U.S.
      SECURITIES AND EXCHANGE COMMISSION


Washington,
      D.C. 20549





**FORM
      10-KSB**





(Mark
      One)


x
              ANNUAL
                  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                  OF 1934FOR
                  THE FISCAL YEAR ENDED MAY 31, 2006o
              TRANSITION
                  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                  OF 1934For
                  the transition period from ___________ to
                  _______________Commission
                  File Number
                  0-22182




**PATRIOT
      SCIENTIFIC CORPORATION**


(Name
      of
      small business issuer 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)





(Issuer’s
      telephone number): (760) 547-2700





Securities
      registered under Section 12(b) of the Exchange Act: NONE





Securities
      registered under Section 12(g) of the Exchange Act:





Common
      Stock, $.00001 par value


(Title
      of
      Class)





Check
      whether the issuer (1) filed all reports required to be filed by
      Section 13 or 15(d) of the Exchange Act during the past 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
oNO
x




Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B contained in this form, and no disclosure will be contained,
      to
      the best of the registrant’s knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-KSB or any
      amendment to this Form 10-KSB. o


Issuers
        revenues for its most recent fiscal year was $10,309,709 (which amount does
        not
        include approximately $27,848,000 in income resulting from the Companys
        investment in Phoenix Digital Solutions, LLC). Issuers net income for its
        most
        recent fiscal year was $28,672,688.




The
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates of the registrant on October 2, 2006 was $321,496,396 based
      on a
      closing price of $0.87 as reported on the OTC Electronic Bulletin Board
      system.




On
      October 2, 2006, 369,536,087 shares of common stock, par value $.00001 per
      share
      (the issuer’s only class of voting stock) were outstanding.




Documents
      Incorporated By Reference: None.




Transitional
      Small Business Disclosure Format (check one): YES o NO x




1





**TABLE
      OF CONTENTS**


**PART
                  I**
              
              **5**ITEM
                  1.
              DESCRIPTION
                  OF BUSINESS
              5ITEM
                  2.
              DESCRIPTION
                  OF PROPERTY
              11ITEM
                  3.
              LEGAL
                  PROCEEDINGS
              11ITEM
                  4.
              SUBMISSION
                  OF MATTERS TO A VOTE OF SECURITY HOLDERS
              12**PART
                  II**
              
              **13**ITEM
                  5.
              MARKET
                  FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
                SMALL
                  BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES
              13ITEM
                  6.
              MANAGEMENT’S
                  DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
              14ITEM
                  7.
              FINANCIAL
                  STATEMENTS
              21ITEM
                  8.
              CHANGES
                  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
                AND
                  FINANCIAL DISCLOSURE
              21ITEM
                  8A.
              CONTROLS
                  AND PROCEDURES
              21ITEM
                  8B.
              OTHER
                  INFORMATION
              23**PART
                  III**
              
              **23**ITEM
                  9.
              DIRECTORS,
                  EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
                COMPLIANCE
                  WITH SECTION 16(a) OF THE EXCHANGE ACT
              23ITEM
                  10.
              EXECUTIVE
                  COMPENSATION
              26ITEM
                  11.
              SECURITY
                  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
                AND
                  RELATED STOCKHOLDER MATTERS
              28ITEM
                  12.
              CERTAIN
                  RELATIONSHIPS AND RELATED TRANSACTIONS
              29ITEM
                  13.
              EXHIBITS
              29ITEM
                  14.
              PRINCIPAL
                  ACCOUNTANT FEES AND SERVICES
              37**INDEX
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
              **F1**




2





CAUTIONARY
      NOTE REGARDING FORWARD-LOOKING STATEMENTS




This
      Annual Report on Form 10-KSB, 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 absence of
      significant revenues and financial resources until the current fiscal year,
      no
      guarantee that the development of technology can be completed or that its
      completion will not be delayed, significant competition, 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. Patriot undertakes 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.** **DESCRIPTION
      OF BUSINESS**




**The
      Company**




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 1997, we emerged from the
      development stage, primarily as a result of the acquisition of Metacomp Inc.
      In
      June 2005, we entered into a joint venture agreement with Technology Properties
      Limited, Inc. to form Phoenix Digital Solutions, LLC. Our address is 6183 Paseo
      Del Norte, Suite 180, Carlsbad, California 92011, and our telephone number
      is (760) 547-2700. Our internet home page can be located on the World Wide
      Web
      at http://www.ptsc.com.




We
      are an
      intellectual property company holding various patents (described below). Our
      primary strategy is to exploit our microprocessor technologies through licensing
      and strategic alliances and to litigate against those who may be infringing
      on
      our patents. We also sell microprocessor chips from our suspended Ignite product
      line.




**Our
      Microprocessor Technology**




General
      Background .
      Effective May 31, 1994, we entered into an asset purchase agreement and
      plan of reorganization with nanoTronics Corporation located in Eagle Point,
      Oregon, and Helmut Falk to acquire certain microprocessor technology.
      nanoTronics had acquired a base technology for an advanced microprocessor
      integrated on a single computer chip and had fabricated a first-generation
      microprocessor. We used the technology we acquired from nanoTronics to develop
      a
      sophisticated yet low cost microprocessor by enhancing the microprocessor
      design, adding additional technical features to further modernize the design,
      and improving and testing the new design.




We
      initially fabricated a prototype 0.8-micron microprocessor in May 1996. The
      next generation was a 0.5-micron microprocessor that was delivered in
      September 1997. The 0.5-micron microprocessor was employed in
      demonstrations for prospective customers and was shipped in limited numbers
      to
      customers as an embedded microprocessor. In 1998 we introduced a 0.35-micron
      microprocessor whose features included a reduction in size and improved
      performance. In addition, in September 2000 we completed a VHDL model of
      this technology, which enabled customers to purchase intellectual property
      incorporating microprocessor functions with other parties’ applications to
      arrive at a system on a chip solution. By purchasing this software model,
      customers could significantly reduce their time to market by simulating results
      as opposed to trial and error commitments to silicon production. In 2003 we
      further reduced the size of our silicon production to 0.18-microns.




Industry
      Background .
      The
      semiconductor logic market has three major sectors:




·
            standard
                logic products;


·
            application
                specific standard products; and


·
            application
                specific integrated circuits.





Standard
      logic products, such as the Intel’s X86 and Pentium and Motorola’s 680X0
      microprocessor families, are neither application nor customer specific. They
      are
      intended to be utilized by a large group of systems designers for a broad range
      of applications. Because they are designed to be used in a broad array of
      applications, they may not be cost effective for specific applications.
      Application specific integrated circuits are designed to meet the specific
      application of one customer. While cost effective for that application,
      application specific integrated circuits require large sales volumes of that
      application to recover their development costs. Application specific standard
      processors are developed for one or more applications but are not generally
      proprietary to one customer. Examples of these applications include modems,
      cellular telephones, other wireless communications devices, multimedia
      applications, facsimile machines and local area networks. We have designed
      our
      microprocessor to be combined with application specific software to serve as
      an
      embedded control product for the application specific standard processor market
      sector.




Application
      specific standard processors are typically used in embedded control systems
      by
      manufacturers to provide an integrated solution for application specific control
      requirements. Such systems usually contain a microprocessor or microcontroller,
      logic circuitry, memory and input/output circuitry. Electronic system
      manufacturers combine one or more of these elements to fit a specific
      application. The microprocessor provides the intelligence to control the system.
      The logic circuitry provides functions specific to the end application. The
      input/output circuitry may also be application specific or an industry standard
      component. The memory element, if not on the microprocessor, is usually a
      standard product used to store program instructions and data. In the past,
      these
      functions have been executed through multiple integrated circuits assembled
      on a
      printed circuit board. The requirements for reduced cost and improved system
      performance have created market opportunities for semiconductor suppliers to
      integrate some or all of these elements into a single application specific
      standard processor or chip set, such as our Ignite family of microprocessors.
      The Ignite family provides close integration of the microprocessor and
      input/output function with the logic circuitry, thereby providing an advanced
      application specific standard processor.




4




Embedded
      control systems enable manufacturers to differentiate their products, replace
      less efficient electromechanical control devices, add product functionality
      and
      reduce product costs. In addition, embedded control systems facilitate the
      emergence of completely new classes of products. Embedded control systems have
      been incorporated into thousands of products and subassemblies worldwide,
      including automotive systems, remote controls, appliances, portable computers
      and devices, cordless and cellular telephones, motor controls and many other
      systems.




Microprocessors
      are generally available in 4-bit through 64-bit architectures, which refers
      to
      the amount of data they can process. 4-bit microprocessors are relatively
      inexpensive, typically less than $1.00 each. Although they lack certain
      performance capabilities and features, they account for more than 40% of
      worldwide microcontroller sales volume. Also in general use today are 8-bit
      architectures, generally costing $1.00 to $10.00 each and accounting for an
      additional 40% of worldwide microcontroller sales volume. To date 16-bit, 32-bit
      and 64-bit architectures, with typical costs of over $10.00 each, have offered
      very high performance but are generally considered to be too expensive for
      most
      high-volume embedded control applications. The use of 16-bit, 32-bit and 64-bit
      architectures offers fewer internal limitations, making programming easier
      and
      providing higher performance. Although generally more expensive per unit and
      requiring more support logic and memory, these devices offer many advantages
      for
      more sophisticated embedded control systems.




Electronic
      system designers, driven by competitive market forces, seek semiconductor
      products with more intelligence, functionality and control that can be used
      to
      reduce system costs and improve performance. For these needs, the Ignite product
      family was designed to be a sophisticated 32-bit microprocessor with advanced
      features. The Ignite product family uses a smaller number of transistors
      compared to other RISC (reduced instruction set computer) processors, which
      results in less power consumption and more economical prices compared to other
      embedded control applications. This creates the opportunity for the development
      of new, cost-effective applications.




Technology
      Description .
      Conventional high-performance microprocessors are register-based with large
      register sets. These registers are directly addressable storage locations
      requiring a complex architecture that consumes costly silicon. This conventional
      architecture provides processing power for computer applications but complicates
      and slows the execution of individual instructions and increases silicon size,
      thereby increasing the microprocessor cost.




Our
      technology is different from most other microprocessors, in that the data is
      stored in groups and certain information is known to be at the top of a stack
      as
      opposed to being stored in a register. Our microprocessor employs certain
      features of both register and stack designs. The resultant merged stack-register
      architecture improves program execution for a wide range of embedded
      applications. Our design combines two processors in one highly integrated
      package, a microprocessing unit for performing conventional processing tasks,
      and an input-output processor for performing input-output functions. This
      replaces many dedicated peripheral functions supplied with other processors.
      The
      microprocessor's design simplifies the manipulation of data. Our architecture
      employs instructions that are shrunk from 32-bits to 8-bits. This simplified
      instruction scheme improves execution speed for computer instructions. Our
      architecture incorporates many on-chip system functions, thus eliminating the
      requirement of support microprocessors and reducing system cost to
      users.




The
      0.8-micron microprocessor was designed to operate at a speed of 50Mhz; the
      0.5-micron microprocessor at a speed of 100Mhz; the 0.35-micron microprocessor
      at 150MHz; and the 0.18-micron operates at a speed of 360Mhz. They are all
      compatible with a wide range of memory technology from low cost dynamic random
      access memory to high-speed static random access memory. The microprocessors
      can
      be packaged in various surface-mount and die-form packaging. We cannot be
      certain that the designed speed will be achieved with the production model
      of
      the 0.18-micron microprocessor or future versions or that all of the desired
      functions will perform as anticipated.




Our
      technology is not designed or targeted to compete with high-end processors
      for
      use in personal computers. It is targeted for embedded control applications.
      We
      believe that the features described above differentiate the Ignite family from
      other 8-bit to 64-bit microprocessors targeted for embedded control
      applications. Considering the reduced requirement for support microprocessors,
      the Ignite family is intended to be available at a high volume price that should
      be price competitive with high-end 8-bit microprocessor and general 16-bit
      microprocessor systems but with higher performance (speed and functional
      capability). The Ignite family has been designed to allow high-speed and
      high-yield fabrication using generally available wafer fabrication technology
      and facilities.




5




The
      Ignite Microprocessor as a Java Processor .
      We
      believe the Ignite microprocessor architecture is capable of being an efficient
      and cost effective Java programming language processor, because Java is designed
      to run on a stack-oriented architecture and the Ignite architecture executes
      the
      virtual stack machine internal to Java efficiently. Many Java byte codes or
      instructions require only a single 8-bit Ignite family instruction to be
      executed, providing a performance advantage over other more expensive processors
      that require six or more 32-bit instructions to do the same task. This feature
      allows the execution of Java programs with increased speed and reduced code
      size
      thereby enabling lower system memory costs. In addition, the incorporation
      of
      many on-chip system functions is expected to allow the Ignite family to perform
      most of the other functions required of an Internet computer device or Java
      accelerator, thereby eliminating components. Since Internet computers are
      designed to be inexpensive appliances for Internet access, cost, speed and
      performance are expected to be key requirements for designers. We believe the
      Ignite technology can compete favorably on the basis of such requirements,
      although we may not be able to successfully exploit Java related applications
      or
      that competitors will not create superior Java processors.




We
      have
      ported the Java operating environment to the Ignite family, which currently
      uses
      the C programming language for software support. We are a licensee of Sun
      Microsystems Inc. This enables us to develop and distribute products based
      on
      Sun's personalJava, a platform on which to run Java applications. We have also
      licensed from Wind River an operating system, VxWorks, and entered into a
      relationship with Forth Inc. (Forth) whereby Forth will provide software support
      and operating system development tools for the Forth Programming language.
      We
      believe this solution is competitive in the Java virtual machine and embedded
      applications markets. We believe that, if the implementation is successfully
      completed, the Ignite family will be competitive with Java microprocessors
      announced by competitors. However, we do not know whether implementation of
      this
      package of software or of a market for an Ignite family Java microprocessor
      will
      be successful.




Stages
      of Development .
      In
      early 1994, nanoTronics initiated production of a first generation of wafers
      at
      a contract fabrication facility using 6 inch wafers employing 0.8-micron
      double-metal CMOS technology. After the May 31, 1994 acquisition, we improved
      the original design, added new features and performed simulations and tests
      of
      the improved designs. In October 1995, a run of six wafers of second generation
      0.8-micron microprocessors was fabricated by a contract fabrication facility.
      Subsequently, we tested these microprocessors, while completing a C computer
      language compiler and preparing application development tools. The compiler
      and
      application development tools are necessary to enable system designers to
      program the Ignite family for specific applications. We made corrections to
      the
      design suggested by the testing of prototype units and produced an additional
      run of second generation microprocessors from remaining wafers in May 1996.
      In
      July 1996, we employed these microprocessors in demonstration boards for use
      by
      developers and prospective customers and licensees.




In
      December 1997, we completed development of and started shipping a 0.5-micron
      microprocessor based on the Ignite technology and found that 0.5-micron
      double-metal CMOS technology improved operating speed, reduced power
      requirements, reduced physical size and reduced fabrication cost. In May 1998,
      we began a production run of a 0.35-micron microprocessor that further increased
      operating speed and cost performance over the previous generations of the Ignite
      family of microprocessors.




At
      each
      stage of development, microprocessors require extensive testing to ascertain
      performance limitations and the extent and nature of errors, if any. When
      significant limitations or errors are discovered, additional rounds of design
      modifications and fabrication are required prior to having functional and
      demonstrable microprocessors for prospective customers and licensees. Although
      our 0.5 and 0.35-micron microprocessors have been sent to prospective customers
      in anticipation of production orders, it is not certain that we, during our
      continued testing of these products, will not identify errors requiring
      additional rounds of design and fabrication prior to commercial production.
      Additional delays could have an adverse effect on the marketability of our
      Ignite technology and potential revenues from that source.




In
      September 2000, we completed the VHDL soft-core version of the Ignite
      microprocessor family. The hardware design inside a microprocessor, or silicon
      device, can be represented as a software program. This, in essence, replaces
      the
      old style of designing microprocessors using schematics. VHDL is the predominant
      software language used to design semiconductors. In addition to the design
      aspects, sophisticated simulation tools and PLD development kits can execute
      VHDL, allowing the designer to simulate the functionality of the entire design
      before committing to silicon. Also VHDL enables a designer to easily modify
      and
      enhance the design. A design represented in VHDL goes through a synthesis
      process whereby it is converted to the most basic element of a design, logical
      gates. This gate level representation in turn is used with computer aided
      engineering tools to translate the design into the most fundamental component
      of
      semiconductors, transistors. The characteristics of the transistors can be
      given
      as a library to a foundry. Therefore, a design represented in VHDL is technology
      and foundry independent and can be targeted for any given transistor geometry
      (such as 0.18, 0.25, or 0.35- micron) for any foundry of choice.




6




We
      have
      developed marketing materials, product manuals and application development
      tools
      for Ignite for use by Ignite licensees and customers. The manuals and tools
      are
      necessary to enable system designers to quickly and easily program the Ignite
      family for specific applications. We are not currently working on any additional
      tools for Ignite or engaging in any additional research and development of
      the
      Ignite family.




Competition .
      The
      semiconductor industry is intensely competitive and has been characterized
      by
      price erosion, rapid technological change and foreign competition in many
      markets. The industry consists of major domestic and international semiconductor
      companies, most of which have greater financial, technical, marketing,
      distribution, development and other resources than we do. The market for
      microprocessors and for embedded control applications is at least as
      competitive.




While
      our
      strategy, when marketing Ignite, is to target high-volume licensees and
      microprocessor customers requiring more sophisticated but low-cost, low-power
      consumption devices, we can still expect significant competition. We may also
      elect to develop embedded control system products utilizing our own architecture
      or by contract for other manufacturers.




We
      expect
      that the Ignite family, if marketed and successfully commercialized in the
      embedded controller market, will compete with a variety of 16/64-bit
      microprocessors including those based on intellectual property from ARM and
      MIPS
      and microprocessors from Hitachi, Motorola and IBM. As a Java processor, we
      expect our Ignite family will compete with a broad range of microprocessors
      including those incorporating co-processor accelerator technologies. The
      producers of these microprocessors have significantly greater resources than
      we
      do.




A
      new
      entrant, such as ours, is at a competitive disadvantage compared to these and
      other established producers. A number of factors contribute to this,
      including:




·
            the
                lack of product performance
                experience,


·
            lack
                of experience by customers in using application development
                systems,


·
            no
                record of technical service and support,
                and


·
            limited
                marketing and sales capabilities.







We
      are
      currently focusing our business activity primarily on the licensing of the
      intellectual property in our patent portfolio and are not currently marketing
      our Ignite family of products. We sell a limited number of chips from our
      remaining inventory of that suspended product line. We presently intend to
      continue to focus primarily on intellectual property licensing activities for
      an
      indefinite period and may not resume marketing the Ignite family of products
      in
      the future.




Phoenix
      Digital Solutions .
      On
      June 7, 2005, we entered into a Master Agreement (the “Master Agreement”)
      with Technology Properties Limited Inc., a California corporation (“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, our initial capitalization
                obligations and those of TPL with regard to Phoenix Digital Solutions,
                LLC
                (defined below) were satisfied, 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 Phoenix Digital Solutions, LLC a limited liability
                company owned 50% by us and 50% by
                TPL.




7




●
            Phoenix
                Digital Solutions, LLC engaged TPL to commercialize the Microprocessor
                Patents pursuant to a Commercialization Agreement among Phoenix Digital
                Solutions, LLC, 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 consent
                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, Phoenix Digital Solutions, LLC 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 Phoenix Digital Solutions, LLC, 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, Phoenix Digital Solutions, LLC 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 Phoenix
      Digital Solutions, LLC.




Pursuant
      to the Master Agreement, we and TPL have entered into the Limited Liability
      Company Operating Agreement of Phoenix Digital Solutions, LLC (“LLC Agreement”).
      We and TPL each own 50% of the membership interests of Phoenix Digital
      Solutions, LLC, 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 Phoenix Digital Solutions, LLC (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 Phoenix Digital Solutions, LLC 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 Phoenix
      Digital Solutions, LLC, if the person seeking indemnification acted in good
      faith and in a manner reasonably believed to be in the best interest of Phoenix
      Digital Solutions, LLC.




**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 and 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.




8




We
      believe that we may have claims against numerous companies that use
      semiconductors in their products. In December 2003, we initiated legal
      actions against five companies to enforce our patents. We subsequently dismissed
      that litigation in 2005, at which time legal action was initiated by TPL against
      four of these companies to enforce the patents in our portfolio. Two of these
      companies involved in the litigation we originated have subsequently purchased
      licenses through Phoenix Digital Solutions, LLC and have been excluded from
      the
      litigation currently pending. There can be no assurance that we will be
      successful in enforcing any potential patent claims against these or other
      companies. In February 2004, Intel initiated a legal action against us and
      we filed a counterclaim against them related to the initial five lawsuits.
      That
      litigation was settled and dismissed in June 2005, and Intel is now under
      license for our patented technology. See Legal Proceedings.




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.




In
      November, 2004, a patent application was filed titled “Remote Power Charging of
      Electronic Devices” with assignment to Patriot Scientific Corporation. We are in
      the initial early stages of evaluating this technology and its applicability
      and
      feasibility for further research and development.




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 market our microprocessor chips from our suspended line of Ignite
      products, although we continue to sell a limited number of chips from our
      remaining inventory. 100% of our sales for fiscal years ended May 31, 2006
      and 2005 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 have a material adverse
      effect on operations.




**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:




2006
            
            2005AMD
                License
            
            
            -----
            
            $
            2,956,250Space
                and Naval Warfare Systems
            
            $
            262,500
            
            
            -----





We
      had no
      backlog as of May 31, 2006 or 2005.




Most
      of
      our net income for the year ended May 31, 2006, was attributable to our equity
      in the earnings of our affiliate, Phoenix Digital Solutions, LLC.




**Government
      Regulation** **and Environmental Compliance**




We
      believe our products are not subject to governmental regulation by any federal,
      state or local agencies that would 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 do not anticipate
      any
      unusual difficulties in complying with governmental regulations which may be
      adopted in the future.




9




We
      have
      not incurred costs associated with environmental laws and do not anticipate
      such
      laws will have any significant effect on our future business. ****




**Research
      and Development**




We
      incurred research and development expenditures of $225,565 and $294,735 for
      our
      fiscal years ended May 31, 2006 and 2005, respectively. The majority of
      these expenditures have been devoted to our microprocessor technology. As our
      primary business strategy is to enforce our intellectual property patents
      through licensing, we do not anticipate significant expenditures relating to
      research and development in the near future.




**Employees**




We
      currently have five employees. All 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 is represented by a labor union,
      and we consider our relations with our employees to be good. None of our
      employees is covered by key man life insurance policies.




**ITEM
      2.** **DESCRIPTION
      OF PROPERTY**




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 2010. The current floor space provides adequate and
      suitable facilities for all of our corporate functions.




We
      have
      one 10,300 square foot office located at 10989 Via Frontera, San Diego,
      California. The facility is leased under a non-cancelable lease through
      July 2006. In February 2006, we relocated our offices to the Carlsbad,
      California facility. In connection with our remaining contractual lease
      obligation for this facility we accrued $77,207 at the time of our relocation
      to
      the Carlsbad facility.




