis. By exercising on a
cashless basis, the warrant holder authorizes us to withhold from issuance
shares of common stock that would otherwise be issuable upon exercise of the
warrant which when multiplied by the market price of the common stock as of the
date of exercise is equal to the aggregate exercise price. The market price, as
defined in the warrant, is the average closing price of our common stock during
the 5 trading days prior to the date of exercise, less the exercise price of the
warrant, this product is then divided by the 5 day average closing price and the
result is multiplied by the number of shares in the warrant to arrive at the net
number of shares to issue.
 
 On May 1,
2008 warrants to purchase 200,000 shares of our common stock at an exercise
price of $0.06 were exercised by an investor on a cashless basis. The number of
shares of common stock that would otherwise have been issuable upon the exercise
of such warrants was reduced by 34,286, an aggregate value of $28,408, based on
the average closing price of our common stock during the 5 trading days prior to
date of exercise of $0.35. Accordingly, we issued 165,714 shares of our common
stock upon the exercise.
 
 Issuer
Purchases of Equity Securities
 
 On April
28, 2006 our Board of Directors authorized a stock repurchase program. We
commenced the program in July 2006 and plan to repurchase outstanding shares of
our common stock on the open market from time to time. We repurchased common
stock during the fourth quarter of fiscal year 2008 using available cash
resources as follows:
  Period
              Total
                Number
      of
                Shares
                Purchased
              
              Average
                Price
      Paid
                per
      Share
              
              Total
      Number of
                Shares
      Purchased as Part of
                Publicly
                Announced Plans or
      ProgramsMarch
      1 - 31, 2008
              -
              
              $
              -
              
              -April
      1 - 30, 2008
              1,829,200
              
              $
              0.37
              
              1,829,200May
      1 - 31, 2008
              568,700
              
              $
              0.32
              
              568,700Total
              2,397,900
              
              $
              0.35
              
              2,397,900
 
 The
repurchase plan has no maximum number of shares and is solely at the discretion
of the Board of Directors. The repurchase plan has no set expiration
date.
 
 13
  ITEM
6.          SELECTED FINANCIAL
DATA
 
 The
selected consolidated financial data set forth below for the fiscal years ended
May 31, 2008, 2007 and 2006, is derived from our audited consolidated
financial statements included elsewhere in this report. This information should
be read in conjunction with those consolidated financial statements, the notes
thereto, and with the section herein entitled “Management’s Discussion and
Analysis of Financial Condition and Results of Operations.” The selected
consolidated financial data set forth below for the fiscal years ended
May 31, 2005 and 2004, are derived from our audited consolidated financial
statements that are contained in reports previously filed with the Securities
and Exchange Commission, not included herein. There are no accounting changes,
business combinations or dispositions of business operations, other than the
consolidation of SSDI for the fiscal years ended May 31, 2008 and 2007 and the
inclusion of Talis in the equity in earnings of affiliated companies for the
fiscal year ended May 31, 2008, that materially affect the comparability of the
information provided in the charts below.
 
 Summary
Consolidated Financial Information
  Fiscal
      Years Ended May 31,Statement
      of operations data:
              
              2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Net
      sales
              
              $
              3,708,218
              
              
              $
              638,784
              
              
              $
              10,309,709
              
              
              $
              2,982,586
              
              
              $
              76,417Operating
      income (loss)
              
              $
              (5,603,493
              )
              
              $
              (14,763,839
              )
              
              $
              3,911,640
              
              
              $
              87,421
              
              
              $
              (1,737,370
              )Equity
      in earnings of affiliated companies
              
              $
              19,917,769
              
              
              $
              48,965,084
              
              
              $
              27,848,363
              
              
              $
              —
              
              
              $
              —Net
      income (loss)
              
              $
              9,388,321
              
              
              $
              23,691,187
              
              
              $
              28,672,688
              
              
              $
              (10,518,704
              )
              
              $
              (5,760,883
              )Basic
      income (loss) per common share
              
              $
              0.02
              
              
              $
              0.06
              
              
              $
              0.09
              
              
              $
              (0.05
              )
              
              $
              (0.04
              )Diluted
      income (loss) per common share
              
              $
              0.02
              
              
              $
              0.06
              
              
              $
              0.07
              
              
              $
              (0.05
              )
              
              $
              (0.04
              )Weighted
      average number of common shares outstanding - basic
              
              
              390,956,153
              
              
              
              378,036,989
              
              
              
              316,100,499
              
              
              
              222,495,047
              
              
              
              139,767,276Weighted
      average number of common shares outstanding - diluted
              
              
              397,485,699
              
              
              
              413,599,373
              
              
              
              412,963,173
              
              
              
              222,495,047
              
              
              
              139,767,276Cash
      dividends declared and paid per share
              
              $
              —
              
              
              $
              0.02
              
              
              $
              0.06
              
              
              $
              —
              
              
              $
              —
 
 
 May 31,Balance
      sheet data:
              
              2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Cash
      and cash equivalents
              
              $
              6,424,015
              
              
              $
              21,605,428
              
              
              $
              3,984,240
              
              
              $
              591,426
              
              
              $
              355,940Total
      assets
              
              $
              25,431,902
              
              
              $
              34,414,629
              
              
              $
              12,071,667
              
              
              $
              3,724,034
              
              
              $
              926,228Long-term
      obligations
              
              $
              1,085,181
              
              
              $
              12,222,944
              
              
              $
              -
              
              
              $
              9,320,654
              
              
              $
              6,102,669Total
      liabilities
              
              $
              2,014,719
              
              
              $
              14,243,738
              
              
              $
              1,244,116
              
              
              $
              10,964,418
              
              
              $
              6,650,711Stockholders’
      equity (deficit)
              
              $
              23,301,777
              
              
              $
              20,170,891
              
              
              $
              10,827,551
              
              
              $
              (7,240,384
              )
              
              $
              (5,724,483
              )
 
 
 14
  Fiscal Quarters
      EndedQuarterly
      statement of operations data for
              
              August 31,
              
              
              November
      30,
              
              
              February
      29,
              
              
              May 31,fiscal
      2008 (Unaudited):
              
              2007
              
              
              2007
              
              
              2008
              
              
              2008Net
      sales
              
              $
              521,369
              
              
              $
              945,830
              
              
              $
              801,284
              
              
              $
              1,439,735Gross
      profit
              
              $
              369,834
              
              
              $
              589,492
              
              
              $
              456,200
              
              
              $
              782,242Net
      income (loss)
              
              $
              (1,962,386
              )
              
              $
              2,416,536
              
              
              $
              6,292,185
              
              
              $
              2,641,986Basic
      income (loss) per common share
              
              $
              (
      0.01
              )
              
              $
              0.01
              
              
              $
              0.02
              
              
              $
              0.01Diluted
      income (loss) per common share
              
              $
              (0.01
              )
              
              $
              0.01
              
              
              $
              0.02
              
              
              $
              0.01Weighted
      average number of common shares outstanding - basic
              
              
              390,455,132
              
              
              
              391,245,755
              
              
              
              391,472,101
              
              
              
              390,660,391Weighted
      average number of common shares outstanding - diluted
              
              
              390,455,132
              
              
              
              392,627,522
              
              
              
              395,666,621
              
              
              
              391,717,950Cash
      dividends declared and paid per share
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              $
              -
   Fiscal
      Quarters EndedQuarterly statement of
      operations data for
              
              August 31,
              
              
              November
      30,
              
              
              February
      28,
              
              
              May 31,fiscal
      2007 (Unaudited):
              
              2006
              
              
              2006
              
              
              2007
              
              
              2007Net
      sales
              
              $
              26,375
              
              
              $
              18,500
              
              
              $
              22,175
              
              
              $
              571,734Gross
      profit
              
              $
              26,375
              
              
              $
              18,500
              
              
              $
              22,175
              
              
              $
              252,360Net
      income (loss)
              
              $
              5,990,273
              
              
              $
              (1,881,998
              )
              
              $
              9,617,559
              
              
              $
              9,965,353Basic
      income per common share
              
              $
              0.02
              
              
              $
              —
              
              
              $
              0.03
              
              
              $
              0.03Diluted
      income per common share
              
              $
              0.01
              
              
              $
              —
              
              
              $
              0.02
              
              
              $
              0.02Weighted
      average number of common shares outstanding - basic
              
              
              368,837,051
              
              
              
              378,817,682
              
              
              
              381,031,577
              
              
              
              387,903,643Weighted
      average number of common shares outstanding - diluted
              
              
              420,646,769
              
              
              
              378,817,682
              
              
              
              410,747,949
              
              
              
              407,392,062Cash
      dividends declared and paid per share
              
              $
              —
              
              
              $
              —
              
              
              $
              0.02
              
              
              $
              —
 
 
 ITEM
7.         MANAGEMENT’S DISCUSSION
AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
 THIS
ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS CONCERNING
FUTURE EVENTS AND PERFORMANCE OF OUR COMPANY. YOU SHOULD NOT RELY ON THESE
FORWARD-LOOKING STATEMENTS, BECAUSE THEY ARE ONLY PREDICTIONS BASED ON OUR
CURRENT EXPECTATIONS AND ASSUMPTIONS. MANY FACTORS COULD CAUSE OUR ACTUAL
RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED IN THESE FORWARD-LOOKING
STATEMENTS. YOU SHOULD REVIEW CAREFULLY THE FACTORS IDENTIFIED IN THIS REPORT AS
SET FORTH BELOW AND UNDER THE CAPTION “RISK FACTORS.” WE DISCLAIM ANY INTENT TO
UPDATE ANY FORWARD-LOOKING STATEMENTS TO REFLECT SUBSEQUENT ACTUAL EVENTS OR
DEVELOPMENTS.
 
 Overview
 
 In June
2005, we entered into a series of agreements with TPL and others to facilitate
the pursuit of infringers of our intellectual property. We intend to continue
our joint venture with TPL to pursue license agreements with infringers of our
technology. We believe that utilizing the option of working through TPL, as
compared to creating and using a Company licensing team for those activities,
avoids a competitive devaluation of our principal assets and is a prudent way to
achieve the desired results as we seek to obtain fair value from users of our
intellectual property.
 
 With the
proceeds generated by these licensing efforts, we are undertaking to make
investments in technologies, and acquisitions of companies operating in the
electronics technology market sector by way of i) selective expansion of our IP
portfolio, ii) pursuit of strategic minority investments in certain early-stage
revenue or technology ventures that represent a technology or capability of
interest to us, and iii) full M&A transactions.
 
 15
 
 Critical
Accounting Policies and Estimates
 
 Our
consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America, which
require us to make estimates and judgments that significantly affect the
reported amounts of assets, liabilities, revenues and expenses, and related
disclosure of contingent assets and liabilities. Actual results could differ
from those estimates, and such differences could affect the results of
operations reported in future periods. We believe the following critical
accounting policies affect our most significant estimates and judgments used in
the preparation of our consolidated financial statements.
 
 1.
              Revenue
      Recognition
 
 Accounting
for revenue recognition is complex and affected by interpretations of guidance
provided by several sources, including the Financial Accounting Standards Board
(“FASB”) and the Securities and Exchange Commission (“SEC”). This guidance is
subject to change. We follow the guidance established by the SEC in Staff
Accounting Bulletin No. 104, as well as generally accepted criteria for revenue
recognition, which require that, before revenue is recorded, there is persuasive
evidence of an arrangement, the fee is fixed or determinable, collection is
reasonably assured, and delivery to our customer has occurred. Applying these
criteria to certain of our revenue arrangements requires us to carefully analyze
the terms and conditions of our license agreements. Revenue from our technology
license agreements is recognized at the time we enter into a contract, determine
the license model (paid-in-advance or on-going royalty), and provide our
customer with the licensed technology, if applicable. These criteria are
generally met during the fiscal quarter of license announcement for
paid-in-advance licenses, or the subsequent quarter immediately following. We
believe that this is the point at which we have performed all of our obligations
under the agreement; however, this remains a highly interpretive area of
accounting and future license agreements may result in a different method of
revenue recognition. To date all of our technology licenses have been
paid-in-advance, however, on-going royalty license terms may be opted for by
future licensees of our technology. Fees for maintenance or support of our
licenses are recorded on a straight-line basis over the underlying period of
performance.
 
 Our
consolidated variable interest entity recognizes revenue upon shipment of its
product and recognizes revenue on its short-term installation contracts as time
and materials costs are incurred.
 
 2.
              Assessment
      of Contingent Liabilities
 
 We are
involved in various legal matters, disputes, and patent infringement claims
which arise in the ordinary course of our business. We accrue for estimated
losses at the time when we can make a reliable estimate of such loss and it is
probable that it has been incurred. By their very nature, contingencies are
difficult to estimate. We continually evaluate information related to all
contingencies to determine that the basis on which we have recorded our
estimated exposure is appropriate.
 
 3.
              Stock
      Options and Warrants
  On June
1, 2006, we adopted the provisions of SFAS No. 123(R), Share-Based Payment, which
establishes standards for the accounting of transactions in which an entity
exchanges its equity instruments for goods or services, primarily focusing on
accounting for transactions where an entity obtains employee services in
share-based payment transactions. SFAS No. 123(R) requires a public entity
to measure the cost of employee services received in exchange for an award of
equity instruments, including stock options, based on the grant-date fair value
of the award and to recognize it as compensation expense over the period the
employee is required to provide service in exchange for the award, usually the
vesting period.  Stock-based awards to non-employees are accounted for
using the fair value method in accordance with SFAS No. 123, Accounting for Stock Based
Compensation.
  In
November 2005, FASB issued FASB Staff Position No. FAS 123R-3, Transition Election Related to
Accounting for Tax Effects of Share-Based Payment Awards
(“FAS123R-3”).  We have elected to adopt the alternative transition
method provided in FAS 123R-3.  The alternative transition method
includes a simplified method to establish the beginning balance of the
additional paid-in capital pool (“APIC pool”) related to the tax effects of
employee share-based compensation, which is available to absorb tax deficiencies
recognized subsequent to the adoption of SFAS No. 123(R).
  16
 Stock-based
compensation expense recognized during the period is based on the value of the
portion of share-based payment awards that is ultimately expected to vest during
the period. Stock-based compensation expense recognized in our consolidated
statement of operations for the fiscal year ended May 31, 2007 included
compensation expense for share-based payment awards granted prior to, but not
yet vested as of May 31, 2006 based on the grant date fair value estimated
in accordance with the pro forma provisions of SFAS No. 123 and compensation
expense for the share-based payment awards granted subsequent to May 31,
2006 based on the grant date fair value estimated in accordance with the
provisions of SFAS No. 123(R). Stock-based compensation expense recognized in
our consolidated statement of operations for the fiscal year ended May 31, 2008
included compensation expense for share-based payment awards granted subsequent
to May 31, 2007 based on the grant date fair value estimated in accordance
with the provisions of SFAS No. 123(R). As stock-based compensation expense
recognized in the consolidated statements of operations is based on awards
ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS
No. 123(R) requires forfeitures to be estimated at the time of grant and
revised, if necessary, in subsequent periods if actual forfeitures differ from
those estimates. The estimated average forfeiture rate for the fiscal year ended
May 31, 2008 and 2007, of approximately 5% was based on historical
forfeiture experience and estimated future employee forfeitures.
 
 4.
              Income
      Taxes
 
 We must
assess the likelihood that we will be able to recover our deferred tax assets.
If recovery is not likely, we must increase our provision for taxes by recording
a valuation allowance against the deferred tax assets that we estimate will not
ultimately be recoverable. We believe that a substantial majority of the
deferred tax assets recorded on our balance sheet will ultimately be recovered.
However, should there be a change in our ability to recover the deferred tax
assets; the tax provision would increase in the period in which we determined
that the recovery was not probable.
 
 Additionally,
we adopted Financial Accounting Standards Board, (“FASB”) Interpretation No. 48,
Accounting for Uncertainty in
Income Taxes – An Interpretation of FASB Statement No. 109,or FIN 48, on
June 1, 2007, the first day of fiscal 2008.  FIN 48 seeks to reduce
the diversity in practice associated with certain aspects of measurement and
recognition in accounting for income taxes.  FIN 48 prescribes a
recognition threshold and measurement requirement for the financial statement
recognition of a tax position that has been taken or is expected to be taken on
a tax return and also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure and
transition.  Under FIN 48 we may only recognize tax positions that
meet a “more likely than not” threshold.
 
 5.
              Investments
      in Affiliated Companies
 
 We have a
50% interest in PDS. We account for our investment using the equity method of
accounting since the investment provides us the ability to exercise significant
influence, but not control, over the investee. Significant influence is
generally deemed to exist if we have an ownership interest in the voting stock
of the investee of between 20% and 50%, although other factors, such as
representation on the investee’s Board of Directors, are considered in
determining whether the equity method of accounting is appropriate. Under the
equity method of accounting, the investment, originally recorded at cost, is
adjusted to recognize our share of net earnings or losses of the investee and is
recognized in the consolidated statement of operations in the caption “Equity in
earnings of affiliated companies”.
 
 We have a
15.09% interest in Talis.  We account for our investment using the
equity method of accounting pursuant to paragraph 8 of AICPA Statement of
Position 78-9, Accounting for
Investments in Real Estate Ventures(which has applicability to non-Real
Estate accounting matters as well) as our membership share of this limited
liability company is more than minor.  Under the equity method of
accounting, the investment, originally recorded at cost, is adjusted to
recognize our share of net earnings or losses of the investee and is recognized
in the consolidated statement of operations in the caption “Equity in earnings
of affiliated companies”.
 
 On August
1, 2008, we increased our investment in Talis to 37.4% as a result of purchasing
additional shares offered by Talis, as well as acquiring shares from minority
shareholders which included the acquisition of all Talis shares previously held
by SSDI. The acquisition of Talis shares previously owned by SSDI was made for
$100,000 in cash and a reduction on their outstanding line of credit of
$219,000.
 
 We review
our investments in these affiliated companies to determine whether events or
changes in circumstances indicate that the carrying amounts may not be
recoverable. The primary factors we consider in our determination are the
financial condition, operating performance and near term prospects of the
investees. If the decline in value is deemed to be other than temporary, we
would recognize an impairment loss.
 
 
 17
  6.
              Variable
      Interest Entity
 
 We own
100% of the preferred stock of SSDI. On March 27, 2007 we entered into an 18
month revolving line of credit with SSDI for a maximum amount of $500,000. The
line of credit caused us to have a variable interest in SSDI, a variable
interest entity, and we have determined that we are the primary beneficiary as
we absorb more than half of the variable interest entity’s expected losses.
FIN46(R), Consolidation of
Variable Interest Entities, requires us to consolidate SSDI as long as we
are deemed to be the primary beneficiary.
 
 We
reevaluate our primary beneficiary position at each of our balance sheet dates
using the guidance in FIN46(R). If we are no longer deemed to be the primary
beneficiary of the variable interest entity, we will discontinue
consolidation.
 
 RESULTS
OF OPERATIONS
 
 Comparison
of fiscal 2008 and 2007
 
 Our
revenues increased from approximately $639,000 for the fiscal year ended May 31,
2007 to approximately $3,708,000 for the fiscal year ended May 31, 2008. Our
revenue amounts do not include approximately $48,965,000 in income resulting
from our investment in PDS for the fiscal year ended May 31, 2007 and
approximately $19,918,000 in income resulting from our investments in PDS and
Talis for the fiscal year ended May 31, 2008.  During the 2008 fiscal
year we recorded sales amounting to approximately $3,650,000 by our consolidated
variable interest entity, SSDI, with cost of sales amounting to approximately
$1,510,000 as compared to the fourth quarter of the 2007 fiscal year during
which we recorded SSDI sales amounting to approximately $559,000 with cost of
sales amounting to approximately $308,000. During the 2008 and the 2007 fiscal
years we recognized maintenance fee revenues totaling approximately $25,000 per
year in connection with an agreement with AMD Corporation during the 2005 fiscal
year. The agreement called for maintenance fees totaling $100,000 connected with
a license agreement for our Ignite technology; the license fee revenue is being
recognized as revenue evenly over the four year period of the license. In
addition during the 2008 fiscal year, we recorded sales of approximately $33,000
from the sale of microprocessor chips that we no longer market as compared to
approximately $55,000 during the 2007 fiscal year. Inventory associated with the
sales of these microprocessor chips is carried at zero value.
 
 Selling,
general and administrative expenses decreased from approximately $7,559,000 for
the fiscal year ended May 31, 2007 to approximately $6,965,000 for the fiscal
year ended May 31, 2008. Legal and accounting related expenses decreased by
approximately $668,000 for the fiscal year ended May 31, 2008 compared with the
fiscal year ended May 31, 2007 due to settlement of legal matters during fiscal
year 2008 and reduced accounting expenses in fiscal year 2008.  Fiscal
year 2007 included fees related to legal and accounting matters in connection
with the restatement of our financial statements for the fiscal years 2005,
2004, 2003 and 2002 as well as the quarterly reports for the periods ended
August 31, 2005 and February 28, 2006 and our required compliance with
Sarbanes-Oxley regulations. Salary costs and related expenses included non-cash
expenses associated with the fair value of options granted during the fiscal
years ended May 31, 2008 and 2007 in accordance with SFAS No. 123(R). Total
non-cash compensation for the fiscal year ended 2008 was approximately $502,770
for PTSC as compared to approximately $2,359,036 for PTSC during the fiscal year
ended 2007.  The decrease is primarily due to the June 5, 2006 grant
of 1,500,000 options to our former chief executive officer resulting in non-cash
compensation expense amounting to approximately $1,527,000 during the fiscal
year ended 2007. Other salary expenses for PTSC increased by approximately
$292,000 for the fiscal year ended May 31, 2008 as compared with the fiscal year
ended May 31, 2007.  The increase is primarily due to the hire of an
additional executive position and severance payments to our past chief executive
officers.  Salaries and related expenses for SSDI during the fiscal
year ended 2008 were approximately $1,198,000 as compared to approximately
$242,538 for the fourth quarter of the 2007 fiscal year. Public and investor
relations expenses decreased by approximately $128,000 for the fiscal year ended
May 31, 2008 as compared with the 2007 fiscal year primarily due to one-time
contracts with investor relations firms in fiscal year 2007.
 
 Settlement
and license expenses amounting to approximately $7,525,000 were recorded during
the fiscal year ended May 31, 2007, relating to the mediation agreement with
Russell H. Fish III (“Fish”).  During fiscal year 2008 we recorded
approximately $836,000 relating to royalty payments due to the Fish
parties.  In January 2008, we made the final payment under the Fish
settlement agreement.
 
 Our other
income and expenses for the fiscal years ended May 31, 2008 and 2007 include
equity in the earnings of PDS.  For the fiscal year ended May 31, 2008
our other income and expense also includes our share of loss in Talis. Our
investments are accounted for in accordance with the equity method of
accounting. Our investment in PDS for the fiscal year ended May 31, 2008
provided income after expenses in the amount of approximately $19,926,000 as
compared to income after expenses in the amount of approximately $48,965,000 for
the fiscal year ended May 31, 2007.  For the fiscal year ended May 31,
2008 our investment in Talis generated a loss of approximately $8,000. Total
other income and expense for the fiscal year ended May 31, 2008 amounted to net
other income of approximately $21,533,000 compared with total other income and
expense for the fiscal year ended May 31, 2007 of net other income amounting to
approximately $49,210,000.  Interest income and other income increased
from approximately $715,000 for the fiscal year ended May 31, 2007 to
approximately $1,470,000 for the fiscal year ended May 31, 2008.  The
increase is primarily due to the interest earned and accrued on our auction rate
securities of approximately $363,000 and an increase in other income of
approximately $382,000 relating to retainer refunds from legal firms, settlement
of a legal matter and reimbursement items billed to PDS for prior fiscal year
legal expenses we incurred. During the fiscal year ended May 31, 2007 we
recorded an impairment charge on the value of our note receivable from Holocom
Networks, Inc. of approximately $340,000. Also, we recorded an impairment charge
of approximately $127,000 on the carrying value of SSDI, the successor company
to Holocom Networks, Inc., prior to the March 27, 2007 consolidation of
SSDI.  There was no such impairment charges during the fiscal year
ended May 31, 2008.
 
 18
 Our
provision for income taxes was approximately $6,426,000 for the year ended May
31, 2008 as compared to approximately $10,755,000 for the year ended May 31,
2007.  As of May 31, 2008 we have utilized all of our remaining
available federal net operating loss carry-forwards of approximately
$4,870,000.   At May 31, 2007, we had utilized all of our state
net operating loss carry-forwards of approximately $17,822,000.
 
 Comparison
of fiscal 2007 and 2006
 
 Our
revenues declined from approximately $10,310,000 for the fiscal year ended May
31, 2006 to approximately $639,000 for the fiscal year ended May 31, 2007. Our
revenue amounts do not include approximately $27,848,000 and approximately
$48,965,000 in income resulting from our investment in Phoenix Digital
Solutions, LLC for the fiscal years ended May 31, 2006 and May 31, 2007,
respectively. In the first quarter of the 2006 fiscal year we entered into an
agreement with Intel Corporation licensing our intellectual property, in
connection with which we received a one-time payment of $10,000,000. The license
revenue was recognized during the 2006 fiscal year. In addition, product sales
amounting to approximately $310,000 were also recorded during the 2006 fiscal
year in connection with communications products that we no longer market.
Inventory associated with the sales of these communications products was carried
at zero value. Cost of sales of approximately $103,000 consisted of payments
made to subcontractors for materials and labor in connection with the product
sales. During the fourth quarter of the 2007 fiscal year we recorded sales
amounting to approximately $559,000 by our consolidated variable interest
entity, SSDI with cost of sales amounting to approximately $308,000. Also during
the 2007 fiscal year we recognized maintenance fee revenues totaling
approximately $25,000 in connection with an agreement with AMD Corporation
during the 2005 fiscal year. The agreement called for maintenance fees totaling
$100,000 connected with a license agreement for our Ignite technology; the
license fee revenue is being recognized as revenue evenly over the four year
period of the license. In addition during the 2007 fiscal year, we recorded
sales of approximately $55,000 from the sale of microprocessor chips that we no
longer market. Inventory associated with the sales of these microprocessor chips
is carried at zero value.
 
