UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549










Form 10-Q



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



For the quarterly period ended June 30,
2012



OR



| |  ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
| | - | ----------------------------------------------------------------------------------------



For the transition period from          to



Commission File Number:     0-13111



AXION INTERNATIONAL HOLDINGS, INC

(Exact name of registrant as specified
in its charter)



|Colorado                                                               |  | 84-0846389                       
|---------------------------------------------------------------------- |  | ---------------------------------
|(State or other jurisdiction of incorporation or
        organization) |  | (IRS Employer Identification No.)



180 South Street, Suite 104, New Providence,
NJ 07974

(Address of principal executive offices)



908-542-0888

(registrant’s telephone number,
including area code)










Indicate
by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.  YesþNo ̈



Indicate
by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive
Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the
preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  YesþNo ̈



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



|Large accelerated filer ̈ | Accelerated filer ̈        
|------------------------ | --------------------------
|                         |                           
|Non-accelerated filer ̈   | Smaller reporting companyþ



Indicate by check mark whether the registrant
is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ̈Noþ



The number of outstanding shares of the
registrant’s common stock, without par value, as of August 17, 2012 was 26,781,378.











TABLE OF CONTENTS



|                              |                                                                                       | PAGE
|----------------------------- | ------------------------------------------------------------------------------------- | ----
|PART I. FINANCIAL INFORMATION
|Item 1.                       | Financial Statements                                                                  | 3   
|Item 2.                       | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 28  
|Item 3.                       | Quantitative and Qualitative Disclosures About Market Risk                            | 34  
|Item 4.                       | Controls and Procedures                                                               | 34  
|PART II. OTHER INFORMATION   
|Item 1.                       | Legal Proceedings                                                                     | 36  
|Item 2.                       | Unregistered Sales of Securities and Use of Proceeds                                  | 36  
|Item 3.                       | Defaults Upon Senior Securities                                                       | 36  
|Item 4.                       | Mine Safety Disclosures                                                               | 36  
|Item 5.                       | Other Information                                                                     | 36  
|Item 6.                       | Exhibits                                                                              | 37  
|                              | SIGNATURES                                                                            | 38  



2







PART 1. FINANCIAL INFORMATION



Item 1. Financial Statements.