**ITEM
      3.** **LEGAL
      PROCEEDINGS**




*Beatie
      and Osborne, LLP v. Patriot Scientific Corporation*




Beatie
      and Osborne, LLP is a New York law firm that formerly represented the Company
      in
      the Inventorship Litigation and the Infringement Litigation. On March 8,
      2005, Beatie and Osborne was disqualified by United States District Judge Jeremy
      Fogel in the Inventorship Litigation. Beatie and Osborne thereafter withdrew
      from the representation of the Company in the Infringement Litigation. Beatie
      and Osborne initiated litigation in the Supreme Court of New York on
      June 8, 2005 claiming breach of contract, quantum meruit, and unjust
      enrichment and alleging claims against the Company, and former Company
      representatives, Jeffrey Wallin and Lowell Giffhorn, for fraud and interference
      with contractual relationship. Beatie and Osborne claimed a contingency fee
      under the terms of its contingency fee agreement with respect to licensing
      agreements entered into, and possibly with respect to license agreements to
      be
      entered into, by the Company. The Company caused a removal of the Beatie and
      Osborne lawsuit to the United States District Court for the Southern District
      of
      New York and moved to transfer the action to the Southern District of
      California. The transfer motion was denied on May 9, 2006, but Wallin and
      Giffhorn were ordered dismissed from the action at that time. The circumstances
      of the disqualification of Beatie and Osborne in the Inventorship Litigation
      and
      its withdrawal from the Infringement Litigation were claimed by the Company
      to
      have worked a forfeiture of any rights in Beatie and Osborne to a contingency
      fee of any kind. In July, 2006 the Company and Beatie and Osborne reached a
      settlement agreement whereby the Company has paid Beatie and Osborne $340,000
      and Beatie and Osborne has retained $96,000 of the Company’s funds in its
      possession through a retainer account. This settled the case in
      full.




10




*Patriot
      Scientific Corporation v. Russell Fish*




On
      April 6, 2006, we filed a declaratory relief lawsuit against Russell Fish
      and The Fish Family Trust in the United States District Court for the Southern
      District of California. As a consequence of licensing agreements entered into
      by
      or on behalf of Patriot, Mr. Fish has presented demands for payment by us
      under his July 2004 agreement related to the Inventorship Litigation. We contend
      that Mr. Fish has been paid all sums that may have been owed to him. Our
      action seeks declaratory relief that no further sums are owed to Mr. Fish.
      Also,
      on April 6, 2006, Fish and, later, Robert Anderson, allegedly as trustee of
      The
      Fish Family Trust, filed a lawsuit against the Company in the District Court
      of
      Dallas County, Texas. The case was subsequently removed to the United States
      District Court for the Northern District of Texas. The lawsuit is based on
      an
      alleged breach of the contract entered into on July 27, 2004 and seeks
      enforcement of the contract or damages. The California action has been
      transferred to the Northern District of Texas. A mediation commenced on
      September 11, 2006 and is continuing while the proceedings are
      stayed.




*Lowell
      Giffhorn Arbitration*




On
      September 23, 2005, Lowell Giffhorn, a former executive officer
      and a former director of Patriot, submitted a demand for arbitration with the
      American Arbitration Association related to the termination of
      Mr. Giffhorn’s employment with the Company. Mr. Giffhorn asserts 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 has demanded damages of
      approximately $4,500,000 (excluding claims for punitive damages and attorneys
      fees). The Company denies the allegations and believes the claims to be
      frivolous and totally devoid of merit. The Company has retained litigation
      counsel and intends to vigorously defend the claims. The amount, if any, of
      ultimate liability with respect to the foregoing cannot be determined. Despite
      the inherent uncertainties of litigation, the Company at this time does not
      believe that Mr. Giffhorn's claim will have a material adverse impact on
      its financial condition, results of operations, or cash flows.




*Patent
      Litigation*




Pursuant
      to the joint venture that the Company entered into in June 2005 with Technology
      Properties Ltd. (in settlement of inventorship/ownership litigation between
      the
      parties, and in return for a 50-50 sharing of net licensing and enforcement
      revenues), the Company granted Technology Properties Ltd. (TPL) the complete
      and
      exclusive right to enforce and license its microprocessor patent portfolio.
      The
      Company then dismissed its patent infringement claims against Fujitsu Computer
      Systems, Inc.; Matsushita Electric Corporation of America; NEC Solutions
      (America) Inc.; Sony Electronics Inc.; and Toshiba America Inc., which had
      been
      pending in the Federal District Court for the Northern District of California.
      Thereafter, TPL, on behalf of the TPL/Patriot joint venture and Patriot, filed
      patent infringement actions against the foregoing defendants (except Sony)
      in
      the Federal District Court for the Eastern District of Texas, which litigation
      is currently pending. Litigation is not currently pending with regard to
      Fujitsu.




In
      February 2006, a license agreement was entered into with Fujitsu Corporation
      regarding the Company’s patent portfolio, and in connection with that
      transaction, litigation involving Fujitsu and TPL and the Company in both
      California and Texas was dismissed.




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




At
      our
      fiscal 2005 Annual Meeting of Shareholders held on April 28, 2006, the
      following individuals were elected to the Board of Directors of the Company:
      David H. Pohl, Carlton M. Johnson, Jr., Helmut Falk, Jr., Gloria H. Felcyn
      and
      James L. Turley.




The
      following proposals were approved at our Annual Meeting of
      Shareholders:


1.
              Proposal
                  to approve the Patriot Scientific Corporation 2006 Stock Option
                  Plan:Votes
                  For
              Votes
                  Against
              Votes
                  Abstaining87,617,201
              8,839,939
              9,131,981




2.
            Proposal
                  to ratify management’s selection of Corbin & Company, LLP as the
                  Company’s independent auditors:Votes
                For
            Votes
                Against
            Votes
                Abstaining297,015,975
            704,459
            354,822




11




3.
            Election
              of
              Directors:Director
            
            Votes
                For
            
            Votes
                Abstaining and/or
              AgainstDavid
                H. Pohl
            
            296,950,324
            
            1,124,933Carlton
                M. Johnson, Jr.
            
            285,507,445
            
            12,567,812Helmut
                Falk, Jr.
            
            286,800,552
            
            11,274,705Gloria
                H. Felcyn
            
            294,981,337
            
            3,093,920James
                L. Turley
            
            297,117,897
            
            957,360





PART
      II




**ITEM  5.**
            
            **MARKET
                FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS
                ISSUER
                PURCHASES OF EQUITY
                SECURITIES**




Our
      Common Stock (“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. 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 the
      Common Stock for the fiscal years ended May 31, 2006 and 2005.




BID
                QUOTATIONSHIGH
            
            LOWFiscal
                Year Ended May 31, 2005First
                Quarter
            
            $
            0.09
            
            $
            0.03Second
                Quarter
            
            $
            0.05
            
            $
            0.03Third
                Quarter
            
            $
            0.25
            
            $
            0.05Fourth
                Quarter
            
            $
            0.18
            
            $
            0.07Fiscal
                Year Ended May 31, 2006First
                Quarter
            
            $
            0.18
            
            $
            0.11Second
                Quarter
            
            $
            0.15
            
            $
            0.09Third
                Quarter
            
            $
            0.91
            
            $
            0.08Fourth
                Quarter
            
            $
            1.96
            
            $
            0.69





We
      had
      approximately 614 shareholders of record as of May 31, 2006. 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**




We
      paid
      our first dividend of $0.02 per common share on March 22, 2006. We paid a
      $0.04 per common share dividend on April 24, 2006. The Board of Directors
      may declare additional dividends in the future with due regard for the financial
      resources of the Company and alternative applications of those financial
      resources. Prior to the fiscal year ended May 31, 2006 we had never paid a
      cash dividend on our Common Stock.




**Equity
      Compensation Plan Information**




The
      Company’s 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
      the
      Company’s 1996, 2001, 2003 and 2006 Stock Option Plans as of May 31,
      2006.




12




Shares
      of
      common stock issuable on the exercise of warrants have not been approved by
      the
      Company’s stockholders and, accordingly, have been segregated in the table
      below. For a narrative description of the material features of the plans, refer
      to Footnote 8 of our consolidated financial statements.


**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 plans**Equity
                    compensation plans
                  approved
                    by security holders
                
                
                5,460,000
                
                $
                0.34
                
                
                5,229,000Equity
                    compensation plans not
                  approved
                    by security holders
                
                
                53,349,220
                
                $
                0.05
                
                
                —Total
                
                
                58,809,220
                
                
                
                
                
                5,229,000





**RECENT
      SALE OF UNREGISTERED SECURITIES**




During
      the fourth fiscal quarter ended May 31, 2006, we did not offer for sale any
      unregistered securities.




**ITEM
      6.** **MANAGEMENT’S
      DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**





OVERVIEW


During
        the fiscal years ended May 31, 2005 and May 31, 2006, the Company entered
        into
        agreements for the licensing of its technology with Advanced Micro Devices
        Inc.
        ("AMD") and Intel Corporation, among the largest of the microprocessor
        manufacturers. During the 2006 fiscal year the Company entered into licensing
        agreements with Hewlett-Packard, Fujitsu and Casio. We believe the agreements
        represent validation of the Company's position that its intellectual property
        was and is being infringed by major manufacturers of microprocessor technology.
        Also, we believe the agreements demonstrate the value
        of
        the Company's intellectual property in
        that
        they are "arms
        length" transactions with major electronics manufacturers.
 
 In
        June
        2005, the Company entered into a series of agreements with Technology Properties
        Limited, Inc. (“TPL”) and others to facilitate the pursuit of infringers of
        its
        intellectual property. The Company intends
        to continue its
        joint
        venture with TPL to
        pursue
        license agreements with infringers of its technology. Management believes
        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 the Company’s principal assets and is
        a
        prudent way to achieve the desired results as the Company seeks to obtain
        fair
        value from users of
        its intellectual property.




RESTATEMENT
      OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS




On
        September 8, 2006, the Company determined that the manner in which it had accounted
        for the reset conversion feature and embedded put option of certain of its
        convertible debentures was not in accordance with Statement of Financial
        Accounting Standards (“SFAS”) No. 133, *Accounting
        For Derivative Instruments and Hedging Activities* ,
        as
        amended, and Emerging Issues Task Force (“EITF”) Issue No. 00-19, *Accounting
        for Derivative Financial Instruments Indexed to, and Potentially Settled
        in, a
        Company's Own Stock* .
        The
        Company 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. The accounting treatment of derivative financial instruments
        required that the Company 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 No. 00-19, as a result of entering into the convertible
        debenture agreements, the Company was 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 required
        to be 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, the Company was required to record a
        non-operating, non-cash charge.  If the fair value of the derivatives was
        lower at the subsequent balance sheet date, the Company was required to record
        non-operating, non-cash income.  Accordingly, in connection with its restatement adjustments, the Company has appropriately reflected the
        non-operating, non-cash income or expense resulting from changes
        in fair value. The Company had previously not recorded the embedded derivative
        instruments as a liability and did not record the related changes in fair
        value.
        The Company did not have
        any derivative instruments at May 31, 2006 as all derivative instruments
        were
        settled prior to May 31, 2006.




13




Based
        on
        the foregoing, the Company’s Board of Directors determined that the Company was
        required to restate its financial results for the year ended May 31, 2005.
  See
        Note
        3 to the accompanying Consolidated Financial Statements included in this
        Annual
        Report on Form 10-KSB for a summary of the effects of the restatement
        adjustments on the Company's consolidated financial statements. The information
        provided in this Management's Discussion and Analysis of Financial Condition or Plan of Operation
        reflects the effect of the restatement adjustments.




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 generally recognized at the time we enter into a contract
      and provide our customer with the licensed technology. We believe that this
      is
      the point at which we have performed all of our obligations under the
      agreements; however, this remains a highly interpretive area of accounting,
      and
      future license agreements may result in a different method of revenue
      recognition. Fees for maintenance or support of our licenses are recorded on
      a
      straight-line basis over the underlying period of performance.





2.
            Assessment
                of Contingent Liabilities





We
      are
      involved in various legal matters, disputes, and patent infringement claims
      which arise in the ordinary conduct 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 and properly disclosed.




3.
            Stock
                Options and Warrants




14





The
      Company applies Accounting Principles Board (“APB”) Opinion 25, “Accounting for
      Stock Issued to Employees,” and related Interpretations in accounting for all
      stock option plans. Under APB Opinion 25, compensation cost has been recognized
      for stock options granted to employees when the option price is less than the
      market price of the underlying common stock on the date of grant.





Statement
      of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based
      Compensation,” and SFAS No. 148, “Accounting for Stock-Based
      Compensation-Transition and Disclosure,” require the Company to provide pro
      forma information regarding net income as if compensation cost for the Company's
      stock option plans had been determined in accordance with the fair value based
      method prescribed in SFAS No. 123. To provide the required pro forma
      information, the Company estimates the fair value of each stock option at the
      grant date by using the Black-Scholes option-pricing model. SFAS No. 148 also
      provides for alternative methods of transition for a voluntary change to the
      fair value based method of accounting for stock-based employee compensation.
      The
      Company has elected to continue to account for stock based compensation under
      APB Opinion 25.





The
      Company applies SFAS No. 123 in valuing options and warrants granted to
      consultants and others and estimates the fair value of such options and warrants
      using the Black-Scholes option-pricing model. The fair value is recorded as
      expense as services are provided or other obligations are incurred. Options
      and
      warrants granted to consultants for which vesting is contingent based on future
      performance are measured at their then current fair value at each period end,
      until vested. The Black-Scholes model requires the use of various inputs,
      including the volatility of our stock price, duration of the option or warrant,
      and interest rates, over which we use our judgment. Given that we have recorded
      significant non-cash expenses related to the issuance of our warrants to
      third-parties, our estimate of the value of warrants issued remains a critical
      component of our financial statements.





4.
            Debt
                Discount





We
      have
      issued warrants as part of our convertible debentures and other financings.
      We
      value the warrants using the Monte Carlo simulation model based on the fair
      value at issuance, and the fair value is recorded as debt discount.
      The debt discount is amortized to non-cash interest over the life of the
      debenture assuming the debenture will be held to maturity, which has normally
      been two years. If the debenture is converted to common stock prior to its
      maturity date, any debt discount not previously amortized is expensed to
      non-cash interest.





5.
            Derivative
                Financial Instruments





In
      connection with the issuance of certain convertible debentures, the terms of
      the
      debentures included a reset conversion feature which provided for a conversion
      of the debentures into shares of the Company's common stock at a rate which
      was
      determined to be variable. The conversion option was therefore deemed to be
      an
      embedded put option pursuant to Statement of Financial Accounting Standards
      (“SFAS”) No. 133, *Accounting
      For Derivative Instruments and Hedging Activities* ,
      as
      amended, and Emerging Issues Task Force (“EITF”) Issue No. 00-19, *Accounting
      for Derivative Financial Instruments Indexed to, and Potentially Settled in,
      a
      Company's Own Stock* .
      The
      Company 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. The accounting treatment of derivative financial instruments
      required that the Company 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 No. 00-19, as a result of entering into the convertible
      debenture agreements, the Company was 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, the Company recorded a non-operating, non-cash charge.  If the fair
      value of the derivatives was lower at the subsequent balance sheet date, the
      Company recorded non-operating, non-cash income. As of May 31, 2006, the Company
      does not have any outstanding derivative instruments as the related debt
      instruments were settled prior to May 31, 2006.





6.
            Patents
                and Trademarks





Patents
      and trademarks are carried at cost less accumulated amortization and are
      amortized over their estimated useful lives of four years. The carrying value
      of
      patents and trademarks is periodically reviewed and impairments, if any, are
      recognized when the expected future benefit to be derived from an individual
      intangible asset is less than its carrying value.





7.
            Income
                Taxes




15




Deferred
      income taxes are provided for by recognizing temporary differences in certain
      income and expense items for financial and tax reporting purposes. Deferred
      tax
      assets consist primarily of income tax benefits from net operating loss
      carry-forwards. A valuation allowance is recorded to fully offset the deferred
      tax asset if it is more likely than not that the assets will not be utilized.
      We
      have historically provided a valuation allowance equal to 100% of our net
      deferred tax asset. In spite of the net income recorded by us during the years
      ended May 31, 2005 and  May 31, 2006, we do not believe that we have ample
      evidence of overcoming the “more likely than not” criteria established by
      generally accepted accounting principles. We will continue to monitor our
      financial operating results, and other factors, to determine when, if ever,
      we
      meet these criteria.





8.
            Investment
                in Affiliated Company





The
      Company has a 50% interest in Phoenix Digital Systems, LLC. This investment
      is
      accounted for using the equity method of accounting since the investment
      provides the Company the ability to exercise significant influence, but not
      control, over the investee. Significant influence is generally deemed to exist
      if the Company has 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 the Company’s
      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 company”.





The
      Company reviews its investment in affiliated company to determine whether events
      or changes in circumstances indicate that its carrying amount may not be
      recoverable. The primary factors the Company considers in its determination
      are
      the financial condition, operating performance and near term prospects of the
      investee. If a decline in value is deemed to be other than temporary, the
      Company would recognize an impairment loss.





RESULTS
      OF OPERATIONS





Total
      revenues increased from approximately $2,983,000 for the fiscal year ended
      May
      31, 2005 to approximately $10,310,000 (which
      amount does not include approximately $27,848,000 in income resulting from
      the
      Company’s investment in Phoenix Digital Solutions, LLC)for the fiscal
      year ended May 31, 2006. In the third quarter of fiscal year 2005 we entered
      into an agreement with AMD Corporation that granted licenses for our Ignite
      microprocessor and for our patent portfolio of microprocessor technologies.
      The
      Ignite license called for payments totaling $1,220,000 with $300,000 paid upon
      closing of the agreement, $292,500 to be paid in the fourth quarter of fiscal
      2005 and the remaining balance to be paid during fiscal 2006. The revenues
      associated with the Ignite license were all recognized in fiscal 2005. The
      agreement also called for a maintenance fee totaling $100,000 connected with
      the
      Ignite license. That fee is considered to support the Ignite license over a
      period of four years and is being recognized as revenue evenly over the four
      year period. The Ignite license contains provisions for royalties based upon
      deliveries of products using the technology. However we cannot make reliable
      projections of quantities or the timing of shipments that could lead to royalty
      payments resulting from this agreement. The agreement with AMD also included
      a
      non-exclusive license for our portfolio of intellectual property. A one-time
      license fee amounting to $1,730,000 was agreed upon with four equal payments
      of
      $432,500 to be paid during fiscal 2005 and 2006. The entire amount of the
      license fee was recognized as revenue in fiscal 2005. In June 2005, 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 fiscal 2006. In connection with entering into the agreement
      with Intel Corporation, we entered into an agreement with the co-owner of our
      patented technologies, through which we settled all legal disputes between
      us
      and agreed to jointly pursue others who have infringed upon our joint rights.
      Product sales amounting to approximately $310,000 were also recorded during
      the
      2006 fiscal year in connection with communications products that are no longer
      marketed by the Company. Inventory associated with the sales of these
      communications products is carried at zero value. Cost of sales of approximately
      $103,000 consists of payments made to sub contractors for materials and labor
      in
      connection with the products sales. Sales of communications and microprocessor
      products that have been discontinued amounted to approximately $25,000 for
      the
      2005 fiscal year.





Research
      and development expenses declined from approximately $295,000 for the fiscal
      year ended May 31, 2005 to approximately $226,000 for the fiscal year ended
      May
      31, 2006. Expenses related to salaries, benefits, training and other employee
      expenses declined approximately $114,000 resulting from staff reductions.
      Consulting and related support expenses increased from approximately $15,000
      during fiscal 2005 to approximately $65,000 for fiscal 2006 as research and
      development activities moved to outside contractors. Costs of components,
      supplies and equipment increased by approximately $5,000 for the 2006 fiscal
      year as compared with the 2005 fiscal year connected with product development
      and support of the Ignite product line. Depreciation for fixed assets associated
      with research and development activities declined from approximately $11,000
      for
      the fiscal year ended May 31, 2005 to less than $1,000 for the fiscal year
      ended
      May 31, 2006 as equipment became fully depreciated and was not replaced.




16





Selling,
      general and administrative expenses increased from approximately $2,600,000
      for
      the fiscal year ended May 31, 2005 to approximately $4,151,000 for the fiscal
      year ended May 31, 2006. Legal and accounting related expenses increased by
      approximately $997,000 for the 2006 fiscal year compared with the 2005 fiscal
      year related to legal matters in connection with intellectual property and
      formation of a limited liability company, the license agreement with Intel
      Corporation, and legal issues related to former employees and other corporate
      matters. In addition, salary costs increased approximately $605,000 for the
      2006
      fiscal year compared with the 2005 fiscal year as a result of changes in
      management personnel that included severance costs. Other increases for the
      2006
      fiscal year as compared with the 2005 fiscal year included public relations
      and
      consultant expenses of approximately $308,000, insurance expenses of
      approximately $73,000 and travel expenses of approximately $85,000. Offsetting
      these increases were decreases in legal contingency fees of approximately
      $560,000 and decreases in patent enforcement expenses of approximately $290,000.





Settlement
      and license expenses amounting to approximately $1,918,000 were recorded during
      the fiscal year May 31, 2006 in connection with the agreements involving the
      formation of a limited liability company 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 the Company 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 $1,328,000, to co-owners
      of
      various intellectual property assets of approximately $960,000 and to a
      committee of the Company's 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
      to the Company from the reconveyance of warrants, amounting to approximately
      $622,000.





Other
      income and expenses for the Company in the fiscal year ended May 31, 2006
      included equity in the earnings of Phoenix Digital Solutions LLC, a joint
      venture entity. The investment is accounted for in accordance with the equity
      method of accounting for investments. The Company’s investment in the joint
      venture for the fiscal year ended May 31, 2006 provided income in the amount
      of
      approximately $27,848,000 resulting from licensing agreements for our
      intellectual property with Hewlett-Packard, Fujitsu and Casio for one time
      payments. Total other income and expense for the fiscal year ended May 31,
      2006
      amounted to approximately $24,761,000 compared with total other income and
      expense for the fiscal year ended May 31, 2005 of net expenses amounting to
      approximately $10,606,000. Changes in the fair value of warrant and derivative
      liabilities amounted to net expense in the 2005 fiscal year of approximately
      $7,564,000 and net expense of approximately $2,457,000 in the 2006 fiscal year.
      Expenses were incurred during the 2006 fiscal year of approximately $445,000
      in
      connection with debt extinguishment and no such expenses were incurred during
      the 2005 fiscal year. Interest expense amounted to approximately $3,082,000
      for
      the 2005 fiscal year and approximately $517,000 for the 2006 fiscal year. The
      non-cash portion of interest expense amounted to approximately $2,941,000 for
      the 2005 fiscal year and approximately $471,000 for the 2006 fiscal year
      associated primarily with convertible debenture debt discount amortization
      and
      write-off of debt discount upon conversion of convertible debentures. Interest
      income and other income increased from approximately $56,000 for the 2005 fiscal
      year to approximately $330,000 for the 2006 fiscal year, as interest bearing
      account balances increased from license revenues. Gain on sale of assets
      amounted to approximately $4,000 for the 2005 fiscal year and approximately
      $3,000 for the 2006 fiscal year. Unrealized loss on marketable securities
      amounted to approximately $21,000 for the 2005 fiscal year and $1,000 for the
      2006 fiscal year.