 Research
and development expenses for the fiscal year ended May 31, 2006 amounted to
approximately $226,000. Expenses related to salaries, benefits, training and
other employee expenses amounted to approximately $152,000 for the 2006 fiscal
year. Consultants related to research and development activities amounted to
approximately $64,000 for the 2006 fiscal year and remaining expenses of
approximately $10,000 connected with travel and overhead costs supporting
research and development activities during the 2006 fiscal year. Research and
development activities were terminated during the 2006 fiscal year and no such
costs were incurred during the 2007 fiscal year.
 
 Selling,
general and administrative expenses increased from approximately $4,151,000 for
the fiscal year ended May 31, 2006 to approximately $7,559,000 for the fiscal
year ended May 31, 2007. Legal and accounting related expenses increased by
approximately $847,000 for the fiscal year ended May 31, 2007 compared with the
fiscal year ended May 31, 2006 related to legal and accounting matters in
connection with the restatement of our financial statements for the fiscal years
2005, 2004, 2003 and 2002 as well as the quarterly reports for the periods ended
August 31, 2005 and February 28, 2006 and our required compliance with
Sarbanes-Oxley regulations. Legal expenses related to a dispute with a former
officer as well as other legal proceedings involving a co-inventor of a portion
of our technology and other legal expenses connected with SSDI contributed to
the increase in legal expenses for the 2007 fiscal year. Salary costs and
related expenses included non-cash expenses associated with the fair value of
options granted during the fiscal year ended May 31, 2007 in accordance with
SFAS No. 123(R). On June 5, 2006, 1,500,000 options were granted to our former
chief executive officer resulting in non-cash compensation expense amounting to
approximately $1,527,000. On October 23, 2006, 230,000 options were granted to
employees resulting in non-cash compensation expense of approximately $184,000.
On February 9, 2007, 1,070,000 options were granted to employees and directors
resulting in non-cash compensation expense of $584,000. Additional non-cash
compensation for the fiscal year ended May 31, 2007 amounted to $61,000 for
vesting of employee stock options in accordance with SFAS No. 123(R). No such
compensation expense was incurred for the 2006 fiscal year. Other salary
expenses increased by approximately $398,000 for the fiscal year ended May 31,
2007 as compared with the fiscal year ended May 31, 2006 including approximately
$223,000 in salaries and related expenses for SSDI during the fourth quarter of
the 2007 fiscal year. Salary expenses for PTSC including expenses connected with
bonuses and 401(k) employer matching of salaries increased by approximately
$175,000 in the 2007 fiscal year as compared with the 2006 fiscal year.
Marketing related expenses decreased by approximately $139,000 for the fiscal
year ended May 31, 2007 as compared with the fiscal year ended May 31, 2006 as
product marketing activities were largely discontinued. Public and investor
relations expenses increased by approximately $165,000 for the fiscal year ended
May 31, 2007 as compared with the 2006 fiscal year as a result of a change in
our public relations firm and one-time contracts with investor relations
consultants. Insurance expense increased by approximately $158,000 for the
fiscal year ended May 31, 2007 as compared with the 2006 fiscal year primarily
as a result of increased costs of directors and officers insurance coverage.
Travel and related expenses for the 2007 fiscal year increased by approximately
$44,000 as expenses for SSDI were combined with travel expenses for PTSC which
increased due to travel to attend various lawsuit mediations.
 
 19
 Settlement
and license expenses amounting to approximately $1,918,000 were recorded during
the year ended May 31, 2006 in connection with the agreements involving the
formation of a joint venture and, separately, a license agreement with Intel
Corporation. The expenses consisted of both cash and non-cash elements related
to incremental, direct costs of completing the transactions. In connection with
the transactions, it was necessary for us to obtain the consent of certain
debenture and warrant holders. The necessary consents, together with certain
warrants held by the debenture holders and the release of their security
interests in our intellectual property, were obtained in exchange for cash, new
warrants and repriced warrants. The expenses resulted primarily from cash
payments to debt holders of approximately $1,300,000, to co-owners of various
intellectual property assets of approximately $960,000 and to a committee of our
board of directors of approximately $170,000. Non-cash expenses totaled
approximately $82,000 and resulted primarily from the incremental value of the
effect of repricing various warrants and granting other warrants in excess of
the expense previously recognized for warrants granted to these security
holders. Offsetting the non-cash expenses were non-cash benefits from the
reconveyance of warrants, amounting to approximately $622,000. During the fiscal
year ended May 31, 2007, we recorded $7,525,000 of settlement and license
expense relating to the mediation agreement with Russell H. Fish III
(“Fish”).
 
 Our other
income and expenses for the fiscal year ended May 31, 2007 included equity in
the earnings of PDS. The investment is accounted for in accordance with the
equity method of accounting for investments. Our investment in the joint venture
for the fiscal year ended May 31, 2007 provided income after expenses in the
amount of approximately $48,965,000. Our investment in the joint venture
provided net income after expenses in the amount of approximately $27,848,000
for the fiscal year ended May 31, 2006. Total other income and expense for the
fiscal year ended May 31, 2007 amounted to net other income of approximately
$49,210,000 compared with total other income and expense for the fiscal year
ended May 31, 2006 of net other income amounting to approximately $24,761,000.
Changes in the fair value of warrant and derivative liabilities amounted to net
other expense for the fiscal year ended May 31, 2006 of approximately $2,457,000
with no corresponding amount for the fiscal year ended May 31, 2007 as all
convertible debt had been retired in prior fiscal periods. Non-cash adjustments
to interest expense for the 2006 fiscal year amounted to expenses of
approximately $471,000 resulting from amortization of debt discount and
conversion of the remaining debentures. During the 2006 fiscal year we recorded
a loss on debt extinguishment of $445,000 related to the 7,000,000 warrants
issued to a debenture holder as consideration for entering into the reset
agreements. Interest income and other income increased from approximately
$330,000 for the fiscal year ended May 31, 2006 to approximately $715,000 for
the fiscal year ended May 31, 2007 as interest bearing account balances
increased from cash received as distributions from our investment in PDS. During
the fiscal year ended May 31, 2007 we recorded an impairment charge on the value
of our note receivable from Holocom Networks, Inc. of approximately $340,000.
Also, we recorded an impairment charge of approximately $127,000 on the carrying
value of SSDI, the successor company to Holocom Networks, Inc., prior to the
March 27, 2007 consolidation of the VIE (see Note 8 to our consolidated
financial statements for more information).
 
 Our
provision for income taxes was approximately $10,755,000 for the year ended May
31, 2007 due to recognition of deferred taxes of approximately $9,783,000 and a
current tax liability of approximately $972,070. The increase in deferred taxes
was due to the release of the valuation allowance as we determined that we would
utilize our net operating loss carryforwards and other deferred tax assets due
to our share of income from PDS. At May 31, 2007 we have utilized all of our
state net operating loss carryforwards of approximately $17,822,000 and utilized
approximately $29,090,000 of our federal net operating loss
carryforwards.
 
 
 20
 LIQUIDITY
AND CAPITAL RESOURCES
 
 Liquidity
 
 Our cash,
marketable securities and short-term investment balances decreased from
approximately $25,955,000 as of May 31, 2007 to approximately $6,722,000 as of
May 31, 2008. We also have restricted cash balances amounting to approximately
$51,000 as of May 31, 2008 and approximately $102,000 as of May 31, 2007. Total
current assets decreased from approximately $31,399,000 as of May 31, 2007 to
approximately $9,851,000 as of May 31, 2008. Total current liabilities amounted
to approximately $930,000 and approximately $2,021,000 as of May 31, 2008 and
May 31, 2007, respectively. The change in our current position as of May 31,
2008 as compared with the previous year primarily results from the investment of
idle cash in auction rate securities which are classified as long-term and the
decrease in distributions received from PDS during fiscal year
2008.
 
 Cash
Flows From Operating Activities
 
 Cash used
in operating activities for the fiscal years ended May 31, 2008 and 2007 was
approximately $19,260,000 and $14,151,000 as compared with cash provided by
operating activities for the fiscal year ended May 31, 2006 of approximately
$6,474,000. The principal components of the current year amount were: net income
of approximately $9,388,000 adjusted for: minority interest in SSDI of
approximately $115,000, non-cash charges of approximately $510,000 related to
issuance and vesting of stock options and warrants. These increases were
partially offset by: the equity in earnings of our investees of approximately
$19,918,000, change in deferred taxes of approximately $9,937,000, and a
decrease in trade payables and accrued expenses of approximately $1,091,000
primarily due to our accrual of royalties payable at May 31, 2007 of which we
have no obligation at May 31, 2008.  The cash provided by operating
activities during fiscal year 2006 was primarily due to our one-time license of
$10,000,000 from Intel Corporation.
 
 Cash
Flows From Investing Activities
 
 Cash
provided by investing activities for the fiscal year ended May 31, 2008 was
approximately $10,725,000 as compared to cash provided by investing activities
of approximately $48,529,000 for the fiscal year ended May 31, 2007. The
decrease was primarily due to a reduction in distributions from PDS of
approximately $29,746,000 from fiscal year 2007 as compared to fiscal year
2008.  Additionally we used approximately $8,849,000 of cash in net
purchases of investments.
 
 Cash
provided by investing activities increased to approximately $48,529,000 for the
fiscal year ended May 31, 2007 from approximately $21,121,000 for the fiscal
year ended May 31, 2006. The increase was primarily due to distributions of
approximately $50,034,000 we received from our investment in an affiliate offset
by cash used of approximately $830,000 in net purchases of short-term
investments and an issuance of a line of credit of approximately $590,000 to
Holocom Networks, Inc.
 
 Cash
Flows From Financing Activities
 
 Cash used
in financing activities for the fiscal year ended May 31, 2008 was approximately
$6,647,000 as compared to cash used in financing activities of approximately
$16,757,000 for the fiscal year ended May 31, 2007. Cash used in fiscal year
2008 consisted primarily of approximately $2,761,000 to repurchase warrants from
an investor and approximately $3,891,000 used to repurchase shares of our common
stock for treasury. The cash used in fiscal year 2008 was partially offset by
proceeds received of approximately $31,000 from the exercise of common stock
options and warrants. Cash used in financing activities in fiscal year 2007
consisted primarily of approximately $8,115,000 in cash dividends to common
shareholders and approximately $8,832,000 used to repurchase shares of our
common stock for treasury.
 
 Cash used
in financing activities for the fiscal year ended May 31, 2007 was approximately
$16,757,000 as compared to approximately $24,202,000 for the fiscal year ended
May 31, 2006 primarily due to payments of approximately $8,115,000 in cash
dividends to our common shareholders and qualifying warrant holders for fiscal
year 2007 as compared to approximately $24,698,000 in cash dividends paid for
fiscal year 2006, and approximately $8,832,000 paid to repurchase shares of our
common stock for treasury in fiscal year 2007. The cash used in fiscal 2007 was
partially offset by cash received of approximately $214,000 from the exercise of
common stock options and warrants.
 
 
 21
 Capital
Resources
 
 Our
current position as of May 31, 2008 is expected to provide the funds necessary
to support our operations through the fiscal year ended May 31,
2009.
 
 MANAGEMENT
OUTLOOK
 
 During
recent years we have relied upon financing activities to provide the funds
necessary for our operations. The number of shares of our common stock
outstanding increased from 171,156,363 at May 31, 2004 to 366,199,765 at May 31,
2006, largely as a result of financing activities including sales of common
stock, the issuance of convertible debentures and notes payable and related
conversions and exercises of common stock warrants. Beginning in fiscal year
2006, we were able to finance operations utilizing distributions we received
from PDS. As we pursue our investment and acquisition strategy, we may use a
combination of cash, debt, and common stock to finance these
efforts.
 
 CONTRACTUAL
OBLIGATIONS AND COMMITMENTS
 
 A summary
of our outstanding contractual obligations at May 31, 2008 is as
follows:
  Contractual
                Cash
      Obligations
              
              Total
      Amounts
                Committed
              
              
              1-3
                YearsOperating
      leases - facilities
              
              $
              192,423
              
              
              $
              192,423
 
 RECENT
ACCOUNTING PRONOUNCEMENTS
 
 In July
2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income
Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). This
interpretation clarifies the application of SFAS No. 109, Accounting for Income Taxes,
by defining criteria that an individual tax position must meet for any part of
the benefit of that position to be recognized in a company’s financial
statements and also provides guidance on measurement, derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure and transition. We adopted FIN 48 on June 1, 2007 and did not record
any cumulative effect adjustment to retained earnings as a result of adopting
FIN 48.  Interest and penalties, if any, related to unrecognized tax
benefits are recorded in income tax expense.  As of June 1, 2007, we
are subject to U.S. Federal income tax examinations for the tax years May 31,
1991 through May 31, 2007, and we are subject to state and local income tax
examinations for the tax years May 31, 1999 through May 31, 2007 due to the
carryover of net operating losses from previous years.
 
 In
September 2006, the FASB issued SFAS No. 157, Fair Value
Measurements.  SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principals
and expands disclosures about fair value measurements.  The statement does
not require new fair value measurements, but is applied to the extent that other
accounting pronouncements require or permit fair value measurements.  The
statement emphasizes that fair value is a market-based measurement that should
be determined based on the assumptions that market participants would use in
pricing an asset or liability.  Companies that have assets and liabilities
measured at fair value will be required to disclose information that enables the
users of its financial statements to access the inputs used to develop those
measurements.  The reporting entity is encouraged, but not required, to
combine the fair value information disclosed under this statement with the fair
value information disclosed under other accounting pronouncements.  SFAS
No. 157 is effective for fiscal years beginning after November 15, 2007. We
expect to adopt SFAS No. 157 on June 1, 2008.  In February 2008, the FASB
released FASB Staff Position 157-2, Effective Date of FASB StatementNo. 157,which
delayed the effective date of SFAS No. 157 for all nonfinancial assets and
nonfinancial liabilities, except those that are recognized or disclosed at fair
value in the financial statements on a recurring basis (at least annually) until
the fiscal year beginning May 31, 2009.  We are in the process of
evaluating the provisions of the statement, but do not anticipate that the
adoption of SFAS No. 157 will have a material impact on our consolidated
financial statements.
 
 22
 In
February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial
Assets and Financial Liabilities. SFAS No. 159 permits entities to choose
to measure at fair value many financial instruments and certain other items that
are not currently required to be measured at fair value. The objective is to
improve financial reporting by providing entities with the opportunity to
mitigate volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. SFAS No. 159 also establishes presentation and disclosure
requirements designed to facilitate comparisons between entities that choose
different measurement attributes for similar types of assets and liabilities.
SFAS No. 159 does not affect any existing accounting literature that
requires certain assets and liabilities to be carried at fair value.
SFAS No. 159 does not establish requirements for recognizing and
measuring dividend income, interest income, or interest expense. This Statement
does not eliminate disclosure requirements included in other accounting
standards. SFAS No. 159 is effective in fiscal years beginning after
November 15, 2007. We are in the process of evaluating the provisions of
the statement, but do not anticipate that the adoption of SFAS No. 159 will have
a material impact on our consolidated financial statements.
 
 In
December 2007, the FASB issued SFAS No. 141(R), Business Combinations. SFAS
No. 141(R) requires acquiring entities in a business combination to recognize
the assets acquired and liabilities assumed in the transaction; establishes the
acquisition-date fair value as the measurement objective for all assets acquired
and liabilities assumed; and requires the acquirer to disclose to investors the
information it needs to evaluate and understand the nature and financial effect
of the business combination. SFAS No. 141(R) is effective in fiscal years
beginning after December 15, 2008. We expect to adopt SFAS No. 141(R) on June 1,
2009.  We are currently assessing the impact the adoption of SFAS No.
141(R) will have on our consolidated financial statements.
 
 In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements. SFAS No. 160 requires entities to
report noncontrolling (minority) interests in subsidiaries as equity in the
consolidated financial statements. SFAS No. 160 is effective in fiscal
years beginning after December 15, 2008. We expect to adopt SFAS No. 160 on June
1, 2009.  We are currently assessing the impact the adoption of SFAS
No. 160 will have on our consolidated financial statements.
 
 ITEM
7A.          QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK
 
 Interest
rate risk
 
 The
primary objective of our investment activities is to maintain surplus cash in
accounts that provide a high level of funds accessibility in large, respected
financial institutions with asset safety as a primary consideration.
Accordingly, we maintain our cash and cash equivalents with high quality
financial institutions. Amounts deposited with these institutions may exceed
federal depository insurance limits.
 
 Cash
and Cash Equivalents
 
 We
maintain cash and cash equivalents in institutional money market accounts. In
general, money market funds are not subject to interest rate risk because the
interest paid on these funds fluctuates with the prevailing interest
rate.
 
 Our
commercial checking account is linked to a sweep account. This sweep account is
maintained by our financial institution in an offshore account located in the
Cayman Islands. This sweep account is a deposit liability of our financial
institution, the funds are not insured by the Federal Deposit Insurance
Corporation (“FDIC”), in liquidation the funds have a lesser preference than
deposits held in the United States, and the funds are subject to cross-border
risks.
 
 Auction
Rate Securities
 
 Our
exposure to market risk for changes in interest rates relates primarily to our
auction rate securities.  During the quarter ended February 29, 2008,
investment banks were reporting an inability to successfully obtain subscribers
for high credit quality auction rate securities.  As of May 31, 2008,
we held such auction rate securities with a par value totaling $12.9 million
that failed to sell at auction. In the event we need to access funds invested in
these auction rate securities we will not be able to liquidate these securities
until: a future auction of these securities is successful, they are refinanced
and redeemed by the issuers, or a buyer is found outside of the auction
process.  The investments consist of student loan auction rate
instruments issued by various state agencies pursuant to the Federal Family
Educational Loan Program (“FFELP”).  These investments are of high
credit quality and the AAA credit ratings of the investments have been
reaffirmed since May 2008.  These instruments are collateralized in
excess of the underlying obligations, are insured by the various state
educational agencies, and are guaranteed by the Department of Education as an
insurer of last resort.
 
 23
 At May
31, 2008, the fair value of our auction rate securities was estimated at $12.5
million based on a valuation by Houlihan Smith & Company, Inc.  We
recorded the net temporary valuation adjustment of $220,617 in other
comprehensive income, which represents the gross valuation adjustment of
$372,325, net of the related tax benefit of $151,708.  We have
concluded that the unrealized losses on these investments are temporary because
(i) we believe that the decline in market value and absence of liquidity that
has occurred is due to general market conditions, (ii) the auction rate
securities continue to be of a high credit quality and interest is paid as due
and (iii) we have the intent and ability to hold these investments until a
recovery in market value occurs.  Since this valuation adjustment is
deemed to be temporary, it did not affect our earnings for the fiscal year ended
May 31, 2008.
 
 We are
not currently able to predict how long these investments will remain illiquid,
and as such, they have been classified as long-term investments in marketable
securities in the accompanying consolidated balance sheet at May 31,
2008.
 
 The fair
value of our long-term investments in marketable securities could change
significantly in the future and we may be required to record
other-than-temporary impairment charges or additional unrealized losses in
future periods.
 
 We do not
believe that the illiquidity of these investments will materially impact our
ability to fund our working capital needs, capital expenditures or other
business requirements.
 
 During
June 2008 we obtained a credit facility which provides for financing up to 50%
of the par value balance of our outstanding auction rate securities. The
facility is collateralized by the full value of the outstanding auction rate
securities, required no origination fee, and if drawn upon will bear interest at
the federal funds rate plus 3%.
 
 ITEM
8.           FINANCIAL STATEMENTS AND SUPPLEMENTARY
DATA
 
 The
financial statements required by this item begin on page F-1 with the index to
consolidated financial statements.
 
 ITEM
9.           CHANGES IN AND DISAGREEMENTS WITH
ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
 None.
 
 ITEM
9A.        CONTROLS AND
PROCEDURES
 
 Evaluation
of Disclosure Controls and Procedures
 
 Our
management is responsible for establishing and maintaining adequate internal
controls over financial reporting, as defined in Exchange Act Rules 13a-15(f).
We have designed and maintain disclosure controls and procedures to ensure that
information required to be disclosed in the our reports is recorded, processed,
summarized and reported within the time periods specified in the rules and forms
of the Securities and Exchange Commission and 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 these controls and procedures, our
management recognizes that any system of controls and procedures, no matter how
well designed and operated, can provide only reasonable assurance of achieving
the desired objectives and necessarily applies judgment in evaluating the
cost-benefit relationship of other possible controls and procedures. In
addition, we consolidate SSDI, a variable interest entity as defined in
Financial Accounting Standards Board Interpretation (“FIN”) No. 46(R), Consolidation of Variable Interest
Entities, an interpretation of ARB No. 51 (“FIN 46(R)”), that we do not
control or manage and consequently, our disclosure controls and procedures with
respect to this entity are necessarily limited to oversight or monitoring
controls that we have implemented to provide reasonable assurance that the
objectives of our disclosure controls and procedures as described above are
met.
 
 As of the
end of the period covered by this report, we carried out an evaluation, under
the supervision and with the participation of our management, including our
Chief Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures (as defined in
Rule 13(a)-15(e) of the Exchange Act).  Based on that evaluation, our
Chief Executive Officer and Chief Financial Officer concluded that, as of May
31, 2008 our disclosurecontrols and procedures
were not effective to provide reasonable assurance that the information required
to be disclosed in the reports we file and submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in the Securities and Exchange Commission’s rules and forms, as a result of the
material weakness identified and discussed below.
  24
 Changes
in Internal Controls over Financial Reporting
 
 There has
been no change in our internal control over financial reporting (as defined in
Rule 13a-15(f) under the Exchange Act) during our fourth fiscal quarter
ended May 31, 2008, that has materially affected, or is reasonably likely
to materially affect our internal control over financial reporting.
 
 Management’s
Report on Internal Control Over Financial Reporting
 
 Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Exchange Act
Rules 13a-15(f) and 15d-15(f).
 
 Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
 
 Under the
supervision and with the participation of our management, including our
principal executive officer and principal financial officer, we conducted an
evaluation of the effectiveness of our internal control over financial reporting
based on the framework inInternal Control — Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our
evaluation under the framework inInternal Control — Integrated
Framework , our management concluded that our internal control over
financial reporting was not effective as of May 31, 2008.
 
 A
material weakness is a deficiency, or a combination of control deficiencies, in
internal control over financial reporting, such that there is a reasonable
possibility that a material misstatement of our annual or interim financial
statements will not be prevented or detected on a timely basis.
 
 As
discussed above, we consolidate SSDI, a variable interest entity as defined in
FIN No. 46(R) that we do not control or manage and consequently, our disclosure
controls and procedures with respect to this entity are necessarily limited to
oversight or monitoring controls that we have implemented to provide reasonable
assurance that the objectives of the our disclosure controls and procedures are
met.  In connection with our assessment of internal control over
financial reporting, we identified the following material weakness in our
internal control over financial reporting:
 
 As of May
31, 2008, a material weakness existed relating to SSDI’s information technology
general controls, including ineffective controls relating to
following:
 
 ·
              There
      is no IT security policy,
 ·
              There
      is no change management policy,
 ·
              There
      is no evidence of changes which have been
  performed,
 ·
              There
      is no physical security over servers, firewall, router and
      switches,
 ·
              There
      is no documentation of the granting of user access rights
      process,
 ·
              There
      is no documentation of the user access termination
  process,
 ·
              The
      firewall configuration does not reflect SSDI’s current
    usage,
 ·
              Remote
      access is not well controlled,
 ·
              Two
      of five systems did not have recent antivirus signature
    files,
 ·
              The
      antivirus software is not installed on the
  server,
 ·
              All
      named users, plus the CIO using the administrator account, have full
      access to all areas of QuickBooks,
 ·
              All
      authenticated users are allowed full access to the files in the Finance
      directory,
 ·
              The
      domain administrator list is not limited to the minimum appropriate
      personnel,
 ·
              Passwords
      are only required to be five characters which is deemed insufficient for
      good security,
 ·
              There
      is no evidence of the CIO’s weekly backup review occurring, and management
      is not being notified of failures,
 ·
              There
      are no stored backup tapes off-site or in a media safe,
  and
 ·
              There
      are no regularly run test
restorations.
 
 Because
of the material weakness described above, we concluded that we did not maintain
effective internal control over financial reporting as of May 31,
2008.
 
 25
 Our
internal controls over financial reporting as of May 31, 2008 have been audited
by KMJ Corbin & Company LLP, our independent registered public accounting
firm, as stated in their report which appears herein.
 
 Plans
for Remediation of Material Weakness
 
 We are in
the process of developing and implementing remediation plans to address our
material weakness.  Our remediation plans include many actions that
are in various stages of completion and designed to strengthen our internal
controls over financial reporting.  They include the
following:
  As of May
31, 2008, there were multiple control deficiencies which when combined
constituted a material weakness in our internal control over financial reporting
relating to our consolidated variable interest entity, Scripps Secured Data,
Inc.  These deficiencies centered on the information technology control
environment, with many of these controls incomplete and under development or in
the process of implementation at May 31, 2008.  Accordingly, we expect that
by the close of our first fiscal quarter of 2009, the majority of the
deficiencies will have been either remediated or satisfactorily
mitigated.
  Through
these steps, we believe we are addressing the deficiencies that affected our
internal control over financial reporting as of May 31, 2008, and we intend to
continue to evaluate and strengthen our systems of internal control over
financial reporting.
 
 
 
 26
  Report
of Independent Registered Public Accounting Firm
 
 To the
Board of Directors and Stockholders of Patriot Scientific
Corporation:
 
 We have
audited the internal control over financial reporting of Patriot Scientific
Corporation and subsidiaries, and Scripps Secured Data, Inc., a consolidated
variable interest entity. (collectively, the "Company") as of May 31, 2008,
based on criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (“COSO”). 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 ,
included in the accompanying Management's Report on Internal Control over
Financial Reporting included in Item 9A. Our responsibility is to express an
opinion on 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, assessing the risk that a material weakness exists, testing
and evaluating the design and operating effectiveness of internal control based
on the assessed risk, 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 accounting principles generally accepted in the
United States of America. 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 accounting principles
generally accepted in the United States of America, 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 its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections
of any evaluation of effectiveness to future periods are subject to the risk
that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may
deteriorate.
 
 A
material weakness is a control deficiency, or combination of deficiencies, in
internal control over financial reporting, such that there is a reasonable
possibility that a material misstatement of the Company’s annual or interim
financial statements will not be prevented or detected on a timely
basis.  The following material weakness has been identified and
included in management’s assessment:
 
 Information
Technology Control Environment at Scripps Secured Data, Inc.
 