AXION INTERNATIONAL HOLDINGS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                                 |  | June 30,    |             |   | December 31, |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------- | ----------- | - | ------------ | -
|                                                                                                                                                                                 |  | 2012        |             |   | 2011         |  
|                                                                                                                                                                                 |  | (Unaudited) |             |   | (Restated)   |  
|                                                                                                                                                                                 |  |             |             |   |              |  
|ASSETS                                                                                                                                                                           |  |             |             |   |              |  
|Current assets:                                                                                                                                                                  |  |             |             |   |              |  
|Cash and cash equivalents                                                                                                                                                        |  | $           | 2,353,513   |   |              | $
|Accounts receivable, net of allowance                                                                                                                                            |  |             | 848,713     |   |              |  
|Inventories                                                                                                                                                                      |  |             | 2,357,768   |   |              |  
|Prepaid expenses and deposits                                                                                                                                                    |  |             | 235,026     |   |              |  
|Total current assets                                                                                                                                                             |  |             | 5,795,020   |   |              |  
|                                                                                                                                                                                 |  |             |             |   |              |  
|Property and equipment, net                                                                                                                                                      |  |             | 1,822,061   |   |              |  
|                                                                                                                                                                                 |  |             |             |   |              |  
|Other long-term and intangible assets                                                                                                                                            |  |             | 68,284      |   |              |  
|                                                                                                                                                                                 |  |             |             |   |              |  
|Total assets                                                                                                                                                                     |  | $           | 7,685,365   |   |              | $
|                                                                                                                                                                                 |  |             |             |   |              |  
|LIABILITIES AND STOCKHOLDERS' DEFICIT                                                                                                                                            |  |             |             |   |              |  
|Current liabilities:                                                                                                                                                             |  |             |             |   |              |  
|Accounts payable                                                                                                                                                                 |  | $           | 2,171,366   |   |              | $
|Accrued liabilities                                                                                                                                                              |  |             | 488,688     |   |              |  
|Demand promissory notes                                                                                                                                                          |  |             | 5,000,001   |   |              |  
|Convertible revolving credit agreement, net of discounts                                                                                                                         |  |             | -           |   |              |  
|Derivative liability – conversion options                                                                                                                                        |  |             | -           |   |              |  
|Derivative liability – warrants                                                                                                                                                  |  |             | -           |   |              |  
|Derivative liability – bonus warrants                                                                                                                                            |  |             | -           |   |              |  
|Convertible debt                                                                                                                                                                 |  |             | -           |   |              |  
|Total current liabilities                                                                                                                                                        |  |             | 7,660,055   |   |              |  
|                                                                                                                                                                                 |  |             |             |   |              |  
|Fair value of 10% convertible preferred stock warrants                                                                                                                           |  |             | 140,458     |   |              |  
|                                                                                                                                                                                 |  |             |             |   |              |  
|Total liabilities                                                                                                                                                                |  |             | 7,800,513   |   |              |  
|                                                                                                                                                                                 |  |             |             |   |              |  
|Commitments and contingencies                                                                                                                                                    |  |             |             |   |              |  
|                                                                                                                                                                                 |  |             |             |   |              |  
|10% convertible preferred stock, no par value; authorized 880,000 shares; 726,023 and 752,273 shares issued and outstanding at June 30, 2012 and December 31, 2011, respectively |  |             | 5,800,935   |   |              |  
|Redeemable common stock, no par value; no shares
    and 250,000     shares issued and outstanding at June 30, 2012 and December 31, 2011, respectively                          |  |             | -           |   |              |  
|                                                                                                                                                                                 |  |             |             |   |              |  
|Stockholders' deficit:                                                                                                                                                           |  |             |             |   |              |  
|Common stock, no par value; authorized, 100,000,000 shares; 26,188,550 and 25,007,261 shares issued and outstanding at June 30, 2012 and December 31, 2011, respectively         |  |             | 26,869,774  |   |              |  
|Accumulated deficit                                                                                                                                                              |  |             | (32,785,857 | ) |              |  
|Total stockholders' deficit                                                                                                                                                      |  |             | (5,916,083  | ) |              |  
|Total liabilities and stockholders' deficit                                                                                                                                      |  | $           | 7,685,365   |   |              | $



(See accompanying notes to the unaudited condensed consolidated
financial statements.)



3







AXION INTERNATIONAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS

FOR THE THREE MONTHS ENDED JUNE 30

(Unaudited)



|                                                                         |  | 2012 |            |   | 2011       |  
|------------------------------------------------------------------------ |  | ---- | ---------- | - | ---------- | -
|                                                                         |  |      |            |   | (Restated) |  
|                                                                         |  |      |            |   |            |  
|Revenue                                                                  |  | $    | 1,796,222  |   |            | $
|Costs of sales                                                           |  |      | 1,756,119  |   |            |  
|Gross margin                                                             |  |      | 40,103     |   |            |  
|                                                                         |  |      |            |   |            |  
|Operating expenses:                                                      |  |      |            |   |            |  
|Product development and quality management                               |  |      | 328,363    |   |            |  
|Marketing and sales                                                      |  |      | 248,290    |   |            |  
|General and administrative                                               |  |      | 1,024,331  |   |            |  
|Total operating costs and expenses                                       |  |      | 1,600,984  |   |            |  
|                                                                         |  |      |            |   |            |  
|Loss from operations                                                     |  |      | (1,560,881 | ) |            |  
|                                                                         |  |      |            |   |            |  
|Other expenses:                                                          |  |      |            |   |            |  
|Interest expense                                                         |  |      | 95,575     |   |            |  
|Amortization of debt discount                                            |  |      | 203,471    |   |            |  
|Change in fair value of
    derivative liabilities                       |  |      | (129,574   | ) |            |  
|Total other expenses                                                     |  |      | 169,472    |   |            |  
|                                                                         |  |      |            |   |            |  
|Loss before provision for income taxes                                   |  |      | (1,730,353 | ) |            |  
|Provision for income taxes                                               |  |      | -          |   |            |  
|Net loss                                                                 |  |      | (1,730,353 | ) |            |  
|Accretion of preferred stock dividends and beneficial conversion feature |  |      | (477,678   | ) |            |  
|Net loss attributable to common shareholders                             |  | $    | (2,208,031 | ) |            | $
|                                                                         |  |      |            |   |            |  
|Weighted average common shares - basic and diluted                       |  |      | 26,070,061 |   |            |  
|                                                                         |  |      |            |   |            |  
|Basic and diluted net loss per share                                     |  | $    | (0.08      | ) |            | $