The
      Company's net income for the fiscal year ended May 31, 2006 amounted to
      approximately $28,673,000 compared with a loss of approximately $10,519,000
      for
      the fiscal year ended May 31, 2005.





LIQUIDITY
      AND CAPITAL RESOURCES





The
      Company's cash, marketable securities and short-term investment balances
      increased from approximately $1,289,000 as of May 31, 2005 to approximately
      $7,503,000 as of May 31, 2006. We also held short term certificates of deposit
      and restricted cash balances amounting to approximately $202,000 as of May
      31,
      2005 and approximately $100,000 as of May 31, 2006. Total current assets
      increased from approximately $3,612,000 as of May 31, 2005 to approximately
      $8,015,000 as of May 31, 2006. Total current liabilities amounted to
      approximately $1,644,000 and approximately $1,244,000 as of May 31, 2005 and
      May
      31, 2006, respectively. The decrease as of the end of the 2006 fiscal year
      resulted primarily from the retirement of convertible debentures with current
      amounts due as of the end of the 2005 year of approximately $422,000, net of
      debt discount of approximately $301,000. In addition, accrued liabilities
      decreased by approximately $350,000 as of May 31, 2006 as compared with the
      amount as of May 31, 2005. Partially offsetting these decreases in current
      liabilities was an increase in accounts payable balances from approximately
      $269,000 as of May 31, 2005 to approximately $695,000 as of May 31, 2006. The
      improvement in the Company’s current position as of May 31, 2006 as compared
      with the previous year primarily results from increased revenues during the
      2006
      fiscal year.




17




Non-current
      liabilities at May 31, 2005 included a derivative liability associated with
      convertible debentures and outstanding warrants amounting to approximately
      $9,275,000. Also as of May 31, 2005, the non-current portion of outstanding
      convertible debentures amounted to approximately $46,000, net of debt discount
      of approximately $112,000. There were no amounts associated with these items
      as
      of May 31, 2006 as a result of the Company’s retirement of all remaining
      convertible debt during the 2006 fiscal year.





During
      recent years we have relied upon financing activities to provide the funds
      necessary for the Company's operations. The number of shares of the Company's
      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.
      We
      believe that the Company will be able to avoid such methods of financing
      operations for the foreseeable future.





The
      Company's current position as of May 31, 2006 is expected to provide the funds
      necessary to support the Company's operations through the fiscal year ended
      May
      31, 2007.





**RECENT
      ACCOUNTING PRONOUNCEMENTS**




In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
      123 (revised 2004), *Share-Based Payment* ("SFAS
      No. 123(R)"), which is a revision of SFAS No. 123.  SFAS 123(R) supersedes
      APB Opinion No. 25 and amends SFAS No. 95, *Statement
      of Cash Flows* . 
      Generally, the approach in SFAS No. 123(R) is similar to the approach described
      in SFAS No. 123.  However, SFAS No. 123(R) requires all share-based
      payments to employees, including grants of employee stock options, to be
      recognized in the income statement based on their fair values.  Pro forma
      disclosure is no longer an alternative.  The provisions of this statement
      are effective for the Company as of June 1, 2006.  The Company expects to
      adopt SFAS No. 123(R) in the first fiscal quarter of 2007.




SFAS
      No.
      123(R) requires companies to recognize in the income statement the grant-date
      fair value of stock options and other equity-based compensation issued to
      employees.  SFAS No. 123(R) also establishes accounting requirements for
      measuring, recognizing and reporting share-based compensation, including income
      tax considerations.  Upon adoption of SFAS No. 123(R), the Company will be
      required to determine the transition method to be used at the date of
      adoption.  The allowed transition methods are the modified prospective
      application and the modified retrospective application.  Under the modified
      prospective application, the cost of new awards and awards modified, repurchased
      or cancelled after the required effective date and the portion of awards for
      which the requisite service has not been rendered (unvested awards) that are
      outstanding as of the required effective date will be recognized as the
      requisite service is rendered on or after the required effective date.  The
      compensation cost for that portion of awards shall be based on the grant-date
      fair value of those awards as calculated for either recognition or pro forma
      disclosures under SFAS No. 123.  The modified retrospective application
      requires companies to record compensation expense for all unvested stock options
      and restricted stock beginning with the first disclosed period restated. 
The Company plans to adopt SFAS No. 123(R) using the modified prospective
      application.





As
      permitted by SFAS No. 123, the Company currently accounts for share-based
      payments to employees using APB Opinion No. 25's intrinsic value method and,
      as
      such, generally recognizes no compensation cost for employee stock
      options.  Accordingly, the adoption of SFAS No. 123(R)'s fair value method
      will have a negative impact on the Company's results of operations, although
      it
      will have no impact on its overall financial position.  The impact of
      adopting SFAS No. 123(R) cannot be predicted at this time because it will depend
      on levels of share-based payments granted in the future.  However, had the
      Company adopted SFAS No. 123(R) in prior periods, the impact of that standard
      would have approximated the impact of SFAS No. 123 as described in the
      disclosure of pro forma net income (loss) and income (loss) per share. 
SFAS No. 123(R) also requires the benefits of tax deductions in excess of
      recognized compensation cost to be reported as a financing cash flow, rather
      than as an operating cash flow as required under current accounting
      literature.  The requirement will reduce net operating cash flows and
      increase net financing cash flows in periods of adoption.




18





In
      December 2004, the FASB issued SFAS No. 153, “Exchange of Nonmonetary Assets,”
an amendment of APB Opinion No. 29, “Accounting for Nonmonetary Transaction.”
SFAS No. 153 is based on the principle that exchanges of nonmonetary assets
      should be measured based on the fair market value of the assets exchanged.
      SFAS
      No. 153 eliminates the exception of nonmonetary exchanges of similar productive
      assets and replaces it with a general exception for exchanges of nonmonetary
      assets that do not have commercial substance. SFAS 153 is effective for
      nonmonetary asset exchanges in fiscal periods beginning after June 15, 2005.
      The
      Company does not believe that the provisions of SFAS No. 153 will have a
      material impact on its financial statements.





In
      May
      2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,”
which replaces APB Opinion No. 20, “Accounting Changes,” and FASB Statement No.
      3, “Reporting Accounting Changes in Interim Financial Statements,” and changes
      the requirements for the accounting for and reporting of a change in accounting
      principle. SFAS No. 154 requires retrospective application to prior periods'
      financial statements of changes in accounting principle, unless it is
      impracticable to determine either the period-specific effects or the cumulative
      effect of the change. SFAS No. 154 is effective for accounting changes and
      correction of errors made in fiscal years beginning after December 15, 2005.
      Early adoption is permitted for accounting changes and correction of errors
      made
      in fiscal years beginning after the date SFAS No. 154 was issued. At the present
      time, the Company does not believe that adoption of SFAS No. 154 will have
      a
      material effect on its financial statements.





**RISK
      FACTORS**





You
      should consider the following discussion of risks as well as other information
      regarding our common stock. The risks and uncertainties described below are
      not
      the only ones, as additional risks and uncertainties not presently known to
      us
      or that we currently deem immaterial also may impair our business operations.
      If
      any of the following risks actually occur, our business could be harmed.





**WE
      ARE CURRENTLY INVOLVED IN A LEGAL DISPUTE WHICH COULD IMPACT OUR FUTURE RESULTS
      OF OPERATIONS AND WORKING CAPITAL**





The
      Company is being sued by a co-inventor of the patent portfolio technology
      relating to proceeds we received under our recently signed license agreements.
      We believe that the co-inventor’s claim lacks merit, a claim which the Company
      disputes and which the Company intends to defend vigorously. Should we not
      prevail in this dispute, the amount payable to the co-inventor could affect
      our
      business and operations. In addition, if we are required to litigate this
      matter, or otherwise settle the matter outside of court, the cost of resolving
      this matter may impact our future reported results of operations and consume
      a
      significant amount of cash.





**RELATED
      TO OUR BUSINESS**





**WE
      HAVE A HISTORY OF LOSSES AND, THEREFORE, MAY NOT CONTINUE ANNUAL
      PROFITABILITY**





We
      have a
      history of reported losses. Although we have entered into various license
      agreements in fiscal 2006, which have resulted in our reporting significant
      revenue, we may not be able to achieve sustained profitable operations in the
      future. Should the funds generated from these agreements be insufficient to
      fund
      our operations, we may be forced to curtail our operations or seek additional
      external funding. Additional funding may not be available to us or, if it is
      available, it may not be on terms favorable to us.







**RELATED
      TO OUR INDUSTRY**





**OUR
      LIMITED ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY MAY INADVERTENTLY ADVERSELY
      AFFECT OUR ABILITY TO COMPETE**





A
      successful challenge to our ownership of our technology could materially damage
      our business prospects. Our technologies may infringe upon the proprietary
      rights of others. Licenses required by us from others may not be available
      on
      commercially reasonable terms, if at all. 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 eight U.S. patents,
      one European patents 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.





19


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 may assert that our technologies or products infringe on their
        patents or proprietary rights or
        that
        their products do not infringe upon our patents .
        If
        infringement claims against us are deemed valid, we may not be able to obtain
        appropriate licenses on acceptable terms, or at all. If
        an
        infringement asserted by us is determined not to exist, the value of our
        patent
        portfolio could be affected adversely. Litigation is costly
        and time-consuming but may be necessary to protect our future patent and/or
        technology license positions or to defend against infringement claims. (See
        our
        discussion of Legal Proceedings below.) We did not develop the
        technology which is
        the basis for our products. This technology, which was originally known as
        the
        ShBoom technology, was acquired through a series of agreements from one of
        two
        co- inventors. We have been, are
        now, and
        may
        i n
        the
        future be subject
        to claims from such prior parties related to the technology. Such parties
        may
        also attempt to exploit the technology independently of our rights to do
        so. The
        asset purchase agreement and plan of reorganization between us, nanoTronics
        Corporation and Helmut Falk was the agreement under which we acquired the
        basic
        ShBoom technology. The agreement also contained a number of warranties and
        indemnities related to the ownership of the technology and other matters.
        We
        believe nanoTronics Corporation has been liquidated and, due to Mr. Falk’s death
        in July 1995, our ability to obtain satisfaction for any future claims as
        a
        result of a breach of the agreement may be limited.




**RELATED
      TO OUR DEBT AND EQUITY OFFERINGS AND SHARE PRICE**





**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**





Our
      common stock is currently listed for trading in the NASD Over-The-Counter
      Bulletin Board Market and is subject to the “penny stock rules” adopted pursuant
      to Section 15(g) of the Securities Exchange Act of 1934, as amended (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” to
      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
      attract competitive funding.





**OUR
      SHARE PRICE COULD BE LOWERED AS A RESULT OF SHORT SALES**





The
      downward pressure on the price of our common stock as the debenture holders
      convert and sell material amounts of common stock could encourage short sales
      by
      the debenture holders or others. 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, will buy the stock at a later date. If the price of the
      stock goes down, the seller will profit to the extent of the difference between
      the amount the seller originally sold it for less the amount the seller later
      had to pay to buy it. 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.





20


**WE
      COULD BE SUBJECT TO A CHANGE IN CONTROL IF OUR SIGNIFICANT WARRANT HOLDERS
      EXERCISE THEIR WARRANTS**





There
      is
      a possibility that a significant number of warrants may be exercised, if
      so, it could result in a change in control of our Company. Such a change in
      control could have a material adverse effect on our operations and business
      plans. We are unable to determine the impact such a change in control could
      have
      on our Company.




**ITEM
      7.** **FINANCIAL
      STATEMENTS**




The
      financial statements required by this item begin on page F-1 with the index
      to
      consolidated financial statements.




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




None.




**ITEM
      8A.**  **CONTROLS
      AND PROCEDURES**




***Evaluation
      of Disclosure Controls and Procedures***




As
      required by Rule 13a-15(e) under the Exchange Act, as of May 31, 2006,
      the end of the period to which this annual report relates, we have carried
      out
      an evaluation of the effectiveness of the design and operation of the Company’s
      disclosure controls and procedures. This evaluation was carried out under the
      supervision and with the participation of our management, including our Chief
      Executive Officer and our Chief Financial Officer.




Disclosure
      controls and procedures are controls and other procedures that are designed
      to
      ensure that information required to be disclosed in our reports filed or
      submitted 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. Disclosure controls and procedures include,
      without limitation, controls and procedures designed to ensure that information
      required to be disclosed in our reports filed under the Exchange Act is
      accumulated and communicated to management, including the Chief Executive
      Officer and Chief Financial Officer as appropriate, to allow timely decisions
      regarding required disclosure. Management recognizes that any controls and
      procedures, no matter how well designed and operated, can provide only
      reasonable assurance of achieving their objectives, and management necessarily
      applies its judgment in evaluating the cost-benefit relationship of possible
      controls and procedures.  Based on the evaluation of our disclosure
      controls and procedures as of May 31, 2006, our Chief Executive Officer and
      Chief Financial Officer concluded that, as of such date, our disclosure controls
      and procedures were not effective due to the following two discrete issues,
      that
      pertain to material weaknesses, discussed in more detail, below.




Notwithstanding
      the material weaknesses discussed below, the Company's management has concluded
      that the consolidated financial statements included in this Annual Report on
      Form 10-KSB fairly present in all material respects the Company's financial
      condition, results of operations and cash flows for the periods presented in
      conformity with accounting principles generally accepted in the United States
      of
      America.




***Effect
      of Restatement on Disclosure Controls***




As
      disclosed in Item 8B herein, the Audit Committee of our Board of Directors
      authorized us to amend and restate our financial statements and other financial
      information for the year ended May 31, 2005, and the quarters ended
      August 31, 2005, November 30, 2005, and February 28,
      2006, **** as
      a
      result of a change in judgment regarding (i) the accounting treatment for
      our previously outstanding convertible debentures and (ii) our accounting
      treatment of our interest in Phoenix Digital Solutions, LLC. The issue
      pertaining to the convertible debentures also relates to the previous years
      ended May 31, 2004, 2003 and 2002. See the Notes to the 2006 consolidated
      financial statements for more information.




In
      connection with the restatement, and in light of the change in judgment which
      gave rise to it, our Chief Executive Officer and our Chief Financial Officer
      considered the effect of the error on the adequacy of our disclosure controls
      and procedures as of the end of the period covered by this Annual Report on
      Form
      10-KSB for the year ended May 31, 2006.  The certifying officers determined
      that disclosure controls and procedures were not effective as a consequence
      of
      the material weaknesses described below.




21


A
      material weakness is a control deficiency, or combination of control
      deficiencies, that results in more than a remote likelihood that a material
      misstatement of the annual or interim financial statements will not be prevented
      or detected.  As a result of the restatements described above, the
      following material weaknesses were identified in the Company's assessment of
      the
      effectiveness of disclosure controls and procedures as of May 31,
      2006:




i)  The
      Company did not maintain effective controls over the identification of a
      variable conversion feature and put option embedded within its convertible
      debt
      instruments and the determination of the appropriate accounting treatment for
      those debt instruments.





ii)     The
      Company did not maintain effective controls over the accounting for its
      investment in Phoenix Digital, LLC and the determination of the appropriate
      accounting treatment for the investment.




As
      a
      result of these weaknesses, management has taken steps, including the retention
      of new and additional accounting personnel, and continues to monitor the
      controls and procedures, to ensure that the errors will not occur again and
      that
      the Company’s disclosure controls and procedures are operating at the reasonable
      assurance level. In addition, management has engaged our current auditors to
      perform a re-audit of the fiscal years ended May 31, 2005, 2004, 2003 and 2002
      (including the beginning balances for 2001).




***Changes
      in Internal Control over Financial Reporting***




There
      were no changes to our internal control over financial reporting (as defined
      in
      Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our most
      recently completed fiscal quarter that materially affected, or are reasonably
      likely to materially affect, our internal control over financial
      reporting.




**ITEM
      8B.**  **OTHER
      INFORMATION**




**Non-Reliance
      on Previously Issued Financial Statements or a Related Audit Report or Completed
      Interim Review** .




On
      September 8, 2006, the Company reached a determination that the prior accounting
      treatment of (i) our previously outstanding non-conventional convertible notes
      which allowed such note holders to convert the notes payable into shares of
      our
      common stock at prices that were variable and potentially based upon several
      factors including the market price of our common stock at the time of
      conversion, and (ii) our accounting treatment of our interest in Phoenix Digital
      Solutions, LLC, should be reassessed. The Company has also determined that
      the
      adjustments required as a result of our reassessments are material to our
      financial statements and, therefore, will require us to restate our financial
      statements for the year ended May 31, 2005, and restate our quarterly reports
      for the quarters ended August 31, 2005, November 30, 2005 and February 28,
      2006.
      The issue pertaining to the embedded derivatives also relates to the previous
      years ended May 31, 2004, 2003, 2002.




The
      Company’s consolidation of the financial results of Phoenix Digital Solutions,
      LLC was based on discussions with the Company’s prior auditors. Following
      discussions with the Company’s current auditors, the Company has reassessed its
      accounting for its interest in Phoenix Digital Solutions, LLC and after further
      consideration of FIN 46R, has determined that it incorrectly consolidated the
      financial results of Phoenix Digital Solutions, LLC when it should have
      accounted for its interest in Phoenix Digital Solutions, LLC in accordance
      with
      the equity method of accounting for investments. The change in accounting was
      the result of the Company concluding that it did not have a controlling
      financial interest in Phoenix Digital Solutions, LLC and was not the primary
      beneficiary of the relationship.




Based
      on
      recent SEC guidance, the Company re-evaluated its accounting for its previously
      outstanding convertible debentures to determine whether the embedded conversion
      options required bifurcation and fair value accounting in accordance with FASB
      Statement No. 133, “Accounting for Derivative Instruments and Hedging
      Activities,” and EITF 00-19, “Accounting for Derivative Financial Instruments
      Indexed to, and Potentially Settled in a Company’s Own Stock.” The Company
      concluded that bifurcation of the embedded derivative from the host instrument
      was required and that the embedded derivative should be accounted for as a
      derivative at fair value with changes in fair value recorded in earnings. The
      Company determined that the initial accounting treatment for the previously
      outstanding debentures was not correctly applied and that, therefore, a
      restatement of the Company's financial statements was required.




The
      Company also considered the guidance issued by the SEC’s Division of Corporation
      Finance with respect to the variable nature of the conversion price of its
      previously outstanding convertible debentures, noting that there is no explicit
      limit on the number of shares that are to be delivered upon exercise of the
      conversion feature, and EITF No. 00-19 which states that “if the number of
      shares that could be required to be delivered to net-share settle the contract
      is indeterminate, a company will be unable to conclude that it has sufficient
      available authorized and unissued shares, and therefore, net-share settlement
      is
      not within the control of the Company.” Because this condition under EITF No.
      00-19 was not met, the Company determined that it was precluded from classifying
      the embedded derivative instrument as equity. Accordingly, the feature should
      have been accounted for as a derivative liability at fair value, with changes
      in
      fair value recorded in earnings The Company has determined that it should have
      classified all of its non-employee warrants as a liability as it is presumed
      under EITF No. 00-19 that the Company will not have a sufficient number of
      authorized shares to settle its other commitments that may require the issuance
      of stock during the period the derivative contract could remain outstanding.
      The
      Company did not previously apply the aforementioned guidance in accounting
      for
      the variable nature of the conversion price and therefore, a restatement of
      the
      Company’s financial statements was required.




**PART
      III**




**ITEM 
              9.**
            
            **DIRECTORS,
                EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH
                SECTION 16(a) OF THE EXCHANGE
                ACT**




The
      following table and biographical summaries set forth information, including
      principal occupation and business experience, about our directors and executive
      officers at September 19, 2006. There is no familial relationship between or
      among the nominees, directors or executive officers of the Company.




NAME
            
            AGE
            
            POSITION,
                OFFICE and TERMHelmut
                Falk, Jr.
            
            50
            
            Director
                (since December 1997)Gloria
                H. Felcyn
            
            59
            
            Director
                (since October 2002)Carlton
                M. Johnson, Jr.
            
            46
            
            Director
                (since August 2001)David
                H. Pohl
            
            69
            
            Director
                (since April 2001) / President and Chief Executive
                OfficerThomas
                J. Sweeney
            
            56
            
            Chief
                Financial Officer/SecretaryJames
                L. Turley
            
            44
            
            Director
                (since February 2006)





**BIOGRAPHICAL
      INFORMATION**




**HELMUT
      FALK, JR.** From
      1992 until 2000, Dr. Falk served as the Director of Anesthesia of, and served
      on
      the medical executive committee for, The Johnson Memorial Hospital in Franklin,
      Indiana. Since 2000, Dr. Falk has worked at St. Francis Hospital in Mooresville,
      Indiana as a staff anesthesiologist and has been Chairman of its Pharmacy and
      Therapeutics Committee. Dr. Falk received his D.O. degree from the College
      of
      Osteopathic Medicine of the Pacific in 1987 and his B.S. in Biology from the
      University of California, Irvine in 1983. Dr. Falk is the son of the late Helmut
      Falk, who was the sole shareholder of nanoTronics and the Chairman and CEO
      of
      the Company until his death in July 1995. Dr. Falk is also an heir to the Helmut
      Falk Estate, which is the beneficial owner of the Company's shares held by
      the
      Helmut Falk Family Trust.




**GLORIA
      H. FELCYN.** Gloria
      Felcyn has served as a Director of the Company since 2002 and is the Chairman
      of
      the Audit Committee of the Board of Directors. Since 1982, Ms. Felcyn has
      been the principal in her own certified public accounting firm. Prior to
      establishing her own firm, Ms. Felcyn was employed by Main Hurdman &
Cranston from 1969 through 1970 and at Price Waterhouse & Co., in the San
      Francisco and New York offices from 1970 through 1976. Subsequent to that,
      Ms. Felcyn worked in the field of off-shore tax planning with a major real
      estate syndication company. Ms. Felcyn received her B.S. degree in Business
      Economics from Trinity University in 1968 and is a member of the American
      Institute of CPAs.




**CARLTON
      M. JOHNSON, JR.** Carlton
      Johnson has served as a Director of the Company since 2001, and is Chairman
      of
      the Executive Committee of the Board of Directors. Mr. Johnson is in-house
      legal counsel for Roswell Capital Partners, LLC, a position he has held since
      June 1996. Mr. Johnson has been admitted to the practice of law in Alabama
      since 1986, Florida since 1982 and Georgia since 1997. He has been a shareholder
      in the Pensacola, Florida AV- rated law firm of Smith, Sauer, DeMaria Johnson
      and was President-Elect of the 500 member Escambia-Santa Rosa Bar Association.
      He also served on the Florida Bar Young Lawyers Division Board of Governors.
      Mr. Johnson earned a degree in History/Political Science at Auburn
      University and Juris Doctor at Samford University - Cumberland School of Law.
      Mr. Johnson is also a director and member of the audit committee of
      Peregrine Pharmaceuticals, Inc., a publicly held company.