 As of May
31, 2008, a material weakness existed relating to SSDI’s information technology
general controls, including ineffective controls relating to
following:
 
 ·
              There
      is no IT security policy,
 ·
              There
      is no change management policy,
 ·
              There
      is no evidence of changes which have been
  performed,
 ·
              There
      is no physical security over servers, firewall, router and
      switches,
 ·
              There
      is no documentation of the granting of user access rights
      process,
 ·
              There
      is no documentation of the user access termination
  process,
 ·
              The
      firewall configuration does not reflect SSDI’s current
    usage,
 ·
              Remote
      access is not well controlled,
 ·
              Two
      of five systems did not have recent antivirus signature
    files,
 ·
              The
      antivirus software is not installed on the
  server,
 ·
              All
      named users, plus the CIO using the administrator account, have full
      access to all areas of QuickBooks,
 ·
              All
      authenticated users are allowed full access to the files in the Finance
      directory,
 ·
              The
      domain administrator list is not limited to the minimum appropriate
      personnel,
 ·
              Passwords
      are only required to be five characters which is deemed insufficient for
      good security,
 ·
              There
      is no evidence of the CIO’s weekly backup review occurring, and management
      is not being notified of failures,
 ·
              There
      are no stored backup tapes off-site or in a media safe,
  and
 ·
              There
      are no regularly run test
restorations.
 
 27
 In our
opinion, because of the effect of the material weakness described above on the
achievement of the objectives of the control criteria, the Company has not
maintained effective internal control over financial reporting as of May 31,
2008, based on the COSO criteria.
 
 We also
have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated
balance sheets of Patriot Scientific Corporation as of May 31, 2008 and 2007,
and the related consolidated statements of income, stockholders' equity and cash
flows for each of the three years in the period ended May 31, 2008 and our
report dated August 14, 2008 expressed an unqualified opinion on those
consolidated financial statements and included an explanatory paragraph
regarding the Company’s adoption of Statement of Financial Accounting Standards
No. 123(R), Share-Based
Payment, effective June 1, 2006.
 
 The
material weakness described above was considered in determining the nature,
timing, and extent of audit tests applied in our audit the 2008 consolidated
financial statements, and this report does not affect our report dated August
14, 2008 on those consolidated financial statements.
 
 
 /s/ KMJ
Corbin & Company LLP
 Irvine,
California
 August
14, 2008
   28
 ITEM
9B.            OTHER
INFORMATION
 
 None.
 
 PART
III
 
 ITEM
10.             DIRECTORS,
EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
 The
information regarding Directors, Executive Officers, Promoters and Control
Persons, Compliance with Section 16(a) of the Exchange Act, and Corporate
Governance is incorporated by reference to the information contained in our
definitive proxy statement which will be filed with the Securities and Exchange
Commission in connection with our 2008 Annual Meeting of
Shareholders.
 
 CODE
OF ETHICS
 
 We have
adopted a Code of Ethics that applies to our principal executive officer,
principal financial officer, principal accounting officer or controller, or
persons performing similar functions.  Our Code of Ethics is available
on our website at www.ptsc.com.
 
 ITEM
11.             EXECUTIVE
COMPENSATION
 
 The
information regarding Director Compensation, Report of the Compensation
Committee, Compensation Discussion and Analysis and Executive Compensation is
incorporated by reference to the information contained in our 2008 definitive
proxy statement.
 
 ITEM
12.             SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS
 
 The
information regarding Security Ownership of Certain Beneficial Owners and
Management and Equity Compensation Plan Information is incorporated by reference
to the information contained in our 2008 definitive proxy
statement.
 
 ITEM
13.             CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
 The
information regarding Certain Relationships and Related Transactions and
Corporate Governance is incorporated by reference to the information contained
in our 2008 definitive proxy statement.
 
 ITEM
14.             PRINCIPAL ACCOUNTING FEES AND
SERVICES
 
 The
information regarding Principal Accounting Fees and Services is incorporated by
reference to the information contained in our 2008 definitive proxy
statement.
 
 
 29
  PART
IV
 
 ITEM
15.             EXHIBITS,
FINANCIAL STATEMENT SCHEDULES
 
 (a)   
The following documents are filed as a part of this Report:
  1.
              Financial Statements.
      The following consolidated financial statements and Report of Independent
      Registered Public Accounting Firm are included starting on page F-1 of
      this Report:
 
 Patriot Scientific
Corporation
 
 Report of
KMJ Corbin & Company LLP, Independent Registered Public Accounting
Firm
 
 Consolidated
Balance Sheets as of May 31, 2008 and 2007
 
 Consolidated
Statements of Income for the Years Ended May 31, 2008, 2007 and
2006
 
 Consolidated
Statements of Stockholders’ Equity and Comprehensive Income for the Years Ended
May 31, 2008, 2007 and 2006
 
 Consolidated
Statements of Cash Flows for the Years Ended May 31, 2008, 2007 and
2006
 
 Notes to
Consolidated Financial Statements
 
 Phoenix Digital Solutions,
LLC
 
 Report of
KMJ Corbin & Company LLP, Independent Registered Public Accounting
Firm
 
 Balance
Sheets as of May 31, 2008 and 2007
 
 Statements
of Income for the Years Ended May 31, 2008, 2007 and 2006
 
 Statement
of Members’ Equity for the Years Ended May 31, 2008, 2007 and 2006
 
 Statements
of Cash Flows for the Years Ended May 31, 2008, 2007 and 2006
 
 Notes to
Financial Statements
  2.
              Financial Statement
      Schedules. All financial statement schedules have been omitted
      since the information is either not applicable or required or is included
      in the financial statements or notes
thereof.
  3.
              Exhibits. Those
      exhibits marked with a (*) refer to exhibits filed herewith. The other
      exhibits are incorporated herein by reference, as indicated in the
      following list. Those exhibits marked with a (†) refer to management
      contracts or compensatory plans or
arrangements.
  
 30
 Exhibit No.
              Document2.1
              Agreement
      to Exchange Technology for Stock in the Company, incorporated by reference
      to Exhibit 2.1 to Form 8-K dated August 10, 1989 (Commission
      file No. 33-23143-FW)2.2
              Assets
      Purchase Agreement and Plan of Reorganization dated June 22, 1994,
      among the Company, nanoTronics Corporation and Helmut Falk, incorporated
      by reference to Exhibit 10.4 to Form 8-K dated July 6, 1994
      (Commission file No. 000-22182)2.2.1
              Amendment
      to Development Agreement dated April 23, 1996 between the Company and
      Sierra Systems, incorporated by reference to Exhibit 2.2.1 to
      Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2
      filed April 29, 1996 (Commission file No. 333-01765)2.3
              Form
      of Exchange Offer dated December 4, 1996 between the Company and
      certain shareholders of Metacomp, Inc., incorporated by reference to
      Exhibit 2.3 to Form 8-K filed January 9, 1997 (Commission file
      No. 000-22182)2.4
              Letter
      of Transmittal to Accompany Shares of Common Stock of Metacomp, Inc.
      Tendered Pursuant to the Exchange Offer Dated December 4, 1996,
      incorporated by reference to Exhibit 2.4 to Form 8-K filed
      January 9, 1997 (Commission file No. 000-22182)3.1
              Original
      Articles of incorporation of the Company’s predecessor, Patriot
      Financial Corporation, incorporated by reference to Exhibit 3.1 to
      registration statement on Form S-18, (Commission file No.
      33-23143-FW)3.2
              Articles of
      Amendment of Patriot Financial Corporation, as filed with the Colorado
      Secretary of State on July 21, 1988, incorporated by reference to
      Exhibit 3.2 to registration statement on Form S-18, (Commission file
      No. 33-23143-FW)3.3
              Certificate
      of Incorporation of the Company, as filed with the Delaware Secretary of
      State on March 24, 1992, incorporated by reference to
      Exhibit 3.3 to Form 8-K dated May 12, 1992 (Commission file No.
      33-23143-FW)3.3.1
              Certificate
      of Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on April 18, 1995, incorporated
      by reference to Exhibit 3.3.1 to Form 10-KSB for the fiscal year
      ended May 31, 1995 (Commission file No. 000-22182)3.3.2
              Certificate
      of Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on June 24, 1997, incorporated
      by reference to Exhibit 3.3.2 to Form 10-KSB for the fiscal year
      ended May 31, 1997, filed July 18, 1997 (Commission file No.
      000-22182)3.3.3
              Certificate
      of Amendment to the Certificate of Incorporation of the Company,
      as filed with the Delaware Secretary of State on April 28, 2000,
      incorporated by reference to Exhibit 3.3.3 to Registration Statement
      on Form S-3 filed May 5, 2000 (Commission file No.
      333-36418)3.3.4
              Certificate
      of Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on May 6, 2002, incorporated by
      reference to Exhibit 3.3.4 to Registration Statement on Form S-3
      filed June 27, 2002 (Commission file No. 333-91352)3.3.5
              Certificate
      of Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on October 16, 2003,
      incorporated by reference to Exhibit 3.3.5 to Registration Statement
      on Form SB-2 filed May 21, 2004 (Commission file No.
      333-115752)
  31
 3.4
              Articles and
      Certificate of Merger of Patriot Financial Corporation into the Company
      dated May 1, 1992, with Agreement and Plan of Merger attached thereto
      as Exhibit A, incorporated by reference to Exhibit 3.4 to Form
      8-K dated May 12, 1992 (Commission file No. 33-23143-FW)3.5
              Certificate
      of Merger issued by the Delaware Secretary of State on May 8, 1992,
      incorporated by reference to Exhibit 3.5 to Form 8-K dated
      May 12, 1992 (Commission file No. 33-23143-FW)3.6
              Certificate
      of Merger issued by the Colorado Secretary of State on May 12, 1992,
      incorporated by reference to Exhibit 3.6 to Form 8-K dated
      May 12, 1992 (Commission file No. 33-23143-FW)3.7
              Bylaws
      of the Company, incorporated by reference to Exhibit 3.7 to Form 8-K
      dated May 12, 1992 (Commission file No.
  33-23143-FW)4.1
              Specimen
      common stock certificate, incorporated by reference to Exhibit 4.1
      Form 8-K dated May 12, 1992 (Commission file No.
      33-23143-FW)
 
 4.2†
              1996
      Stock Option Plan of the Company dated March 25, 1996 and approved by
      the Shareholders on May 17, 1996, incorporated by reference to
      Exhibit 10.13 to Pre-Effective Amendment No. 2 to Registration
      Statement on Form SB-2 filed May 23, 1996 (Commission file No.
      333-01765)4.3†
              2001
      Stock Option Plan of the Company dated February 21, 2001 incorporated
      by reference to Exhibit 4.19 to Registration Statement on Form S-8
      filed March 26, 2001 (Commission file No.
  333-57602)4.4†
              2003
      Stock Option Plan of the Company dated July 2, 2003 incorporated by
      reference to Exhibit 4.27 to Registration Statement on Form S-8 filed
      September 4, 2003 (Commission file No. 333-108489)4.5†
              2006
      Stock Option Plan of the Company dated March 31, 2006 incorporated by
      reference to Exhibit 4.19 to Registration Statement on Form S-8 filed
      June 20, 2006 (Commission file No. 333-135156)4.6
              Approval
      Rights Agreement and Termination of Antidilution Agreement and Addendum to
      Warrants dated October 10, 2006, incorporated by reference to
      Exhibit 4.29 to Form 10-KSB for the fiscal year ended May 31,
      2006, filed on October 13, 2006 (Commission file No.
      000-22182)10.1
              IGNITE
      License Agreement with Advanced Micro Devices, Inc., dated
      February 21, 2005, incorporated by reference to Exhibit 10.38 to
      Form 10-KSB for the fiscal year ended May 31, 2006, filed on October
      13, 2006 (Commission file No. 000-22182)10.2
              Patent
      Portfolio License Agreement with Advanced Micro Devices, Inc., dated
      February 21, 2005, incorporated by reference to Exhibit 10.39 to
      Form 10-KSB for the fiscal year ended May 31, 2006, filed on October
      13, 2006 (Commission file No. 000-22182)10.3
              Master
      Agreement, dated as of June 7, 2005, by and among the Company,
      Technology Properties Limited Inc., a California corporation and Charles
      H. Moore, an individual, incorporated by reference to Exhibit 10.40
      to Form 8-K filed June 15, 2005 (Commission file No.
      000-22182)10.4
              Commercialization
      Agreement dated as of June 7, 2005 by and among the JV LLC,
      Technology Properties Limited Inc., a California corporation, and the
      Company, incorporated by reference to Exhibit 10.41 to Form 8-K filed
      June 15, 2005 (Commission file No. 000-22182)10.5
              Limited
      Liability Company Operating Agreement of JV LLC, a Delaware limited
      liability company, dated as of June 7, 2005, incorporated by
      reference to Exhibit 10.42 to Form 8-K filed June 15, 2005
      (Commission file No. 000-22182)10.6†
              Agreement
      for Part-Time Employment dated August 3, 2005 between the Company and
      Thomas J. Sweeney, incorporated by reference to Exhibit 99.3 to Form
      8-K filed August 9, 2005 (Commission file No.
    000-22182)10.7
              Settlement
      Agreement dated February 13, 2007 by and among the Company, Russell H.
      Fish, III and Robert C. Anderson as trustee of the Fish Family Trust
      incorporated by reference to Exhibit 10.45 to Registration Statement en
      Form SB-2 filed March 21, 2007 (Commission file No.
      333-134362)
  32
 10.8†
              Employment
      Agreement dated June 5, 2007 by and between the Company and James Turley,
      incorporated by reference to Exhibit 10.1 to Form 8-K filed June 8, 2007
      (Commission file No. 000-22182)10.9†
              Employment
      Agreement dated September 17, 2007 by and between the Company and Clifford
      L. Flowers, incorporated by reference to Exhibit 10.1 to Form 8-K filed
      September 19, 2007 (Commission file No. 000-22182)10.10†
              Employment
      Agreement dated February 29, 2008 by and between the Company and Frederick
      C. Goerner, incorporated by reference to Exhibit 99.1 to Form 8-K filed
      May 20, 2008 (Commission file No. 000-22182)14.1
              Code
      of Ethics for Senior Financial Officers incorporated by reference to
      Exhibit 14.1 to Form 10-K for the fiscal year ended May 31,
      2003, filed August 29, 2003 (Commission file No.
      000-22182)21.1
              List
      of subsidiaries of the Company incorporated by reference to Exhibit 21.1
      of the Company’s annual report on Form 10-KSB filed October 13, 2006
      (Commission file No. 000-22182)23.1*
              Consent
      of Independent Registered Public Accounting Firm23.2*
              Consent
      of Independent Valuation Firm31.1*
              Certification
      of Frederick C. Goerner, CEO, pursuant to Rule
      13a-14(a)/15d-14(a)31.2*
              Certification
      of Clifford L. Flowers, CFO, pursuant Rule
    13a-14(a)/15d-14(a)32.1*
              Certification
      of Frederick C. Goerner, CEO, pursuant to Section 135032.2*
              Certification
      of Clifford L. Flowers, CFO, pursuant to Section 135099.1
              Form
      of ISO Plan Option (Gaspar) dated May 29, 1992, incorporated by
      reference to Exhibit 28.2 to registration statement on
      Form SB-2, 1996 (Commission file No. 33-57858)99.2
              Form
      of NSO Plan Option (Berlin) dated May 29, 1992, incorporated by
      reference to Exhibit 28.3 to registration statement on
      Form SB-2, 1996 (Commission file No. 33-57858)99.3
              Form
      of Incentive Stock Option Agreement to the Company’s 1996 stock Option
      Plan (individual agreements differ as to number of shares, dates, prices
      and vesting), incorporated by reference to Pre-Effective Amendment
      No. 2 to Registration Statement on Form SB-2 filed May 23, 1996
      (Commission file No. 333-01765)99.4
              Form
      of Non-Qualified Stock Option Agreement to the Company’s 1996 Stock Option
      Plan (individual agreement differ as to number of shares, date, prices and
      vesting), incorporated by reference to Pre-Effective Amendment No. 2
      to Registration Statement on Form SB-2 filed May 23, 1996
      (Commission file No. 333-01765)99.5
              Press
      Release of the Company dated November 4, 1996 incorporated by
      reference to Exhibit 99.5 to Form 8-K filed January 9, 1997
      (Commission file No. 000-22182)99.6
              Form
      of Incentive Stock Option Agreement to the Company’s 2001 Stock Option
      Plan incorporated by reference to Exhibit 99.6 to Registration
      Statement on Form S-8 filed March 26, 2001 (Commission file No.
      333-57602)99.7
              Form
      of Non-Qualified Stock Option Agreement to the Company’s 2001 Stock Option
      Plan incorporated by reference to Exhibit 99.7 to Registration
      Statement on Form S-8 filed March 26, 2001 (Commission file No.
      333-57602)99.8
              Form
      of Incentive Stock Option Agreement to the Company’s 2003 Stock Option
      Plan incorporated by reference to Exhibit 99.8 to Registration
      Statement on Form S-8 filed September 4, 2003 (Commission file No.
      333-108489)99.9
              Form
      of Non-Qualified Stock Option Agreement to the Company’s 2003 Stock Option
      Plan incorporated by reference to Exhibit 99.9 to Registration
      Statement on Form S-8 filed September 4, 2003 (Commission file
      No. 333-108489)
 
 33
 Patriot
Scientific Corporation
 
 INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 
 PageReport
      of Independent Registered Public Accounting Firm
              
              
              F-2Financial
      Statements:Consolidated
      Balance Sheets
              
              
              F-3Consolidated
      Statements of Income
              
              
              F-4Consolidated
      Statements of Stockholders’ Equity and Comprehensive
Income
              
              
              F-5Consolidated
      Statements of Cash Flows
              
              
              F-7Notes
      to Consolidated Financial Statements
              
              
              F-9
  
 F-1
 REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 To the
Stockholders and Board of Directors
 Patriot
Scientific Corporation
 
 We have
audited the accompanying consolidated balance sheets of Patriot Scientific
Corporation and subsidiaries (the “Company”) as of May 31, 2008 and 2007, and
the related consolidated statements of income, stockholders’ equity and cash
flows for each of the years in the three-year period ended May 31, 2008. 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 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
consolidated financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the consolidated financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall consolidated financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
 
 In our
opinion, the consolidated financial statements referred to above, present
fairly, in all material respects, the financial position of Patriot Scientific
Corporation and subsidiaries as of May 31, 2008 and 2007, and the results of
their operations and their cash flows for each of the years in the three-year
period ended May 31, 2008 in conformity with accounting principles generally
accepted in the United States of America.
 
 As
discussed in Note 2 to the consolidated financial statements, effective June 1,
2006, the Company changed its method of accounting for share-based compensation
to adopt Statement of Financial Accounting Standards No. 123(R), Share-Based
Payment.
 
 We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the Company’s internal control over financial
reporting as of May 31, 2008, based on the criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission, and our report dated August 14, 2008 expressed an adverse
opinion on the Company’s internal control over financial reporting.
 
 /s/ KMJ
Corbin & Company LLP
 Irvine,
California
 August
14, 2008
 
 F-2
 Patriot
Scientific Corporation
 Consolidated
Balance Sheets
 
 May
      31,
              
              2008
              
              
              2007ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              6,424,015
              
              
              $
              21,605,428Restricted
      cash and cash equivalents
              
              
              51,122
              
              
              
              102,346Marketable
      securities and short term investments
              
              
              298,243
              
              
              
              4,349,314Accounts
      receivable
              
              
              538,500
              
              
              
              352,390Accounts
      receivable – affiliated company
              
              
              7,501
              
              
              
              -Notes
      receivable
              
              
              450,115
              
              
              
              -Inventory
              
              
              388,141
              
              
              
              46,361Prepaid
      income taxes
              
              
              222,311
              
              
              
              2,070,981Deferred
      tax assets
              
              
              1,390,832
              
              
              
              2,439,975Prepaid
      expenses and other current assets
              
              
              79,840
              
              
              
              431,840Total
      current assets
              
              
              9,850,620
              
              
              
              31,398,635Marketable
      securities
              
              
              12,527,675
              
              
              
              -Property and equipment,
      net
              
              
              68,504
              
              
              
              85,518Other
      assets
              
              
              8,190
              
              
              
              8,190Investments in affiliated
      companies
              
              
              2,913,614
              
              
              
              2,883,969Patents and trademarks,
      net of accumulated amortization of $622,003 and $607,657
              
              
              63,299
              
              
              
              38,317Total
      assets
              
              $
              25,431,902
              
              
              $
              34,414,629LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
              
              $
              555,690
              
              
              $
              934,298Accrued
      expenses and other
              
              
              373,848
              
              
              
              1,086,496Total
      current liabilities
              
              
              929,538
              
              
              
              2,020,794Deferred tax
      liabilities
              
              
              1,085,181
              
              
              
              12,222,944Total
      liabilities
              
              
              2,014,719
              
              
              
              14,243,738Commitments and
      contingenciesMinority
      interest
              
              
              115,406
              
              
              
              -Stockholders’
      equityPreferred
      stock, $.00001 par value; 5,000,000 shares authorized: none
      outstanding
              
              
              -
              
              
              
              -Common
      stock, $.00001 par value: 500,000,000 shares authorized: 410,979,163
      shares issued and 389,414,915 shares outstanding at May 31, 2008 and
      406,668,661 shares issued and 393,201,134 shares outstanding at May 31,
      2007
              
              
              4,109
              
              
              
              4,066Additional
      paid-in capital
              
              
              70,004,814
              
              
              
              72,150,581Accumulated
      deficit
              
              
              (33,763,357
              )
              
              
              (43,151,678
              )Common
      stock held in treasury, at cost – 21,564,248 shares at May 31, 2008 and
      13,467,527 shares at May 31, 2007
              
              
              (12,723,172
              )
              
              
              (8,832,078
              )Accumulated
      other comprehensive loss
              
              
              (220,617
              )
              
              
              -Total
      stockholders’ equity
              
              
              23,301,777
              
              
              
              20,170,891Total
      liabilities and stockholders’ equity
              
              $
              25,431,902
              
              
              $
              34,414,629
 
 See
      accompanying notes to consolidated financial
  statements
  F-3
 Patriot
Scientific Corporation
 Consolidated
Statements of Income
 
 Years
      Ended May 31,
              
              2008
              
              
              2007
              
              
              2006Revenues:Licenses
      and royalties
              
              $
              -
              
              
              $
              -
              
              
              $
              10,000,000Product
      sales and other
              
              
              3,708,218
              
              
              
              638,784
              
              
              
              309,7093,708,218
              
              
              
              638,784
              
              
              
              10,309,709Cost
      of sales
              
              
              1,510,450
              
              
              
              319,374
              
              
              
              103,351Gross
      profit
              
              
              2,197,768
              
              
              
              319,410
              
              
              
              10,206,358Operating
      expenses:Research
      and development
              
              
              -
              
              
              
              -
              
              
              
              225,565Selling,
      general and administrative
              
              
              6,964,861
              
              
              
              7,558,712
              
              
              
              4,151,099Settlement
      and license expense
              
              
              836,400
              
              
              
              7,524,537
              
              
              
              1,918,054Total
      operating expenses
              
              
              7,801,261
              
              
              
              15,083,249
              
              
              
              6,294,718Operating
      income (loss)
              
              
              (5,603,493
              )
              
              
              (14,763,839
              )
              
              
              3,911,640Other
      income (expense):Unrealized
      loss on marketable securities
              
              
              -
              
              
              
              -
              
              
              
              (1,466
              )Interest
      and other income
              
              
              1,470,008
              
              
              
              714,790
              
              
              
              330,055Gain
      (loss) on sale of assets
              
              
              (4,139
              )
              
              
              (3,163
              )
              
              
              2,724Interest
      expense
              
              
              (389
              )
              
              
              (355
              )
              
              
              (516,465
              )Loss
      on debt extinguishments
              
              
              -
              
              
              
              -
              
              
              
              (445,427
              )Change
      in fair value of warrant and derivative liabilities
              
              
              -
              
              
              
              -
              
              
              
              (2,456,736
              )Impairment
      of note receivable
              
              
              -
              
              
              
              (339,551
              )
              
              
              -Impairment
      of investment in affiliated company
              
              
              -
              
              
              
              (126,746
              )
              
              
              -Gain
      on sale of subsidiary interest
              
              
              150,000
              
              
              
              -
              
              
              
              -Equity
      in earnings of affiliated companies
              
              
              19,917,769
              
              
              
              48,965,084
              
              
              
              27,848,363Total
      other income, net
              
              
              21,533,249
              
              
              
              49,210,059
              
              
              
              24,761,048Income
      before income taxes and minority interest
              
              
              15,929,756
              
              
              
              34,446,220
              
              
              
              28,672,688Provision
      for income taxes
              
              
              6,426,029
              
              
              
              10,755,033
              
              
              
              -Minority
      interest
              
              
              115,406
              
              
              
              -
              
              
              
              -Net
      income
              
              $
              9,388,321
              
              
              $
              23,691,187
              
              
              $
              28,672,688Basic
      income per common share
              
              $
              0.02
              
              
              $
              0.06
              
              
              $
              0.09Diluted
      income per common share
              
              $
              0.02
              
              
              $
              0.06
              
              
              $
              0.07Weighted
      average number of common shares outstanding - basic
              
              
              390,956,153
              
              
              
              378,036,989
              
              
              
              316,100,499Weighted
      average number of common shares outstanding - diluted
              
              
              397,485,699
              
              
              
              413,599,373
              
              
              
              412,963,173
  See
      accompanying notes to consolidated financial
  statements.
  F-4
 Patriot
Scientific Corporation
 Consolidated
Statements of Stockholders’ Equity and Comprehensive Income
 
 Common
      Stock
              
              
              
              
              
              
              
              
              
              
              
              AccumulatedShares
              
              
              Amounts
              
              
              AdditionalPaid-in
      Capital
              
              
              Accumulated
      Deficit
              
              
              Treasury
      Stock
              
              
              Other
      Comprehensive Loss
              
              Stockholders’
      Equity (Deficit)
              Comprehensive
      IncomeBalance,
      June 1, 2005
              
              
              280,492,013
              
              
              $
              2,805
              
              
              $
              55,459,253
              
              
              $
              (62,702,442
              )
              
              $
              -
              
              
              $
              -
              
              
              $
              (7,240,384
              )
              
              $
              -Issuance
      of common stock for services at $1.53 per share
              
              
              193,548
              
              
              
              2
              
              
              