(See accompanying notes to the unaudited
condensed consolidated financial statements.)



4







AXION INTERNATIONAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS

FOR THE SIX MONTHS ENDED JUNE 30

(Unaudited)



|                                                                         |  | 2012 |            |   | 2011       |  
|------------------------------------------------------------------------ |  | ---- | ---------- | - | ---------- | -
|                                                                         |  |      |            |   | (Restated) |  
|                                                                         |  |      |            |   |            |  
|Revenue                                                                  |  | $    | 4,092,795  |   |            | $
|Costs of sales                                                           |  |      | 4,041,569  |   |            |  
|Gross margin                                                             |  |      | 51,226     |   |            |  
|                                                                         |  |      |            |   |            |  
|Operating expenses:                                                      |  |      |            |   |            |  
|Product development and quality management                               |  |      | 563,842    |   |            |  
|Marketing and sales                                                      |  |      | 387,062    |   |            |  
|General and administrative                                               |  |      | 1,859,722  |   |            |  
|Total operating costs and expenses                                       |  |      | 2,810,626  |   |            |  
|                                                                         |  |      |            |   |            |  
|Loss from operations                                                     |  |      | (2,759,400 | ) |            |  
|                                                                         |  |      |            |   |            |  
|Other expenses:                                                          |  |      |            |   |            |  
|Interest expense                                                         |  |      | 133,549    |   |            |  
|Amortization of debt  discount                                           |  |      | 373,553    |   |            |  
|Loss on debt extinguishment                                              |  |      | -          |   |            |  
|Fair value of bonus warrants at debt extinguishment                      |  |      | -          |   |            |  
|Change in fair value of derivative liabilities                           |  |      | (126,579   | ) |            |  
|Total other expenses                                                     |  |      | 380,523    |   |            |  
|                                                                         |  |      |            |   |            |  
|Loss before provision for income taxes                                   |  |      | (3,139,923 | ) |            |  
|Provision for income taxes                                               |  |      | -          |   |            |  
|Net loss                                                                 |  |      | (3,139,923 | ) |            |  
|Accretion of preferred stock dividends and beneficial conversion feature |  |      | (823,204   | ) |            |  
|Net loss attributable to common shareholders                             |  | $    | (3,963,127 | ) |            | $
|                                                                         |  |      |            |   |            |  
|Weighted average common shares - basic and diluted                       |  |      | 25,850,191 |   |            |  
|                                                                         |  |      |            |   |            |  
|Basic and diluted net loss per share                                     |  | $    | (0.15      | ) |            | $



(See accompanying notes to the unaudited
condensed consolidated financial statements.)