22


**DAVID
      H. POHL.** David
      Pohl has served as a Director of the Company since April 2001, and served
      as an officer of the Company from January 2001 to March 2002. He was
      elected Chairman, Chief Executive Officer and President on June 13, 2005.
      Except for his service with the Company, Mr. Pohl has been in the private
      practice of law counseling business clients since 1997, and most recently was
      Of
      Counsel with the law firm of Herold & Sager in Encinitas, California. He is
      a member of the Intellectual Property Law and Business Law Sections of the
      State
      Bar of California. In 1995 and 1996, Mr. Pohl was Special Counsel to the Ohio
      Attorney General regarding investments in entrepreneurial firms by state pension
      funds. Previously he was a senior attorney with a large U.S. law firm, and
      held
      positions as a senior officer and general counsel in large financial services
      corporations. Mr. Pohl earned a J.D. degree in 1962 from The Ohio State
      University College of Law, and also holds a B.S. in Administrative Sciences
      from
      Ohio State. Mr. Pohl is also a director and member of the audit committee
      of Peregrine Pharmaceuticals, Inc., a publicly held company.




**THOMAS
      J. SWEENEY.** Mr. Sweeney became the Company's Chief Financial Officer on August 3, 2005
      and is Secretary of the Company. Since 2000, Mr. Sweeney has been a Partner
      in
      the San Diego office of Tatum CFO Partners, a national financial services firm.
      While a Partner of Tatum and for three and one-half years, Mr. Sweeney served
      as
      the Chief Financial Officer of New Visual Corporation, now named Rim
      Semiconductor, a publicly held development stage company in the
      telecommunications industry with more than 8,000 shareholders. Also while with
      Tatum, he served as the Chief Financial Officer of Mitchell International,
      Inc.,
      a 700 person firm that is a provider of information software, print publications
      and total business solutions. Also while with Tatum, Mr. Sweeney worked in
      Johannesburg and Cape Town, South Africa on a project basis for an investment
      group that was organized under Astrata Group, Inc., a publicly held U.S.
      company, as it completed acquisitions of satellite technology subsidiaries.
      Earlier in his career, Mr. Sweeney worked as an auditor for Ernst &
Young LLP, where he earned his CPA certificate, and worked for the international
      consulting firm of McKinsey & Company. Mr. Sweeney earned his B.B.A.
      and M.B.A. degrees from The University of Texas at Austin and is a member of
      the
      American Institute of CPAs.




**JAMES
      L. TURLEY.** Jim
      Turley has been a Director of the Company since February, 2006, and is Chairman
      of the Technology Committee of the Board of Directors. Mr. Turley is an
      acknowledged authority on microprocessor chips, semiconductor intellectual
      property, computers, and silicon technology. Mr. Turley has served as the
      Editor-in-Chief of Embedded Systems Design, a global magazine for high-tech
      developers and managers, and Conference Chairman of the Embedded Systems
      Conferences, a series of electronics design shows. In addition, since August
      2001, Mr. Turley has managed his own technology consulting and analysis
      business, Silicon Insider. From 1999 to 2001, he served as Senior Vice President
      of Marketing for ARC International, a microprocessor intellectual property
      company based in the UK. Mr. Turley has authored seven books on microprocessor
      chips, semiconductor intellectual property, computers, and silicon technology.
      He has served as editor of the prestigious industry journal Microprocessor
      Report (a three-time winner of the Computer Press Award), and is a frequent
      speaker at industry events. Mr. Turley also serves on the board of directors
      and/or technical advisory boards of several high-tech companies in the U.S.
      and
      Europe.




**COMMITTEES
      OF THE BOARD OF DIRECTORS**




Our
      board
      has standing Audit, Compensation, Executive, Nominating and Technology
      Committees.




Audit
      Committee. The
      Audit Committee reviews the audit and control functions of the Company, the
      Company's accounting principles, policies and practices and financial reporting,
      the scope of the audit conducted by the Company's auditors, the fees and all
      non-audit services of the independent auditors and the independent auditors'
      opinion and letter of comment to management and management's response
      thereto.




The
      Audit
      Committee is composed of two directors, both of whom were determined by the
      Board of Directors to be independent directors. During fiscal 2006 and to date,
      the Audit Committee has consisted of Ms. Felcyn (Chairperson) and Mr. Johnson.
      The Board of Directors has determined that Ms. Felcyn is an audit committee
      financial expert as defined in Item 401 of Regulation S-B, promulgated by the
      SEC. The Board’s conclusions regarding the qualifications of Ms. Felcyn as an
      audit committee financial expert were based on her standing as a certified
      public accountant and her degree in business economics.




Compensation
      Committee. The
      Compensation Committee reviews and recommends to the Board the salaries, bonuses
      and perquisites of the Company's executive officers. The Compensation Committee
      also reviews and recommends to the Board any new compensation or retirement
      plans and administers the Company's 1996, 2001, 2003 and 2006 Stock Option
      Plans. The Compensation Committee is composed of Mr. Johnson (Chairman), Ms.
      Felcyn and Mr. Falk.




23


Executive
      Committee. The
      Executive Committee exercises certain powers of the Board of Directors between
      normally scheduled Board meetings. The Executive Committee is composed of Mr.
      Johnson (Chairman), Ms. Felcyn, Dr. Falk and Mr. Turley.




Nominating
      Committee. The
      Nominating Committee reviews and recommends to the Board for nomination
      candidates for election to the Board. The entire Board acted in lieu of the
      Nominating Committee and in accordance with the policies that apply to the
      Nominating Committee.




Technology
      Committee. The
      Technology Committee reviews and makes recommendations to the Board regarding
      current and proposed technology. The Technology Committee is composed of Mr.
      Turley (Chairman), Mr. Johnson and Mr. Pohl.




Each
      member of the Audit Committee and Compensation Committee is independent as
      defined under the National Association of Securities Dealers’ (NASDAQ) listing
      standards.




Other
      Committees. Effective August 1, 2006, a Technology Committee was formed. The Technology
      Committee is composed of Mr. Turley (Chairman), Mr. Johnson and Mr.
      Pohl.




**COMPLIANCE
      WITH SECTION 16(A) OF THE EXCHANGE ACT**




Section
      16(a) of the Exchange Act requires the Company's directors, executive officers
      and persons who beneficially own 10% or more of a class of securities registered
      under Section 12 of the Exchange Act to file reports of beneficial ownership
      and
      changes in beneficial ownership with the SEC. Directors, executive officers
      and
      greater than 10% stockholders are required by the rules and regulations of
      the
      SEC to furnish the Company with copies of all reports filed by them in
      compliance with Section 16(a).




Based
      solely on the Company's review of those reports furnished to the Company by
      the
      persons required to make such filings during the 2006 fiscal year and the
      Company’s own records, the Company believes, that from the period June 1, 2005
      through May 31, 2006, Mr. Turley failed to file timely one Form 3 with the
      SEC
      to report his changes in beneficial ownership.




**CODE
      OF ETHICS**




The
      Company has adopted a Code of Ethics that applies to the small business issuer’s
      principal executive officer, principal financial officer, principal accounting
      officer or controller, or persons performing similar functions.




**ITEM
      10.** **EXECUTIVE
      COMPENSATION**




The
      following table sets forth the compensation, for the years indicated, of the
      Company's chief executive officer and the most highly compensated executive
      officers whose salary and bonus exceeded $100,000 (each a “Named
      Officer”).


Long
                  Term CompensationAnnual
                  Cash Compensation
              
              Awards
              
              PayoutsName
                  and
                Principal
                  Position
              
              Fiscal
                  Year
              
              Salary
                  ($)
              
              Securities
                  Underlying
                Options
                  (#)
              
              All
                  other compensationDavid
                  H. Pohl
                President
                  & CEO
              
              2006
              
              $
              236,154
              
              900,000
              
              NoneThomas
                  J. Sweeney
                CFO
              
              2006
              
              $
              243,563
              
              50,000
              
              NoneJeffrey
                  E. Wallin(2)
                President
                  & CEO
              
              
              2006
                2005
                2004
              
              $
                $
                $
              25,131
                146,317
                145,933
              (1)
                (1)
                (1)
              
              None
                250,000
                673,000
              
              $
              142,642
                None
                None
              (5)Lowell
                  W. Giffhorn(3)
                Exec.
                  VP, CFO & Secy.
              
              
              2006
                2005
                2004
              
              $
                $
                $
              22,893
                148,227
                148,800
              (1)
                (1)
                (1)
              
              None
                650,000
                239,000
              
              
              None
                None
                NonePatrick
                  O. Nunally(4)
                VP
                  and CTO
              
              
              2006
                2005
                2004
              
              $
                $
                $
              1,380
                122,734
                180,000
              (1)
                (1)
                (1)
              
              None
                200,000
                173,000
              
              
              None
                None
                None




24





(1)
      Includes cash compensation of $400 per month for car allowance.


(2)
      Mr.
      Wallin left the Company in June 2005. He was replaced by Mr. David H. Pohl
      who
      became the Company's President and CEO on June 13, 2005.


(3)
      Mr.
      Giffhorn left the Company as an executive officer in June 2005. He was replaced
      by Mr. Thomas J. Sweeney who became the Company's CFO on August 3,
      2005.


(4)
      Dr.
      Nunally left the Company in May 2005.


(5)
      Amount represents payments through May 31, 2006 to Mr. Wallin under terms of
      his
      severance agreement.




The
      Company maintains employee benefits that are generally available to all of
      its
      employees, including medical, dental and life insurance benefits and a
      401(k) retirement plan. The Company did not make any matching contributions
      under the 401(k) plan for any of the above named officers during the fiscal
      years ended May 31, 2005, or 2004. During the fiscal year ended May 31,
      2006 the Company made a matching contribution of $1,417 for Mr.
      Pohl.




**Employment
      Contracts**




The
      Company had a consulting agreement dated March 18, 2004 with San Diego
      Millennia Consultants, Inc. whereby San Diego Millennia Consultants agreed
      to
      provide the services of Mr. Wallin to be the President and Chief Executive
      Officer of the Company. Mr. Wallin's employment with the Company ended on
      June 12, 2005, and the Company's agreement with San Diego Millennia
      Consultants terminated on that date. In September 2005, the Company agreed
      to
      pay Mr. Wallin approximately $148,700 in full settlement of all amounts
      owed to him under the consulting agreement.




The
      Company had an employment agreement dated September 1, 2004 with
      Mr. Giffhorn providing for his employment as Executive Vice President and
      Chief Financial Officer. Mr. Giffhorn's employment with the Company ended
      on June 13, 2005. The Company did not pay Mr. Giffhorn any severance
      compensation or otherwise due to awaiting resolution of a dispute initiated
      by
      Mr. Giffhorn in connection with his termination of employment. The Company
      is
      currently maintaining a vigorous defense against claims made by Mr. Giffhorn
      in
      an arbitration proceeding he initiated seeking compensation and damages based
      on
      claims and assertions that are related to the termination of his employment.
      The
      Company denies the validity of Mr. Giffhorn’s claims and assertions. (See Legal
      Proceedings.)




The
      Company entered into an employment agreement dated June 1, 2004, as amended
      on July 12, 2004, with Dr. Nunally providing for his employment as the
      Chief Technical Officer of the Company. Pursuant to the terms of the employment
      agreement, Dr. Nunally's employment with the Company terminated on May 31,
      2005.




The
      Company has an employment agreement with Mr. Sweeney. Under the terms of the
      agreement, Mr. Sweeney is paid a salary of $1,125 per day, subject to
      increase in the Company's sole discretion. Mr. Sweeney is also entitled to
      a cash bonus, stock options and severance pay, in each case, as may be
      determined by the Compensation Committee in its sole discretion. During the
      course of Mr. Sweeney's employment with the Company, Mr. Sweeney remains a
      partner of Tatum CFO Partners, LLP. As a partner of Tatum, Mr. Sweeney is to
      share with Tatum a portion of his economic interest in any stock options or
      equity bonus that the Company may pay him, to the extent specified in the
      Part-Time Engagement Resources Agreement between the Company and Tatum. Mr.
      Sweeney is eligible for any Company employment retirement and/or 401(k) plan
      and
      for vacation and holidays consistent with the Company's policy as it applies
      to
      senior management. Either party may terminate the employment relationship upon
      at least 30 days' prior written notice, unless the Company has not remained
      current in its obligations under the employment agreement or the Part-Time
      Engagement Resources Agreement or if the Company engages in or asks Mr. Sweeney
      to engage in or to ignore any illegal or unethical conduct, in which case
      Mr. Sweeney may terminate his employment immediately.




25




**Option
      Grants**




The
      following table sets forth certain information concerning stock options granted
      to the Named Officers during the year ended May 31, 2006, pursuant to the
      Company's 1996, 2001, 2003 and 2006 Stock Option Plans.




Name
            
            
            Number
                of Securities Underlying
              Options
                Granted
            
            
            %
                of Total Options Granted to Employees in FY
            
            
            
            Exercise
                Price
            
            
            Expiration
                DateDavid
                H. Pohl
            
            
            500,000
            (1)
            
            None
            
            
            $
            0.163
            
            
            6/22/2010400,000
            (1)
            
            None
            
            
            $
            0.700
            
            
            5/25/2011Thomas
                J. Sweeney
            
            
            50,000
            
            
            52.6
            %
            
            $
            0.700
            
            
            5/25/2011





(1)
      Options are fully vested and were granted in recognition of his service on
      the
      Board.





**Aggregated
      Option Exercises and Fiscal Year End Option Values**




The
      following table sets forth certain information with respect to the Named
      Officers concerning exercised and unexercised stock options held as of
      May 31, 2006.




Name
            
            Shares
                Acquired
              on
                Exercise
            
            Value
                Realized
            
            Number
                of Unexercised
              Options
              Held
                at May 31, 2006
            
            Value
                of Unexercised In-The-Money Options
              at
                May 31, 2006Exercisable
            
            Unexercisable
            
            Exercisable
            
            UnexercisableJeffrey
                E. Wallin
            
            
            1,750,000
            
            $
            1,042,201
            
            
            250,000
            
            
            --
            
            $
            215,000
            
            $
            --Lowell
                W. Giffhorn
            
            
            1,120,000
            
            $
            1,194,700
            
            
            --
            
            
            --
            
            $
            --
            
            $
            --Patrick
                Nunally
            
            
            450,000
            
            $
            17,100
            
            
            --
            
            
            --
            
            $
            --
            
            $
            --David
                H. Pohl
            
            
            200,000
            
            $
            26,250
            
            
            1,075,000
            
            
            --
            
            $
            668,800
            
            $
            --Thomas
                J. Sweeney
            
            
            --
            
            
            --
            
            
            --
            
            
            50,000
            
            $
            --
            
            $
            13,500





The
      fair
      market value of the unexercised in-the-money options at May 31, 2006 was
      determined by subtracting the option exercise price from the last sale price
      as
      reported on the OTC Bulletin Board on May 31, 2006, $0.97.




The
      Company has not awarded stock appreciation rights to any of its employees.
      The
      Company has no long-term incentive plans.




**Compensation
      of Directors**




During
      fiscal year 2006, an aggregate of $294,000 was paid to the Company’s board
      members including $170,000 paid to certain members in connection with their
      efforts in the consummation of the TPL and Charles H. Moore Agreement. Expenses
      of the Company’s directors in connection with the attendance of board or
      committee meetings and company related activities are reimbursed by the
      Company.




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




**SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT**




The
      following table sets forth, as of August 31, 2006, the stock ownership of each
      officer and director of the Company, of all officers and directors of the
      Company as a group, and of each person known by the Company to be a beneficial
      owner of 5% or more of its Common Stock. Except as otherwise noted, each person
      listed below is the sole beneficial owner of the shares and has sole investment
      and voting power over such shares. No person listed below has any option,
      warrant or other right to acquire additional securities of the Company, except
      as otherwise noted.




26




Title
                of Class
            
            Name
                and Address of Beneficial Owners
            
            Amount &
                Nature of Beneficial Ownership
            
            Percent
                of ClassCommon
                stock par value $0.00001
            
            Helmut
                Falk, Jr.
              6183
                Paseo Del Norte, Suite 180
              Carlsbad,
                CA 92011
            
            3,303,231
                (1)
            
            *SAME
            
            Gloria
                Felcyn, CPA
              Same
                Address As Above
            
            1,234,070
                (2)
            
            *SAME
            
            Carlton
                M. Johnson, Jr.
              Same
                Address As Above
            
            1,475,000
                (3)
            
            *SAME
            
            David
                H. Pohl
              Same
                Address As Above
            
            2,775,000
                (4)
            
            *SAME
            
            Thomas
                J. Sweeney
              Same
                Address As Above
            
            50,000
                (5)
            
            *SAME
            
            James
                Turley
              Same
                Address As Above
            
            475,000
                (6)
            
            *SAME
            
            Lincoln
                Ventures, LLC
              1125
                Sanctuary Parkway, Suite 275
              Alpharetta,
                GA 30004
            
            36,900,446
                (7)
            
            9.99%SAME
            
            Swartz
                Private Equity, LLC
              1125
                Sanctuary Parkway, Suite 275
              Alpharetta,
                GA 30004
            
            36,900,446
                (7)
            
            9.99%SAME
            
            All
                directors & officers as a group
              (first
                6 persons above)
              *
                Indicates less than 1%
            
            9,312,301
                (8)
            
            1.87%





(1)  Includes
      890,000 shares issuable upon the exercise of outstanding stock
      options.




(2)  Includes
      950,000 shares issuable upon the exercise of outstanding stock
      options.




(3)  Includes
      1,475,000 shares issuable upon the exercise of outstanding stock
      options.




(4)  Represents
      2,575,000 shares issuable upon the exercise of outstanding stock options and
      200,000 shares held directly by David Pohl. This amount does not include 700,000
      shares owned by his spouse, Janet Valenty, as her separate property and for
      which he disclaims beneficial ownership.




(5)  Includes
      50,000 shares issuable upon the exercise of outstanding stock
      options.




(6)  Includes
      425,000 shares issuable upon the exercise of outstanding stock
      options.




(7)  Lincoln
      Ventures, LLC (“Lincoln”) and Swartz Private Equity, LLC (“SPE” and together
      with Lincoln, the “Reporting Person”) have shared voting power and shared
      dispositive power as to these shares. These amounts include 36,900,446 shares
      (in total between Lincoln and SPE, each of which hold warrants to purchase
      Common Stock of the Company) issuable upon exercise of outstanding warrants
      exercisable within 60 days of August 31, 2006. The documents governing the
      terms
      of such warrants contain a provision prohibiting Lincoln and SPE, as applicable,
      from exercising warrants for shares of Common Stock if doing so would result
      in
      the Reporting Person and their affiliates beneficially owning shares of Common
      Stock that represent more than 9.99% of the outstanding shares of Common Stock
      as determined under Section 13(d) of the Securities Exchange Act of 1934. This
      percentage assumes that Lincoln and SPE may be deemed to be affiliated and
      under
      common control.




(8)  Includes
      2,947,301 shares issued and outstanding and 6,365,000 shares issuable upon
      exercise of stock options.




27







**ITEM
              12.**
            **CERTAIN
                RELATIONSHIPS AND RELATED
                TRANSACTIONS**




None.









**ITEM
              13.**
            **EXHIBITS******








(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 in
                Part II of this Report:Report of Corbin & Company, LLP,
              Independent Registered Public Accounting FirmConsolidated Balance Sheets as of
              May 31, 2006 and 2005 (as restated)Consolidated Statements of Operations
              for the
              Years Ended May 31, 2006 and 2005 (as restated)Consolidated Statement of Stockholders’
              Equity for the Years Ended May 31, 2006 and 2005 (as
              restated)Consolidated Statements of Cash Flows
              for the
              Years Ended May 31, 2006 and 2005 (as restated)Notes to Consolidated Financial
              Statements2.
            Exhibits.
                  The following Exhibits are filed as part of, or incorporated by
                  reference into, this Report:




**Exhibit No.**
            **Document**2.1
            Agreement
                to Exchange Technology for Stock in Patriot Scientific Corporation,
                incorporated by reference to Exhibit 2.1 to Form 8-K dated
                August 10, 1989*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*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*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*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*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, 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, 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*




28




**Exhibit No.**
            **Document**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*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*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*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*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*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*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*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*3.7
            Bylaws
                of the Company, incorporated by reference to Exhibit 3.7 to Form 8-K
                dated May 12, 1992*4.1
            Specimen
                common stock certificate, incorporated by reference to Exhibit 4.1
                Form 8-K dated May 12, 1992*4.2
            Form
                of Stock Purchase Warrant (Labway Corporation) dated February 29,
                1996, exercisable to purchase 253,166 common shares at $1.58 per
                share
                until August 31, 1996, granted to investors in connection with an
                offering of securities made in reliance upon Regulation S, incorporated
                by
                reference to Exhibit 4.2 to Form 10-QSB for fiscal quarter ended
                February 29, 1996, filed March 15, 1996*4.3
            Form
                of 6% Convertible Subordinated Promissory Note due September 30, 1998
                aggregating $1,500,000 to six investors incorporated by reference
                to
                Exhibit 4.3 to Form 10-QSB for fiscal quarter ended August 31,
                1996, filed October 15, 1996*4.4
            Form
                of 5% Convertible Term Debenture (CC Investments, LDC) due June 2,
                1999 aggregating $2,000,000 to two investors incorporated by reference
                to
                Exhibit 4.4 to Form 8-K dated June 16, 1997*4.5
            Form
                of Stock Purchase Warrant (CC Investments, LDC) dated June 2, 1997
                exercisable to purchase an aggregate of 400,000 common shares at
                $1.69125
                per share until June 2, 2002, granted to two investors in connection
                with the offering of securities in Exhibit 4.4 incorporated by
                reference to Exhibit 4.5 to Form 8-K filed June 17,
                1997*4.6
            Registration
                Rights Agreement dated June 2, 1997 by and among the Company and CC
                Investments, LDC and the Matthew Fund, N.V. related to the registration
                of
                the common stock related to Exhibits 4.4 and 4.5 incorporated by
                reference to Exhibit 4.6 to Form 8-K filed June 17,
                1997*