              296,127
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              296,129
              
              
              
              -Exercise
      of warrants and options at $.02 to $.69 per share
              
              
              12,824,544
              
              
              
              128
              
              
              
              851,070
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              851,198
              
              
              
              -Conversion
      of debentures payable plus accrued interest at $.02 and $.04 per
      share
              
              
              30,819,187
              
              
              
              308
              
              
              
              998,729
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              999,037
              
              
              
              -Cashless
      exercise of warrants
              
              
              41,245,473
              
              
              
              412
              
              
              
              (412
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Issuance
      of common stock to co-inventor of technology at $.13 per
    share
              
              
              625,000
              
              
              
              6
              
              
              
              81,244
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              81,250
              
              
              
              -Extension
      of term of options previously issued to consultant
              
              
              -
              
              
              
              -
              
              
              
              125,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              125,000
              
              
              
              -Repurchase
      of warrants
              
              
              -
              
              
              
              -
              
              
              
              (252,420
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (252,420
              )
              
              
              -Issuance
      of warrants to a consultant
              
              
              -
              
              
              
              -
              
              
              
              108,102
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              108,102
              
              
              
              -Intrinsic
      value of options issued to employees and directors
              
              
              -
              
              
              
              -
              
              
              
              120,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              120,000
              
              
              
              -Cash
      dividends at $.02 and $.04 per share
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (24,698,337
              )
              
              
              -
              
              
              
              -
              
              
              
              (24,698,337
              )
              
              
              -Reclassification
      of derivative value associated with debt conversions and warrant
      exercises
              
              
              -
              
              
              
              -
              
              
              
              5,021,353
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              5,021,353
              
              
              
              -Reclassification
      of warrant and derivative liabilities at settlement date
              
              
              -
              
              
              
              -
              
              
              
              6,743,935
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              6,743,935
              
              
              
              -Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              28,672,688
              
              
              
              -
              
              
              
              -
              
              
              
              28,672,688
              
              
              
              -Balance,
      May 31, 2006
              
              
              366,199,765
              
              
              $
              3,661
              
              
              $
              69,551,981
              
              
              $
              (58,728,091
              )
              
              $
              -
              
              
              $
              -
              
              
              $
              10,827,551
              
              
              $
              -Exercise
      of warrants and options at $.05 to $.40 per share
              
              
              1,787,500
              
              
              
              18
              
              
              
              213,982
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              214,000
              
              
              
              -Cashless
      exercise of warrants
              
              
              38,681,396
              
              
              
              387
              
              
              
              (387
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Non-cash
      compensation
              
              
              -
              
              
              
              -
              
              
              
              2,359,036
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              2,359,036
              
              
              
              -Extension
      of stock options previously issued to a consultant
              
              
              -
              
              
              
              -
              
              
              
              324
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              324
              
              
              
              -Tax
      effect of exercise of stock options granted under APB 25
              
              
              -
              
              
              
              -
              
              
              
              25,645
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              25,645
              
              
              
              -Purchase
      of common stock for treasury
              
              
              (13,467,527
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (8,832,078
              )
              
              
              -
              
              
              
              (8,832,078
              )
              
              
              -Cash
      dividends at $.02 per share
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (8,114,774
              )
              
              
              -
              
              
              
              -
              
              
              
              (8,114,774
              )
              
              
              -Net
      income
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              23,691,187
              
              
              
              -
              
              
              
              -
              
              
              
              23,691,187
              
              
              
              --Balance,
      May 31, 2007
              
              
              393,201,134
              
              
              $
              4,066
              
              
              $
              72,150,581
              
              
              $
              (43,151,678
              )
              
              $
              (8,832,078
              )
              
              $
              -
              
              
              $
              20,170,891
              
              
              $
              -
 
 
 F-5
  Patriot
Scientific Corporation
 Consolidated
Statements of Stockholders’ Equity and Comprehensive Income,
continued
 
  Common
      StockShares
              
              
              Amounts
              
              
              Additional
      Paid-in Capital
              
              
              Accumulated
      Deficit
              
              
              Treasury
      Stock
              
              
              AccumulatedOther
      Comprehensive Loss
              
              
              Stockholders’
      Equity (Deficit)
              
              
              Comprehensive
      IncomeExercise
      of warrants and options at $.05 to $.10 per share
              
              
              425,000
              
              
              $
              4
              
              
              $
              30,846
              
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              $
              30,850
              
              
              $
              -Cashless
      exercise of options
              
              
              982,846
              
              
              
              10
              
              
              
              (10
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Cashless
      exercise of warrants
              
              
              2,702,656
              
              
              
              27
              
              
              
              (27
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Non-cash
      compensation
              
              
              -
              
              
              
              -
              
              
              
              509,971
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              509,971
              
              
              
              -Repurchase
      of warrants
              
              
              -
              
              
              
              -
              
              
              
              (2,760,900
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (2,760,900
              )
              
              
              -Tax
      effect of exercise of stock options granted under APB 25
              
              
              -
              
              
              
              -
              
              
              
              (25,645
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (25,645
              )
              
              
              -Issuance
      of stock in connection with settlement with former CFO
              
              
              200,000
              
              
              
              2
              
              
              
              99,998
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              100,000
              
              
              
              -Purchase
      of common stock for treasury
              
              
              (8,096,721
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (3,891,094
              )
              
              
              -
              
              
              
              (3,891,094
              )
              
              
              -Net
      income
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              9,388,321
              
              
              
              -
              
              
              
              -
              
              
              
              9,388,321
              
              
              
              9,388,321Unrealized
      loss on investments, net of tax
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (220,617
              )
              
              
              (220,617
              )
              
              
              (220,617
              )Total
      comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              9,167,704Balance,
      May 31, 2008
              
              
              389,414,915
              
              
              $
              4,109
              
              
              $
              70,004,814
              
              
              $
              (33,763,357
              )
              
              $
              (12,723,172
              )
              
              $
              (220,617
              )
              
              $
              23,301,777
 
 
 See
      accompanying notes to consolidated financial
  statements.
   F-6
 Patriot
Scientific Corporation
 Consolidated
Statements of Cash Flows
 
 Years
      Ended May 31,
              
              2008
              
              
              2007
              
              
              2006Operating
      activities:Net
      income
              
              $
              9,388,321
              
              
              $
              23,691,187
              
              
              $
              28,672,688Adjustments
      to reconcile net income to net cash provided by (used in) operating
      activities:Minority
      interest in variable interest entity
              
              
              115,406
              
              
              
              -
              
              
              
              -Amortization
      and depreciation
              
              
              50,705
              
              
              
              64,861
              
              
              
              59,415Non-cash
      interest expense related to convertible debentures, notes payable and
      warrants
              
              
              -
              
              
              
              -
              
              
              
              470,736Expense
      related to extension of expiration date of stock options
              
              
              -
              
              
              
              324
              
              
              
              125,000Net
      gain related to warrant re-pricing, reconveyance and
    issuance
              
              
              -
              
              
              
              -
              
              
              
              (538,208
              )Loss
      on extinguishment of debt
              
              
              -
              
              
              
              -
              
              
              
              445,427Accrued
      interest income added to investments
              
              
              (1,391
              )
              
              
              (2,026
              )
              
              
              (19,778
              )Equity
      in earnings of affiliated companies
              
              
              (19,917,769
              )
              
              
              (48,965,084
              )
              
              
              (27,848,363
              )(Gain)
      loss on sale of assets
              
              
              4,139
              
              
              
              3,163
              
              
              
              (2,724
              )Unrealized
      loss on marketable securities
              
              
              -
              
              
              
              -
              
              
              
              1,466Issuance
      of stock, options and warrants for services
              
              
              100,000
              
              
              
              -
              
              
              
              554,245Change
      in fair value of derivative liabilities
              
              
              -
              
              
              
              -
              
              
              
              2,456,736Intrinsic
      value of options issued
              
              
              -
              
              
              
              -
              
              
              
              120,000Non-cash
      compensation relating to issuance and vesting of stock options and vesting
      of warrants
              
              
              509,971
              
              
              
              2,359,036
              
              
              
              -Impairment
      of note receivable
              
              
              -
              
              
              
              339,551
              
              
              
              -Impairment
      of investment in affiliated company
              
              
              -
              
              
              
              126,746
              
              
              
              -Gain
      on variable interest entity sale of portion of subsidiary
      interest
              
              
              (150,000
              )
              
              
              -
              
              
              
              -Deferred
      taxes
              
              
              (9,936,912
              )
              
              
              9,782,969
              
              
              
              -Changes
      in operating assets and liabilities:Accounts
      receivable
              
              
              (186,110
              )
              
              
              (186,560
              )
              
              
              (4,113
              )Receivable
      from affiliated company
              
              
              (7,501
              )
              
              
              -
              
              
              
              -Inventory
              
              
              (341,780
              )
              
              
              1,970
              
              
              
              -Prepaid
      expenses and other current assets
              
              
              355,990
              
              
              
              (24,294
              )
              
              
              (261,769
              )Prepaid
      income taxes
              
              
              1,848,670
              
              
              
              (2,070,981
              )
              
              
              -Licenses
      receivable
              
              
              -
              
              
              
              -
              
              
              
              2,000,000Accounts
      payable and accrued expenses
              
              
              (1,091,256
              )
              
              
              1,122,499
              
              
              
              194,811Accrued
      contested fee payable
              
              
              -
              
              
              
              (394,063
              )
              
              
              48,063Net
      cash provided by (used in) operating activities
              
              
              (19,259,517
              )
              
              
              (14,150,702
              )
              
              
              6,473,632Investing
      activities:Proceeds
      from sale of short-term investments
              
              
              22,076,589
              
              
              
              8,832,078
              
              
              
              2,027,557Purchase
      of short-term investments
              
              
              (30,925,518
              )
              
              
              (9,662,513
              )
              
              
              (4,832,482
              )Proceeds
      from sale of fixed assets
              
              
              225
              
              
              
              -
              
              
              
              6,540Purchase
      of restricted investments
              
              
              -
              
              
              
              -
              
              
              
              (100,000
              )Proceeds
      from sale of restricted investments
              
              
              52,500
              
              
              
              -
              
              
              
              203,210Payment
      for security deposit
              
              
              -
              
              
              
              -
              
              
              
              (8,190
              )Purchase
      of property and equipment
              
              
              (27,699
              )
              
              
              (5,827
              )
              
              
              (71,037
              )Costs
      incurred for patents and trademarks
              
              
              (39,328
              )
              
              
              -
              
              
              
              -Proceeds
      from variable interest entity sale of portion of subsidiary
      interest
              
              
              100,000
              
              
              
              -
              
              
              
              -Investment
      in affiliated companies
              
              
              (400,000
              )
              
              
              (120,000
              )
              
              
              (2,000,000
              )Distributions
      from affiliated company
              
              
              20,288,124
              
              
              
              50,034,029
              
              
              
              25,895,449Purchase
      of convertible note receivable
              
              
              (400,000
              )
              
              
              -
              
              
              
              -Issuance
      of note receivable
              
              
              -
              
              
              
              (589,551
              )
              
              
              -Cash
      received in consolidation of variable interest entity
              
              
              -
              
              
              
              40,970
              
              
              
              -Net
      cash provided by investing activities
              
              
              10,724,893
              
              
              
              48,529,186
              
              
              
              21,121,047Financing
      activities:Payment
      of cash dividends
              
              
              -
              
              
              
              (8,114,774
              )
              
              
              (24,698,337
              )Principal
      payments on notes payable
              
              
              -
              
              
              
              (50,089
              )
              
              
              (100,000
              )Payments
      for capital lease obligations
              
              
              -
              
              
              
              -
              
              
              
              (2,306
              )Proceeds
      from exercise of common stock warrants and options
              
              
              30,850
              
              
              
              214,000
              
              
              
              851,198Repurchase
      of warrants
              
              
              (2,760,900
              )
              
              
              -
              
              
              
              (252,420
              )Repurchase
      of common stock for treasury
              
              
              (3,891,094
              )
              
              
              (8,832,078
              )
              
              
              -Tax
      effect of exercise of options granted under APB 25
              
              
              (25,645
              )
              
              
              25,645
              
              
              
              -Net
      cash used in financing activities
              
              
              (6,646,789
              )
              
              
              (16,757,296
              )
              
              
              (24,201,865
              )
  F-7
 Patriot
Scientific Corporation
 Consolidated
Statements of Cash Flows, continued
 
  Years
      Ended May 31,
              
              2008
              
              
              2007
              
              
              2006Net
      increase (decrease) in cash and cash equivalents
              
              
              (15,181,413
              )
              
              
              17,621,188
              
              
              
              3,392,814Cash and cash equivalents,beginning of year
              
              
              21,605,428
              
              
              
              3,984,240
              
              
              
              591,426Cash
      and cash equivalents, end of year
              
              $
              6,424,015
              
              
              $
              21,605,428
              
              
              $
              3,984,240Supplemental
      Disclosure of Cash Flow Information:Cash
      payments for interest
              
              $
              389
              
              
              $
              355
              
              
              $
              2,983Cash
      payments for income taxes
              
              $
              14,528,000
              
              
              $
              3,017,400
              
              
              $
              -Supplemental
      Disclosure of Non-Cash Investing and Financing Activities:Convertible
      debentures, notes payable and accrued interest exchanged for common
      stock
              
              $
              -
              
              
              $
              -
              
              
              $
              999,037Reclassification
      of derivative liabilities associated with debt conversions and warrant
      exercises
              
              $
              -
              
              
              $
              -
              
              
              $
              5,021,353Reclassification
      of warrant and derivative liabilities at settlement date
              
              $
              -
              
              
              $
              -
              
              
              $
              6,743,935Cashless
      exercise of warrants
              
              $
              27
              
              
              $
              387
              
              
              $
              412Cashless
      exercise of stock options
              
              $
              10
              
              
              $
              -
              
              
              $
              -Note
      receivable issued in connection with variable interest entity sale of
      portion of subsidiary interest
              
              $
              50,000
              
              
              $
              -
              
              
              $
              -Reclassification
      of prepaid software costs to property and equipment
              
              $
              3,990
              
              
              $
              -
              
              
              $
              -Deferred
      taxes related to unrealized loss on investments in marketable securities
      charged to other comprehensive income
              
              $
              151,708
              
              
              $
              -
              
              
              $
              -Fair
      market value of assets received in collection of note receivable and
      subsequently contributed for preferred stock of affiliate
              
              $
              -
              
              
              $
              250,000
              
              
              $
              -
 
 
 See
      accompanying notes to consolidated financial
  statements.
   F-8
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements
 
 1.
Organization and Business
 
 Patriot
Scientific Corporation (“we”, “us”, or “our”), was organized under Delaware law
on March 24, 1992 and is the successor by merger to Patriot Financial
Corporation, a Colorado corporation, incorporated on June 10, 1987. In 1997 we
acquired Metacomp, Inc. and in June 2005 we entered into a joint venture
agreement with Technology Properties Limited, Inc. (“TPL”) to form Phoenix
Digital Solutions, LLC (“PDS”). In March 2007, we became the primary beneficiary
of Scripps Secured Data, Inc. (“SSDI”), a variable interest entity and were
required to consolidate SSDI effective in March 2007.  During May
2008, we acquired a 15% interest in Talis Data Systems, LLC (“Talis”), a
Delaware LLC that produces multi-domain hardware.  At May 31, 2008,
SSDI has a 12% interest in Talis.
 
 Our
primary operating activity has been as an intellectual property company that
licenses our jointly held patent portfolio technology, through our interest in
PDS, to others and litigates against those who infringe upon the patent
portfolio technology.
 
 SSDI
develops and manufactures network-security hardware to government, military, and
other high-security facilities.
 
 2.
Summary of Significant Accounting Policies
 
 Basis
of Consolidation
 The
consolidated statement of income for the fiscal year ended May 31, 2006 includes
our accounts and those of our majority owned inactive subsidiaries, Metacomp,
Inc. and Plasma Scientific Corporation. The consolidated balance sheets at May
31, 2008 and 2007 and the statements of income for the fiscal years ended May
31, 2008 and 2007 include our accounts, those of our majority owned inactive
subsidiaries that are not considered variable interest entities (“VIE”s) and all
VIEs for which we are the primary beneficiary. All significant intercompany
accounts and transactions have been eliminated.
 
 Consolidation
of Affiliate
 In
January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation 46, Consolidation of Variable Interest
Entities, an Interpretation of ARB No. 51 (“FIN 46”). In December 2003,
the FASB modified FIN 46 (“FIN 46(R)”). FIN 46 provides a new framework for
identifying VIEs and determining when a company should include the assets,
liabilities, noncontrolling interests and results of activities of a VIE in its
consolidated financial statements.
 
 A VIE is
a corporation, partnership, limited liability corporation, trust or any other
legal structure used to conduct activities or hold assets that either (1) has an
insufficient amount of equity to carry out its principal activities without
additional subordinated financial support, (2) has a group of equity owners that
are unable to make significant decisions about its activities, or (3) has a
group of equity owners that do not have the obligation to absorb losses or the
right to receive returns generated by its operations.
 
 FIN 46
requires a VIE to be consolidated if a party with an ownership, contractual or
other financial interest in the VIE is obligated to absorb a majority of the
risk of loss from the VIE’s activities, is entitled to receive a majority of the
VIE’s residual returns (if no party absorbs a majority of the VIE’s losses), or
both. A variable interest holder that consolidates the VIE is called the primary
beneficiary. Upon consolidation, the primary beneficiary generally must
initially record all of the VIE’s assets, liabilities, and noncontrolling
interests at fair value and subsequently account for the VIE as if it were
consolidated based on majority voting interest.
 
 FIN 46
was effective immediately for VIEs created after January 31, 2003. The
provisions of FIN 46(R), were adopted as of December 31, 2003, for our interests
in all VIEs. Beginning with the quarter ended May 31, 2007, we consolidated
SSDI as SSDI was deemed a VIE and we determined that we were the primary
beneficiary of SSDI.
 
 F-9
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Financial
Instruments and Concentrations of Credit Risk
 Financial
instruments that potentially subject us to concentrations of credit risk consist
principally of cash, cash equivalents, investments in marketable securities, and
trade accounts receivable.
 
 At times,
our balance of cash maintained with our bank may exceed the Federal Deposit
Insurance Corporation’s (“FDIC”) insured limit of $100,000. At May 31, 2008,
PTSC’s cash and cash equivalents balance exceeding the FDIC limit was
$25,000.  At May 31, 2008, SSDI’s cash and cash equivalents balance
exceeding the FDIC limit was $203,888.  Certain other cash equivalents
are not insured by the FDIC. At May 31, 2008, PTSC’s cash and cash equivalents
balance consisting of money market accounts not subject to FDIC insurance was
$6,121,546.  We limit our exposure of loss by maintaining our cash
with financially stable financial institutions. When we have excess cash, our
cash equivalents are placed in high quality money market accounts with major
financial institutions. We believe this investment policy limits our exposure to
concentrations of credit risk.
 
 Investments
in marketable securities consist of AAA rated student loan auction rate
instruments issued by various state agencies pursuant to the Federal Family
Educational Loan Program (“FFELP”).  These investments are
collateralized in excess of the underlying obligations, are insured by the
various state educational agencies, and are guaranteed by the Department of
Education as an insurer of last resort.
 
 Concentrations
of credit risk with respect to accounts receivable are limited due to the wide
variety of customers and markets which comprise our customer base, as well as
their dispersion across many different geographic areas. We routinely assess the
financial strength of our customers and, as a consequence, believe that our
accounts receivable credit risk exposure is limited. Generally, we do not
require collateral or other security to support customer
receivables.  As of May 31, 2008, Anixter accounted for 15.8% of gross
accounts receivable and Graybar Electric Company, Inc. accounted for 38% of
gross accounts receivable.  As of May 31, 2007, Anixter accounted for
80.7% of gross accounts receivable and Graybar Electric Company, Inc. accounted
for 11.1% of gross accounts receivable.
 
 Fair
Value of Financial Instruments
 
 Our
financial instruments consist principally of cash and cash equivalents,
investments in marketable securities and short-term investments, accounts
receivable, accounts payable and accrued expenses.  The carrying value
of these financial instruments, other than the investments in marketable
securities, approximates fair value because of the immediate or short-term
maturity of the instruments.
 
 Our
investments in marketable securities consist of auction rate
securities.  Historically, the carrying value of auction rate
securities approximated fair value due to the frequent resetting of the interest
rate.  While we continue to receive interest payments on our auction
rate investments despite failed auctions, we believe the carrying value of these
auction rate securities no longer approximates fair value.  We
estimated the fair value of these securities at May 31, 2008 based on an
independent valuation performed by Houlihan Smith & Company Inc., an
independent valuation firm.  In determining the estimate of fair
value, consideration was given to credit quality, estimated cash flows, and
estimated probabilities of default, auction failure and a successful auction at
par or repurchase at par.  Based on this valuation, we recorded a net
temporary impairment of $220,617 in other comprehensive income at May 31, 2008,
which represents the gross valuation adjustment of $372,325, net of the related
tax benefit of $151,708 (see Note 6).
 
 Cash
Equivalents, Restricted Cash, and Short-Term Investments
 For
purposes of balance sheet classification and the statements of cash flows, we
consider all highly liquid investments acquired with a maturity of three months
or less to be cash equivalents.
 
 Restricted
cash and cash equivalents at May 31, 2008 and 2007 consist of two savings
accounts required to be held as collateral for corporate credit card
accounts.
 
 F-10
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Cash
Equivalents, Restricted Cash, and Short-Term Investments
(continued)
 
 At May
31, 2007, our short-term investments consist primarily of money market mutual
funds and accounts, and are reported at cost, which approximate fair market
value.  At May 31, 2008, PTSC’s short-term investments in the amount
of $288,099 consist of accrued interest receivable on our auction rate
securities which is receivable semi-annually according to the terms specified in
each auction rate security instrument.  At May 31, 2008, SSDI’s
short-term investments consist of a certificate of deposit
in the amount of $10,144 with a maturity date of December 11,
2008.  These values are reported at cost, which approximate fair
market value.
 
 Accounts
Receivable
 Our
accounts receivable consists primarily of the accounts of
SSDI.  SSDI’s accounts receivable consist of trade receivables
recorded at the original invoice amount, less an estimated allowance for
uncollectible accounts of which there was none at May 31, 2008.  Trade
receivables are periodically evaluated for collectibility based on past credit
histories with customers and their current financial
condition.  Changes in the estimated collectibility of trade
receivables are recorded in the results of operations for the period in which
the estimate is revised.  Trade receivables that are deemed
uncollectible are offset against the allowance for uncollectible
accounts.  SSDI also calculates a sales returns reserve based on terms
of its distribution contracts with Anixter and Graybar Electric Company,
Inc.
 
 Inventory
 Inventory
of SSDI consists of raw materials and finished goods manufactured by third party
vendors. The cost of inventory is determined using a method that approximates
first-in, first-out and has been stated at the lower of cost or net realizable
value.
 
 Investments
in Marketable Securities
 We
account for our investments in marketable securities in accordance with
Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments
in Debt and Equity Securities, and FASB Staff Position SFAS No. 115-1,
The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain
Investments.  We determine the appropriate classification of
our investments at the time of purchase and reevaluate such designation at each
balance sheet date.  Our investments in marketable securities have
been classified and accounted for as available-for-sale based on management’s
investment intentions relating to these
securities.  Available-for-sale marketable securities are stated at
market value based on market quotes.  Unrealized gains and losses, net
of deferred taxes, are recorded as a component of other comprehensive income
(loss).  We follow the guidance provided by Emerging Issues Task Force
(“EITF”) Issue No. 03-1, The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments, to assess whether our investments with unrealized loss
positions are other than temporarily impaired.  Realized gains and
losses and declines in value judged to be other than temporary are determined
based on the specific identification method and are reported in other income
(expense), net in the consolidated statements of income.
 
 Property,
Equipment and Depreciation
 Property
and equipment are stated at cost and are depreciated using the straight-line
method over the estimated useful lives of the assets, ranging from two to five
years.  Major betterments and renewals are capitalized, while routine
repairs and maintenance are charged to expense when incurred.
 
 Patents
and Trademarks
 PTSC’s
patents and trademarks are carried at cost less accumulated amortization and are
amortized over their estimated useful lives of four years. In fiscal year 2008
PTSC’s patents were fully amortized.
 
 SSDI
holds patents expiring in 14 years and 20 years. Estimated future annual
amortization expense arising from these patents is approximately $4,112 per
year.
 
 Total
amortization expense related to patents and trademarks was $14,346, $23,192 and
$34,824 during the years ended May 31, 2008, 2007 and 2006,
respectively.
 
 F-11
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Investments
in Affiliated Companies
 We have a
50% interest in PDS (see Note 9). This investment is accounted for using the
equity method of accounting since the investment provides us the ability to
exercise significant influence, but not control, over the investee. Significant
influence is generally deemed to exist if we have an ownership interest in the
voting stock of the investee of between 20% and 50%, although other factors,
such as representation on the investee’s board of directors, are considered in
determining whether the equity method of accounting is appropriate. Under the
equity method of accounting, the investment, originally recorded at cost, is
adjusted to recognize our share of net earnings or losses of the investee and is
recognized in the consolidated statements of income in the caption “Equity in
earnings of affiliated companies”.
 
 We have a
15.09% interest in Talis (see Note 9).  We account for our investment
using the equity method of accounting pursuant to paragraph 8 of AICPA Statement
of Position 78-9, Accounting
for Investments in Real Estate Ventures (which has applicability to
non-real estate entities as well) as our membership share of this limited
liability company is more than minor.  Under the equity method of
accounting, the investment, originally recorded at cost, is adjusted to
recognize our share of net earnings or losses of the investee and is recognized
in the consolidated statement of income in the caption “Equity in earnings of
affiliated companies”.
 
 We review
our investments in these affiliated companies to determine whether events or
changes in circumstances indicate that the carrying amounts may not be
recoverable. The primary factors we consider in our determination are the
financial condition, operating performance and near term prospects of the
investees. If the decline in value is deemed to be other than temporary, we
would recognize an impairment loss.
 
 Long-Lived
Assets
 Management
assesses the recoverability of our long-lived assets by determining whether the
depreciation and amortization of long-lived assets over their remaining lives
can be recovered through projected undiscounted future cash flows.  The
amount of long-lived asset impairment, if any, is measured based on fair value
and is charged to operations in the period in which long-lived asset impairment
is determined by management.  At May 31, 2008, management believes there is
no impairment of our long-lived assets.  There can be no assurance,
however, that market conditions will not change or demand for our products will
continue, which could result in impairment of long-lived assets in the
future.
 