29




**Exhibit No.**
            **Document**4.7
            Form
                of Warrant to Purchase Common Stock (Swartz Family Partnership, L.P.)
                dated June 2, 1997 exercisable to purchase an aggregate of 211,733
                common shares at $1.69125 per share until June 2, 2002, granted to a
                group of investors in connection with the offering of securities
                in
                Exhibit 4.4 incorporated by reference to Exhibit 4.7 to Form 8-K
                filed June 17, 1997*4.8
            Registration
                Rights Agreement dated June 2, 1997 by and among the Company and
                Swartz Investments, LLC related to the registration of the common
                stock
                related to Exhibit 4.7 incorporated by reference to Exhibit 4.8
                to Form 8-K filed June 17, 1997*4.9
            Form
                of 5% Convertible Term Debenture (CC Investments, LDC) due June 2,
                1999 aggregating $1,000,000 to two investors incorporated by reference
                to
                Exhibit 4.9 to Form 10-KSB for the fiscal year ended May 31,
                1998, filed August 19, 1998*4.10
            Form
                of Stock Purchase Warrant (CC Investments, LDC) dated November 24,
                1997 exercisable to purchase an aggregate of 200,000 common shares
                at
                $1.50 per share until June 2, 2002, granted to two investors in
                connection with the offering of securities described in Exhibit 4.9
                incorporated by reference to Exhibit 4.10 to Form 10-KSB for the year
                ended May 31, 1998, filed August 19, 1998*4.11
            Form
                of Warrant to Purchase Common Stock (Swartz Family Partnership, L.P.)
                dated November 24, 1997 exercisable to purchase an aggregate of
                105,867 common shares at $1.50 per share until June 2, 2002, granted
                to a group of investors in connection with the offering of securities
                described in Exhibit 4.9 incorporated by reference to
                Exhibit 4.11 to Form 10-KSB for the year ended May 31, 1998,
                filed August 19, 1998*4.12
            Form
                of Warrant to Purchase Common Stock (Investor Communications Group,
                Inc.)
                dated June 16, 1997 exercisable to purchase an aggregate of 130,000
                common shares at prices ranging from $2.50 to $7.50 per share until
                June 15, 1999 incorporated by reference to Exhibit 4.12 to Form
                10-KSB for the year ended May 31, 1998, filed August 19,
                1998*4.13
            Warrant
                to Purchase Common Stock issued to Spellcaster Telecommunications,
                Inc.
                dated April 28, 1998 exercisable to purchase an aggregate of 100,000
                common shares at $1.25 per share until April 28, 2000 incorporated by
                reference to Exhibit 4.13 to Form 10-KSB for the year ended
                May 31, 1998, filed August 19, 1998*4.14
            Investment
                agreement dated February 24, 1999 by and between the Company and
                Swartz Private Equity, LLC for a maximum aggregate amount of $5,000,000
                incorporated by reference to Exhibit 4.14 to Form 10-QSB/A for the
                fiscal quarter ended November 30, 1998, filed March 5,
                1999*4.15
            Registration
                Rights Agreement dated February 24, 1999 by and between the Company
                and Swartz Private Equity, LLC related to the registration of the
                common
                stock related to Exhibit 4.14 incorporated by reference to
                Exhibit 4.15 to Form 10-QSB/A for the fiscal quarter ended
                November 30, 1998, filed March 5, 1999*4.16
            Form
                of Warrant to Purchase Common Stock (Swartz Private Equity, LLC)
                dated
                February 24, 1999 exercisable to purchase common shares in connection
                with the offering of securities in Exhibit 4.14 incorporated by
                reference to Exhibit 4.16 to Form 10-QSB/A for the fiscal quarter
                ended November 30, 1998, filed March 5, 1999*4.17
            Amended
                and Restated Investment Agreement dated July 12, 1999 by and between
                the Company and Swartz Private Equity, LLC for a maximum aggregate
                amount
                of $5,000,000 incorporated by reference to Exhibit 4.17 to
                Pre-Effective Amendment No. 2 to Registration Statement on Form SB-2
                filed July 15, 1999*4.18
            Investment
                Agreement dated May 2, 2000 by and between the Company and Swartz
                Private Equity, LLC for a maximum aggregate amount of $30,000,000
                incorporated by reference to Exhibit 4.18 to Registration Statement
                on Form S-3 filed May 5, 2000*




30




**Exhibit No.**
            **Document**4.18.1
            Waiver
                and Agreement dated September 24, 2001 amending the Investment
                Agreement (1) dated May 2, 2000 by and between the Company and
                Swartz Private Equity, LLC for a maximum aggregate amount of $30,000,000
                incorporated by reference to Exhibit 4.18.1 to Registration Statement
                on Form S-1 filed October 11, 2001*4.19
            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*4.20
            Investment
                agreement dated September 17, 2001 by and between the Company and
                Swartz Private Equity, LLC for a maximum aggregate amount of $25,000,000
                incorporated by reference to Exhibit 4.20 to Registration Statement
                on Form S-1 filed October 11, 2001*4.21
            Registration
                Rights Agreement dated September 17, 2001 by and between the Company
                and Swartz Private Equity, LLC related to the registration of the
                common
                stock related to Exhibit 4.20 incorporated by reference to
                Exhibit 4.21 to Registration Statement on Form S-1 filed
                October 11, 2001*4.22
            Warrant
                to Purchase Common Stock dated September 17, 2001 exercisable to
                purchase common shares in connection with the Offering of securities
                in
                Exhibit 4.20 incorporated by reference to Exhibit 4.22 to
                Registration Statement on Form S-1 filed October 11,
                2001*4.23
            Financial
                Consulting Services Agreement between the Company and M. Blaine
                Riley, Randall Letcavage and Rosemary Nguyen incorporated by reference
                to
                Exhibit 4.23 to Registration Statement on Form S-8 filed
                January 22, 2002*4.24
            Form
                of 8% Convertible Debenture (Lincoln Ventures, LLC) due June 10, 2004
                aggregating $1,000,000 to six investors incorporated by reference
                to
                Exhibit 4.24 to Registration Statement on Form S-3 filed
                June 27, 2002*4.25
            Form
                of Stock Purchase Warrant (Lincoln Ventures, LLC) dated June 10, 2002
                exercisable to purchase an aggregate of 12,859,175 common shares
                at
                initial exercise prices ranging from $0.08616 to $0.10289 per share
                until
                June 10, 2007, granted to six investors in connection with the
                offering of securities described in Exhibit 4.24 incorporated by
                reference to Exhibit 4.25 to Registration Statement on Form S-3 filed
                June 27, 2002*4.26
            Form
                of Registration Rights Agreement (Lincoln Ventures, LLC) dated
                June 10, 2002 by and among the Company and six investors related to
                the registration of the common stock related to Exhibit 4.24
                incorporated by reference to Exhibit 4.26 to Registration Statement
                on Form S-3 filed June 27, 2002*4.27
            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*4.28
            Form
                of 8% Convertible Debenture, Stock Purchase Warrant, Registration
                Rights
                Agreement and Securities Purchase Agreement for financings entered
                into
                between September 28, 2004 and January 17, 2005 incorporated by
                reference to Exhibit 4.28 to Registration Statement on Form SB-2
                filed February 2, 2005.*4.29
            Approval
                Rights Agreement and Termination of Antidilution Agreement and Addendum
                to
                Warrants dated October 10, 2006**10.1
            1992
                Incentive Stock Option Plan of the Company, incorporated by reference
                to
                Exhibit 10.1 to Form 8-K dated May 12,
                1992*10.1.1
            Amendment
                to 1992 Incentive Stock Option Plan dated January 11, 1995,
                incorporated by reference to Exhibit 10.1.1 to Form S-8 filed
                July 17, 1996*10.2
            1992
                Non-Statutory Stock Option Plan of the Company, incorporated by reference
                to Exhibit 10.2 to Form 8-K dated May 12,
                1992*




31




**Exhibit No.**
            **Document**10.2.1
            Amendment
                to 1992 Non-Statutory Stock Option Plan dated January 11, 1995
                incorporated by reference to Exhibit 10.2.1 to Form 10-KSB for fiscal
                year ended May 31, 1996, filed August 16,
                1996*10.3
            Lease
                Agreement between the Company’s subsidiary Metacomp, Inc. and Clar-O-Wood
                Partnership, a California limited partnership dated April 11, 1991 as
                amended November 11, 1992 and November 2, 1995 incorporated by
                reference to Exhibit 10.3 to Form 10-KSB for fiscal year ended
                May 31, 1997, filed July 18, 1997*10.4
            Stock
                Purchase Agreement dated November 29 and 30, 1995, between the
                Company and SEA, Ltd., incorporated by reference to Exhibit 10.4 to
                Form 8-K filed December 11, 1995*10.4.1
            Letter
                Amendment to Stock Purchase Agreement dated January 31, 1996, between
                the Company and SEA, Ltd., incorporated by reference to
                Exhibit 10.4.1 to Form 10-QSB for fiscal quarter ended
                February 29, 1996, filed March 15, 1996*10.5
            1995
                Employee Stock Compensation Plan of the Company, incorporated by
                reference
                to Exhibit 10.5 to Form 10-QSB for fiscal quarter ended
                November 30, 1995, filed December 28, 1995*10.6
            Letter
                Stock and Warrant Agreement dated January 10, 1996 between the
                Company and Robert E. Crawford, Jr., incorporated by reference to
                Exhibit 10.6 to Form 10-QSB for fiscal quarter ended
                February 29, 1996, filed March 15, 1996*10.7
            Non-Exclusive
                Manufacturing and Line of Credit Agreement dated February 28, 1996,
                between the Company and Labway Corporation, incorporated by reference
                to
                Exhibit 10.7 to Form 10-QSB for fiscal quarter ended
                February 29, 1996, filed March 15, 1996*10.8
            Distribution
                and Representation Agreement dated February 28, 1996, between the
                Company and Innoware, Inc., incorporated by reference to Exhibit 10.8
                to Form 10-QSB for fiscal quarter ended February 29, 1996, filed
                March 15, 1996*10.9
            Employment
                Agreement dated November 20, 1995 between the Company and Elwood G.
                Norris, incorporated by reference to Exhibit 10.9 to Registration
                Statement on Form SB-2 filed March 18, 1996*10.9.1
            First
                Amendment to Employment Agreement dated May 17, 1996 between the
                Company and Elwood G. Norris, incorporated by reference to
                Exhibit 10.9.1 to Pre-Effective Amendment No. 2 to Registration
                Statement on Form SB-2 filed May 23, 1996*10.10
            Employment
                Agreement dated November 20, 1995 between the Company and Robert
                Putnam, incorporated by reference to Exhibit 10.10 to Registration
                Statement on Form SB-2 filed March 18, 1996*10.11
            Sales
                Contractual Agreement dated March 19, 1996 between the Company and
                Evolve Software, Inc., incorporated by reference to Exhibit 10.11 to
                Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2
                filed April 29, 1996*10.11.1
            Two
                Year Stock Purchase Warrant dated March 19, 1996 Granted to Evolve
                Software, Inc. Providing for the Purchase of up to 50,000 Common
                Shares at
                $2.85, incorporated by reference to Exhibit 10.11.1 to Pre-Effective
                Amendment No. 1 to Registration Statement on Form SB-2 filed
                April 29, 1996*10.12
            Employment
                Agreement dated as of May 8, 1996 between the Company and
                Michael A. Carenzo, including Schedule A - Stock Option
                Agreement, incorporated by reference to Exhibit 10.12 to
                Pre-Effective Amendment No. 2 to Registration Statement on
                Form SB-2 filed May 23, 1996*10.12.1
            First
                Amendment to Employment Agreement dated as of May 8, 1996 between the
                Company and Michael A. Carenzo dated September 23, 1996, incorporated
                by reference to Exhibit 10.12.1 to Form 10-KSB for the fiscal
                year ended May 31, 1997, filed July 18,
                1997*




32




**Exhibit No.**
            **Document**10.13
            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*10.14
            Sales
                Contractual Agreement dated June 20, 1996 between the Company and
                Compunetics Incorporated incorporated by reference to Exhibit 10.14
                to Form 10-KSB for fiscal year ended May 31, 1996, filed
                August 16, 1996*10.15
            Sales
                Contractual Agreement dated July 31, 1996 between the Company and
                Premier Technical Sales, Inc. incorporated by reference to
                Exhibit 10.15 to Form  10-KSB for fiscal year ended May 31,
                1996, filed August 16, 1996*10.16
            Employment
                Agreement dated January 1, 1997 between the Company and
                Norman J. Dawson incorporated by reference to Exhibit 10.16 to
                Form 10-KSB for fiscal year ended May 31, 1997, filed July 18,
                1997*10.17
            Employment
                Agreement dated January 1, 1997 between the Company and
                Jayanta K. Maitra incorporated by reference to Exhibit 10.17 to
                Form 10-KSB for fiscal year ended May 31, 1997, filed
                July 18, 1997*10.18
            Technology
                License and Distribution Agreement dated June 23, 1997 between the
                Company and Sun Microsystems, Inc. incorporated by reference to
                Exhibit 10.18 to Form 10-KSB for the fiscal year ended May 31,
                1997, filed July 18, 1997*10.19
            Employment
                Agreement dated March 23, 1999 between the Company and James T.
                Lunney incorporated by reference to Exhibit 10.19 to Form 10-KSB for
                the fiscal year ended May 31, 1998, filed August 19,
                1998*10.20
            Employment
                Agreement dated July 28, 1997 between the Company and Phillip
                Morettini incorporated by reference to Exhibit 10.20 to
                Form 10-KSB for the fiscal year ended May 31, 1998, filed
                August 19, 1998*10.21
            Employment
                Agreement dated July 23, 1998 between the Company and Lowell W.
                Giffhorn incorporated by reference to Exhibit 10.21 to
                Form 10-KSB for the fiscal year ended May 31, 1998, filed
                August 19, 1998*10.22
            Secured
                Promissory Note dated June 12, 2000 between the Company and
                James T. Lunney incorporated by reference to Exhibit 10.22 to
                Form 10-KSB for the fiscal year ended May 31, 2000, filed
                August 29, 2000*10.23
            Purchase
                Agreement dated June 29, 2000 between the Company and 4S 37/38, LLC
                incorporated by reference to Exhibit 10.23 to Form 10-KSB for the
                fiscal year ended May 31, 2000*10.24
            Employment
                Agreement dated October 2, 2000 between the Company and
                Miklos B. Korodi incorporated by reference to Exhibit 10.24 to
                Form 10-QSB for the fiscal quarter ended November 30, 2000, filed
                January 12, 2001*10.25
            Employment
                Agreement dated December 1, 2000 between the Company and
                Richard G. Blum incorporated by reference to Exhibit 10.25 to
                Form 10-QSB for the fiscal quarter ended November 30, 2000, filed
                January 12, 2001*10.26
            Employment
                Agreement dated January 29, 2001 between the Company and Serge J.
                Miller incorporated by reference to Exhibit 10.26 to Form 10-KSB
                for the fiscal year ended May 31, 2001, filed August 29,
                2001*




33




**Exhibit No.**
            **Document**10.27
            Lease
                Agreement dated February 23, 2001 between the Company and Arden
                Realty Finance IV, LLC incorporated by reference to Exhibit 10.27 to
                Form 10-KSB for the fiscal year ended May 31, 2001, filed
                August 29, 2001*10.28
            Employment
                Agreement dated January 1, 2001 between the Company and David H.
                Pohl incorporated by reference to Exhibit 10.28 to Form 10-KSB
                for the fiscal year ended May 31, 2001, filed August 29,
                2001*10.29
            Employment
                Agreement dated April 26, 2001 between the Company and David H.
                Pohl incorporated by reference to Exhibit 10.29 to Form 10-KSB for
                the fiscal year ended May 31, 2001, filed August 29,
                2001*10.30
            Employment
                Agreement dated November 17, 2001 between the Company and
                Lowell W. Giffhorn incorporated by reference to Exhibit 10.30 to
                Registration Statement on Form S-3 filed June 27,
                2002*10.31
            Employment
                Agreement dated December 20, 2001 between the Company and Jayanta
                Maitra incorporated by reference to Exhibit 10.31 to Registration
                Statement on Form S-3 filed June 27, 2002*10.32
            Consulting
                Agreement dated March 7, 2002 between the Company and SDMC, Inc.
                incorporated by reference to Exhibit 10.32 to Registration Statement
                on Form S-3 filed June 27, 2002*10.33
            Employment
                Agreement dated January 2, 2004 between the Company and Jayanta
                Maitra incorporated by reference to Exhibit 10.33 to Registration
                statement on Form SB-2 filed May 21, 2004*10.34
            Consulting
                Agreement dated March 18, 2004 between the Company and SDMC, Inc.
                incorporated by reference to Exhibit 10.34 to Registration Statement
                en Form SB-2 filed May 21, 2004*10.35
            Employment
                Agreement dated June 1, 2004 between the Company and Patrick Nunally
                incorporated by reference to Exhibit 10.35 to Form 10-KSB for the
                fiscal year ended May 31, 2004, filed August 19,
                2004*10.36
            Amendment
                No. 1 to Employment Agreement dated July 12, 2004 between the
                Company and Patrick Nunally incorporated by reference to
                Exhibit 10.36 to Form 10-KSB for the fiscal year ended May 31,
                2004, filed August 19, 2004*10.37
            Employment
                Agreement dated September 1, 2004 between the Company and Lowell W.
                Giffhorn incorporated by reference to Exhibit 10.37 to Registration
                Statement on Form SB-2 filed February 2, 2005*10.38
            IGNITE
                License Agreement with Advanced Micro Devices, Inc., dated
                February 21, 2005**10.39
            Patent
                Portfolio License Agreement with Advanced Micro Devices, Inc., dated
                February 21, 2005**10.40
            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*10.41
            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*10.42
            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*10.43
            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*




34




**Exhibit No.**
            **Document**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*21.1
            Subsidiaries
                of the small business issuer**31.1
            Certification
                of David H. Pohl, CEO, pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002**31.2
            Certification
                of Thomas J. Sweeney, CFO, pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002**32.1
            Certification
                of David H. Pohl, CEO, pursuant to Section 906 of the Sarbanes-Oxley
                Act of 2002**32.2
            Certification
                of Thomas J. Sweeney, CFO, pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002**99.1
            Form
                of ISO Plan Option (Gaspar) dated May 29, 1992, incorporated by
                reference to Exhibit 28.2 to registration statement on
                Form SB-2, 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, 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*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*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*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*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*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*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*




*
            Previously
                filed in indicated registration statement or
                report.




**
            Exhibit filed
                herewith this Annual Report on Form 10-KSB for the fiscal year ended
                May 31, 2006.




**ITEM
        14.** **PRINCIPAL
        ACCOUNTANT FEES AND SERVICES** ****




On
      November 21, 2005, the Company received notice from Mayer Hoffman McCann
      P.C. (“Mayer Hoffman”), that they resigned effective November 21, 2005, as
      the Company's independent registered accounting firm. Mayer Hoffman's reports
      on
      the consolidated financial statements of the Company and its subsidiaries for
      the two most recent fiscal years ended May 31, 2005, did not contain any
      adverse opinion or disclaimer of opinion, nor were they qualified or modified
      as
      to uncertainty, audit scope, or accounting principles, except only that their
      report for the fiscal year ending May 31, 2004 was modified as to an
      uncertainty regarding the Company's ability to continue as a going
      concern.




On
      November 21, 2005, the Executive Committee of the Board, upon the
      recommendation of the Audit Committee, elected to engage Corbin & Company
      LLP (“Corbin”) to serve as the Company's independent registered accounting firm.
      On November 23, 2005, the Company was informed that it had been accepted as
      a client of Corbin.




35




During
      the Company's two most recent fiscal years ended May 31, 2005 and the
      subsequent interim period through November 23, 2005, there were no
      disagreements between the Company and Mayer Hoffman on any matter of accounting
      principles or practices, financial statement disclosure, or auditing scope
      or
      procedure, which disagreements, if not resolved to Mayer Hoffman's satisfaction,
      would have caused them to make reference to the subject matter of the
      disagreement in their reports on the financial statements for such
      years.




The
      Company had authorized Mayer Hoffman to respond fully to the inquiries of Corbin
      concerning their resignation and provided Mayer Hoffman with a copy of the
      foregoing disclosures. Attached as Exhibit 16 to the Company's Current
      Report on Form 8-K filed with the SEC on November 28, 2005, is a copy of
      Mayer Hoffman's letter, dated November 28, 2005, stating its agreement with
      the statements related to it.




To
      help
      ensure the independence of the Company's independent auditor, the Audit
      Committee has approved and adopted a Policy on Engagement of Independent
      Auditor, which is available on the Company's web site at
      www.ptsc.com.




Pursuant
      to the Policy on Engagement of Independent Auditor, the Audit Committee is
      directly responsible for the appointment, compensation and oversight of the
      independent auditor. The Audit Committee preapproves all audit services and
      non-audit services to be provided by the independent auditor. The Audit
      Committee may delegate to one or more of its members the authority to grant
      the
      required approvals, provided that any exercise of such authority is presented
      at
      the next Audit Committee meeting for ratification.




Each
      audit, non-audit and tax service that is approved by the Audit Committee will
      be
      reflected in a written engagement letter or writing specifying the services
      to
      be performed and the cost of such services, which will be signed by either
      a
      member of the Audit Committee or by an officer of the Company authorized by
      the
      Audit Committee to sign on behalf of the Company.




The
      Audit
      Committee will not approve any prohibited non-audit service or any non-audit
      service that individually or in the aggregate may impair, in the Audit
      Committee's opinion, the independence of the independent auditor.




In
      addition, since January 1, 2003, the Company's independent auditor may not
      provide any services to officers of the Company or Audit Committee members,
      including financial counseling or tax services.




**Audit
      Fees**




During
      the fiscal years ended May 31, 2006 and 2005, the aggregate fees billed by
      the Company's principal accountants for professional services rendered for
      the
      audit of the Company's annual financial statements and review of its financial
      statements included in the Company's Form 10-QSB, and audit services provided
      in
      connection with other statutory or regulatory filings were $337,364 and
      $105,900, respectively.




**Audit-Related
      Fees**




During
      the fiscal year ended May 31, 2006, the aggregate fees billed by the
      Company's principal accountants for assurance and related services reasonably
      related to the performance of the audit or review of the Company's financial
      statements that are not reported under “Audit Fees” were $23,228, which were
      primarily for review of registration and proxy statements. No such fees were
      billed during the fiscal year ended May 31, 2005.




**Tax
      Fees**




During
      the fiscal years ended May 31, 2006 and 2005, the aggregate fees billed by
      the Company's principal accountant for tax compliance, tax advice and tax
      planning rendered on behalf of the Company were $8,000 and $6,500, respectively,
      which related to the preparation of federal and state income tax
      returns.




**All
      Other Fees**




The
      Company's principal accountant billed no other fees for the fiscal years ended
      May 31, 2006 and 2005, except as disclosed above.




36


Patriot
                Scientific CorporationIndex
                  to Consolidated Financial StatementsReport
                  of Independent Registered Public Accounting Firm-
                  May 31, 2006 and 2005
              F-2Consolidated
                  Balance Sheets as of May 31, 2006 and 2005 (as restated)
              F-3Consolidated
                  Statements of Operations for the Years Ended May 31,2006
                  and 2005 (as restated)
              F-4Consolidated
                  Statements of Stockholders’ Equity (Deficit) for theYears
                  Ended May 31, 2006 and 2005 (as restated)
              F-5Consolidated
                  Statements of Cash Flows for the Years EndedMay
                  31, 2006 and 2005 (as restated)
              F-6Notes
                  to Consolidated Financial Statements
              F-7
                  to F-30









**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 (the "Company") as of May 31, 2006 and 2005, and the related
      consolidated statements of operations, stockholders' equity (deficit) and cash
      flows for the years then ended. 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 standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the
      consolidated financial statements are free of material misstatement. The Company
      is not required to have, nor were we engaged to perform, an audit on its
      internal control over financial reporting. Our audit 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 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 consolidated financial position of Patriot
      Scientific Corporation as of May 31, 2006 and 2005, and the consolidated
      results of its operations and its cash flows for the years then ended in
      conformity with accounting principles generally accepted in the United States
      of
      America.





As
      discussed in Note 3, the accompanying consolidated financial statements for
      the
      year ended May 31, 2005 have been restated.








/s/
      Corbin & Company, LLP


Irvine,
      California


October
      11, 2006




F-2





**Patriot
      Scientific Corporation**


**Consolidated**  **Balance
      Sheets**





****May
                31,
            
            **2006**
            
            **2005****ASSETS**
            
            
            
            **(AS
                RESTATED, SEE NOTE 3)**Current
                Assets:Cash
                and cash equivalents
            
            $
            3,984,240
            
            $
            591,426Restricted
                cash and cash equivalents
            
            
            100,320
            
            
            201,648Marketable
                securities and short term investments
            
            
            3,518,879
            
            
            697,524Accounts
                receivable
            
            
            4,113
            
            
            -Licenses
                receivable
            
            
            -
            
            
            2,000,000Prepaid
                expenses and other current assets
            
            
            407,418
            
            
            121,758Total
                current assets
            
            
            8,014,970
            
            
            3,612,356**Property
                and equipment**,
                net (Note 4)
            
            
            64,006
            
            
            21,376**Other
                assets, net**
            
            
            8,190
            
            
            23,891Investment
                in affiliated company (Note 6)
            
            
            3,952,914
            
            
            -**Patents
                and trademarks**,
                net of accumulated amortization of $584,387 and $549,563
            
            
            31,587
            
            
            66,411$
            12,071,667
            
            $
            3,724,034**LIABILITIES
                AND STOCKHOLDERS’ EQUITY (DEFICIT)**Current
                liabilities:Line
                of credit
            
            **$**
            -
            
            $
            100,000Current
                portion of 8% convertible debentures, net of debt discount of $301,320
                at
                May 31, 2005 (Note 8)
            
            
            -
            
            
            421,847Accounts
                payable
            
            
            695,323
            
            
            268,458Accrued
                liabilities and other (Note 7)
            
            
            154,730
            
            
            505,153Current
                portion of capital lease obligation
            
            
            -
            
            
            2,306Accrued
                contested fee payable (Note 11)
            
            
            394,063
            
            
            346,000Total
                current liabilities
            
            
            1,244,116
            
            
            1,643,764**8%
                Convertible Debentures**,
                net of discount of $111,559 at May 31, 2005 (Note 8)
            
            
            -
            
            
            45,942Warrant
                and derivative liabilities (Notes 8 and 9)
            
            
            -
            
            
            9,274,712Total
                liabilities
            
            
            1,244,116
            
            
            10,964,418**Commitments
                and contingencies**(Notes 5 and 11)**Stockholders’
                equity (deficit)**(Note
                9)Preferred
                stock, $.00001 par value; 5,000,000 shares authorized: none
                outstanding
            
            
            -
            
            
            -Common
                stock, $.00001 par value: 500,000,000 shares authorized: 366,199,765
                and
                280,492,013 shares issued and outstanding
            
            
            3,661
            
            
            2,805Additional
                paid-in capital
            
            
            69,551,981
            
            
            55,459,253Accumulated
                deficit
            
            
            (58,728,091
            )
            
            (62,702,442
            )Total
                stockholders’ equity (deficit)
            
            
            10,827,551
            
            
            (7,240,384
            )**$**
            12,071,667
            
            $
            3,724,034





*See
      accompanying notes to consolidated financial statements.*







F-3





**Patriot
      Scientific Corporation**


**Consolidated
      Statements of Operations**








**Years
                Ended May 31,**
            
            **2006**
            
            **2005**Revenues
            
            
            
            **(AS
                RESTATED, SEE NOTE 3)**Licenses
                and royalties
            
            $
            10,000,000
            
            $
            2,957,509Other
            
            
            309,709
            
            
            25,07710,309,709
            
            
            2,982,586Cost
                of sales
            
            
            103,351
            
            
            -Gross
                profit
            
            
            10,206,358
            
            
            2,982,586Operating
                expenses:Research
                and development
            
            
            225,565
            
            
            294,735Selling,
                general and administrative
            
            
            4,151,099
            
            
            2,600,430Settlement
                and license expense
            
            
            1,918,054
            
            
            -Total
                operating expenses
            
            
            6,294,718
            
            
            2,895,165Operating
                income
            
            
            3,911,640
            
            
            87,421Other
                income (expense):Unrealized
                loss on marketable securities
            
            
            (1,466
            )
            
            (21,180
            )Interest
                and other income
            
            
            330,055
            
            
            56,251Gain
                on sale of assets
            
            
            2,724
            
            
            4,128Interest
                expense (Note 8)
            
            
            (516,465
            )
            
            (3,081,760
            )Loss
                on debt extinguishments
            
            
            (445,427
            )
            
            -Change
                in fair value of warrant and derivative liabilities
            
            
            (2,456,736
            )
            
            (7,563,564
            )Equity
                in earnings of affiliated company
            
            
            27,848,363
            
            
            -Total
                other income (expense), net
            
            
            24,761,048
            
            
            (10,606,125
            )Net
                income (loss)
            
            **$**
            28,672,688
            
            **$**
            (10,518,704
            )Basic
                income (loss) per common share
            
            **$**
            0.09
            
            $
            (0.05
            )Diluted
                income (loss) per common share
            
            **$**
            0.07
            
            $
            (0.05
            )Weighted
                average number of common shares outstanding - basic
            
            
            316,100,499
            
            
            222,495,047Weighted
                average number of common shares outstanding - diluted
            
            
            412,963,173
            
            
            222,495,047





*See
      accompanying notes to consolidated financial statements.*




F-4


**Patriot
      Scientific Corporation**


**Consolidated
      Statements of Stockholders’ Equity (Deficit)**




Common
                StockShares
            
            Amounts
            
            Additional
                Paid-in Capital
            
            **ACCUMULATED
                DEFICIT**
            
            **STOCKHOLDERS’**
              **EQUITY**
              **(DEFICIT)**Balance,
                May 31, 2004(as
                previously reported)
            
            
            171,156,363
            
            $
            1,712
            
            $
            49,990,485
            
            $
            (49,844,018
            )
            $
            148,179Prior
                period restatement adjustment (Note 3)
            
            
            -
            
            
            -
            
            
            (3,532,942
            )
            
            (2,339,720
            )
            
            (5,872,662
            )Balance,
                May 31, 2004
            
            
            171,156,363
            
            
            1,712
            
            
            46,457,543
            
            
            (52,183,738
            )
            
            (5,724,483
            )Issuance
                of common stock at $.03 and $.10 per share
            
            
            4,625,000
            
            
            46
            
            
            453,204
            
            
            -
            
            
            453,250Exercise
                of warrants and options at $.02 to $.06 per share
            
            
            39,028,511
            
            
            390
            
            
            820,899
            
            
            -
            
            
            821,289Issuance
                of common stock for services at $.05 and $.09 per share
            
            
            796,000
            
            
            8
            
            
            58,792
            
            
            -
            
            
            58,800Conversion
                of debentures payable plus accrued interest at $.02 and $.05 per
                share
            
            
            64,886,139
            
            
            649
            
            
            2,169,287
            
            
            -
            
            
            2,169,936Non-cash
                compensation
            
            
            -
            
            
            -
            
            
            59,675
            
            
            -
            
            
            59,675Reclassification
                of derivative value associated with debt conversions and warrant
                exercises
                (as restated, see Note 3)
            
            
            -
            
            
            -
            
            
            5,439,853
            
            
            -
            
            
            5,439,853Net
                loss (as restated, see Note 3)
            
            
            -
            
            
            -
            
            
            -
            
            
            (10,518,704
            )
            
            (10,518,704
            )Balance,
                May 31, 2005
              (as
                restated, see Note 3)
            
            
            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
            
            
            -
            
            
            296,129Exercise
                of warrants and options at $.02 to $.69 per share
            
            
            12,824,544
            
            
            128
            
            
            851,070
            
            
            -
            
            
            851,198Conversion
                of debentures payable plus accrued interest at $.02 and $.04 per
                share
            
            
            30,819,187
            
            
            308
            
            
            998,729
            
            
            -
            
            
            999,037Cashless
                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
            
            
            -
            
            
            81,250Extension
                of term of options previously issued to consultant
            
            
            -
            
            
            -
            
            
            125,000
            
            
            -
            
            
            125,000Repurchase
                of warrants
            
            
            -
            
            
            -
            
            
            (252,420
            )
            
            -
            
            
            (252,420
            )Issuance
                of warrants to a consultant
            
            
            -
            
            
            -
            
            
            108,102
            
            
            -
            
            
            108,102Intrinsic
                value of options issued to employees
              and
                directors
            
            
            -
            
            
            -
            
            
            120,000
            
            
            -
            
            
            120,000Cash
                dividends $.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
            
            
            -
            
            
            5,021,353Reclassification
                of warrant and derivative liabilities at settlement date
            
            
            -
            
            
            -
            
            
            6,743,935
            
            
            -
            
            
            6,743,935Net
                income
            
            
            
            
            
            
            
            
            
            
            
            28,672,688
            
            
            28,672,688Balance,
                May 31, 2006
            
            
            366,199,765
            
            $
            3,661
            
            $
            69,551,981
            
            $
            (58,728,091
            )
            $
            10,827,551





*See
      accompanying notes to consolidated financial statements.*








F-5





**Patriot
      Scientific Corporation**


**Consolidated
      Statements of Cash Flows**





*Years
                Ended May 31,*
            
            2006
            
            2005(As
                restated, see Note 3)**Operating
                activities:**Net
                income (loss)
            
            $
            28,672,688
            
            $
            (10,518,704
            )Adjustments
                to reconcile net income (loss) to net cash provided by (used in)
                operating
                activities:Amortization
                and depreciation
            
            
            59,415
            
            
            94,353Non-cash
                interest expense related to convertible debentures, notes payable
                and
                warrants
            
            
            470,736
            
            
            2,940,608Expense
                related to extension of expiration date of stock options
            
            
            125,000
            
            
            -Net
                gain related to warrant re-pricing, reconveyance and
                issuance
            
            
            (538,208
            )
            
            -Loss
                on extinguishment of debt
            
            
            445,427
            
            
            -Accrued
                interest income added to investments
            
            
            (19,778
            )
            
            -Equity
                in earnings of investee
            
            
            (27,848,363
            )
            
            -Gain
                on disposal of fixed assets
            
            
            (2,724
            )
            
            (4,012
            )Unrealized
                loss on marketable securities
            
            
            1,466
            
            
            21,180Issuance
                of stock, options and warrants for services
            
            
            554,245
            
            
            118,476Change
                in fair value of derivative liabilities
            
            
            2,456,736
            
            
            7,563,564Intrinsic
                value of options issued
            
            
            120,000
            
            
            -Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            (4,113
            )
            
            -Prepaid
                and other assets
            
            
            (261,769
            )
            
            218,865Licenses
                receivable
            
            
            2,000,000
            
            
            (2,000,000
            )Accounts
                payable and accrued expenses
            
            
            194,811
            
            
            435,644Accrued
                contested fee payable
            
            
            48,063
            
            
            501,700Net
                cash provided by (used in) operating activities
            
            
            6,473,632
            
            
            (628,326
            )**Investing
                activities:**Proceeds
                from sale of short-term investments
            
            
            2,027,557
            
            
            **-**Purchase
                of short-term investments
            
            
            (4,832,482
            )
            
            (897,706
            )Proceeds
                from sale of fixed assets
            
            
            6,540
            
            
            5,000Purchase
                of restricted investments
            
            
            (100,000
            )
            
            -Proceeds
                from sale of restricted investments
            
            
            203,210
            
            
            -Payment
                for security deposit
            
            
            (8,190
            )
            
            -Purchase
                of property and equipment
            
            
            (71,037
            )
            
            -Investment
                in investee
            
            
            (2,000,000
            )
            
            -Distributions
                from investee
            
            
            25,895,449
            
            
            -Net
                cash provided by (used in) investing activities
            
            
            (21,121,047
            )
            
            (892,706
            )**Financing
                activities:******Payment
                of cash dividends
            
            
            (24,698,337
            )
            
            -Payment
                of shareholder note
            
            
            -
            
            
            (100,000
            )Proceeds
                from line of credit
            
            
            -
            
            
            100,000Principal
                payments on secured notes payable
            
            
            (100,000
            **)**
            
            -Payments
                for capital lease obligations
            
            
            (2,306
            )
            
            (8,020
            )Proceeds
                from issuance of convertible debentures
            
            
            -
            
            
            490,000Proceeds
                from issuance of common stock
            
            
            -
            
            
            453,250Proceeds
                from exercise of common stock warrants and options
            
            
            851,198
            
            
            821,288Repurchase
                of warrants
            
            
            (252,420
            )
            
            -Net
                cash provided by (used in) financing activities
            
            
            (24,201,865
            )
            
            1,756,518**Net
                increase in cash and cash equivalents**
            
            
            3,392,814
            
            
            235,486**Cash
                and cash equivalents,**beginning
                of year
            
            
            591,426
            
            
            355,940**Cash
                and cash equivalents, end of year**
            
            **$**
            3,984,240
            
            $
            591,426**Supplemental
                Disclosure of Cash Flow Information:**Cash
                payments for interest
            
            $
            2,983
            
            $
            15,406Cash
                payments for income taxes
            
            $
            -
            
            $
            4,800**Supplemental
                Disclosure of Non-Cash Investing and Financing
                Activities:**Convertible
                debentures, notes payable and accrued interest exchanged for common
                stock
            
            $
            999,037
            
            $
            2,169,936Debt
                discount arising from issuance of detachable warrants
            
            $
            -
            
            $
            490,000Reclassification
                of derivative liabilities associated with debt conversions and warrant
                exercises
            
            $
            5,021,353
            
            $
            5,439,853Reclassification
                of warrant and derivative liabilities at settlement date
            
            $
            6,743,935
            
            $
            -Cashless
                exercise of warrants
            
            $
            412
            
            $
            -


*See
      accompanying notes to consolidated financial statements.*




F-6




**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements**





**1.
      Organization and Business**


Patriot
      Scientific Corporation (the “Company”), 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. to form Phoenix Digital Solutions, LLC.





The
      Company is an intellectual property company that licenses its jointly held
      patent portfolio technology to others and litigates against those who infringe
      upon the patent portfolio technology.





**2.
      Summary of Significant Accounting Policies**





**Basis
      of Consolidation**


The
      consolidated financial statements include the accounts of the Company and its
      majority owned subsidiaries, Metacomp, Inc. (“Metacomp”) and Plasma Scientific
      Corporation. All material intercompany transactions and balances have been
      eliminated in consolidation.





**Reclassifications**


Certain
      reclassifications have been made to the 2005 financial statements in order
      for
      them to conform to the 2006 presentation. Such reclassifications have no impact
      on the Company’s financial position or results of operations.





**Financial
      Instruments and Concentrations of Credit Risk**


Financial
      instruments that potentially subject the Company to concentrations of credit
      risk consist principally of cash, short-term investments and trade accounts
      receivable.





At
      times,
      the Company’s balance of cash and investments in certificates of deposits
      maintained with its bank may exceed 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. When the
      Company has excess cash, the Company’s cash equivalents are placed in high
      quality money market accounts with major financial institutions and high grade
      short-term commercial paper. The Company believes this investment policy limits
      its exposure to concentrations of credit risk. Money market accounts are
      federally insured; however, commercial paper is not insured. The Company has
      not
      experienced any losses in such accounts.





Concentrations
      of credit risk with respect to accounts receivable are limited due to the wide
      variety of customers and markets which comprise the Company’s customer base, as
      well as their dispersion across many different geographic areas. The Company
      routinely assesses the financial strength of its customers and, as a
      consequence, believes that its accounts receivable credit risk exposure is
      limited. Generally, the Company does not require collateral or other security
      to
      support customer receivables.





The
      carrying value of financial instruments, including cash, cash equivalents, short-term
      investments, accounts
      receivable, accounts payable and accrued liabilities, approximate fair value
      because of the immediate or short-term maturity of these instruments.





**Cash
      Equivalents, Marketable Securities, and Short Term
      Investments**


For
      purposes of balance sheet classification and the statements of cash flows,
      the
      Company considers 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, 2006 consist of two savings accounts
      required to be held as collateral for corporate credit card
      accounts.





F-7


**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





At
      May
      31, 2005, the Company had investments in marketable equity securities having
      a
      carrying value of $1,466. Marketable equity securities are carried at their
      fair
      value, with unrealized gains or losses reflected in the statements of
      operations. During the years ended May 31, 2006 and 2005, the Company recognized
      unrealized losses related to the change in the carrying value of the securities
      of $1,466 and $21,180, respectively.





The
      Company’s short term investments consist primarily of money market mutual funds
      and accounts and commercial paper, and are reported at cost, which approximates
      fair market value.





**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 three to
      five
      years.  Major betterments and renewals are capitalized, while routine
      repairs and maintenance are charged to expense when incurred.





**Patents
      and Trademarks**


Patents
      and trademarks are carried at cost less accumulated amortization and are
      amortized over their estimated useful lives of four years. Estimated future
      annual amortization expense arising from the patents is approximately $23,000
      and $9,000 in fiscal years 2007 and 2008, respectively.





**Investment
      in Affiliated Company**


The
      Company has a 50% interest in Phoenix Digital Systems, LLC (“Phoenix Digital”)
      (see Note 6). This investment is accounted for using the equity method of
      accounting since the investment provides the Company the ability to exercise
      significant influence, but not control, over the investee. Significant influence
      is generally deemed to exist if the Company has 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 the Company’s 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 company”.





The
      Company reviews its investment in affiliated company to determine whether events
      or changes in circumstances indicate that its carrying amount may not be
      recoverable. The primary factors the Company considers in its determination
      are
      the financial condition, operating performance and near term prospects of the
      investee. If the decline in value is deemed to be other than temporary, the
      Company would recognize an impairment loss.





**Long-Lived
      Assets**


The
      Company's management assesses the recoverability of its 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, 2006,
      the Company's management believes there is no impairment of its long-lived
      assets.  There can be no assurance, however, that market conditions will
      not change or demand for the Company's products will continue, which could
      result in impairment of long-lived assets in the future.




F-8


**Patriot
        Scientific Corporation**
 **Notes
        to Consolidated Financial Statements (Continued)**




**Derivative
        Financial Instruments**
 In
        connection with the issuance of certain convertible debentures (see Note
        8), the
        terms of the debentures included an embedded reset conversion feature which
        provided for a conversion of the debentures into shares of the Company's
        common
        stock at a rate which was determined to be variable. The Company determined
        that
        the reset conversion feature was an embedded derivative instrument
        and that the conversion option was an embedded put option pursuant to Statement
        of Financial Accounting Standards (“SFAS”) No. 133, *Accounting
        for Derivative Instruments and Hedging Activities* ,
        as
        amended, and Emerging Issues Task Force (“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 the
        Company 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, the Company was 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, the Company
        recorded a non-operating, non-cash charge.  If the fair value of the
        derivatives was lower at the subsequent balance sheet date, the Company recorded
        non-operating, non-cash income.




During
      the years ended May 31, 2006 and 2005, the Company recognized other expense
      of
      approximately $2,457,000 and $7,564,000, respectively, related to recording
      the
      warrant and derivative liabilities at fair value. At May 31, 2006, there are
      no
      derivative liabilities since the related variable debt instruments were settled
      in full during fiscal 2006. At the settlement date, the remaining warrant
      liabilities with a value of approximately $6,744,000 were reclassified to
      additional paid-in capital.





The
      Company’s derivative instruments were valued using a Monte Carlo simulation
      model incorporating the instruments’ multiple reset dates.





The
      following assumptions were used for valuing the embedded derivatives during
      the
      years ended May 31, 2006 and 2005:




**May
                31, 2006**
            
            **May
                31, 2005**Estimated
                dividends
            
            None
            
            NoneExpected
                volatility
            
            101
                - 229%
            
            161
                - 266%Risk-free
                interest rate
            
            3.5
                - 5.1%
            
            1.3
                - 4.4%Expected
                term (years)
            
            2
                -
                7
            
            2
                -
                7





**Revenue
      Recognition**


The
      Company recognizes revenue from the sale of its product upon shipment to the
      customer, at which time title transfers and the Company has 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 the Company enters into a contract and
      provides the customer with the licensed technology. At this point, the Company
      has performed all of its obligations under contract, the rights to the Company’s
      technology have been transferred and no significant performance obligations
      remain.





**Research
      and Development Costs**


Research
      and development costs are expensed as incurred.





F-9


**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





**Advertising**


The
      Company expenses advertising costs as incurred. There was no advertising expense
      for the year ended May 31, 2006. Advertising expense was approximately $14,000
      for the year ended May 31, 2005.





**Income
      Taxes**


The
      Company accounts 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.





**Net
      Income (Loss) Per Share**


The
      Company applies SFAS No. 128, *Earnings
      Per Share* ,
      for the
      calculation of "Basic" and "Diluted" earnings (loss) per share. Basic earnings
      (loss) per share includes no dilution and is computed by dividing income (loss)
      available to common stockholders by the weighted average number of common shares
      outstanding for the period. Diluted earnings (loss) per share reflects the
      potential dilution of securities that could share in the earnings (loss) of
      an
      entity. At May 31, 2006, potential common shares of 2,295,000 related to the
      Company’s outstanding warrants and options were not included in the calculation
      of diluted income per share as they had an anti-dilutive effect. At May 31,
      2005, potential common shares of 143,826,204 related to the Company’s
      outstanding convertible debentures, warrants and options were not included
      in
      the calculation of diluted loss per share as they had an anti-dilutive
      effect.






**Year
                Ended May 31, 2006**Numerator
                (Income)
            
            Denominator
                (Shares)
            
            Per
                Share AmountBasic
                EPS:Net
                income
            
            $
            28,672,688
            
            
            316,100,499
            
            $
            0.09Diluted
                EPS:Interest
                onconvertibledebentures
            
            
            458,467Effect
                ofdilutivesecurities:Options
                andwarrants
            
            
            -
            
            
            80,273,769Convertibledebentures
            
            
            -
            
            
            16,588,905Income
                available to common shareholders
            
            $
            29,131,155
            
            
            412,963,173
            
            $
            0.07





F-10





**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**




**Year
                Ended May 31, 2005**Numerator
                (Loss)
            
            Denominator
                (Shares)
            
            Per
                Share AmountBasic
                EPS:Net
                loss
            
            $
            (10,518,704
            )
            
            222,495,047
            
            $
            (0.05
            )Diluted
                EPS:
            
            
            -
            
            
            -Loss
                available to common shareholders
            
            $
            (10,518,704
            )
            
            222,495,047
            
            $
            (0.05
            )





**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 and disclosure of contingent assets and liabilities at the date
      of
      the consolidated financial statements and the reported amounts of revenues
      and
      expenses during the reporting period. Significant estimates made by management
      are, among others, the realizability of accounts receivable, recoverability
      of
      long-lived assets, and valuation of stock options, warrants, derivative
      liabilities, and deferred tax assets. Actual results could differ from those
      estimates.





**Stock
      Based Compensation**


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* ,
      and
      EITF Issue No. 96-18, *Accounting
      for Equity Instruments that are Issued to Other Than Employees for Acquiring,
      or
      in Conjunction with Selling Goods or Services* .
      All
      transactions in which goods or services are the consideration received for
      the
      issuance of equity instruments are accounted for based on the fair value of
      the
      consideration received or the fair value of the equity instrument issued,
      whichever is more reliably measurable. The measurement date used to determine
      the fair value of the equity instrument issued is the earlier of the date on
      which the third-party performance is complete or the date on which it is
      probable that performance will occur.





In
      December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
      148, *Accounting
      for Stock-Based Compensation—Transition and Disclosure* ,
      effective for fiscal years ending after December 15, 2002. SFAS No. 148 amends
      SFAS No. 123 to provide alternative methods of transition to the fair value
      method of accounting for stock-based employee compensation. SFAS No. 148
      also amends the disclosure provisions of SFAS No. 123 to require disclosure
      in
      the summary of significant accounting policies of the effects of an entity’s
      accounting policy with respect to stock-based employee compensation on reported
      net income and earnings per share in annual and interim financial statements.
      SFAS No. 148 does not amend SFAS No. 123 to require companies to account for
      their employee stock-based awards using the fair value method. The disclosure
      provisions are required, however, for all companies with stock-based employee
      compensation, regardless of whether they utilize the fair value method of
      accounting described in SFAS No. 123 or the intrinsic value method described
      in
      Accounting Principles Board (“APB”) Opinion No. 25, *Accounting
      for Stock Issued to Employees* .