 Treasury
Stock
 We
account for treasury stock under the cost method and include treasury stock as a
component of stockholders’ equity.
 
 Derivative
Financial Instruments
 In
connection with the issuance of certain convertible debentures (see Note 12),
the terms of the debentures included an embedded reset conversion feature which
provided for a conversion of the debentures into shares of our common stock at a
rate which was determined to be variable. We determined that the reset
conversion feature was an embedded derivative instrument and that the conversion
option was an embedded put option pursuant to SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, as amended, and EITF Issue No. 00-19,
Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company's Own
Stock. The accounting treatment of derivative financial instruments
required that we record the derivatives and related warrants at their fair
values as of the inception date of the convertible debenture agreements and at
fair value as of each subsequent balance sheet date.  In addition, under
the provisions of EITF Issue No. 00-19, as a result of entering into the
convertible debenture agreements, we were required to classify all other
non-employee warrants as derivative liabilities and record them at their fair
values at each balance sheet date.  Any change in fair value was recorded
as non-operating, non-cash income or expense at each balance sheet date. 
If the fair value of the derivatives was higher at the subsequent balance sheet
date, we recorded a non-operating, non-cash charge.  If the fair value of
the derivatives was lower at the subsequent balance sheet date, we recorded
non-operating, non-cash income.
 
 During
the year ended May 31, 2006, we recognized other expense of approximately
$2,457,000 related to recording the warrant and derivative liabilities at fair
value. During fiscal 2006, the related variable debt instruments were settled in
full.  At the settlement date, the remaining warrant liabilities with
a value of approximately $6,744,000 were reclassified to additional paid-in
capital.
 
 Our
derivative instruments were valued using a Monte Carlo simulation model
incorporating the instruments’ multiple reset dates.
  F-12
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Derivative
Financial Instruments (continued)
 
 The
following assumptions were used for valuing the embedded derivatives during the
year ended May 31, 2006:
  May
      31, 2006Estimated
      dividends
              NoneExpected
      volatility
              101
      - 229%Risk-free
      interest rate
              3.5
      - 5.1%Expected
      term (years)
              2 -
      7
 
 Comprehensive
Income
 Comprehensive
income as presented in the consolidated statements of stockholders’ equity
includes unrealized gains and losses which are excluded from the consolidated
statements of income in accordance with SFAS No. 130, Reporting Comprehensive
Income.  For the fiscal year ended May 31, 2008, this amount
included unrealized losses on investments classified as
available-for-sale.  The amount is presented net of tax-related
effects of $151,708.
 
 Revenue
Recognition
 We
recognize revenue from the sale of our product upon shipment to the customer, at
which time title transfers and we have no further obligations. Fees for
maintenance or support are recorded on a straight-line basis over the underlying
period of performance. Revenue from technology license agreements is recognized
at the time we enter into a contract, determine the license method
(paid-in-advance or on-going royalty), and provide the customer with the
licensed technology, if applicable.
 
 SSDI
recognizes revenue upon shipment of its product and recognizes revenue on its
short-term installation contracts as time and materials costs are
incurred.
 
 SSDI
maintains agreements with stocking distributors. These agreements provide for a
limited product warranty for a period of one year from the date of sale to the
end user. The warranty does not cover damage to the product after it has been
delivered to the distributor. SSDI’s stocking distributor agreements also allow
limited rights to periodic stock rotation.  These rotation rights
allow for the exchange of a percentage of distributor inventory for replacement
products of the distributor’s choosing.  At May 31, 2008,
SSDI  has evaluated the potential for rotated product and has provided
for the estimated impact in the accounting records.
 
 Sales
through large distributors account for the majority of SSDI’s product revenues,
with a majority of sales to Anixter during the fiscal year 2007, and Anixter,
Graybar Electric Company, Inc. and Victory Global Solutions, Inc. during fiscal
year 2008.
 
 Shipping
and Handling
 EITF
Issue No. 00-10, Accounting
for Shipping and Handling Fees and Costs,requires shipping and
handling fees billed to customers to be classified as revenue and shipping and
handling costs to be classified as either cost of sales or disclosed in the
notes to the financial statements. SSDI includes shipping and handling fees
billed to customers in net sales. Shipping and handling costs associated with
inbound freight are included in cost of sales.
 
 Advertising
 We
expense advertising costs as incurred. For the fiscal year ended May 31, 2008,
we incurred $2,097 of advertising costs.  There were no advertising
costs for the years ended May 31, 2007 and 2006.
 
 
 F-13
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Income
Taxes
 We
account for income taxes under SFAS No. 109,Accounting for Income
Taxes. Deferred income taxes are recognized for the tax consequences in
future years of differences between the tax basis of assets and liabilities and
their financial reporting amounts at each year end based on enacted tax laws and
statutory tax rates applicable to the periods in which the differences are
expected to affect taxable income. Valuation allowances are established when
necessary to reduce deferred tax assets to the amount expected to be realized.
 
 Additionally,
we adopted Financial Accounting Standards Board, (“FASB”) Interpretation No. 48,
Accounting for Uncertainty in
Income Taxes – An Interpretation of FASB Statement No. 109,(“FIN 48”),
on June 1, 2007, the first day of fiscal 2008.  FIN 48 seeks to reduce
the diversity in practice associated with certain aspects of measurement and
recognition in accounting for income taxes.  FIN 48 prescribes a
recognition threshold and measurement requirement for the financial statement
recognition of a tax position that has been taken or is expected to be taken on
a tax return and also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure and
transition.  Under FIN 48 we may only recognize tax positions that
meet a “more likely than not” threshold.
 
 Net
Income Per Share
 We apply
SFAS No. 128, Earnings Per
Share, for the calculation of "Basic" and "Diluted" earnings per share.
Basic earnings per share includes no dilution and is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding for the period. Diluted earnings per share reflects the potential
dilution of securities that could share in the earnings of an entity. At May 31,
2008, 2007 and 2006, potential common shares of 2,645,000, 330,000 and
2,295,000, respectively,  related to our outstanding warrants and
options were not included in the calculation of diluted income per share as they
had an anti-dilutive effect.
 
 Year Ended May
      31, 2008Numerator
      (Income)
              
              Denominator
      (Shares)
              
              Per
      Share AmountBasic
      EPS:Net
      income
              
              $
              9,388,321
              
              390,956,153
              
              $
              0.02Diluted
      EPS:Effect
      of dilutive securities:Options
      and warrants
              
              
              -
              
              6,529,546Income
      available to common shareholders
              
              $
              9,388,321
              
              397,485,699
              
              $
              0.02
 
 
 F-14
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Net
Income Per Share (continued)
 
 Year Ended May
      31, 2007Numerator
      (Income)
              
              Denominator
      (Shares)
              
              Per
      Share AmountBasic
      EPS:Net
      income
              
              $
              23,691,187
              
              378,036,989
              
              $
              0.06Diluted
      EPS:Effect
      of dilutive securities:Options
      and warrants
              
              
              -
              
              35,562,384Income
      available to common shareholders
              
              $
              23,691,187
              
              413,599,373
              
              $
              0.06
 
 Year Ended May
      31, 2006Numerator
      (Income)
              
              Denominator
      (Shares)
              
              Per
      Share AmountBasic
      EPS:Net
      income
              
              $
              28,672,688
              
              316,100,499
              
              $
              0.09Diluted
      EPS:Interest
      on convertible debentures
              
              
              458,467Effect
      of dilutive securities:Options
      and warrants
              
              
              -
              
              80,273,769Convertible
      debentures
              
              
              -
              
              16,588,905Income
      available to common shareholders
              
              $
              29,131,155
              
              412,963,173
              
              $
              0.07
  Use
of Estimates
 The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, revenues and expenses, and the disclosure of contingent assets and
liabilities in the consolidated financial statements and accompanying
footnotes.  Actual results could differ from those
estimates.  On an ongoing basis we evaluate our estimates, including,
but not limited to: the realizability of accounts and notes receivable,
valuation of inventory, fair values of investments in marketable securities, the
use, recoverability, and /or realizability of certain assets, including
investments in affiliated companies, deferred tax assets, and stock-based
compensation.
 
 Minority
Interest
 Minority
interest in our consolidated financial statements results from the accounting
for the acquisition of a noncontrolling interest in SSDI. Noncontrolling
interest represents a partially owned subsidiary’s income, losses, and
components of other comprehensive income which should be attributed to the
controlling and noncontrolling interests or other parties with a right or
obligation that affects the attribution of comprehensive income or loss, on the
basis of their contractual rights or obligations, if any, otherwise, on the
basis of ownership interests.
 
 F-15
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Net
Income Per Share (continued)
 
 The
noncontrolling interest in SSDI, which we are required to consolidate as we are
the primary beneficiary, had been reduced to zero due to the initial allocation
of losses prior to the period in which we were required to consolidate. If a
noncontrolling interest has been reduced to zero, the primary beneficiary must
absorb any losses that are in excess of the value of the noncontrolling
interest’s equity. For the period in which we are required to consolidate, March
27, 2007 through May 31, 2007 we absorbed $169,913 of SSDI’s losses as we are
the primary beneficiary.  For the fiscal year ended May 31, 2008, SSDI
had net income of $285,319 after taxes.  Under the provisions of FIN
46 (R), we are able to recover our absorbed losses before allocating income to
the noncontrolling interest.  At May 31, 2008, the minority interest
presented in our consolidated financial statements is $115,406, the amount of
SSDI’s fiscal 2008 net income after tax less our absorbed losses during fiscal
2007.
 
 Stock-Based
Compensation
 On June
1, 2006, we adopted the provisions of SFAS No. 123(R), Share-Based Payment, which
establishes standards for the accounting of transactions in which an entity
exchanges its equity instruments for goods or services, primarily focusing on
accounting for transactions where an entity obtains employee services in
share-based payment transactions. SFAS No. 123(R) requires a public entity
to measure the cost of employee services received in exchange for an award of
equity instruments, including stock options, based on the grant-date fair value
of the award and to recognize it as compensation expense over the period the
employee is required to provide service in exchange for the award, usually the
vesting period.
 
 We
adopted SFAS No. 123(R) using the modified prospective transition method, which
requires the application of the accounting standard as of June 1, 2006, the
first day of our fiscal year 2007. Our consolidated financial statements as of
May 31, 2007 reflect the impact of adopting SFAS No. 123(R). In accordance with
the modified prospective transition method, our consolidated financial
statements for prior periods have not been restated to reflect, and do not
include, the impact of SFAS No. 123(R). SFAS No. 123(R) requires us to estimate
the fair value of share-based payment awards on the date of grant using an
option-pricing model. The value of the portion of the award that is ultimately
expected to vest is recognized as expense over the requisite service periods in
our consolidated statement of income. Prior to the adoption of SFAS No. 123(R),
we accounted for stock-based awards to employees and directors using the
intrinsic value method in accordance with APB No. 25 as allowed under SFAS No.
123. Under the intrinsic value method, no employee stock-based compensation
expense had been recognized in our consolidated statements of income, other than
as related to option grants to employees and directors below the fair market
value of the underlying stock at the date of grant.
 
 Stock-based
compensation expense recognized during the period is based on the value of the
portion of share-based payment awards that is ultimately expected to vest during
the period. Stock-based compensation expense recognized in our consolidated
statements of income for the fiscal years ended May 31, 2007 and 2008 included
compensation expense for share-based payment awards granted prior to, but not
yet vested as of May 31, 2006 based on the grant date fair value estimated
in accordance with the pro forma provisions of SFAS No. 123, Accounting for Stock-Based
Compensation, and compensation expense for the share-based payment awards
granted subsequent to May 31, 2006 based on the grant date fair value
estimated in accordance with the provisions of SFAS No. 123(R). As stock-based
compensation expense recognized in the consolidated statements of income is
based on awards ultimately expected to vest, it has been reduced for estimated
forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of
grant and revised, if necessary, in subsequent periods if actual forfeitures
differ from those estimates. The estimated average forfeiture rate for the
fiscal years ended May 31, 2008 and May 31, 2007, of approximately 5% was
based on historical forfeiture experience and estimated future employee
forfeitures. The estimated pricing term of option grants for the fiscal years
ended May 31, 2008 and May 31, 2007 was five years.  In our
proforma information required under SFAS123(R) for fiscal 2006, we accounted for
forfeitures as they occurred.
 
 In
November 2005, FASB issued FASB Staff Position No. FAS 123R-3, Transition Election Related to
Accounting for Tax Effects of Share-Based Payment Awards (“FAS
123R-3”).  We have elected to adopt the alternative transition method
provided in FAS 123R-3.  The alternative transition method includes a
simplified method to establish the beginning balance of the additional paid-in
capital pool (“APIC pool”) related to the tax effects of employee share-based
compensation, which is available to absorb tax deficiencies recognized
subsequent to the adoption of SFAS No. 123(R).Excess tax benefits exist
when the tax deduction resulting from the exercise of options exceeds the
compensation cost recorded. SFAS No. 123(R)
 
 F-16
 
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Stock-Based
Compensation (continued)
 
 requires
the cash flows resulting from such excess tax benefits to be classified as
financing cash flows. During the year ended May 31, 2007, we classified excess
tax benefits of $25,645 as financing cash inflows.
 
 The stock
options exercised and canceled during the year ended May 31, 2008 resulted in a
net reduction in a deferred income tax asset of $636,245 because the share-based
compensation cost previously recognized by us was greater than the deduction
allowed for income tax purposes based on the price of our common stock on the
date of exercise. This reduction in the deferred income tax asset resulted in a
reduction to our APIC pool of $25,645. The remaining reduction in the deferred
income tax asset in excess of our APIC pool of $414,782 resulted in an increase
in our effective income tax rate for the year ended May 31, 2008 and an increase
in our income taxes payable of $195,818.
 
 Summary of
Assumptions and Activity
 The
following table illustrates the effect on net income per share for the year
ended May 31, 2006 as if we had applied the fair value recognition provisions of
SFAS No. 123 to options granted under our stock option plans. For purposes of
this pro forma disclosure, the fair value of the options is estimated using the
Black-Scholes option-pricing model and amortized on a straight-line basis to
expense over the options' vesting period:
 
 Year
      Ended
                May
      31, 2006Net
      income - as reported
              
              $
              28,672,688Add:
      Share-based employee compensation included in net income, net of tax
      effects
              
              
              120,000Deduct:
      Share-based employee compensation expense determined under fair value
      method, net of tax effects
              
              
              (1,639,913
              )Net
      income - pro forma
              
              $
              27,152,775Net
      income per common share - as reportedBasic
              
              $
              0.09Diluted
              
              $
              0.07Net
      income per common share - pro formaBasic
              
              $
              0.09Diluted
              
              $
              0.07
 
 The fair
value of stock-based awards to employees and directors is calculated using the
Black-Scholes option pricing model, even though this model was developed to
estimate the fair value of freely tradable, fully transferable options without
vesting restrictions, which differ significantly from our stock options. The
Black-Scholes model also requires subjective assumptions, including future stock
price volatility and expected time to exercise, which greatly affect the
calculated values. The expected term of options granted is derived from
historical data on employee exercises and post-vesting employment termination
behavior. The risk-free rate selected to value any particular grant is based on
the U.S. Treasury rate that corresponds to the pricing term of the grant
effective as of the date of the grant. The expected volatility for the fiscal
years ended May 31, 2008, 2007 and 2006 is based on the historical volatilities
of our common stock.  These factors could change in the future,
affecting the determination of stock-based compensation expense in future
periods.
 
 F-17
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Stock-Based
Compensation (continued)
 
 Year
      Ended
                May
      31, 2008
              
              Year
      Ended
                May
      31, 2007
              
              Year
      Ended
                May
      31, 2006Expected
      term
              
              
              5
      yrs
              
              
              5
      yrs
              
              
              5
      yrsExpected
      volatility
              
              
              122
      - 128%
              
              
              146
      – 156%
              
              
              115
      – 158%Risk-free
      interest rate
              
              
              2.23
      - 4.96%
              
              
              4.78
      - 5.00%
              
              
              3.78
      - 4.93%Expected
      dividends
              
              
              2.82%
              
              
              -
              
              
              -
 
 A summary
of option activity as of May 31, 2008 and changes during the fiscal year then
ended, is presented below:
 
 Shares
              
              
              Weighted
      Average Exercise Price
              
              
              Weighted
      Average Remaining Contractual Term (Years)
              
              
              Aggregate
      Intrinsic ValueOptions
      outstanding at June 1, 2007
              
              
              7,245,000
              
              
              $
              0.40Options
      granted
              
              
              6,625,000
              
              
              $
              0.43Options
      exercised
              
              
              (1,282,846
              )
              
              $
              0.15Options
      forfeited
              
              
              (4,392,154
              )
              
              $
              0.45Options
      outstanding at May 31, 2008
              
              
              8,195,000
              
              
              $
              0.44
              
              
              
              3.79
              
              
              $
              182,900Options
      vested and expected to vest at May 31, 2008
              
              
              7,998,519
              
              
              $
              0.44
              
              
              
              3.77
              
              
              $
              182,900Options
      exercisable at May 31, 2008
              
              
              4,265,372
              
              
              $
              0.47
              
              
              
              2.95
              
              
              $
              182,900
  The
weighted average grant date fair value of options granted during the fiscal
years ended May 31, 2008 and May 31, 2007 was $0.32 and $0.82 per option,
respectively. The total intrinsic value of options exercised during the fiscal
years ended May 31, 2008 and May 31, 2007 was $562,150 and $290,100,
respectively, based on the differences in market prices on the dates of exercise
and the option exercise prices.
 
 The
aggregate intrinsic value in the table above represents the differences in
market price at the close of the year ($0.27 per share on May 31, 2008) and the
exercise price of outstanding, in-the-money options (those options with exercise
prices below $0.27) on May 31, 2008.
 
 As of May
31, 2008, there was approximately $977,602 of total unrecognized compensation
cost related to employee stock option compensation arrangements.  That
cost is expected to be recognized on a straight-line basis over the next 42
months.  Approximately $583,000 of the total unrecognized compensation
cost relates to 2,000,000 performance options granted to our CEO and 200,000
performance options granted to our V.P of Business Development.  We
are not currently recognizing compensation cost relating to these option grants
as we have determined that it is not currently probable that the vesting
conditions in the grants will be met.  When such vesting conditions
are probable to be met, we will record the compensation cost for the
grants.
 
 
 F-18
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Stock-Based
Compensation (continued)
  The
following table summarizes employee and director stock-based compensation
expense related to stock options under SFAS No. 123(R) for the fiscal years
ended May 31, 2008 and 2007, which was recorded as follows:
  Year
      Ended
              
              
              Year
      EndedMay
      31, 2008
              
              
              May
      31, 2007Selling,
      general and administrative expense
              
              $
              502,770
              
              
              $
              2,356,000
 
 Adoption
of Recent Accounting Pronouncements
 On June
1, 2007, we adopted FIN 48. This interpretation clarifies the application of
SFAS No. 109 by defining criteria that an individual tax position must meet for
any part of the benefit of that position to be recognized in a company’s
financial statements and also provides guidance on measurement, derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure and transition.  The adoption of FIN 48 on June 1, 2007 did
not result in any cumulative effect adjustment to retained
earnings.  Interest and penalties, if any, related to unrecognized tax
benefits are recorded in income tax expense.  As of June 1, 2007, we
are subject to U.S. Federal income tax examinations for the tax years May 31,
1991 through May 31, 2007, and we are subject to state and local income tax
examinations for the tax years May 31, 1999 through May 31, 2007 due to the
carryover of net operating losses from previous years.
 
 Recent
Accounting Pronouncements
 In
September 2006, the FASB issued SFAS No. 157, Fair Value
Measurements.  SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principals
and expands disclosures about fair value measurements.  The statement does
not require new fair value measurements, but is applied to the extent that other
accounting pronouncements require or permit fair value measurements.  The
statement emphasizes that fair value is a market-based measurement that should
be determined based on the assumptions that market participants would use in
pricing an asset or liability.  Companies that have assets and liabilities
measured at fair value will be required to disclose information that enables the
users of its financial statements to access the inputs used to develop those
measurements.  The reporting entity is encouraged, but not required, to
combine the fair value information disclosed under this statement with the fair
value information disclosed under other accounting pronouncements.  SFAS
No. 157 is effective for fiscal years beginning after November 15, 2007. We
expect to adopt SFAS No. 157 on June 1, 2008.  In February 2008, the FASB
released FASB Staff Position 157-2, Effective Date of FASB StatementNo. 157,which
delayed the effective date of SFAS No. 157 for all nonfinancial assets and
nonfinancial liabilities, except those that are recognized or disclosed at fair
value in the financial statements on a recurring basis (at least annually) until
the fiscal year beginning May 31, 2009.  We are in the process of
evaluating the provisions of the statement, but do not anticipate that the
adoption of SFAS No. 157 will have a material impact on our consolidated
financial statements.
 
 In February 2007, the
FASB issued SFAS No. 159,The
Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits
entities to choose to measure at fair value many financial instruments and
certain other items that are not currently required to be measured at fair
value. The objective is to improve financial reporting by providing entities
with the opportunity to mitigate volatility in reported earnings caused by
measuring related assets and liabilities differently without having to apply
complex hedge accounting provisions. SFAS No. 159 also establishes
presentation and disclosure requirements designed to facilitate comparisons
between entities that choose differentmeasurement attributes for similar
types of assets and liabilities. SFAS No. 159 does not affect any
existing accounting literature that requires certain assets and liabilities to
be carried at fair value. SFAS No. 159 does not establish requirements
for recognizing and measuring dividend income, interest income, or interest
expense. This Statement does not eliminate disclosure requirements included in
other accounting standards. SFAS No. 159 is effective in fiscal years
beginning after November 15, 2007. We are in the process of evaluating the
provisions of the statement, but do not anticipate that the adoption of SFAS No.
159 will have a material impact on our consolidated financial
statements.
 
 F-19
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Recent
Accounting Pronouncements (continued)
 
 In
December 2007, the FASB issued SFAS No. 141(R), Business Combinations. SFAS
No. 141(R) requires acquiring entities in a business combination to recognize
the assets acquired and liabilities assumed in the transaction; establishes the
acquisition-date fair value as the measurement objective for all assets acquired
and liabilities assumed; and requires the acquirer to disclose to investors the
information it needs to evaluate and understand the nature and financial effect
of the business combination. SFAS No. 141(R) is effective in fiscal years
beginning after December 15, 2008. We expect to adopt SFAS No. 141(R) on June 1,
2009.  We are currently assessing the impact the adoption of SFAS No.
141(R) will have on our consolidated financial statements.
 
 In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements. SFAS No. 160 requires entities to
report noncontrolling (minority) interests in subsidiaries as equity in the
consolidated financial statements. SFAS No. 160 is effective in fiscal
years beginning after December 15, 2008. We expect to adopt SFAS No. 160 on June
1, 2009.  We are currently assessing the impact the adoption of SFAS
No. 160 will have on our consolidated financial statements.
 
 3. 
Accounts Receivable
 
 Trade
accounts receivable at May 31, 2008 is $538,500, of which $511,541 is held by
SSDI.  At May 31, 2007, trade accounts receivable was $352,390, of
which $348,890 was held by SSDI. No allowance for doubtful accounts has been
recorded for the fiscal years ended May 31, 2008 or 2007.
 
 At May
31, 2008, accounts receivable from our investee PDS was $7,501 with no such
amount recorded at May 31, 2007.  The fiscal 2008 balance represents
reimbursements we submit to PDS for our legal and related costs incurred in
various legal matters of which we are listed as co-defendant with
TPL.
 
 4.  Notes
Receivable
 
 During
fiscal year 2008, SSDI sold a membership interest in its subsidiary DataSecurus,
LLC (now known as Talis) to an unrelated third party for $100,000 in cash and a
$50,000 non-interest bearing note receivable due in June 2008.  On
June 1, 2008, SSDI assigned the $50,000 note receivable to us and we agreed to
reduce the amount of our line of credit with SSDI by the amount of the note
receivable.  On June 26, 2008, we were paid in full by the third party
debtor.
 
 On May
30, 2008, we purchased a secured convertible promissory note from Crossflo
Systems, Inc., a California corporation (“Crossflo”) with a face amount of
$400,000.  Interest accrues on the note at a rate of 5.25% per annum
and will be due with principal at the earlier of (i) September 30, 2008, (ii)
consummation of a equity financing by Crossflo which closes on or before
September 30, 2008, in which Crossflo  sells and issues shares of its
convertible preferred stock resulting in aggregate gross proceeds to Crossflo of
at least $2.5 million (a “Qualified Financing”), or (iii) upon or after the
occurrence of an event of default, as defined.  The note is secured by
substantially all assets of Crossflo.
 
 The
Crossflo note receivable is convertible at our option, at any time prior to
September 30, 2008, into shares of Crossflo’s Series F convertible preferred
stock equal to 4% of Crossflo’s then issued and outstanding equity securities.
In addition, the entire principal is automatically convertible into shares of
Crossflo’s Series F convertible preferred stock at the closing of a Qualified
Financing. The number of shares of Series F convertible preferred stock to be
issued upon automatic conversion of the principal amount is the greater of (i)
4% of Crossflo’s then issued and outstanding equity securities, and (ii) the
principal amount divided by the per share purchase price paid by the investors
participating in the Qualified Financing. Upon an event of default, as defined,
the principal amount of the note may be converted into shares of Crossflo’s
Series F convertible preferred stock equal to 4% of Crossflo’s then issued and
outstanding equity securities. Upon maturity on September 30, 2008, the
principal amount of the note will automatically be converted into shares of
Crossflo’s Series F convertible preferred stock equal to 4% of Crossflo’s then
issued and outstanding equity securities.
 
 Upon
conversion of the principal amount of the note pursuant to the above, we are
entitled to receive shares of Crossflo’s common stock equal to all accrued and
unpaid interest divided by $0.20.
 
 F-20
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Notes
Receivable (continued)
 
 In
connection with our purchase of the secured convertible promissory note from
Crossflo, we also received a warrant to purchase 200,000 shares of Crossflo’s
common stock at $0.20 per share.  Notwithstanding the foregoing, in
the event a Qualified Financing is not consummated prior to September 30, 2008,
the warrant will instead be exercisable into 1,000,000 shares of Crossflo’s
common stock at $0.20 per share.  The warrant is exercisable until the
earlier of (i) October 11, 2012, (ii) the closing of an underwritten public
offering by Crossflo pursuant to a registration statement under the Securities
Act, (iii) the closing of a merger or other reorganization by Crossflo with
another entity, or (iv) the closing of a sale of all or substantially all of the
assets of Crossflo.  The value attributed to the warrant was
insignificant, and accordingly, the principal amount of the loan has been
recorded as a note receivable at May 31, 2008.
 
 As of May
31, 2008, the balance of the note receivable is $400,115, including accrued
interest receivable of $115 recognized during the year ended May 31,
2008.
 
 On
November 22, 2006, we entered into a Revolving Line of Credit Facility Agreement
(the “Line of Credit Agreement”) with Holocom Networks (“Holocom”) which
provided for borrowings of up to $700,000 under a revolving line of credit
extended by us to Holocom. On November 22, 2006, we advanced Holocom $350,000
and further advanced an additional $230,000 during the three months ended
February 28, 2007. Borrowings under the Line of Credit Agreement were used by
Holocom for its operating cash flow needs. The borrowings bore interest at the
prime rate, as announced by Bank of America, plus 2% per annum, and
interest-only payments were due monthly. Pursuant to the terms of the Line of
Credit Agreement, all unpaid principal and accrued and unpaid interest was due
February 22, 2007. Borrowings under the Line of Credit Agreement were
collateralized by substantially all of the assets of Holocom.
  During
the quarter ended February 28, 2007, we determined that the outstanding
borrowings under the Line of Credit Agreement of $589,551, which included
accrued interest and late fees of $9,551, were uncollectible as Holocom was
unable to make the required interest payments. As a result, we foreclosed on the
assets of Holocom. At the foreclosure sale, we acquired the patents, trademarks,
equipment, inventory, and certain other collateral of Holocom pursuant to the
terms of a Security Agreement entered into between us and Holocom in connection
with the Line of Credit Agreement.
  We
originally accounted for our loan receivable, and related accrued interest, due
from Holocom at cost. In accordance with SFAS No. 114, Accounting by Creditors for
Impairments of a Loan, based on current information and events, we
determined that we were unable to collect all amounts due from Holocom according
to the contractual terms of the Line of Credit Agreement. As a result, we
determined that the loan receivable was impaired. Accordingly, we recorded
an impairment loss of $339,551 during the three months ended February 28, 2007.
The impairment loss was determined based on an independent valuation of the
assets of Holocom acquired in the foreclosure sale and management’s analysis of
the fair value of such assets at time of acquisition.
  The fair
value of the assets acquired in foreclosure of $250,000 was contributed to
SSDI.
 
 5.
Inventory
 
 Inventory
at May 31, 2008, consisted of raw materials of $142,410 and finished goods of
$245,731.  Inventory at May 31, 2007, consisted of raw materials of
$46,361.
 
 F-21
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 6.
Investments in Marketable Securities
 
 The
following table summarizes unrealized losses on our investments in marketable
securities based on the valuation by Houlihan Smith & Company Inc. at May
31, 2008:
 
 As
      of May 31, 2008Cost
              
              
              Gross
                Unrealized
                Losses
              
              
              Estimated
                Fair
                ValueShort-termAccrued
      interest - auction rate securities
              
              $
              288,099
              
              
              $
              —
              
              
              $
              288,099Long-termAuction
      rate securities
              
              
              12,900,000
              
              
              
              (372,325
              )
              
              
              12,527,675Total
              
              $
              13,188,099
              
              
              $
              (372,325
              )
              
              $
              12,815,774
 
 As of May
31, 2008, we held auction rate securities with a par value totaling $12.9
million that failed to sell at auction.  In the event we need to
access funds invested in these auction rate securities we would not be able to
liquidate these securities until (i) a future auction of these securities is
successful, (ii) they are refinanced and redeemed by the issuers, or (iii) a
buyer is found outside of the auction process.  The investments
consist of student loan auction rate instruments issued by various state
agencies pursuant to the Federal Family Educational Loan Program
(“FFELP”).  These investments are of high credit quality and the AAA
credit ratings of the investments have been reaffirmed since May
2008.  These instruments are collateralized in excess of the
underlying obligations, are insured by the various state educational agencies,
and are guaranteed by the Department of Education as an insurer of last
resort.  We have the intent and the ability to hold these investments
until the anticipated recovery period.
 
 Due to
the uncertainty surrounding the timing of a market recovery, we have classified
our auction rate securities as long- term investments in our consolidated
balance sheet as of May 31, 2008.  As a result of temporary declines
in the fair value of our auction rate securities, which we attribute to
liquidity issues rather than credit issues, we have recorded an unrealized loss
of $220,617 in other comprehensive income at May 31, 2008, which represents the
gross valuation adjustment of $372,325, net of the related tax benefit of
$151,708.
 
 We will
continue to evaluate the fair value of our investments in auction rate
securities each reporting period for a potential other-than-temporary
impairment.
 
 During
June 2008 we obtained a credit facility for as long as needed, which provides
for financing up to 50% of the par value balance of our outstanding auction rate
securities. The facility is collateralized by the full value of the outstanding
auction rate securities, required no origination fee, and if drawn upon will
bear interest at the federal funds rate plus 3%.
 
 
 F-22
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 7.
Property and Equipment
 
 Property
and equipment consisted of the following at May 31, 2008 and 2007:
  2008
              
              
              2007Computer
      equipment and software
              
              $
              50,802
              
              
              $
              42,270Furniture
      and fixtures
              
              
              72,981
              
              
              
              72,454Leasehold
      improvements
              
              
              5,046
              
              
              
              -128,829
              
              
              
              114,724Le
      LLess: accumulated depreciation and amortization
              
              
              (60,325
              )
              
              
              (29,206
              )Net
      property and equipment
              
              $
              68,504
              
              
              $
              85,518
 
 Depreciation
and amortization expense related to property and equipment was $36,359, $24,352
and $24,591 for the years ended May 31, 2008, 2007 and 2006,
respectively.
 
 8.
License Agreements
 
 In
February 2005, we entered into two separate licensing agreements with one
customer for our patent portfolio and Ignite microprocessor technology. The
aggregate amount of the two licenses was $3,050,000, of which $2,950,000 was for
licensing fees and $100,000 was for maintenance services. Maintenance under the
agreement is expected to be provided over a period not to exceed four years.
Maintenance revenue recognized during the fiscal years ended May 31, 2008, 2007
and 2006 was $25,000 per year. The payment terms of the agreements required
aggregate payments of $300,000 at the time of execution, three quarterly
payments of $750,000 each on April 1, August 15, and November 15, 2005 and one
final payment of $500,000 on February 15, 2006. The $500,000 payment due on
February 15, 2006 was paid in March 2006. Total payments received in fiscal 2005
amounted to $1,050,000, and total payments received in fiscal 2006 amounted to
$2,000,000. The agreements also provide for the future payment of royalties to
us based on sales of product using the Ignite licensed technology. In connection
with this license agreement, we became obligated to the co-inventor of the
patent portfolio technology for $207,600 pursuant to a July 2004 agreement under
which we were obligated to pay a percentage of all patent portfolio licensing
proceeds to the co-inventor. The amount due under that license was payable in
four installments of $51,900. The co-inventor of the patent portfolio technology
filed a lawsuit against us seeking damages and/or enforcement of the July 2004
agreement. We challenged the enforceability of the agreement by counterclaim in
that action. On February 14, 2007, a settlement of the litigation was finalized.
Terms of the settlement required us to pay $3,400,000 in cash on February 14,
2007 and $3,000,000 on May 1, 2007, which amounted to approximately the debt
claimed by the co-inventor to be owed to him under the July 2004 agreement. In
addition, the settlement required us to make a donation of $15,000 on February
14, 2007 on behalf of Russell H. Fish III (“Fish”) to Maasai Power and Education
Project, Inc., and to pay Fish the equivalent of 4% of 50% of the next $100
million of gross license fees as they are collected by PDS and as distributions
are made to us, after excluding the first $20 million collected by PDS after
December 1, 2006. Our commitment to make payments to Fish related to such future
license revenues was limited to $2 million. During the fiscal years ended May
31, 2008 and 2007, we recorded $836,400 and $7,524,537, respectively in
settlement and license expenses relating to royalty payments due to the Fish
parties.  In January 2008, we made the final payment under the Fish
settlement agreement.
 
 9.
Investments in Affiliated Companies
 
 Phoenix
Digital Solutions, LLC
 
 On June 7, 2005, we entered into a
Master Agreement (the “Master Agreement”) with TPL, and Charles H. Moore
(“Moore”), the co-inventor of certain of our technology, pursuant to which we,
TPL and Moore resolved all legal disputes between us. Pursuant to the Master
Agreement, we and TPL entered into the Limited Liability Company Operating
Agreement of PDS (the “LLC Agreement”) into which we and Moore contributed our
rights to certain of our technologies.
 
 F-23
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Investments
in Affiliated Companies (continued)
 
 We and
TPL each own 50% of the membership interests of PDS, and each of us has the
right to appoint one member of the three member management committee. The two
appointees are required to select a mutually acceptable third member of the
management committee. Pursuant to the LLC Agreement, we and TPL agreed to
establish a working capital fund for PDS of $4,000,000, of which our
contribution was $2,000,000. The working capital fund increases to a maximum of
$8,000,000 as license revenues are achieved. We and TPL are obligated to fund
future working capital requirements at the discretion of the management
committee of PDS in order to maintain working capital of not more than
$8,000,000. Neither we nor TPL are required to contribute more than $2,000,000
in any fiscal year. Distributable cash and allocation of profits and losses will
be allocated to the members in the priority defined in the LLC Agreement. PDS
has committed to pay a quarterly amount ranging between $500,000 and $1,000,000
(based upon a percentage of the working capital fund balance of PDS) for
supporting efforts to secure licensing agreements by TPL on behalf of PDS.
During the fiscal years ended May 31, 2008, 2007 and 2006, PDS paid $2,952,362,
$3,871,602 and $2,500,000, respectively, to TPL pursuant to this
commitment.
 
 We are
accounting for our investment in PDS under the equity method of accounting, and
accordingly have recorded our share of PDS’ net income of $19,926,145,
$48,965,084 and $27,848,363 during the years ended May 31, 2008, 2007 and 2006,
respectively, as an increase in our investment. Cash distributions of
$20,288,124, $50,034,029 and $25,895,449 received from PDS during the years
ended May 31, 2008, 2007 and 2006, respectively, have been recorded as a
reduction in our investment. Our investment in PDS of $2,521,990 and $2,883,969
at May 31, 2008 and 2007, respectively,  and has been recorded as
“Investments in Affiliated Companies”.  We have recorded our share of
PDS’ net income as “Equity in Earnings of Affiliated Companies” in the
accompanying consolidated statements of income for the years ended May 31, 2008,
2007 and 2006.
 
 Concurrently
with forming PDS, we entered into a license agreement with a third party
pursuant to which we received $10,000,000.  This amount was recorded
as license revenue during the year ended May 31, 2006. In connection with
entering into the license agreement and forming PDS, we incurred various cash
and non-cash expenses. Direct, incremental cash costs incurred with the
transactions included $170,000 paid to a committee of our board of directors for
their efforts in consummating the transactions, approximately $1,328,000 paid to
certain of our warrant holders to obtain their approval of the agreement and
release of their lien and blocking rights. Additionally, $960,000 was paid to
the co-inventor of the technology.
 
 We also
granted new warrants and agreed to re-price other outstanding warrants in order
to obtain the necessary approvals from certain security interest holders as well
as to obtain the release of their security interests in our intellectual
property, and to finalize the LLC Agreement. We granted a warrant to TPL to
acquire up to 3,500,000 shares of our common stock at a per share price of
$0.125. The warrant has a term of seven years. At the date of grant, the right
to acquire 1,400,000 common shares vested. The right to acquire the remaining
2,100,000 shares will vest in 700,000 increments only upon our common stock
attaining a per share stock price of $0.50, $0.75 and $1.00. On February 21,
2006, February 22, 2006 and March 1, 2006 the rights to acquire the remaining
700,000 share increments vested as our stock price reached $0.50, $0.75 and
$1.00, respectively. As additional consideration to the warrant holders for
providing approval for the transaction, we agreed to reset the per share
exercise price of approximately 35,000,000 warrants to $0.015 for which the
warrant holders also conveyed other warrants to acquire 12,000,000 shares back
to us. Further, we issued additional warrants to acquire approximately 290,000
shares of our common stock at a per share price of $0.03. The warrants issued
and re-priced were valued using a Monte Carlo simulation model and the following
assumptions: volatility of 101% to 229%, no dividends, risk-free interest rates
of approximately 3.5% to 5.1%, and contractual terms ranging from two to seven
years. The fair value of the warrants issued and re-priced in excess of
previously recorded expense was approximately $83,000 and the fair value of the
reconveyed warrants was approximately $622,000. These amounts, together with the
direct, incremental cash costs previously described, are recorded as an expense
and included in settlement and license expense in the year ended May 31,
2006.
 
 During
the years ended May 31, 2008, 2007 and 2006, TPL entered into licensing
agreements with third parties, pursuant to which PDS received aggregate proceeds
of approximately $59,283,000, $110,879,000 and $60,000,000,
respectively.
 
 F-24
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Investments
in Affiliated Companies (continued)
 
 The
condensed balance sheets of PDS at May 31, 2008 and 2007 and statements of
income of PDS for the years ended May 31, 2008, 2007 and 2006 are as
follows:
 
 Condensed
Balance Sheets
 
 ASSETS:
 
 2008
              
              
              2007Cash
      and cash equivalents
              
              $
              8,260,288
              
              
              $
              6,989,847Prepaid
      expenses
              
              
              -
              
              
              
              175,000Total
      assets
              
              $
              8,260,288
              
              
              $
              7,164,847
 
 LIABILITIES
AND MEMBERS’ EQUITY:
 
 Accounts
      payable and accrued expenses
              
              $
              3,204,519
              
              
              $
              1,385,118Income
      taxes payable
              
              
              11,790
              
              
              
              11,790Members’
      equity
              
              
              5,043,979
              
              
              
              5,767,939Total
      liabilities and members’ equity
              
              $
              8,260,288
              
              
              $
              7,164,847
 
 Condensed
Statements of Income
 
 2008
              
              
              2007
              
              
              2006License
      revenues
              
              $
              59,282,971
              
              
              $
              110,878,985
              
              
              $
              60,000,000Operating
      expenses
              
              
              18,627,032
              
              
              
              12,189,575
              
              
              
              4,486,955Operating
      income
              
              
              40,655,939
              
              
              
              98,689,410
              
              
              
              55,513,045Interest
      income
              
              
              216,902
              
              
              
              421,407
              
              
              
              183,682Income
      before income taxes
              
              
              40,872,841
              
              
              
              99,110,817
              
              
              
              55,696,727Provision
      for income taxes
              
              
              11,790
              
              
              
              11,790
              
              
              
              -Net
      income
              
              $
              40,861,051
              
              
              $
              99,099,027
              
              
              $
              55,696,727
 
 Talis
Data Systems, LLC
 
 On May
16, 2008, we paid $400,000 to acquire a 15.09% share in Talis, a company that
produces multi-domain computer and network security products to government,
military, and enterprise customers. Talis develops and markets PCs incorporating
the company's Datagent security device, a patented, hardware based data security
solution that avoids the vulnerability of software–based
approaches.
 
 On August
1, 2008, we increased our investment in Talis to 37.4% as a result of purchasing
additional shares offered by Talis, as well as acquiring shares from minority
shareholders which included the acquisition of all Talis shares previously held
by SSDI. The acquisition of SSDI’s Talis shares was made for $100,000 in cash
and a reduction on their outstanding line of credit of $219,000.
 
 F-25
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Investments
in Affiliated Companies (continued)
 
 We are
accounting for our investment in Talis under the equity method of accounting, as
our limited liability company share is deemed more than minor.  We
have recorded our share of Talis’ net loss of $8,376 during the period ended May
31, 2008 as a decrease in our investment.  Our investment in Talis is
$391,624 at May 31, 2008 and has been recorded as “Investments in Affiliated
Companies”.  We have recorded our share of Talis’ net loss as “Equity
in Earnings of Affiliated Companies” in the accompanying consolidated statement
of income for the year ended May 31, 2008.
 
 10.
Consolidated Variable Interest Entity
 
 On
February 2, 2007, we invested an aggregate of $370,000 in SSDI for 2,100,000
shares of convertible preferred stock. This represents all of SSDI’s preferred
stock and a 46% ownership interest in SSDI, a California corporation that
manufactures products that protect information transmitted over secure networks.
The investment consisted of certain assets contributed by us to SSDI valued at
$250,000 and cash of $120,000. The shares are convertible at our option into
shares of SSDI’s common stock on a one-to-one basis. The convertible preferred
stock entitles us to receive non-cumulative dividends at the per annum rate of
$0.04 per share, when and if declared by the Board of Directors of SSDI. The
investment in SSDI’s convertible preferred stock also entitles us to a
liquidation preference of $0.40 per share, plus an amount equal to all declared
but unpaid dividends.
 
 On March
27, 2007, we entered into an 18-month revolving line of credit with SSDI for a
maximum amount of $500,000. The line of credit matures on September 27, 2008. If
we do not provide notice to SSDI at least 90 days prior to the maturity date,
the maturity date automatically extends 12 months. The line of credit is
collateralized by all assets presently owned or hereafter acquired by SSDI. The
carrying value of the collateral is approximately $765,861 at May 31, 2008. The
creditors of SSDI do not have recourse to our other assets. During the fiscal
years ended May 31, 2008 and 2007 we advanced $250,000 and $250,000,
respectively, under terms of the agreement.  The total amount drawn on
the line of credit at May 31, 2008 is $500,000 of which $100,000 has been
repaid. On June 18, 2008, we gave SSDI notice under terms of the line of credit
that we would not be extending the maturity date by the additional twelve month
period provided for in the line of credit. As a result, the line of credit will
terminate, and full payment of any outstanding balance will be due on September
27, 2008.
 
 The line
of credit carries a floating interest rate which is defined as the prime rate as
announced by Bank of America. At May 31, 2008, the interest rate on the
note was 5.00%. SSDI is required to make minimum monthly payments on the line
consisting of unpaid and accrued interest on the first day of the month
following the initial advance.
 
 During
the quarter ended February 29, 2008 we subordinated our interest in the
repayment of principal due under the revolving line of credit, up to a maximum
of $100,000, for the benefit of a customer of SSDI.
 
 As a
result of the line of credit, we have a variable interest in SSDI, a variable
interest entity, and we have determined that we are the primary beneficiary as
we absorb more than half of the variable interest entity’s expected losses. FIN
46(R) requires us to consolidate SSDI as long as we are deemed to be the primary
beneficiary. The equity interests of SSDI not owned by us are reported as a
minority interest in our May 31, 2008 and 2007 consolidated balance
sheets.  As of May 31, 2007, the noncontrolling interest in SSDI,
which we are required to consolidate as we are the primary beneficiary, has been
reduced to zero due to the initial allocation of losses prior to the period in
which we were required to consolidate. If a noncontrolling interest has been
reduced to zero, the primary beneficiary must absorb any losses that are in
excess of the value of the noncontrolling interest’s equity. For the period in
which we were initially required to consolidate, March 27, 2007 through May 31,
2007 we absorbed $169,913 of SSDI’s losses as we are the primary
beneficiary.  For the fiscal year ended May 31, 2008, SSDI had net
income of $285,319 after taxes.  Under the provisions of FIN 46 (R),
we are able to recover our absorbed losses before allocating income to the
noncontrolling interest.  At May 31, 2008 the minority interest
presented in our consolidated financial statements is $115,406, the amount of
SSDI’s fiscal 2008 net income after taxes less our absorbed losses during fiscal
2007.
 
 Prior to
initial consolidation, we recognized a $126,746 impairment loss on our
investment for the losses of SSDI for the period February 2007 through March 26,
2007.
  F-26
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Consolidated
Variable Interest Entity (continued)
 
 Upon
initial consolidation of the variable interest entity, on March 27, 2007,
$251,146 of current assets, $43,199 of net property and equipment, $47,240 of
other assets, $98,331 of current liabilities and no minority interest were
included on the consolidated balance sheet.
 
 During
the three months ended August 31, 2007, SSDI sold a membership interest in
DataSecurus, LLC (now known as Talis Data Systems, LLC) to an unrelated third
party for $100,000 in cash and a $50,000 note receivable due June 1,
2008.  On June 1, 2008, SSDI assigned this note receivable to us and
we agreed to reduce the amount of our line of credit with SSDI by the amount of
the note.  On June 26, 2008 we were paid in full by the third party
debtor.
 
 SSDI
has a 2007 Stock Option Plan that covers its employees, directors, and
consultants and provides for the granting of options to acquire up to 500,000
shares of SSDI’s common stock.  The options under this plan are not
tied to our common stock and do not have a dilutive effect on our
shareholders.  Any option granted under the plan must be exercised
within ten years of the date they are granted.  During the fiscal year
ended May 31, 2008, SSDI granted options to purchase 393,500 shares of its
common stock at $0.10 per share under this plan.  At May 31, 2008,
options to purchase 354,500 shares of SSDI’s common stock are outstanding,
45,900 of the outstanding options are exercisable due to vesting provisions
within the options and 39,000 shares have been
forfeited/cancelled.
  The
weighted average grant date fair value of SSDI’s options granted during the
fiscal year ended May 31, 2008 was $0.06 per option.
 
 As of May
31, 2008, there was approximately $13,095 of total unrecognized compensation
cost related to employee stock option compensation arrangements.  That
cost is expected to be recognized by SSDI on a straight-line basis over the next
24 months.
 
 During
the fiscal year ended May 31, 2008, SSDI recognized $7,201 of employee,
consultant and director stock-based compensation expense related to stock
options under SFAS No. 123(R).
 
 11.
Accrued Expenses and Other
 
 At May
31, 2008 and 2007, accrued expenses and other consisted of the
following:
 
 2008
              
              
              2007Accrued
      lease obligation
              
              $
              4,006
              
              
              $
              7,279Deferred
      maintenance fee
              
              
              18,750
              
              
              
              43,750Compensation
      and benefits
              
              
              210,153
              
              
              
              75,068Deferred
      material credit
              
              
              95,377
              
              
              
              163,399Accrued
      expenses
              
              
              45,562
              
              
              
              -Royalties
      payable
              
              
              -
              
              
              
              797,000$
              373,848
              
              
              $
              1,086,496
 
 12.
Convertible Debentures
 
 From
fiscal 2002 through fiscal 2005, we raised approximately $5,400,000 through the
issuance of convertible debentures, having stated interest rates ranging from 8%
to 12%, to a limited group of investors. The convertible debentures entitled the
debenture holders to convert the principal, and any accrued interest thereon,
into shares of our common stock for up to two years from the date of
issuance.
 
 F-27
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Convertible
Debentures (continued)
 
 The
debentures were initially convertible into shares of common stock at conversion
prices ranging from approximately $0.02 to $0.10 per share. The debentures
contained provisions which allowed for the conversion rate to be reset on a
periodic basis based on a comparison of the market price of our common stock to
the conversion price of the debentures. On the measurement dates when the market
price was less than the conversion rate, a new conversion rate was set based on
a weighted average of the market price for the ten days prior to the reset
measurement date.
 
 Concurrent
with the issuance of the convertible debentures, we issued the debenture holders
warrants to purchase shares of our common stock. These warrants are exercisable
for five years from the date of issuance at either initial negotiated exercise
prices or prices equal to 115% of the volume weighted average price for our
common stock for the ten days previous to the debenture date. The warrant
exercise price is generally subject to being reset on each six-month anniversary
of its issuance; however, if the warrant holder elects to have the warrant
shares registered, then the exercise price is fixed at the price in effect on
the date of the election.
 
 Except
for one debenture issued on March 23, 2004, we are responsible for registering
the resale of the shares of our common stock which will be issued on the
conversion of the debentures. As of May 31, 2008, there have been seven
registration statements. The convertible debentures were secured by
substantially all our assets.
 
 The terms
of the convertible debentures included certain features that were considered
embedded derivative financial instruments, such as the conversion feature and a
reset conversion feature which provided for a conversion of the debentures into
shares of our common stock at a rate which was determined to be variable.
Because the debentures were not conventional convertible debt, we were also
required to record the related warrants at their fair values. In addition, under
the provisions of EITF Issue No. 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,as a result of entering into the convertible debenture agreements, we
were required to classify all other non-employee warrants as derivative
liabilities and record them at their fair values at each balance sheet
date.
 
 During
the year ended May 31, 2006, the value of the warrant and derivative liabilities
increased by $2,456,736 which is reflected as a component of other income
(expense) in the accompanying consolidated statement of income.
 
 During
the year ended May 31, 2006, we entered into two reset agreements with the
debenture holders to fix the conversion price of the then outstanding debentures
at their current price. We determined that one of the debt modifications did not
result in a debt extinguishment under EITF Issue No. 96-19, Debtor’s Accounting for a
Modification or Exchange of Debt Instruments, or EITF Issue No. 05-7,
Accounting for Modifications
to Conversion Options Embedded in Debt Instruments and Related Issues. In
connection with the reset agreement of one of the outstanding debentures, we
issued 7,000,000 warrants to the debenture holder as consideration for entering
into the reset agreement. We determined that the issuance of the warrants, in
connection with the reset agreement, resulted in a debt extinguishment under
EITF Issue No. 96-19. Accordingly, we recorded the fair value of the warrants
issued of $445,427 as a loss on debt extinguishment in the accompanying
consolidated statement of income for the year ended May 31, 2006.
 
 During
the year ended May 31, 2006, holders of debentures with a principal balance of
$880,668 converted their debentures, together with accrued interest thereon of
$118,369, into 30,819,187 shares of our common stock.  As of May 31,
2006, all outstanding debentures were repaid or converted into shares of our
common stock.
 
 As a
result of the settlement of the remaining debentures during 2006, we
reclassified $6,743,935 related to the fair values of all outstanding warrants
at the date of settlement to additional paid-in capital.
 