The
      Company accounts for stock-based awards to employees using the intrinsic value
      method in accordance with Accounting Principles Board (“APB”) Opinion No. 25. As
      permitted by SFAS No. 123, as amended by SFAS No. 148, the Company has chosen
      to
      continue to account for its employee stock-based compensation plans under APB
      Opinion No. 25 and provide the expanded disclosures specified in SFAS No. 123,
      as amended by SFAS No. 148.




F-11










**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**







Had
      employee stock based compensation cost been determined using the fair value
      method the Company’s net income (loss) would have been adjusted to the pro forma
      amounts indicated below:





Year
                Ended May 31,2006
            
            2005(As
                restated, see Note 3)Net
                income (loss) as reported
            
            $
            28,672,688
            
            $
            (10,518,704
            )Add:Stock
                based compensation expense included in reported net income (loss),
                net of
                related tax effects
            
            
            120,000
            
            
            -Deduct:Total
                stock based employee compensation expense under fair value based
                method
                for all awards, net of related tax effects
            
            
            (1,639,913
            )
            
            (138,883
            )Pro
                forma net income (loss)
            
            $
            27,152,775
            
            $
            (10,657,587
            )





Net
                income (loss) per common share, as reported - basic
            
            $
            0.09
            
            $
            (0.05
            )Net
                income (loss) per common share, as reported - diluted
            
            $
            0.07
            
            $
            (0.05
            )Net
                income (loss) per common share, pro forma - basic
            
            $
            0.09
            
            $
            (0.05
            )Net
                income (loss) per common share, pro forma - diluted
            
            $
            0.07
            
            $
            (0.05
            )








**Recent
      Accounting Pronouncements**


In
      December 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based Payment* ("SFAS
      No. 123(R)"), which is a revision of SFAS No. 123.  SFAS No. 123(R)
      supersedes APB Opinion No. 25 and amends SFAS No. 95, *Statement
      of Cash Flows* . 
      Generally, the approach in SFAS No. 123(R) is similar to the approach described
      in SFAS No. 123.  However, SFAS No. 123(R) requires all share-based
      payments to employees, including grants of employee stock options, to be
      recognized in the income statement based on their fair values.  Pro forma
      disclosure is no longer an alternative.  The provisions of this statement
      are effective for the Company as of June 1, 2006.  The Company expects to
      adopt SFAS No. 123(R) in the first fiscal quarter of 2007.




SFAS
      No.
      123(R) requires companies to recognize in the income statement the grant-date
      fair value of stock options and other equity-based compensation issued to
      employees.  SFAS No. 123(R) also establishes accounting requirements for
      measuring, recognizing and reporting share-based compensation, including income
      tax considerations.  Upon adoption of SFAS No. 123(R), the Company will be
      required to determine the transition method to be used at the date of
      adoption.  The allowed transition methods are the modified prospective
      application and the modified retrospective application.  Under the modified
      prospective application, the cost of new awards and awards modified, repurchased
      or cancelled after the required effective date and the portion of awards for
      which the requisite service has not been rendered (unvested awards) that are
      outstanding as of the required effective date will be recognized as the
      requisite service is rendered on or after the required effective date.  The
      compensation cost for that portion of awards shall be based on the grant-date
      fair value of those awards as calculated for either recognition or pro forma
      disclosures under SFAS No. 123.  The modified retrospective application
      requires companies to record compensation expense for all unvested stock options
      and restricted stock beginning with the first disclosed period restated. 
The Company plans to adopt SFAS No. 123(R) using the modified prospective
      application.




F-12





As
      permitted by SFAS No. 123, the Company currently accounts for share-based
      payments to employees using APB Opinion No. 25's intrinsic value method and,
      as
      such, generally recognizes no compensation cost for employee stock
      options.  Accordingly, the adoption of SFAS No. 123(R)'s fair value method
      will have a negative impact on the Company's results of operations, although
      it
      will have no impact on its overall financial position.  The impact of
      adopting SFAS No. 123(R) cannot be predicted at this time because it will depend
      on levels of share-based payments granted in the future.  However, had the
      Company adopted SFAS No. 123(R) in prior periods, the impact of that standard
      would have approximated the impact of SFAS No. 123 as described in the
      disclosure of pro forma net income (loss) and income (loss) per share. 
SFAS No. 123(R) also requires the benefits of tax deductions in excess of
      recognized compensation cost to be reported as a financing cash flow, rather
      than as an operating cash flow as required under current accounting
      literature.  The requirement will reduce net operating cash flows and
      increase net financing cash flows in periods of adoption.





In
      December 2004, the FASB issued SFAS No. 153, *Exchange
      of Nonmonetary Assets,* an
      amendment of APB Opinion No. 29, *Accounting
      for Nonmmonetary Transaction* .
      SFAS
      No. 153 is based on the principle that exchanges of non-monetary assets should
      be measured based on the fair market value of the assets exchanged. SFAS No.
      153
      eliminates the exception of non-monetary exchanges of similar productive assets
      and replaces it with a general exception for exchanges of non-monetary assets
      that do not have commercial substance. SFAS 153 is effective for non-monetary
      asset exchanges in fiscal periods beginning after June 15, 2005. The Company
      does not believe that the provisions of SFAS No. 153 will have a material impact
      on its financial statements.





In
      May
      2005, the FASB issued SFAS No. 154, *Accounting
      Changes and Error Corrections* ,
      which
      replaces APB Opinion No. 20, *Accounting
      Changes* ,
      and
      FASB Statement No. 3, *Reporting
      Accounting Changes in Interim Financial Statements* ,
      and
      changes the requirements for the accounting for and reporting of a change in
      accounting principle. SFAS No. 154 requires retrospective application to prior
      periods’ financial statements of changes in accounting principle, unless it is
      impracticable to determine either the period-specific effects or the cumulative
      effect of the change. SFAS No. 154 is effective for accounting changes and
      correction of errors made in fiscal years beginning after December 15, 2005.
      Early adoption is permitted for accounting changes and correction of errors
      made
      in fiscal years beginning after the date SFAS No. 154 was issued. At the present
      time, the Company does not believe that adoption of SFAS No. 154 will have
      a
      material effect on its financial statements.





**3.
      Restatement of Previously Issued Financial Statements**





During
      fiscal 2006, the Company determined that the manner in which it historically
      accounted for the reset conversion feature and embedded put option of certain
      of
      its convertible debentures issued during fiscal 2002 through fiscal 2005 was
      not
      in accordance with SFAS No. 133, as amended, and EITF Issue No. 00-19. The
      Company 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. The accounting treatment of derivative financial instruments
      required that the Company 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, the Company was 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 required
      to be 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, the Company was required to record a
      non-operating, non-cash charge.  If the fair value of the derivatives was
      lower at the subsequent balance sheet date, the Company was required to record
      non-operating, non-cash income.  Accordingly, in connection with the
      restatement adjustments, the Company has appropriately reflected the
      non-operating, non-cash income or expense resulting from the changes in fair
      value. The Company had previously not recorded the embedded derivative
      instruments as liabilities and did not record the related changes in fair
      value.




F-13




**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





The
      following tables present a summary of the effects of the restatement adjustments
      on the Company's consolidated balance sheet at May 31, 2005 and the consolidated
      statements of operations and cash flows for the year ended May 31,
      2005:






**Consolidated
                Balance Sheet****As
                of May 31, 2005**
            
            
            **As
                Previously Reported**
            
            
            **Adjustments**
            
            
            **As
                Restated**Warrant
                and derivative liabilities
            
            $
            -
            
            $
            9,274,712
            
            $
            9,274,712Total
                liabilities
            
            $
            1,689,706
            
            $
            9,274,712
            
            $
            10,964,418Additional
                paid-in capital
            
            $
            54,569,091
            
            $
            890,162
            
            $
            55,459,253Accumulated
                deficit
            
            $
            (52,537,568
            )
            $
            (10,164,874
            )
            $
            (62,702,442
            )Total
                stockholders’ equity (deficit)
            
            $
            2,034,328
            
            $
            (9,274,712
            )
            $
            (7,240,384
            )






**Statement
                of Income****Year
                ended May 31, 2005**
            
            **As
                Previously Reported**
            
            **Adjustments**
            
            **As
                Restated**Change
                in fair value of warrant and derivativeliabilities
            
            $
            -
            
            $
            (7,563,564
            )
            $
            (7,563,564
            )Interest
                expense
            
            $
            (2,820,170
            )
            $
            (261,590
            )
            $
            (3,081,760
            )Total
                other expense
            
            $
            (2,780,971
            )
            $
            (7,825,154
            )
            $
            (10,606,125
            )Net
                loss
            
            $
            (2,693,550
            )
            $
            (7,825,154
            )
            $
            (10,518,704
            )LOSS
                PER COMMON SHARE:Basic
            
            $
            (0.01
            )
            $
            (0.04
            )
            $
            (0.05
            )Diluted
            
            $
            (0.01
            )
            $
            (0.04
            )
            $
            (0.05
            )




**Statement
                of Cash Flows****Year
                ended May 31, 2005**
            
            
            **As
                Previously Reported**
            
            
            **Adjustments**
            
            
            **As
                Restated**Net
                loss
            
            $
            (2,693,550
            )
            $
            (7,825,154
            )
            $
            (10,518,704
            )Change
                in fair value of warrant and derivativeLiabilities
            
            $
            -
            
            $
            7,563,564
            
            $
            7,563,564Non-cash
                interest expense related to convertible debebtures, notes payable
                and
                warrants
            
            $
            2,679,018
            
            $
            261,590
            
            $
            2,940,608





F-14


**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





**4.
      Property and Equipment**





Property
      and equipment consisted of the following at May 31, 2006 and 2005:





2006
            
            2005Computer
                equipment and software
            
            $
            33,587
            
            $
            857,948Furniture
                and fixtures
            
            
            37,336
            
            
            213,458Laboratory
                equipment
            
            
            -
            
            
            35,67370,923
            
            
            1,107,079Less
                accumulated depreciation and amortization
            
            
            (6,917
            )
            
            (1,085,703
            )Net
                property and equipment
            
            $
            64,006
            
            $
            21,376




Depreciation
      and amortization expense related to property and equipment was $24,591 and
      $46,026 for the years ended May 31, 2006 and 2005.





**5.
      License Agreements**





In
      February 2005, the Company entered into two separate licensing agreements with
      one customer for the Company’s 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 years ended May
      31,
      2006 and 2005 was $25,000 and $6,250, respectively. 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 the Company based on sales of product using the Ignite licensed
      technology. In connection with this license agreement, the Company became
      obligated to the former co-inventor of the patent portfolio technology for
      $207,600 pursuant to a July 2004 agreement under which the Company was obligated
      to pay a percentage of licensed proceeds to the co-inventor. The amount due
      was
      payable in four installments of $51,900; $54,063 remains outstanding at May
      31,
      2006, and is included in accrued contested fee payable. The Company has reviewed
      the potential obligation for future payments to the co-inventor of the patent
      portfolio technology in connection with entering into license agreements. The
      Company believes, based upon consultation with its legal counsel, that it has
      no
      further obligation to the co-inventor and has not provided an accrual for such
      amount. The Company is aware of a lawsuit filed against it by the co-inventor
      of
      the patent portfolio technology The Company intends to vigorously defend itself
      in this matter; however, it is possible that were the Company not to prevail
      in
      the suit, the ultimate amount payable to such co-inventor of the Ignite
      technology could be significant.




F-15


**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





**6.
      Investment in Affiliated Company/License Agreement**


On
      June
      7, 2005, the Company entered into a Master Agreement (the “Master Agreement”)
      with Technology Properties Limited Inc., a California corporation (“TPL”), and
      Charles H. Moore (“Moore”), the co-inventor of certain of the Company’s
      technology, pursuant to which the Company and Moore resolved all legal disputes
      between them. Pursuant to the Master Agreement, the Company and TPL entered
      into
      the Limited Liability Company Operating Agreement of Phoenix Digital Solutions,
      LLC (the “LLC Agreement”) into which the Company and Moore contributed their
      rights to certain of the Company’s technologies. The Company believes, based
      upon consultation with its attorneys, it was not required by applicable law
      or
      other existing agreements to obtain approval for the contribution of the license
      rights to Phoenix Digital from stockholders or any parties other that its
      various warrant holders.





The
      Company and TPL each own 50% of the membership interests of Phoenix Digital,
      and
      each have 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 Company
      and TPL agreed to establish a working capital fund for Phoenix Digital of
      $4,000,000, of which the Company’s contribution was $2,000,000. The working
      capital fund increases to a maximum of $8,000,000 as license revenues are
      achieved. The Company and TPL are obligated to fund future working capital
      requirements at the discretion of the management committee of Phoenix Digital
      in
      order to maintain working capital of not more than $8,000,000. Neither the
      Company nor TPL 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. Phoenix Digital
      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 Phoenix Digital)
      for supporting efforts to secure licensing agreements by the other member on
      behalf of Phoenix Digital. During the year ended May 31, 2006, Phoenix Digital
      paid $2,500,000 to TPL pursuant to this commitment.





The
      Company is accounting for its investment in Phoenix Digital under the equity
      method of accounting, and accordingly has recorded its initial contribution
      of
      $2,000,000 and its 50% share of Phoenix Digital’s net income of $27,848,363
      during the year ended May 31, 2006 as an increase in its investment. Cash
      distributions of $25,895,449 received from Phoenix Digital during the year
      ended
      May 31, 2006 have been recorded as a reduction in the Company’s investment. The
      Company’s investment in Phoenix Digital is $3,952,914 at May 31, 2006 and has
      been recorded as “Investment in Affiliated Company”. The Company has recorded
      its 50% share of Phoenix Digital’s net income as “Equity in Earnings of
      Affiliated Company” in the accompanying consolidated statement of operations for
      year ended May 31, 2006.





Concurrently
      with forming Phoenix Digital, the Company entered into a license agreement
      with
      a third party pursuant to which it received $10,000,000, which amount was
      recorded as license revenue during the quarter ended August 31, 2005. In
      connection with entering into the license agreement and forming Phoenix Digital,
      the Company incurred various cash and non-cash expenses. Direct, incremental
      cash costs incurred with the transactions included $170,000 paid to a committee
      of the Company’s board of directors for their efforts in consummating the
      transactions, approximately $1,328,000 paid to certain of the Company’s warrant
      holders to obtain their approval of the agreement and release of their lien
      and
      blocking rights. Additionally, $960,000 was paid to the former co-inventor
      of
      the technology.




F-16




**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





The
      Company 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
      the Company’s intellectual property, and to finalize the LLC Agreement. The
      Company granted a warrant to TPL to acquire up to 3,500,000 shares of the
      Company’s 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 the Company’s 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 the Company’s stock price reached $0.50, $0.75 and $1.00,
      respectively. As additional consideration to the warrant holders for providing
      approval for the transaction, the Company 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 the
      Company. Further, the Company issued additional warrants to acquire
      approximately 290,000 shares of the Company’s 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.





On
      January 24, 2006, Phoenix Digital entered into a license agreement with a third
      party, pursuant to which it received $26,400,000 and on February 21, 2006 and
      February 24, 2006, Phoenix Digital entered into license agreements with third
      parties for $2,000,000 and $31,600,000, respectively.








The
      condensed balance sheet and statement of income of Phoenix Digital at May 31,
      2006 and for the year then ended are as follows:





**Condensed
      Balance Sheet**


ASSETS:Cash
              
              $
              7,765,708Prepaid
                  expenses
              
              
              15,000Total
                  assets
              
              $
              7,780,708LIABILITIES
                  AND MEMBERS’ EQUITY:Accounts
                  payable and accrued expenses
              
              $
              148,762Members’
                  equity
              
              
              7,631,946Total
                  liabilities and members’ equity
              
              $
              7,780,708**Condensed
                  Statement of Income**Revenues
              
              $
              60,000,000Operating
                  expenses
              
              
              4,486,955Operating
                  income
              
              
              55,513,045Interest
                  income
              
              
              183,682Net
                  income
              
              $
              55,696,727




**7.
      Accrued Liabilities**





At
      May
      31, 2006 and 2005, accrued liabilities consisted of the following:





2006
            
            2005Due
                to co-inventor (Note 5)
            
            $
            -
            
            $
            155,700Accrued
                lease obligation
            
            
            23,323
            
            
            100,000Deferred
                maintenance fee
            
            
            68,750
            
            
            93,750Compensation
                and benefits
            
            
            62,657
            
            
            80,049Interest
            
            
            -
            
            
            75,654$
            154,730
            
            $
            505,153




F-17




**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





**8.
      Convertible Debentures**





From
      fiscal 2002 through fiscal 2005, the Company 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 the Company’s common stock for up to
      two years from the date of issuance.




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 the Company's common
      stock to the conversion price of the debentures. On those measurement dates
      where 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. As of May 31, 2005, the reset conversion rate
      on
      debentures outstanding ranged from $0.02 to $0.04.




Concurrent
      with the issuance of the convertible debentures, the Company issued to the
      debenture holders warrants to purchase shares of the Company's 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, the Company is responsible for
      registering the resale of the shares of its common stock which will be issued
      on
      the conversion of the debentures. As of May 31, 2005, there have been six
      registration statements. The convertible debentures were secured by
      substantially all assets of the Company.




The
      terms
      of the convertible debentures included certain features that are 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 the Company’s common stock at a rate which was determined to be
      variable. Because the debentures were not conventional convertible debt, the
      Company was also required to record the related warrants at their fair values.
      The total of the derivative and warrant liabilities at May 31, 2005 was
      $9,274,712, consisting of the fair value of the conversion feature and reset
      feature of $3,602,365 and the fair value of the warrants of $4,029,634. In
      addition, under the provisions of EITF Issue No. 00-19, as a result of entering
      into the convertible debenture agreements, the Company was required to classify
      all other non-employee warrants as derivative liabilities and record them at
      their fair values at each balance sheet date. The total fair value of the
      non-employee warrants at May 31, 2005 was $1,642,713.




During
      the years ended May 31, 2006 and 2005, the value of the warrant and derivative
      liabilities increased by $2,456,736 and $7,563,564, respectively, which is
      reflected as a component of other income (expense) in the accompanying
      consolidated statements of operations.




During
      the year ended May 31, 2006, the Company entered into two reset agreements
      with
      the debenture holders to fix the conversion price of the then outstanding
      debentures at their current price. The Company 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, the
      Company issued 7,000,000 warrants to the debenture holder as consideration
      for
      entering into the reset agreement. The




F-18




**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**




Company
        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, the Company
        recorded the fair value of the warrants issued of $445,427 as a loss on debt
        extinguishment in the accompanying consolidated statement of operations 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 approximately $119,000, into 30,819,187 shares of the Company’s common stock.
        During the year ended May 31, 2005, the Company converted principal of
        $2,057,500 and related accrued interest of $112,436 into 64,886,139 shares
        of
        the Company’s common stock. As of May 31, 2006, all outstanding debentures have
        been repaid or converted into shares of the Company’s common
        stock.




As
      a
      result of the settlement of the remaining debentures during 2006, the Company
      reclassified $6,743,935 related to the fair values of all outstanding warrants
      at the date of settlement to additional paid-in capital.





The
      following table presents the status and activity of the Company’s convertible
      debentures as of May 31, 2006:


Conversion
                    PricesSeries
                
                Dates
                    of Issuance
                
                Original
                    Principal
                
                Principal
                    Balance at May 31, 2006
                
                Initial
                
                Reset
                
                Effective
                    Registration Date
                
                Shares
                    Converted as of May 31, 2006
                
                Warrant
                    Shares IssuedA
                
                
                4/23/02-6/10/02
                
                $
                1,000,000
                
                $
                -
                
                $
                0.08616-0.10289
                
                $
                0.04190-0.04457
                
                
                10/29/2002
                
                
                24,099,548
                
                
                12,859,175B
                
                
                8/23/02-
                  1/24/03
                
                
                605,000
                
                
                -
                
                
                0.05126-0.0727
                
                
                0.04381-0.04722
                
                
                3/7/2003
                
                
                14,777,350
                
                
                11,234,835C
                
                
                3/24/02-6/9/03
                
                
                510,000
                
                
                -
                
                
                0.041-0.065
                
                
                0.041-0.065
                
                
                6/26/2003
                
                
                10,470,554
                
                
                9,377,943D
                
                
                8/1/03-10/21/03
                
                
                547,500
                
                
                -
                
                
                0.0172-0.048
                
                
                0.0172-0.0477
                
                
                11/18/2003
                
                
                25,178,803
                
                
                22,455,355E
                
                
                12/1/03-5/11/04
                
                
                1,527,500
                
                
                -
                
                
                0.0267-0.10
                
                
                0.0267-0.10
                
                
                6/7/2004
                
                
                46,794,618
                
                
                30,395,392F
                
                
                3/23/04
                
                
                723,168
                
                
                -
                
                
                0.09
                
                
                0.09
                
                
                Not
                    Registered
                
                
                20,877,430
                
                
                8,035,192G
                
                
                9/28/04-1/17/05
                
                
                232,500
                
                
                -
                
                
                0.016710-0.04
                
                
                0.01670-0.04
                
                
                5/22/2006
                
                
                8,267,358
                
                
                8,259,678G
                
                
                11/17/04-11/18/04
                
                
                257,500
                
                
                -
                
                
                0.016710-0.04
                
                
                0.01670-0.04
                
                
                Not
                    Registered
                
                
                14,107,672
                
                
                13,431,137$
                5,403,168
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                164,573,333
                
                
                116,048,707







F-19







**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





Convertible
                debentures outstanding as of May 31, 2005 is as
                follows:




Convertible
                debentures issued
            
            $
            5,403,168Less
                amounts converted to common stock
            
            
            (4,522,500
            )880,668Less
                debt discount
            
            
            (412,879
            )467,789Less
                current portion
            
            
            (421,847
            )Long-term
                portion
            
            $
            45,942





At
      May
      31, 2005, the Company's convertible debentures were convertible into
      approximately 27,556,000 shares of the Company's common stock.





The
      terms
      of the convertible debentures include certain features that were considered
      embedded derivative financial instruments, such as the conversion feature and
      a
      reset conversion feature which provides for the conversion of the debentures
      into shares of the Company’s common stock at a rate which is variable. Because
      the debentures are not conventional convertible debt, the Company was
      required to record the derivative financial instruments and the warrants issued
      in connection with the convertible debentures at their fair values as of the
      issuance date of each of the debentures. The initial fair values assigned to
      the
      embedded derivatives related to convertible debentures issued during the year
      ended May 31, 2005 was $371,246. The initial fair values assigned to the
      warrants issued in connection with the convertible debentures during the year
      ended May 31, 2005 was $681,921. No convertible debentures or warrants in
      connection with convertible debentures were issued during the year ended May
      31,
      2006.