 We
recorded the fair value of the derivative instruments and warrants as a debt
discount which was amortized to interest expense over the term of the
convertible debentures. During the year ended May 31, 2006, we recorded interest
expense of $412,879 related to the amortization of the debt discount. If the
total fair value of the derivative instruments and warrants was in excess of the
proceeds received on the convertible debentures, we recorded the excess as
additional interest expense. Since no convertible debentures or warrants in
connection with convertible debentures were issued during the year ended May 31,
2006, no excess fair value was recorded during fiscal 2006.
  F-28
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 13.
Stockholders’ Equity
 
 Share
Repurchases
 
 During
July 2006, we commenced our Board of Director approved stock buyback program in
which we repurchase our outstanding common stock from time to time on the open
market.  The repurchase plan has no maximum number of shares and is
solely at the discretion of the Board of Directors. The repurchase plan has no
set expiration date.
 
 The
following table summarizes share repurchases during the years ended May 31, 2008
and 2007:
 
 2008
              
              
              2007Number
      of shares repurchased
              
              
              8,096,721
              
              
              
              13,467,527Aggregate
      cost
              
              $
              3,891,094
              
              
              $
              8,832,078
 
 Dividends
 
 During
February 2007, we announced dividends of $0.02 per share to shareholders and
qualified warrant holders of record as of March 6, 2007. The dividend of
$8,114,774 was paid on April 9, 2007. During this time, we announced a
semi-annual dividend policy contingent upon our financial condition, other
possible applications of available resources, and relevant business
considerations.
 
 During
February 2006, we announced a dividend of $0.02 per share of common stock for
stockholders of record and qualified warrant holders as of February 24, 2006.
The dividend of $8,114,378 was paid in March 2006. In March 2006, we announced a
dividend of $0.04 per share of common stock for stockholders of record and
qualified warrant holders as of March 31, 2006. The dividend of $16,583,959 was
paid in April 2006
 
 Private Stock
Offerings
 
 On July
22, 2005, 625,000 shares of common stock valued at $0.13 per share (based on the
fair value on the date of issuance) were issued to the co-inventor of certain
technology. We recorded an expense of $81,250 in connection with the issuance of
these shares.
 
 On March
21, 2006, 193,548 shares of common stock valued at $1.53 per share (based on the
fair value on the date of issuance) were issued to a former debenture holder in
connection with a dispute regarding the number of shares of common stock issued
upon conversion. We recorded an expense of $296,129 in connection with the
issuance of these shares.
 
 On
November 5, 2007, 200,000 shares of common stock valued at $0.50 per share
(based on the fair value on the date of issuance) were issued to a former
officer in connection with a legal settlement.  We recorded an expense
of $100,000 in connection with the issuance of these shares.
 
 Warrants
 
 At May
31, 2006, we had warrants outstanding to purchase 53,349,220 common shares at
exercise prices ranging from $0.02 to $1.00 per share, expiring at various dates
through 2012. Some of those outstanding warrants were not exercisable as of May
31, 2006 as they were subject to meeting vesting criteria. During the year ended
May 31, 2006, we issued warrants to purchase 12,457,049 shares of common stock,
investors exercised warrants to purchase 8,728,544 shares of common stock for
proceeds of $470,657 and investors exercised warrants of 44,110,139 to purchase
41,245,473 shares of common stock on a cashless basis. During the year ended May
31, 2006, we cancelled warrants to purchase 13,391,727 shares of our common
stock. Included in the aforementioned warrants issued during the year ended May
31, 2006 were warrants to purchase 300,000 shares of common stock issued to a
consultant. The value of these warrants of $176,866 was recorded as an expense
during the year ended May 31, 2006. We also granted new warrants and agreed to
re-price certain outstanding warrants in
 
 F-29
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Stockholders’ Equity
(continued)
 
 order to
obtain the necessary approvals from certain security interest holders as well as
to obtain the release of their security interests in our intellectual property,
and to finalize the LLC Agreement to form PDS.   As additional
consideration to the warrant holders for providing approval for the transaction,
we agreed to reset the per share exercise price of approximately 35,000,000
warrants to $0.015 for which the warrant holders also conveyed other warrants to
acquire 12,000,000 shares back to us (see Note 9).
 
 Effective
January 11, 2006, we entered into a warrant redemption agreement with a warrant
holder, whereby at our option, we agreed to redeem certain warrants representing
the right to acquire an aggregate of up to 10,000,000 shares of our common
stock, through April 2006. The warrants may be redeemed in quantities not to
exceed 2,000,000 warrants in any one calendar month, at a price equal to the
product of (a) the volume weighted average of the daily volume weighted average
prices of our common stock for all trading days in the applicable calendar
month, minus the exercise price of the warrant, multiplied by (b) the number of
shares being redeemed from that warrant. On February 3, 2006, we agreed to
redeem 2,000,000 warrants for $252,420 and payment for the redemption occurred
in March 2006.
 
 Effective
February 9, 2006, we entered into “Reset Agreements” with certain warrant
holders and received waivers from the warrant holders with regard to certain
terms of certain warrants held by the warrant holders. Under the terms of the
Reset Agreements, we and the warrant holders agreed to amend the terms of (i)
each of the warrants held by the warrant holders such that the exercise price of
the warrants is no longer subject to downward resets based on the trading price
of our common stock, and (ii) each of the debentures held by the warrant holders
such that the conversion price of the debentures is fixed at its current level.
No additional expense was required for the modification of the exercise price of
the warrants since the new fixed price of the warrants was equal to the original
exercise price at date of issuance or was equal to the then reset price in
effect for which we had previously recognized an expense for the modification.
Under the terms of the Reset Agreements, we and the warrant holders also agreed
to amend all of the agreements entered into between us and the warrant holders
that limit the ability of the warrant holders to be the beneficial owner of more
than 4.99% of our common stock to be amended to provide that the warrant holders
may not, through the exercise of warrants, the conversion of debentures, or
otherwise, be the beneficial owner of more than 9.99% of our common
stock.
 
 Under the
terms of the waiver agreements, the warrant holders agreed to amend their rights
under the terms of certain warrants held by each of them to receive a payment in
the event of a payment of a dividend by us. Prior to entering into the waiver
agreements, if at any time after the issuance date of the subject warrants, we
made any distributions to holders of our common stock, the warrant holders would
be entitled to receive a payment equal to the amount of such distribution which
would have been payable to them had they owned the shares of common stock
issuable upon exercise of the subject warrants as of the record date for the
distribution. Under the terms of the waiver agreement, if the market price of
our common stock on the record date for a distribution is greater than or equal
to $0.15 per share, the payment to the warrant holders would be reduced to the
amount which would be payable to the warrant holders had they engaged in a
cashless exercise of the subject warrants as of the record date for the
distribution. In consideration for entering into the agreements, we issued
warrants for the right to acquire 7,000,000 shares of our common stock to one
warrant holder and recognized a loss on debt extinguishment of $445,427 (see
Note 12).
 
 In
connection with a previous debt agreement, we entered into an Antidilution
Agreement (the “Antidilution Agreement”) with Swartz Private Equity, LLC
(“Swartz”) wherein we were obligated to issue to Swartz warrants equal to 11% of
the common stock issued between January 28, 2002 and March 11, 2002, 20% of the
common stock issued between March 12, 2002 and April 1, 2003, and after April 1,
2003, 30% of the common stock issued to any parties other than Swartz. There
were no warrants issued during the years ended May 31, 2007 or 2006 in
connection with the Antidilution agreement. On October 10, 2006, we entered into
an Approval Rights Agreement and Termination of Antidilution Agreement and
Addendum to Warrants (the “Termination Agreement”) with Swartz to terminate the
Antidilution Agreement. In consideration for entering into the Termination
Agreement, we agreed that through May 31, 2008 we would obtain Swartz’s written
approval at least 30 days prior to entering into (i) any acquisition of any
business entity or asset of any kind where the aggregate number of shares of
common stock and derivative securities (on a fully diluted basis) issued as
consideration for the acquisition equals or exceeds 10% of the number of shares
of our common stock outstanding at the time of the acquisition (on a fully
diluted basis) or (ii) any acquisition (regardless of size) by us of any
business entity or asset of any kind that is not unanimously approved by our
board of directors.
 
 F-30
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Stockholders’ Equity
(continued)
 
 At May
31, 2007, we had warrants outstanding to purchase 12,060,915 common shares at
exercise prices ranging from $0.02 to $1.00 per share, expiring at various dates
through 2012. Some of those outstanding warrants were not exercisable as of May
31, 2007 as they were subject to meeting vesting criteria. During the year ended
May 31, 2007, investors exercised warrants to purchase 1,272,500 shares of
common stock for proceeds of $172,250 and investors exercised warrants of
40,000,805 to purchase 38,681,396 shares of common stock on a cashless basis.
During the year ended May 31, 2007, 15,000 warrants expired and 1,319,409
warrants were cancelled due to cashless exercises.
 
 At May
31, 2008, we had warrants outstanding to purchase 300,000 common shares at
exercise prices ranging from $0.20 to $1.00 per share, expiring at various dates
through 2011.  During the year ended May 31, 2008, we issued no
warrants to purchase shares of common stock, an investor exercised warrants to
purchase 125,000 shares of common stock for proceeds of $6,250, 1,933,259
warrants expired or were cancelled due to cashless exercises, 3,700,000 warrants
were exercised utilizing the cashless method of exercise for 2,702,656 shares,
and we repurchased 7,000,000 warrants for $2,760,900 under terms of our warrant
repurchase agreement with Lincoln Ventures, LLC.
 
 On August
1, 2008, we issued a warrant to purchase 250,000 shares of our common stock for
$0.23 per share to our institutional investor relations firm.  The
warrant is subject to vesting provisions.
 
 The
following table presents outstanding warrants at May 31, 2008 and
2007:
 
 2008
              
              2007Issued
      in conjunction with:Convertible
      debentures
              
              
              -
              
              560,915Anti-dilution
      agreements
              
              
              -
              
              -Equity
      lines of credit
              
              
              -
              
              -Waiver
      agreements
              
              
              -
              
              7,000,000Other
              
              
              300,000
              
              4,500,000Total
      warrants outstanding
              
              
              300,000
              
              12,060,915
 
 1996 Stock Option
Plan
 
 Effective
March 1996, as amended, we adopted the 1996 Stock Option Plan. Under the 1996
Stock Option Plan, which expired March 24, 2006, options to purchase up to
4,000,000 shares of our common stock may be granted to either full or part time
employees, directors and our consultants at a price not less than the fair
market value on the date of grant for incentive stock options or not less than
85% of the fair market value on the date of grant for non-qualified stock
options. In the case of a significant stockholder, the option price of the share
is not less than 110 percent of the fair market value of the shares on the date
of grant. Any option granted under the 1996 Stock Option Plan must be exercised
within ten years of the date they are granted (five years in the case of a
significant stockholder). During the fiscal year ended May 31, 2006, we granted
options to purchase 50,000 shares of common stock at market value, under the
1996 Stock Option Plan. As of May 31, 2008, options to purchase 100,000 shares
of common stock are outstanding under the 1996 Stock Option Plan. The options
outstanding continue to be governed by the terms of the 1996 Stock Option
Plan.
 
 F-31
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Stockholders’
Equity (continued)
 
 2001 Stock Option
Plan
 
 The 2001
Stock Option Plan, which expires in February 2011, provides for the granting of
options to purchase up to 3,000,000 shares of our common stock to either full or
part time employees, directors and our consultants at a price not less than the
fair market value on the date of grant for incentive stock options or not less
than 85% of the fair market value on the date of grant for non-qualified stock
options. In the case of a significant stockholder, the option price of the share
is not less than 110 percent of the fair market value of the shares on the date
of grant. Any option granted under the 2001 Stock Option Plan must be exercised
within ten years of the date they are granted (five years in the case of a
significant stockholder). During the fiscal years ended May 31, 2008, 2007 and
2006, we granted options to purchase 699,000, 230,000 and 145,000 shares of our
common stock, respectively, at market value, under this plan. As of May 31,
2008, options to purchase 874,000 shares of common stock are outstanding under
the 2001 Stock Option Plan.
 
 2003 Stock Option
Plan
 
 The 2003
Stock Option Plan, which expires in 2013, provides for the granting of options
to acquire up to 6,000,000 shares of our common stock to either full or part
time employees, directors and our consultants at a price not less than the fair
market value on the date of grant for incentive stock options or not less than
85% of the fair market value on the date of grant for non-qualified stock
options. In the case of a significant stockholder, the option price of the share
is not less than 110 percent of the fair market value of the shares on the date
of grant. Any option granted under the 2003 Stock Option Plan must be exercised
within ten years of the date they are granted (five years in the case of a
significant stockholder). During the fiscal years ended May 31, 2008 and 2006,
we granted options to purchase 3,723,000 and 1,550,000 shares of our common
stock, respectively, at market value, under this plan. There were no grants made
under the 2003 Stock Option Plan during the fiscal year ended May 31, 2007. As
of May 31, 2008, options to purchase 2,973,000 shares of common stock are
outstanding under the 2003 Stock Option Plan.
 
 2006 Stock Option
Plan
 
 The 2006
Stock Option Plan, which expires in 2016, provides for the granting of options
to acquire up to 5,000,000 shares, with a limit of 3,000,000 Incentive Stock
Option (“ISO”) shares of our common stock to either full or part time employees,
directors and our consultants at a price not less than the fair market value on
the date of grant. In the case of a significant stockholder, the option price of
the share is not less than 110 percent of the fair market value of the shares on
the date of grant. Any option granted under the 2006 Stock Option Plan must be
exercised within ten years of the date they are granted (five years in the case
of a significant stockholder). On March 11, 2008 we amended our 2006 Stock
Option Plan to increase the total number of shares of our common stock issuable
under the plan from 5,000,000 to 7,000,000.  Shareholders will be
asked to ratify the amendment to the plan at our next annual
meeting.  During the fiscal years ended May 31, 2008, 2007 and 2006,
we granted options to purchase 2,203,000, 1,070,000 and 2,050,000 shares of our
common stock, respectively, under this plan, 200,000, 70,000 and 192,857 shares,
respectively, of which were ISOs. In connection with May 31, 2006 option grants,
we recognized compensation expense of $120,000 related to options granted below
the fair market value of our common stock at the date of grant. As of May 31,
2008, options to purchase 4,248,000 shares of common stock are outstanding under
the 2006 Stock Option Plan.
 
 On June
5, 2006, we issued options to acquire 1,500,000 shares of our common stock at a
per share price of $0.165 to an officer outside of the above referenced
plans.
 
 
 F-32
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Stockholders’
Equity (continued)
 
 A summary
of the status of our stock option plans and warrants as of May 31, 2008, 2007
and 2006 and changes during the years ended on those dates is presented
below:
  Options
              
              
              WarrantsShares
              
              
              Weighted
      Average Exercise Price
              
              
              Shares
              
              
              Weighted
      Average Exercise PriceOutstanding,
      June 1, 2005
              
              
              7,148,000
              
              
              $
              0.13
              
              
              
              109,122,581
              
              
              $
              0.04Granted
              
              
              3,795,000
              
              
              
              0.46
              
              
              
              12,457,049
              
              
              
              0.09Cancelled/Expired
              
              
              (1,387,000
              )
              
              
              0.30
              
              
              
              (13,391,727
              )
              
              
              0.05Repurchased
              
              
              -
              
              
              
              -
              
              
              
              (2,000,000
              )
              
              
              0.02Exercised
              
              
              (4,096,000
              )
              
              
              0.09
              
              
              
              (52,838,683
              )
              
              
              0.03Outstanding,
      May 31, 2006
              
              
              5,460,000
              
              
              
              0.34
              
              
              
              53,349,220
              
              
              
              0.05Granted
              
              
              2,800,000
              
              
              
              0.39
              
              
              
              -
              
              
              
              -Cancelled/Expired
              
              
              (500,000
              )
              
              
              0.09
              
              
              
              (1,334,409
              )
              
              
              0.03Exercised
              
              
              (515,000
              )
              
              
              0.08
              
              
              
              (39,953,896
              )
              
              
              0.03Outstanding,
      May 31, 2007
              
              
              7,245,000
              
              
              
              0.40
              
              
              
              12,060,915
              
              
              
              0.10Granted
              
              
              6,625,000
              
              
              
              0.43
              
              
              
              -
              
              
              
              -Cancelled/Expired
              
              
              (4,392,154
              )
              
              
              0.45
              
              
              
              (1,933,259
              )
              
              
              0.09Repurchased
              
              
              -
              
              
              
              -
              
              
              
              (7,000,000
              )
              
              
              0.08Exercised
              
              
              (1,282,846
              )
              
              
              0.15
              
              
              
              (2,827,656
              )
              
              
              0.12Outstanding,
      May 31, 2008
              
              
              8,195,000
              
              
              $
              0.44
              
              
              
              300,000
              
              
              $
              0.57Exercisable,
      May 31, 2006
              
              
              5,115,000
              
              
              $
              0.35
              
              
              
              52,849,220
              
              
              $
              0.05Exercisable,
      May 31, 2007
              
              
              7,245,000
              
              
              $
              0.40
              
              
              
              11,685,915
              
              
              $
              0.10Exercisable,
      May 31, 2008
              
              
              4,265,372
              
              
              $
              0.47
              
              
              
              300,000
              
              
              $
              0.57Weighted
      average fair value of options and warrants granted during the year ended
      May 31, 2006
              
              
              
              
              
              $
              0.49
              
              
              
              
              
              
              $
              0.19Weighted
      average fair value of options granted during the year ended May 31,
      2007
              
              
              
              
              
              $
              0.82
              
              
              
              
              
              
              $
              -Weighted
      average fair value of options granted during the year ended May 31,
      2008
              
              
              
              
              
              $
              0.32
              
              
              
              
              
              
              $
              -
 
 Included
in the above table are certain options and warrants for which vesting is
contingent based on various future performance measures.
  F-33
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Stockholders’
Equity (continued)
 
 The
following table summarizes information about stock options and warrants
outstanding at May 31, 2008:
 
 Range
      of
                Exercise
      Prices
              Outstanding
              ExercisableNumber
      Outstanding
              Weighted
                Average
      Remaining
                Contractual
      Life (Years)
              Weighted
                Average
                Exercise
      Price
              Number
                Exercisable
              Weighted
                Average
                Exercise
      PriceOptions
              $
      0.05-0.20
              1,350,000
              1.82
              $0.13
              1,350,000
              $0.130.30-0.50
              4,625,000
              4.66
              0.41
              695,372
              0.430.60-0.90
              2,220,000
              3.16
              0.68
              2,220,000
              0.68$
      0.05-0.90
              8,195,000
              3.79
              $0.44
              4,265,372
              $0.47Warrants
              $
      0.20-1.00
              300,000
              2.72
              $0.57
              300,000
              $0.57
 
 14.
Income Taxes
 
 The
provision (benefit) for income taxes is as follows for the years ended May
31:
 
 2008
              
              
              2007
              
              
              2006Current:Federal
              
              $
              12,540,914
              
              
              $
              -
              
              
              $
              -State
              
              
              3,973,734
              
              
              
              972,064
              
              
              
              -Total
      current
              
              
              16,514,648
              
              
              
              972,064
              
              
              
              -Deferred:Federal
              
              
              (7,615,720
              )
              
              
              7,767,761
              
              
              
              -State
              
              
              (2,472,899
              )
              
              
              2,015,208
              
              
              
              -Total
      deferred
              
              
              (10,088,619
              )
              
              
              9,782,969
              
              
              
              -Total
      provision
              
              $
              6,426,029
              
              
              $
              10,755,033
              
              
              $
              -
 
 No
provision for income taxes was recorded for the year ended May 31, 2006 due to
the significant net operating loss carryforwards.
 
 F-34
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Income
Taxes (continued)
 
 The
reconciliation of the effective income tax rate to the Federal statutory rate is
as follows for the years ended May 31:
 
 2008
              
              
              2007
              
              
              2006Statutory
      federal income tax rate
              
              
              35.0
              %
              
              
              34.0
              %
              
              
              34.0
              %State
      income tax rate, net of Federal effect
              
              
              6.1
              %
              
              
              5.7
              %
              
              
              -
              %Change
      in tax rate
              
              
              1.3
              %
              
              
              -
              %
              
              
              -
              %Change
      in deferred tax related to non cash compensation
              
              
              2.2
              %
              
              
              -
              %
              
              
              -
              %Foreign
      tax credit
              
              
              (3.7
              )
      %
              
              
              -
              %
              
              
              -
              %Other
              
              
              -
              %
              
              
              0.3
              %
              
              
              -
              %(Decrease)
      increase in valuation allowance
              
              
              (0.6
              )
      %
              
              
              (8.7
              )
      %
              
              
              (34.0
              )
      %Effective
      income tax rate
              
              
              40.3
              %
              
              
              31.0
              %
              
              
              -
              %
 
 Deferred
tax assets and liabilities reflect the net tax effect of temporary differences
between the carrying amount of asset and liabilities for financial reporting
purposes and amounts used for income tax purposes. Significant components of our
deferred tax assets are as follows as of May 31:
 
 2008
              
              
              2007Current
      deferred tax assets (liabilities):Net
      operating loss carryforwards
              
              $
              -
              
              
              $
              1,894,097Accruals
      and state taxes
              
              
              1,412,500
              
              
              
              376,257Basis
      difference in fixed assets
              
              
              -
              
              
              
              -Basis
      difference in intangibles
              
              
              -
              
              
              
              -Investment
      in affiliated companies
              
              
              -
              
              
              
              -Credits
              
              
              -
              
              
              
              242,411Less:
      valuation allowance
              
              
              (21,668
              )
              
              
              (72,790
              )Total
      net deferred tax asset
              
              
              1,390,832
              
              
              
              2,439,975Long-term
      deferred tax assets (liabilities):Investment
      in affiliated company
              
              
              (2,682,823
              )
              
              
              (14,128,084
              )Basis
      difference in fixed assets
              
              
              (1,918
              )
              
              
              (2,870
              )Basis
      difference in intangibles
              
              
              927,088
              
              
              
              1,072,117Stock
      based compensation expense
              
              
              235,779
              
              
              
              835,893Impairment
      of note receivable
              
              
              148,859
              
              
              
              -Deferred
      state taxes
              
              
              94,796
              
              
              
              -Other
      comprehensive loss
              
              
              163,227
              
              
              
              -Capital
      loss carryover
              
              
              29,811
              
              
              
              -Total
      net long-term deferred tax liability
              
              
              (1,085,181
              )
              
              
              (12,222,944
              )Net
      deferred tax asset (liability)
              
              $
              305,651
              
              
              $
              (9,782,969
              )
 
 
 F-35
 
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Income
Taxes (continued)
 
 At May
31, 2008, the $21,668 valuation allowance above relates entirely to SSDI as
management has not determined that it is more likely than not that the deferred
tax asset relating to various accruals will be realized.  For federal
and state tax purposes, SSDI is not consolidated with our corporate income tax
filings. SSDI is consolidated however, in the components of our net deferred tax
assets and liabilities as indicated above.
 
 During
fiscal year 2007, the valuation allowance of $2,872,255 relating to our deferred
tax assets was released as we determined that we would utilize our net operating
loss carryforwards and other deferred tax assets. For federal and state tax
purposes, SSDI is not consolidated with our corporate income tax filings. SSDI
is consolidated however, in the components of our net deferred tax assets and
liabilities as indicated above. The $72,790 valuation allowance above relates
entirely to SSDI as management has not determined that it is more likely than
not that the deferred tax asset relating to net operating loss carryforwards
will be realized.
 
 During
fiscal year 2008, we have utilized our remaining federal net operating loss
carryforward of approximately $4,870,000 and our general business credit
carryforward of $242,411.
 
 On June
1, 2007, we adopted FIN 48. This interpretation clarifies the application of
SFAS No. 109, Accounting for
Income Taxes, by defining criteria that an individual tax position must
meet for any part of the benefit of that position to be recognized in a
company’s financial statements and also provides guidance on measurement,
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure and transition.  The adoption of FIN 48 on June 1,
2007 did not result in any cumulative effect adjustment to retained
earnings.  Interest and penalties, if any, related to unrecognized tax
benefits are recorded in income tax expense.  As of June 1, 2007, we
are subject to U.S. Federal income tax examinations for the tax years May 31,
1991 through May 31, 2007, and we are subject to state and local income tax
examinations for the tax years May 31, 1999 through May 31, 2007 due to the
carryover of net operating losses from previous years.
 
 15.
Commitments and Contingencies
 
 Litigation
 
 Patent
Litigation
 
 On
February 8, 2008, the Company, TPL and Alliacense Ltd. were named as defendants
in three separate lawsuits filed in the United States District Court for the
Northern District of California by Asustek Computer, Inc., HTC Corporation, and
Acer, Inc., and affiliated entities of each of them. On February 13, 2008, the
Asustekclaims were
amended to include claims against MCM Portfolio, LLC (Alliacense and MCM
Portfolio are TPL-related entities), which do not involve the
Company.
 
 The Asustekcase seeks
declaratory relief that its products do not infringe enforceable claims of our
'336, '584 and '749 patents.  The Asustek case also seeks a
similar declaration with respect to two patents owned by TPL that are not a part
of the MMP Portfolio, and as such the Company is not engaged in this aspect of
the litigation and defense.  The Acer case seeks declaratory
relief that its products do not infringe enforceable claims of our '336, '584
and '749 patents.  The HTC case similarly seeks
declaratory relief that its products do not infringe enforceable claims of those
three patents and our '148 patent.
 
 On April
25, 2008, the Company and TPL filed five patent infringement lawsuits in the
Eastern District of Texas against HTC, Acer and Asustek.  These suits
allege infringement by HTC and Acer with respect to our '336 '749 '584 and '148
patents; and by Asustek with respect to our '336, '749 and '584
patents.  On June 4, 2008, the Company and TPL filed patent
infringement lawsuits against those parties in the Eastern District of Texas
with respect to our '890 patent of the MMP Portfolio.  Motions to
dismiss or transfer the Northern District of California actions to the Eastern
District of Texas are currently pending with hearings set for August 29, 2008 in
the Acer case and September 19, 2008 for the HTC and Asustek
 
 F-36
  Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Commitments
and Contingencies (continued)
 
 cases.  At
that point we expect to learn where the T-3 (“Acer, Asustek and HTC”) litigation
will proceed.  Responsive pleadings in those cases are due at varying
times in mid-August and early September 2008.  Similar to the actions
in the Northern District of California, the Asustek action in the Eastern
District of Texas is inclusive of matters with respect to two patents owned by
TPL that are not a part of the MMP Portfolio, and as such we are not engaged in
this aspect of the litigation and defense.
 
 Lowell
Giffhorn Arbitration
 
 On
September 23, 2005, Lowell Giffhorn, a former executive officer
and a former director of the Company, submitted a demand for arbitration with
the American Arbitration Association related to the termination of
Mr. Giffhorn's employment with the Company. Mr. Giffhorn asserted that
the termination of his employment with the Company was unlawful, retaliatory,
wrongful, violated public policy, violated the covenant of good faith and fair
dealing and violated securities laws. Mr. Giffhorn sought damages of
approximately $4,500,000 (excluding claims for punitive damages and attorney’s
fees). On November 1, 2007, the Company and Mr. Giffhorn reached a settlement
where Mr. Giffhorn was given $500,000 and 200,000 shares of restricted Company
stock in exchange for a comprehensive release of all claims against the
Company.  We have recorded these costs in selling, general and
administrative expenses for fiscal year ended May 31, 2008.
 
 401(k)
Plan
 
 We have a
retirement plan that complies with Section 401(k) of the Internal Revenue Code.
All employees are eligible to participate in the plan. We match 50% of each
participant’s voluntary contributions, subject to a maximum contribution of 6%
of the participant’s compensation. Participants vest 33% per year over a three
year period in our contributions. Our matching contributions during the fiscal
years ended May 31, 2008, 2007 and 2006 were $9,596, $11,397 and $1,833,
respectively.
 
 Employment
Contracts
 
 During
the quarter ended August 31, 2005, we terminated two of our officers, each of
whom had an employment contract with us. One of the officers agreed to accept as
severance approximately $150,000 and to have the maturity date of options held
by him extended for one year. Further, we agreed to accelerate the vesting of
all outstanding options held by the officer and to extend their term to June
2006. We recorded an expense of approximately $125,000 related to this option
modification in the year ended May 31, 2006.
 
 On June
5, 2007, Mr. Pohl, our outgoing chief executive officer retired. As a result, we
recorded a severance charge of $100,000 based on terms of his employment
agreement which provided for salary continuation.
 
 In
connection with Mr. Turley’s appointment as President and Chief Executive
Officer, and commencing on June 5, 2007, we entered into an employment
agreement with Mr. Turley for a one-year term.  Pursuant to the
agreement, if Mr. Turley was terminated without cause, he was entitled to his
then current salary level for the remaining term of his agreement conditional
upon the execution of a general release.  On February 28, 2008, Mr.
Turley resigned.  As a result, we recorded a one-time severance charge
of $95,192 during the fiscal year 2008 in full discharge of all remaining
obligations to Mr. Turley.
  In
connection with Mr. Flowers’ appointment as the Chief Financial Officer,
and commencing on September 17, 2007, we entered into an employment
agreement with Mr. Flowers for an initial 120-day term if not terminated
pursuant to the agreement, with an extension period of one year and on a
continuing basis thereafter.  Pursuant to the agreement, if
Mr. Flowers is terminated without cause or resigns with good reason within
the first two years of employment, he is entitled to receive an amount equal to
his annual base salary for the greater of (i) 6 months or (ii) the
period remaining in the extended one-year term.  If Mr. Flowers
is terminated without cause or resigns with good reason any time after two years
of continuous employment, he is entitled to receive an amount equal to 12 months
of his annual base salary.  Mr. Flowers is also entitled to
certain payments upon a change of control of the Company if the surviving
corporation does not retain him. All such payments are conditional upon the
execution of a general release.
  F-37
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Commitments
and Contingencies (continued)
 
 In
connection with Mr. Goerner’s appointment as Interim President and Chief
Executive Officer, and commencing on February 29, 2008 (the “Effective Date”),
we entered into an Employment Agreement (the “Agreement”) with Mr. Goerner,
terms of which were finalized May 19, 2008. The agreement is for an initial
120-day term if not terminated pursuant to the agreement, with an extension
period of one year and on a continuing basis thereafter.  Pursuant to
the Agreement, Mr. Goerner is to receive a base salary of $250,000 per year
and is eligible to receive a bonus of 100% of his base salary at the time his
position is converted by the Board of Directors to standing President/CEO or
nine months from the effective date of the agreement.  If Mr. Goerner
is terminated without cause during the nine month period after the effective
date he shall receive a pro-rata portion of the bonus based on the term of his
actual employment with us.  Also pursuant to the Agreement and on the
date of the Agreement, Mr. Goerner received a grant of incentive stock
options to purchase 250,000 shares of our common stock and non-qualified stock
options to purchase 50,000 shares of our common stock.  Mr. Goerner
also received a grant of non-qualified stock options to purchase 700,000 shares
of our common stock to vest upon conversion of his position to
standing President/CEO or nine months from the effective date of the agreement,
whichever is first to occur and Mr. Goerner also received a grant of
non-qualified stock options to purchase 2,000,000 shares of our common stock to
vest upon meeting performance conditions outlined in the grant.  The
Agreement also provides for Mr. Goerner to receive customary employee
benefits, including health, life and disability insurance, and an automobile
allowance.
 
 Pursuant
to the agreement, if Mr. Goerner is terminated without cause within the
first year of employment, after the initial 120-day term, he is entitled to
receive an amount equal to his base salaryfor the period remaining
in the agreement.  Payments are conditional upon the execution of a
general release.
 
 Guarantees and
Indemnities
 
 We have
made certain guarantees and indemnities, under which we may be required to make
payments to a guaranteed or indemnified party. We indemnify our directors,
officers, employees and agents to the maximum extent permitted under the laws of
the State of Delaware and California for SSDI. In connection with our facility
leases, we have indemnified our lessors for certain claims arising from the use
of the facilities. The duration of the guarantees and indemnities varies, and in
many cases is indefinite. These guarantees and indemnities do not provide for
any limitation of the maximum potential future payments we could be obligated to
make. Historically, we have not been obligated to make any payments for these
obligations and no liabilities have been recorded for these guarantees and
indemnities in the accompanying consolidated balance sheets.
 
 Operating
Leases
 
 We have a
non-cancelable operating lease agreement for our Carlsbad, California office
facility. Future minimum lease payments required under the operating lease are
$73,710 in fiscal year 2009. Rent expense for the fiscal years ended May 31,
2008, 2007 and 2006 was $113,734, $92,928 and $30,976,
respectively.
 
 SSDI
subleases their Carlsbad, California office facility which expired in June 2008
with a month-to-month option until not later than December
2008.  Future minimum lease payments required under the operating
lease are $7,351 in fiscal year 2009.  Rent expense for the fiscal
year ended May 31, 2008 and the fourth quarter of fiscal 2007 was $89,082 and
$15,138, respectively.
 
 SSDI
leases their Anaheim, California warehouse facility under a lease which expires
November 30, 2009.  Future minimum lease payments required under the
operating lease are $75,432 in fiscal year 2009 and $31,430 in fiscal year
2010.  Rent expense for the fiscal year ended May 31, 2008 and the
fourth quarter of fiscal 2007 was $58,800 and $14,700,
respectively.
 
 SSDI
subleases a  San Diego, California office facility under a lease which
began September 1, 2007 and expires August 31, 2008.  Future minimum
lease payments required under the operating lease are $4,500 in fiscal year
2009.  Rent expense for the fiscal year ended May 31, 2008 was
$13,500.
 
 
 F-38
 
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Commitments
and Contingencies (continued)
 
 Earn-Out
Agreement
 
 SSDI
entered into an earn-out agreement with a former debt holder of Holocom Networks
upon our contribution of the foreclosure sale collateral of Holocom Networks to
SSDI. The agreement required the former debt holder to release all of his rights
to any Holocom collateral in exchange for receiving 3% of the net sales (defined
as cash revenues actually received less credits or discounts and other claims of
customers) of SSDI’s protected distribution system products for a period of 48
months from the foreclosure sale date of February 2, 2007. The earn-out is to be
paid each calendar quarter.A liability for payment
under this agreement of $29,747 is included in accounts payable in the
accompanying consolidated balance sheet at May 31, 2008.  Amounts paid
under the earn-out agreement for the fiscal year ended May 31, 2008 and the
fourth quarter of fiscal 2007 were $62,570 and $6,783,
respectively.
 
 16.
Segment Information
 
 SSDI
began operations in February 2007 and we consolidated SSDI in our financial
statements in March 2007. SSDI is an operating segment under SFAS No. 131, Disclosures About Segments of an
Enterprise, as revenue is 10% or more of the total revenue of all
operating segments.
 
 SSDI is
engaged in the business of developing and manufacturing network-security
hardware to government, military, and other high-security facilities. There is
no inter-segment revenue and the accounting policies for segment reporting are
the same as for us as a whole.
 
 The “all
other” category includes the results for Patriot Scientific
Corporation.
 
 Operating
segment net revenue, operating income (loss) and income (loss) before taxes for
each of the years ended May 31 were as follows:
 
 2008
              
              
              2007
              
              
              2006Net
      revenue:SSDI
              
              $
              3,649,898
              
              
              $
              558,484
              
              
              $
              -All
      other
              
              
              58,320
              
              
              
              80,300
              
              
              
              10,309,709Total
      net revenue
              
              $
              3,708,218
              
              
              $
              638,784
              
              
              $
              10,309,709Operating
      income (loss):SSDI
              
              $
              146,131
              
              
              $
              (176,432
              )
              
              $
              -All
      other
              
              
              (5,749,624
              )
              
              
              (14,587,407
              )
              
              
              3,911,640Total
      operating income (loss)
              
              $
              (5,603,493
              )
              
              $
              (14,763,839
              )
              
              $
              3,911,640
 
 2008
              
              
              2007
              
              
              2006Income
      (loss) before taxes:SSDI
              
              $
              297,235
              
              
              $
              (169,913
              )
              
              $
              -All
      other
              
              
              15,632,521
              
              
              
              34,616,133
              
              
              
              28,672,688Total
      income (loss) before taxes
              
              $
              15,929,756
              
              
              $
              34,446,220
              
              
              $
              28,672,688
 
 
 F-39
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Segment
Information (continued)
 
 All sales
were to unaffiliated customers within the United States.
 
 Sales and
accounts receivable concentration information for SSDI for the years ended May
31 were as follows:
  2008
              2007Sales
              %
      of sales
              %
      of A/R
              Sales
              %
      of sales
              %
      of A/RAnixter
              $1,354,494
              37%
              16%
              $461,494
              85%
              85%Graybar
      Electric Company, Inc.
              $889,724
              24%
              38%
              -----
              ----
              -----Victory
      Global Solutions
              $370,301
              10%
              6%
              -----
              ----
              -----
 
 Operating
segment depreciation and amortization for each of the years ended May 31and
total assets at May 31 were as follows:
 
 2008
              
              
              2007
              
              
              2006Depreciation
      and amortization:SSDI
              
              $
              21,877
              
              
              $
              22,740
              
              
              $
              -All
      other
              
              
              28,828
              
              
              
              42,121
              
              
              
              59,415Total
      depreciation and amortization
              
              $
              50,705
              
              
              $
              64,861
              
              
              $
              59,415
 
 
 2008
              
              
              2007Total
      assets:SSDI
              
              $
              1,383,941
              
              
              $
              642,871All
      other
              
              
              24,047,961
              
              
              
              33,771,758Total
      assets
              
              $
              25,431,902
              
              
              $
              34,414,629
 
 17.
Subsequent Events
 
 During
the period June 1, 2008 through August 8, 2008, we purchased 1,966,160 shares of
our common stock at an aggregate cost of $400,906 pursuant to our stock buyback
program.
 
 On June
1, 2008, SSDI assigned its note receivable of $50,000 to us and we agreed to
reduce the amount of our line of credit with SSDI by the amount of the
note.  On June 26, 2008, we were paid in full by the third party
debtor.
 
 On June
18, 2008, we gave SSDI notice under terms of the line of credit that we would
not be extending the maturity date by the additional twelve month period
provided for in the line of credit. As a result, the line of credit will
terminate, and full payment of any outstanding balance will be due on September
27, 2008.
 
 During
June 2008, we obtained a credit facility, for as long as needed, which provides
for financing up to 50% of the par value balance of our outstanding auction rate
securities. The facility is collateralized by the full value of the outstanding
auction rate securities, required no origination fee, and if drawn upon will
bear interest at the federal funds rate plus 3%.
 
 On July
11, 2008, we invested approximately $149,000 to purchase preferred
shares of an unrelated private company which is a networking provider of
software to facilitate the transfer of video content to mobile
devices.  We are accounting for our investment using the cost method
as we do not own any of the voting common stock of the company.
 
 F-40
 Patriot
Scientific Corporation
 Notes
to Consolidated Financial Statements (Continued)
 
 Subsequent
Events (continued)
 
 During
July 2008, SSDI obtained a credit facility for up to $300,000 from a third
party, at an interest rate based on the Wall Street Journal Prime plus 1%
(floating) with a floor of 6%.  The credit facility term extends to
May 1, 2009, and is guaranteed by Patriot.
 
 On August
1, 2008, we increased our investment in Talis to 37.4% as a result of purchasing
additional shares offered by Talis, as well as acquiring shares from minority
shareholders which included the acquisition of all Talis shares previously held
by SSDI. The acquisition of Talis shares previously owned by SSDI was made for
$100,000 in cash and a reduction on their outstanding line of credit of
$219,000. After the purchase of SSDI’s Talis shares and the June 1 assignment of
the $50,000 note receivable from SSDI, SSDI’s outstanding balance on its Patriot
line of credit was reduced to $131,000.
 
 On August
1, 2008, SSDI paid $56,000 on its Patriot line of credit reducing the principal
balance to $75,000.
 
 On August
1, 2008, we issued a warrant to purchase 250,000 shares of our common stock for
$0.23 per share to our institutional investor relations firm.  The
warrant is subject to vesting provisions.
 
 On August
4, 2008, we announced our intent to acquire Crossflo for $10 million comprised
of cash and stock with an effective completion date of September 1, 2008,
subject to approval by Crossflo’s shareholders.
 
 On August
8, 2008, we purchased a secured convertible promissory note with an attached
warrant for common stock from Crossflo with a face amount of
$417,750.  Terms of the note are the same as those outlined in Note
4.
   F-41
 Phoenix
Digital Solutions, LLC
 
 
 INDEX
TO FINANCIAL STATEMENTS
 
 
 PageReport
      of Independent Registered Public Accounting Firm
              
              F-43Financial
      Statements:Balance
      Sheets
              
              F-44Statements of
      Income
              
              F-45Statements of
      Members’ Equity
              
              F-46Statements
      of Cash Flows
              
              F-47Notes
      to Financial Statements
              
              F-48
  
 F-42
 REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 To the
Members
 Phoenix
Digital Solutions, LLC
 
 We have
audited the accompanying balance sheets of Phoenix Digital Solutions, LLC (the
"Company") as of May 31, 2008 and 2007, and the related statements of income,
members' equity and cash flows for each of the years in the three-year period
ended May 31, 2008. 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. The Company is not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting.  Our audits included consideration of
internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the Company's internal control
over financial reporting.  Accordingly, we express no such opinion. 
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 financial statements referred to above, present fairly, in all
material respects, the financial position of Phoenix Digital Solutions, LLC as
of May 31, 2008 and 2007, and the results of its operations and its cash
flows for each of the years in the three-year period ended May 31, 2008 in
conformity with accounting principles generally accepted in the United States of
America.
 
 
 /s/ KMJ
Corbin & Company LLP
 Irvine,
California
 August
14, 2008
 
 F-43
 Phoenix
Digital Solutions, LLC
 Balance
Sheets
 
 
 May
      31,
              
              2008
              
              
              2007ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              8,260,288
              
              
              $
              6,989,847Prepaid
      expenses
              
              
              -
              
              
              
              175,000Total
      current assets
              
              $
              8,260,288
              
              
              $
              7,164,847LIABILITIES
      AND MEMBERS’ EQUITYCurrent
      liabilities:Accounts
      payable
              
              $
              3,204,519
              
              
              $
              1,225,118Accrued
      expenses
              
              
              -
              
              
              
              160,000Income
      tax payable
              
              
              11,790
              
              
              
              11,790Total
      current liabilities
              
              
              3,216,309
              
              
              
              1,396,908Commitments
      and ContingenciesMembers’
      equity
              
              
              5,043,979
              
              
              
              5,767,939Total
      liabilities and members’ equity
              
              $
              8,260,288
              
              
              $
              7,164,847
 
 
 See
accompanying notes to financial statements.
  F-44
 Phoenix
      Digital Solutions, LLC
 Statements
of Income
 
 
 Years
      Ended May 31,
              
              2008
              
              
              2007
              
              
              2006License
      revenues
              
              $
              59,282,971
              
              
              $
              110,878,985
              
              
              $
              60,000,000Operating
      expenses:General
      and administrative
              
              
              18,627,032
              
              
              
              12,189,575
              
              
              
              4,486,955Operating
      income
              
              
              40,655,939
              
              
              
              98,689,410
              
              
              
              55,513,045Other
      income:Interest
      income
              
              
              216,902
              
              
              
              421,407
              
              
              
              183,682Income
      before income taxes
              
              
              40,872,841
              
              
              
              99,110,817
              
              
              
              55,696,727Provision
      for income taxes
              
              
              11,790
              
              
              
              11,790
              
              
              
              -Net
      income
              
              $
              40,861,051
              
              
              $
              99,099,027
              
              
              $
              55,696,727
 
 See
accompanying notes to financial statements.
  F-45
 Phoenix
Digital Solutions, LLC
 Statements
of Members’ Equity
 
 
 Balance
      June 1, 2005
              
              $
              -Contributions
              
              
              4,000,000Net
      income
              
              
              55,696,727Distributions
              
              
              (52,064,781
              )Balance
      May 31, 2006
              
              
              7,631,946Contributions
              
              
              -Net
      income
              
              
              99,099,027Distributions
              
              
              (100,963,034
              )Balance
      May 31, 2007
              
              
              5,767,939Contributions
              
              
              -Net
      income
              
              
              40,861,051Distributions
              
              
              (41,585,011
              )Balance
      May 31, 2008
              
              $
              5,043,979
 
 
 See
accompanying notes to financial statements.
  F-46
 Phoenix
Digital Solutions, LLC
 Statements
of Cash Flows
 
 
 Years
      Ended May 31,
              
              2008
              
              
              2007
              
              
              2006Operating
      activities:Net
      income
              
              $
              40,861,051
              
              
              $
              99,099,027
              
              
              $
              55,696,727Adjustments
      to reconcile net income to net cash provided by operating
      activities:Changes
      in operating assets and liabilities:Prepaid
      expenses
              
              
              175,000
              
              
              
              (160,000
              )
              
              
              (15,000
              )Accounts
      payable and accrued expenses
              
              
              1,819,401
              
              
              
              1,236,356
              
              
              
              148,762Income
      tax payable
              
              
              -
              
              
              
              11,790
              
              
              
              -Net
      cash provided by operating activities
              
              
              42,855,452
              
              
              
              100,187,173
              
              
              
              55,830,489Financing
      activities:Contributions
      from members
              
              
              -
              
              
              
              -
              
              
              
              4,000,000Distributions
      to members
              
              
              (41,585,011
              )
              
              
              (100,963,034
              )
              
              
              (52,064,781
              )Net
      cash used in financing activities
              
              
              (41,585,011
              )
              
              
              (100,963,034
              )
              
              
              (48,064,781
              )Net
      increase (decrease) in cash and cash equivalents
              
              
              1,270,441
              
              
              
              (775,861
              )
              
              
              7,765,708Cash and cash equivalents,beginning of year
              
              
              6,989,847
              
              
              
              7,765,708
              
              
              
              -Cash
      and cash equivalents, end of year
              
              $
              8,260,288
              
              
              $
              6,989,847
              
              
              $
              7,765,708Supplemental
      Disclosure of Cash Flow InformationCash
      payments for income taxes
              
              $
              12,590
              
              
              $
              13,390
              
              
              $
              12,590
 
 
 See
accompanying notes to financial statements.
  F-47
 Phoenix
Digital Solutions, LLC
 Notes
to Financial Statements
 
 
 1.
Organization and Business
 
 Phoenix
Digital Solutions, LLC (the “Company”) is a Delaware limited liability company
organized on June 7, 2005. Through a commercialization agreement dated June 7,
2005, the Company holds the rights to certain patents of its members. The
Company receives license fees from license agreements entered into between
licensees and a member of the Company and distributes license fee proceeds to
its members.
 
 2.
Summary of Significant Accounting Policies
 
 Limited
Liability Company Operating Agreement
 As a
limited liability company, each member’s liability is limited to the capital
invested. Allocation of profits, losses and distributions is in accordance with
the terms as defined in the operating agreement.
 
 The
Company is treated as a partnership for federal income tax purposes.
Consequently, federal income taxes are not payable by the Company. The Company’s
net income or loss is allocated among the members in accordance with the
operating agreement of the Company and members are taxed individually on their
share of the Company’s earnings. The State of California assesses a limited
liability company a fee based on the Company’s income in addition to a flat
limited liability company tax.  Accordingly the financial statements
reflect a provision for these California taxes.
 
 Use
of Estimates
 The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts and disclosures.
Accordingly, actual results could differ from those estimates.
 
 Revenue
Recognition
 The
Company recognizes revenue upon receipt of the license proceeds from the
licensee at which time all obligations of the Company have been performed under
the license agreements.
 
 Cash
Equivalents
 The
Company considers all highly liquid investments with a maturity of three months
or less at the date of acquisition to be cash equivalents.
 
 Financial
Instruments and Concentrations
 Financial
instruments that potentially subject the Company to concentrations of credit
risk consist principally of cash and cash equivalents.
 
 Credit
Risk
 
 The
Company’s balance of cash maintained with its bank exceeds the Federal Deposit
Insurance Corporation’s insured limit of $100,000. The Company limits its
exposure of loss by maintaining its cash with financially stable financial
institutions.
 
 Intellectual Property
Rights
 
 The
Company relies on a combination of patents, trademarks, copyrights, trade secret
laws, confidentiality procedures and licensing arrangements to protect its
intellectual property rights. The Company currently has seven U.S. patents, one
European patent, and one Japanese patent issued. A successful challenge to its
ownership of the technology or the proprietary nature of the intellectual
property would materially damage the Company’s business prospects. Any issued
patent may be challenged and invalidated.
  F-48
 Phoenix
Digital Solutions, LLC
 Notes
to Financial Statements (Continued)
 
 3.
Formation and Commercialization Agreement
 
 The
Company has two members: Technology Properties Limited Inc. (“TPL”), and Patriot
Scientific Corporation (“PTSC”). Each member owns 50% of the membership
interests of the Company. Each member has the right to appoint one member of the
three member management committee. The two appointees are required to select a
mutually acceptable third member of the management committee. Pursuant to the
LLC Agreement, the members agreed to establish a working capital fund for the
Company of $4,000,000, of which each member contributed $2,000,000. The working
capital fund increases to a maximum of $8,000,000 as license revenues are
achieved. The members are obligated to fund future working capital requirements
at the discretion of the management committee of the Company in order to
maintain working capital of not more than $8,000,000. Neither member is required
to contribute more than $2,000,000 in any fiscal year. Distributable cash and
allocation of profits and losses will be allocated to the members in the
priority defined in the LLC Agreement.
 
 On June
7, 2005, the Company entered into a Commercialization Agreement with TPL and
PTSC. This Commercialization Agreement allows TPL to commercialize the patent
portfolio by entering into settlement and/or license agreements, suing in the
name of TPL, PTSC, the Company and Charles Moore, and manage the use of the
patent portfolio by third parties.
 
 Under
terms of the Commercialization Agreement, the Company is required to pay a
quarterly amount ranging between $500,000 and $1,000,000 (based upon a
percentage of the working capital fund balance) to TPL for TPL’s supporting
efforts to secure licensing agreements for the Company. During the years ended
May 31, 2008, 2007 and 2006, the Company paid $2,952,362, $3,871,602 and
$2,500,000, respectively, to TPL pursuant to the agreement. The Company is also
required to reimburse TPL for payment of all legal and third-party expert fess
and other related third party costs and expenses. During the years ended May 31,
2008, 2007 and 2006, the Company paid $12,894,053, $5,914,000 and $1,021,357,
respectively, to TPL pursuant to the agreement.  All of the amounts
are recorded in general and administrative expense in the accompanying
statements of income.
 
 4.
Commitments and Contingencies
 
 Guarantees and
Indemnities
 
 Under the
LLC Operating Agreement, the Company indemnifies its members, managers, officers
and employees from any damages and liabilities by reason of their management or
involvement in the affairs of the Company as long as the indemnitee acted in
good faith and in the best interests of the Company.
 
 Under the
Commercialization Agreement, the Company and PTSC hold harmless TPL and its
representatives with respect to all claims of any nature by or on behalf of the
Company and PTSC related to the preparation, execution and delivery of the
Commercialization Agreement.
 
 The
duration of the guarantees and indemnities varies, and in many cases is
indefinite. These guarantees and indemnities do not provide for any limitation
of the maximum potential future payments the Company could be obligated to make.
Historically, the Company has not been obligated to make any payments for these
obligations and no liabilities have been recorded for these guarantees and
indemnities in the accompanying balance sheets.
 
 5.
Related Party Transactions
 
 At May
31, 2008, PDS had accounts payable balances of approximately $3,197,000 and
$7,500 to TPL and PTSC, respectively.
 
 F-49
 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:
      August 14, 2008
              PATRIOT
      SCIENTIFIC CORPORATION
                
                /S/ FREDERICK C. GOERNER
                Frederick
      C. Goerner
                President
      and Chief Executive Officer
 
 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/ FREDERICK C. GOERNER
                Frederick
      C. Goerner
              
              President
      and Chief Executive Officer
              August
      14, 2008/S/ CLIFFORD L. FLOWERS
                Clifford
      L. Flowers
              
              Chief
      Financial Officer and Principal Accounting Officer
              August
      14, 2008/S/ CARLTON M. JOHNSON
                Carlton
      M. Johnson
              
              Director
              August
      14, 2008/S/ GLORIA H. FELCYN
                Gloria
      H. Felcyn
              
              Director
              August
      14, 2008/S/ HELMUT FALK, JR
                Helmut
      Falk, Jr.
              
              Director
              August
      14, 2008/S/ HARRY L. TREDENNICK
                Harry
      L. Tredennick
              
              Director
              August
      14, 2008/S/ DONALD E. SCHROCK
                Donald
      E. Schrock
              
              Director
              August
      14, 2008