The
      Company 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 years ended May 31, 2006 and 2005, the
      Company recorded interest expense of $412,879 and $2,152,267, respectively,
      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, the Company recorded the excess as additional
      interest expense. The Company recorded additional interest expense of $563,167
      during the year ended May 31, 2005 related to the fair values of derivative
      instruments and warrants in excess of proceeds received. 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-20


**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





**9.
      Stockholders’ Equity**





During
      fiscal 2005, the Company’s shareholders approved an increase in the authorized
      number of common shares from 400,000,000 to 500,000,000.





***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. The Company 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. The Company recorded an expense of $296,129 in connection
      with
      the issuance of these shares.





During
      fiscal 2005, 4,625,000 restricted shares of common stock were issued to a group
      of individual investors in exchange for $453,250. Additionally, the Company
      issued 796,000 shares of common stock, valued at $58,800, to a vendor in
      exchange for services, which was included in selling, general and administrative
      expenses.





During
      February 2006, the Company 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,
      the
      Company 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 .





***Warrants***





At
      May
      31, 2005, the Company had warrants outstanding to purchase 109,122,581 shares
      of
      common stock at exercise prices ranging from approximately $0.02 to $0.065
      per
      share expiring at various dates through 2012. During fiscal 2005, the Company
      issued warrants to purchase 29,021,363 shares of common stock at exercise prices
      ranging from $0.02 to $0.08 per share and issued 38,358,511 shares of common
      stock on the exercise of warrants at exercise prices ranging from $0.02 to
      $0.05
      per share.





At
      May
      31, 2006, the Company 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 are subject to meeting vesting criteria.
      During the year ended May 31, 2006, the Company 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 the Company had
      investors exercise 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, the
      Company 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. The Company re-priced other warrants to
      purchase approximately 35,000,000 common shares to $0.015 during the year ended
      May 31, 2006 (see Note 5).




F-21




**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





Effective
      January 11, 2006, the Company entered into a warrant redemption agreement with
      a
      warrant holder, whereby at the Company's option, the Company agreed to redeem
      certain warrants representing the right to acquire an aggregate of up to
      10,000,000 shares of the Company's 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 the Company's 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, the Company agreed to redeem 2,000,000
      warrants for $252,420 and payment for the redemption occurred in March 2006.





Effective
      February 9, 2006, the Company 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, the Company and the warrant holders agreed to amend
      the
      terms of (i) each of the warrants of the Company 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 the common stock of the Company, and (ii)
      each of the debentures of the Company 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 the Company had previously recognized an expense for the modification
      (see
      Note 5). Under the terms of the Reset Agreements, the Company and the warrant
      holders also agreed to amend all of the agreements entered into between the
      Company and the warrant holders that limit the ability of the warrant holders
      to
      be the beneficial owner of more than 4.99% of the common stock of the Company
      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 the common stock of the Company.





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 the Company. Prior to entering into
      the
      waiver agreements, if at any time after the issuance date of the subject
      warrants, the Company made any distributions to holders of its 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 the Company's 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, the Company issued warrants for the right to acquire 7,000,000
      shares of the Company’s common stock to one warrant holder and recognized a loss
      on debt extinguishment of $445,427 (see Note 8).


On
        July
        31, 2006, the Company received proceeds of $5,500 from the issuance of 50,000
        shares of common stock in connection with the exercise of 50,000 stock
        options.
  From
        June
        1, 2006 through September 7, 2006, the Company received proceeds of $84,500
        from
        the issuance of 395,000 shares of common stock in connection with the exercise
        of warrants. In addition, certain warrants holders received 2,891,322 shares
        of
        common stock in connection with the cashless exercise of warrants.
  In
        connection with a previous debt agreement, the Company entered into an
        Antidilution Agreement (the “Antidilution Agreement”) with Swartz Private
        Equity, LLC (“Swartz”) wherein the Company was 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. During the year ended May 31, 2005, the Company issued
        warrants to Swartz to purchase 7,330,548 shares of the Company’s common stock in
        connection with the Antidilution Agreement. There were no warrants issued
        during
        the year ended May 31, 2006 in connection with the Antidilution agreement.
        On
        October 10, 2006, the Company 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, the Company agrees
        to
        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 common stock of the Company outstanding at the time of
        the
        acquisition (on a fully diluted basis) or (ii) any acquisition (regardless
        of
        size) by the Company of any business entity or asset of any kind that is
        not
        unanimously approved by the Company’s board of directors.




The
      following table presents outstanding warrants at May 31, 2006 and
      2005:





2006
            
            2005Issued
                in conjunction with:Convertible
                debentures
            
            
            40,769,009
            
            
            75,196,854Anti-dilution
                agreements
            
            
            690,211
            
            
            20,813,081Equity
                lines of credit
            
            
            **-**
            
            
            9,965,369Waiver
                agreements
            
            
            7,000,000
            
            
            -Other
            
            
            4,890,000
            
            
            3,147,277Total
                warrants outstanding
            
            
            53,349,220
            
            
            109,122,581




F-22




**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





***1996
      Stock Option Plan***





Effective
      March 1996, as amended, the Company 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 common stock of the Company may be granted to either
      full
      or part time employees, directors and consultants of the Company 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 years
      ended May 31, 2006 and 2005, the Company granted options to purchase 50,000
      and
      645,000 shares of common stock, respectively, under the 1996 Stock Option Plan.





***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 the Company’s common stock to
      either full or part time employees, directors and consultants of the Company
      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, 2006 and 2005, the Company granted options to purchase 145,000
      and
      1,150,000 shares of its common stock, respectively, under this 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 the Company’s common stock to either full
      or part time employees, directors and consultants of the Company 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, 2006 and 2005, the Company granted options to purchase 1,550,000
      and 1,695,000 shares of the Company’s common stock at market value,
      respectively, under this plan.





***2006
      Stock Option Plan***





Effective
      March, 2006 the Company adopted the 2006 Stock Option Plan, which expires in
      2016. The 2006 Stock Option Plan 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 the Company’s common stock to either full or part time employees,
      directors and consultants of the Company 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). During the fiscal
      year ended May 31, 2006, the Company granted options to purchase 2,050,000
      shares of the Company’s common stock at market value, 192,857 of which were
      ISOs. In connection with these option grants, the Company recognized
      compensation expense of $120,000 related to options granted below the fair
      market value of the Company’s common stock at the date of grant.




F-23





**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**




SFAS
      No.
      123, *“Accounting
      for Stock-Based Compensation* ,”
      requires the Company to provide pro forma information regarding net income
      or
      loss and net income or loss per share as if compensation costs for the Company’s
      stock option plans and other stock awards had been determined in accordance
      with
      the fair value based method prescribed in SFAS No. 123. The Company estimates
      the fair value of each stock award at the grant date by using the Black-Scholes
      option-pricing model with the following weighted-average assumptions used for
      the two years ended May 31, 2006 and 2005, respectively: dividend yield of
      zero
      percent for both years; expected volatility of 115% to 158% and 121 % to 129%,
      risk-free interest rates of 3.8 % to 5.0% and 3.4% to 4.0%; and expected lives
      of five years and three to five years.





A
      summary
      of the status of the Company’s stock option plans and warrants as of May 31,
      2006 and 2005 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, 2004
            
            
            7,003,000
            
            $
            0.21
            
            
            121,349,420
            
            $
            0.05Granted
            
            
            3,490,000
            
            
            0.08
            
            
            29,021,363
            
            
            0.04Cancelled
            
            
            (2,675,000
            )
            
            0.31
            
            
            (2,889,691
            )
            
            0.07Exercised
            
            
            (670,000
            )
            
            0.05
            
            
            (38,358,511
            )
            
            0.03Outstanding,
                May 31, 2005
            
            
            7,148,000
            
            
            0.13
            
            
            109,122,581
            
            
            0.04Granted
            
            
            3,795,000
            
            
            0.46
            
            
            12,457,049
            
            
            0.09Cancelled
            
            
            (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
            
            $
            0.05Exercisable,
                May 31, 2005
            
            
            5,748,000
            
            $
            0.14
            
            
            108,622,581
            
            $
            0.04Exercisable,
                May 31, 2006
            
            
            5,115,000
            
            $
            0.35
            
            
            52,849,220
            
            $
            0.05Weighted
                average fair value of options and warrants granted during the year
                ended
                May 31, 2005
            
            
            
            
            $
            0.04
            
            
            
            
            $
            0.05Weighted
                average fair value of options and warrants granted during the year
                ended
                May 31, 2006
            
            
            
            
            $
            0.49
            
            
            
            
            $
            0.19





Included
      in the above table are certain options for which vesting is contingent based
      on
      various future performance measures.




F-24





**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





The
      following table summarizes information about stock options and warrants
      outstanding at May 31, 2006:




Outstanding
              
              ExercisableRange
                  of Exercise Prices
              
              Number
                  Outstanding
              
              Weighted
                  Average Remaining Contractual Life (Years)
              
              Weighted
                  Average Exercise Price
              
              Number
                  Exercisable
              
              Weighted
                  Average Exercise PriceOptions
              
              $
              0.05-0.08
              
              
              975,000
              
              
              2.88
              
              $
              0.07
              
              
              725,000
              
              $
              0.060.10-0.17
              
              
              2,390,000
              
              
              3.74
              
              
              0.14
              
              
              2,390,000
              
              
              0.140.70
              
              
              2,095,000
              
              
              4.99
              
              
              0.70
              
              
              2,000,000
              
              
              0.70$
              0.05-0.70
              
              
              5,460,000
              
              
              4.06
              
              $
              0.34
              
              
              5,115,000
              
              $
              0.35Warrants
              
              $
              0.02-0.03
              
              
              28,020,398
              
              
              5.84
              
              $
              0.02
              
              
              28,020,398
              
              $
              0.020.04-0.08
              
              
              20,138,822
              
              
              5.39
              
              
              0.05
              
              
              19,638,822
              
              
              0.050.10-1.00
              
              
              5,190,000
              
              
              5.94
              
              
              0.15
              
              
              5,190,000
              
              
              0.15$
              0.02-1.00
              
              
              53,349,220
              
              
              5.68
              
              $
              0.05
              
              
              52,849,220
              
              $
              0.05


**10.
      INCOME TAXES**





No
      provision for income taxes was recorded for the years ended May 31, 2006 and
      2005 due to the significant net operating loss carryforwards.





The
      reconciliation of the effective income tax rate to the Federal statutory rate
      is
      as follows for the years ended May 31:





**2006**
            
            2005(As
                restated, see Note 3)Federal
                income tax rate
            
            
            34.0
            %
            
            34.0
            %State
                income tax rate, net of Federal effect
            
            
            -
            %
            
            -
            %(Decrease)
                Increase in valuation allowance and other
            
            
            (34.0
            )%
            
            (34.0
            )%Effective
                income tax rate
            
            
            -
            %
            
            -
            %





F-25









**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





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
      the
      Company’s deferred tax assets are as follows as of May 31:




2006
            
            2005(As
                restated, see Note 3)Deferred
                tax assets:Net
                operating loss carryforwards
            
            $
            12,628,402
            
            $
            13,488,125Accruals
            
            
            1,474,050
            
            
            1,888,087Basis
                difference in fixed assets
            
            
            51,259
            
            
            68,435Investment
                  in affiliated company
            
            
            (11,497,984
            )
            
            -Inventory
                and other reserves
            
            
            -
            
            
            41,446Credits
            
            
            289,318
            
            
            329,583Less:
                valuation allowance
            
            
            (2,945,045
            )
            
            (15,815,676
            )Net
                deferred tax assets
            
            $
            -
            
            $
            -








As
      of May
      31, 2006 and 2005, valuation allowances equal to the net deferred tax asset
      recognized have been recorded as management has not determined that it is more
      likely than not that the deferred tax asset will be realized. No current tax
      provision was recorded for fiscal 2006 and 2005 due to reported net losses
      and
      significant net operating loss carryforwards. The valuation allowance decreased
      by $12,870,631 and $46,182 during the years ended May 31, 2006 and 2005
      respectively.





At
      May
      31, 2006, the Company has federal net operating loss carryforwards of
      approximately $ 34,169,000 that expire during the years 2007 through
      2024. At May 31, 2005 the federal net operating loss carryforwards were
      approximately $34,218,000 expiring 2006 through 2024. All losses are subject
      to
      certain limitations imposed under the Internal Revenue Code of 1986, as amended.
      As such, certain federal net operating loss carryforwards may expire unused
      and
      per year availability may be subject to change of ownership limitations under
      Internal Revenue Code Section 382.





At
      May
      31, 2006 the Company has state net operating loss carryforwards of approximately
      $17,354,000 that expire during the years 2004 through 2013, at May 31, 2005
      state net operating loss carryforwards were approximately $19,173,000 expiring
      during the years 2003 through 2013. The state of California suspended the
      utilization of net operating losses for 2002 and 2003 and removed the suspension
      in 2004.





**11.
      Commitments and Contingencies**





***Litigation***





*Beatie
      and Osborne, LLP v. Patriot Scientific Corporation*




F-26




**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**




Beatie
      and Osborne, LLP is a New York law firm that formerly represented the Company
      in
      the Inventorship Litigation and the Infringement Litigation. On March 8,
      2005, Beatie and Osborne was disqualified by United States District Judge Jeremy
      Fogel in the Inventorship Litigation. Beatie and Osborne thereafter withdrew
      from the representation of the Company in the Infringement Litigation. Beatie
      and Osborne initiated litigation in the Supreme Court of New York on
      June 8, 2005 claiming breach of contract, quantum meruit, and unjust
      enrichment and alleging claims against the Company, and former Company
      representatives, Jeffrey Wallin and Lowell Giffhorn, for fraud and interference
      with contractual relationship. Beatie and Osborne claimed a contingency fee
      under the terms of its contingency fee agreement with respect to licensing
      agreements entered into, and possibly with respect to license agreements to
      be
      entered into, by the Company. The Company caused a removal of the Beatie and
      Osborne lawsuit to the United States District Court for the Southern District
      of
      New York and moved to transfer the action to the Southern District of
      California. The transfer motion was denied on May 9, 2006, but Wallin and
      Giffhorn were ordered dismissed from the action at that time. The circumstances
      of the disqualification of Beatie and Osborne in the Inventorship Litigation
      and
      its withdrawal from the Infringement Litigation were claimed by the Company
      to
      have worked a forfeiture of any rights in Beatie and Osborne to a contingency
      fee of any kind. In July, 2006 the Company and Beatie and Osborne reached a
      settlement agreement whereby the Company has paid Beatie and Osborne $340,000
      and Beatie and Osborne has retained $96,000 of the Company's funds in its
      possession through a retainer account. This settled the case in
      full.




*Patriot
      Scientific Corporation v. Russell Fish*




On
      April 6, 2006, we filed a declaratory relief lawsuit against Russell Fish
      and The Fish Family Trust in the United States District Court for the Southern
      District of California. As a consequence of licensing agreements entered into
      by
      or on behalf of Patriot, Mr. Fish has presented demands for payment by us
      under his July 2004 agreement related to the Inventorship Litigation. We contend
      that Mr. Fish has been paid all sums that may have been owed to him. Our
      action seeks declaratory relief that no further sums are owed to Mr. Fish.
      Also,
      on April 6, 2006, Fish and, later, Robert Anderson, allegedly as trustee of
      The
      Fish Family Trust, filed a lawsuit against the Company in the District Court
      of
      Dallas County, Texas. The case was subsequently removed to the United States
      District Court for the Northern District of Texas. The lawsuit is based on
      an
      alleged breach of the contract entered into on July 27, 2004 and seeks
      enforcement of the contract or damages. The California action has been
      transferred to the Northern District of Texas. A mediation commenced on
      September 11, 2006 and is continuing while the proceedings are
      stayed.





*Lowell
      Giffhorn Arbitration*




On
      September 23, 2005, Lowell Giffhorn, a former executive officer
      and a former director of Patriot, submitted a demand for arbitration with the
      American Arbitration Association related to the termination of
      Mr. Giffhorn's employment with the Company. Mr. Giffhorn asserts 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 has demanded damages of
      approximately $4,500,000 (excluding claims for punitive damages and attorneys
      fees). The Company denies the allegations and believes the claims to be
      frivolous and totally devoid of merit. The Company has retained litigation
      counsel and intends to vigorously defend the claims. The amount, if any, of
      ultimate liability with respect to the foregoing cannot be determined. Despite
      the inherent uncertainties of litigation, the Company at this time does not
      believe that Mr. Giffhorn's claim will have a material adverse impact on
      its financial condition, results of operations, or cash flows.




F-27




**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**




*Patent
      Litigation*




Pursuant
      to the joint venture that the Company entered into in June 2005 with Technology
      Properties Ltd. (in settlement of inventorship/ownership litigation between
      the
      parties, and in return for a 50-50 sharing of net licensing and enforcement
      revenues), the Company granted Technology Properties Ltd. (TPL) the complete
      and
      exclusive right to enforce and license its microprocessor patent portfolio.
      The
      Company then dismissed its patent infringement claims against Fujitsu Computer
      Systems, Inc.; Matsushita Electric Corporation of America; NEC Solutions
      (America) Inc.; Sony Electronics Inc.; and Toshiba America Inc., which had
      been
      pending in the Federal District Court for the Northern District of California.
      Thereafter, TPL, on behalf of the TPL/Patriot joint venture and Patriot, filed
      patent infringement actions against the foregoing defendants (except Sony)
      in
      the Federal District Court for the Eastern District of Texas, which litigation
      is currently pending. Litigation is not currently pending with regard to
      Fujitsu.




In
      February 2006, a license agreement was entered into with Fujitsu Corporation
      regarding the Company's patent portfolio, and in connection with that
      transaction, litigation involving Fujitsu and TPL and the Company in both
      California and Texas was dismissed.




***Profit
      Sharing Plan***





The
      Company has a savings and profit-sharing plan that allows participants to make
      contributions by salary reduction pursuant to Section 401(k) of the Internal
      Revenue Code. At the Company’s discretion, the Company may match contributions
      at 20% of the employee’s contribution up to 6% of the employee’s salary. The
      Company contributions are vested 20% per year beginning with the first year
      of
      service. The Company
      made no matching contributions to the plan in fiscal 2006 or 2005 and on
      December 31, 2005, the Company terminated the plan.








***401(k)
      Plan***





In
      January 2006, the Company adopted a retirement plan that complies with Section
      401(k) of the Internal Revenue Code. All employees are eligible to participate
      in the plan. The Company matches 50% of each participant’s voluntary
      contributions, subject to a maximum contribution of 6% of the participant’s
      compensation. Participants fully vest in the Company’s contributions after three
      years of vesting service. The Company’s matching contributions during fiscal
      year 2006 were $1,833.





***Employment
      Contract***





During
      the quarter ended August 31, 2005, the Company terminated two of its officers,
      each of whom had an employment contract with the Company. 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. $6,058 remains outstanding
      to
      him at May 31, 2006. Further, the Company agreed to accelerate the vesting
      of
      all outstanding options held by the officer and to extend their term to June
      2006. The Company recorded an expense of approximately $125,000 related to
      this
      option modification in the quarter ended August 31, 2005.




F-28




**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





The
      Company has not reached an agreement with the other officer; however, it accrued
      approximately $50,000 during the three month period ended August 31, 2005 for
      amounts which it believes may be due to this individual. The former officer
      has
      filed a complaint against the Company seeking arbitration and claiming he is
      owed approximately $1,500,000. The Company believes the claim is without merit
      and intends to vigorously defend itself. ****





***Guarantees
      and Indemnities***





The
      Company has made certain guarantees and indemnities, under which it may be
      required to make payments to a guaranteed or indemnified party. The Company
      indemnifies its directors, officers, employees and agents to the maximum extent
      permitted under the laws of the State of Delaware. In connection with its
      facility leases, the Company has indemnified its 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 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
      consolidated balance sheets.





***Operating
      Leases***





The
      Company has a non-cancelable operating lease for its office and manufacturing
      facilities located in San Diego, California which expires in July 2006. In
      February 2006 the Company moved its operations to the Carlsbad, California
      facility. Due to the move, the Company accrued its remaining contractual lease
      obligation related to this space. Rent expense for fiscal 2006 and 2005 was
      $103,245 and $180,527, respectively.





The
      Company has a non-cancelable operating lease agreement for its Carlsbad,
      California office facility. Future minimum lease payments required under the
      operating lease are $92,904, $92,904, and $69,678 in fiscal years ended 2007,
      2008, and 2009, respectively. Rent expense for fiscal 2006 was
      $30,976.








**12.
      Segment Information**





The
      Company is engaged in one business segment, the development and marketing of
      microprocessor technology related products and licenses. During the fiscal
      years
      ended May 31, 2006 and 2005, the Company’s product sales of high technology
      computer products and licenses were approximately $285,000 and $9,000,
      respectively. During fiscal 2005, sales of telecommunication products and
      licenses were $16,000. Substantially all of the Company’s products were sold to
      customers located in the United States. During the year ended May 31, 2006,
      one
      customer accounted for 92% of the Company’s total product sales and during the
      year ended May 31, 2005 there were no major customers related to the Company’s
      product sales. During the year ended May 31, 2006, as described in Note 5,
      the
      Company earned $10,000,000 in connection with entering into a license agreement
      and receives proceeds from Phoenix Digital Solutions, LLC for license agreements
      originated by this joint venture. No amounts were due from these licenses at
      May
      31, 2006.





F-29







**Patriot
      Scientific Corporation**


**Notes
      to Consolidated Financial Statements (Continued)**





**13.
      Subsequent Events**





During
      the period June 1, 2006 through October 3, 2006, Phoenix Digital entered into
      license agreements with third parties, pursuant to which it received aggregate
      proceeds totaling $32,699,000.





As
      disclosed in Note 4 and Note 11, in July 2006 the Company settled all claims
      with a former legal advisor relating to claims against the Company for
      intellectual property negotiations. The Company has accrued a liability of
      $340,000 as of May 31, 2006 in connection with the settlement of this
      matter.





In
      July
      2006, the Company commenced its stock buyback program by which the Company
      repurchases its outstanding common stock on the open market. During July 2006,
      the Company purchased 2,075,003 shares under the program at an aggregate cost
      of
      $1,839,085. On September 19, 2006, the Company resumed the stock buyback program
      and purchased 1,199,824 shares at an aggregate cost of $934,490.




On
        October 10, 2006, the Company 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 (see Note 9).





F-30


SIGNATURES




In
      accordance with Section 13 or 15(d) of the Exchange Act, the
      registrant caused this report to be signed on its behalf by the undersigned,
      thereunto duly authorized.






DATED:
                October 13, 2006
            
            PATRIOT
              SCIENTIFIC
              CORPORATION/s/ DAVID
              H.
              POHLDavid
              H. PohlChief
                Executive Officer





In
      accordance with the Exchange Act, 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/ DAVID
              H.
              POHLPresident,
              Chief Executive Officer, and
            
            October
                13, 2006David
                H. Pohl
            
            Director/S/ THOMAS
              J.
              SWEENEYChief
              Financial Officer and Principal
            
            October 13,
                2006Thomas
                J. Sweeney
            
            Accounting
                Officer/S/ CARLTON
              M.
              JOHNSONDirector
            
            October 13,
                2006Carlton
                M. Johnson/S/ GLORIA
              H.
              FELCYNDirector
            
            October 13,
                2006Gloria
                H. Felcyn/S/ HELMUT
              FALK,
              JR.Director
            
            October 13,
                2006Helmut
                Falk, Jr./S/ JAMES
              L.
              TURLEYDirector
            
            October
                  13, 2006James
                L. Turley