5







AXION INTERNATIONAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’
DEFICIT

FOR THE PERIOD FROM JANUARY 1, 2012 THROUGH
JUNE 30, 2012

(Unaudited)



|                                                                                     |  | Common Shares |            |  | Additional Paid-in Capital and Common Stock |   |            | Accumulated Deficit |  |   | Total       |  
|------------------------------------------------------------------------------------ |  | ------------- | ---------- |  | ------------------------------------------- | - | ---------- | ------------------- |  | - | ----------- | -
|                                                                                     |  |               |            |  |                                             |   |            |                     |  |   |             |  
|Balance, January 1, 2012 (Restated)                                                  |  |               | 25,007,261 |  |                                             | $ | 24,410,071 |                     |  | $ | (29,645,934 | )
|                                                                                     |  |               |            |  |                                             |   |            |                     |  |   |             |  
|Shares issued upon conversion of 10% convertible preferred stock                     |  |               | 262,500    |  |                                             |   | 262,500    |                     |  |   | -           |  
|Shares issued for dividend payments                                                  |  |               | 533,789    |  |                                             |   | 348,371    |                     |  |   | -           |  
|Share-based compensation                                                             |  |               | 135,000    |  |                                             |   | 497,039    |                     |  |   | -           |  
|Bonus warrants granted                                                               |  |               | -          |  |                                             |   | 57,034     |                     |  |   | -           |  
|Reclassification of previously redeemable common shares                              |  |               | 250,000    |  |                                             |   | 242,500    |                     |  |   | -           |  
|Dividend on 10% convertible preferred stock                                          |  |               | -          |  |                                             |   | (348,524   | )                   |  |   | -           |  
|Amortization of beneficial conversion feature
    of 10% convertible preferred stock |  |               | -          |  |                                             |   | (474,680   | )                   |  |   | -           |  
|Warrants issued as a result of reset of 10% convertible preferred stock              |  |               | -          |  |                                             |   | 1,875,463  |                     |  |   | -           |  
|Net loss                                                                             |  |               | -          |  |                                             |   | -          |                     |  |   | (3,139,923  | )
|                                                                                     |  |               |            |  |                                             |   |            |                     |  |   |             |  
|Balance, June 30, 2012                                                               |  |               | 26,188,550 |  |                                             | $ | 26,869,774 |                     |  | $ | (32,785,857 | )



(See accompanying notes to the unaudited
condensed consolidated financial statements.)



6







AXION INTERNATIONAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30

(Unaudited)



|                                                                            |  | 2012 |            |   | 2011       |  
|--------------------------------------------------------------------------- |  | ---- | ---------- | - | ---------- | -
|                                                                            |  |      |            |   | (Restated) |  
|                                                                            |  |      |            |   |            |  
|Cash flow from operating activities:                                        |  |      |            |   |            |  
|Net loss                                                                    |  | $    | (3,139,923 | ) |            | $
|Adjustments to reconcile net loss to net cash used in operating activities: |  |      |            |   |            |  
|Depreciation and amortization                                               |  |      | 73,191     |   |            |  
|Amortization of convertible debt discount                                   |  |      | -          |   |            |  
|Amortization of preferred stock discount                                    |  |      | 68,346     |   |            |  
|Amortization of revolving credit agreement discount                         |  |      | 305,206    |   |            |  
|Change in fair value of 10% convertible preferred stock warrants            |  |      | (347,097   | ) |            |  
|Change in fair value of derivative liability - conversion option            |  |      | (113,271   | ) |            |  
|Loss on debt extinguishment                                                 |  |      | -          |   |            |  
|Fair value of bonus warrants at debt extinguishment                         |  |      | -          |   |            |  
|Change in fair value of derivative liability - bonus warrants               |  |      | (13,309    | ) |            |  
|Share-based compensation                                                    |  |      | 497,039    |   |            |  
|Increase in allowance for doubtful accounts                                 |  |      | 100,415    |   |            |  
|Changes in operating assets and liability:                                  |  |      |            |   |            |  
|Accounts receivable                                                         |  |      | (247,973   | ) |            |  
|Inventories                                                                 |  |      | (829,277   | ) |            |  
|Prepaid expenses and deposits                                               |  |      | (20,868    | ) |            |  
|Accounts payable                                                            |  |      | 995,904    |   |            |  
|Accrued liabilities                                                         |  |      | 128,973    |   |            |  
|Net cash used in operating activities                                       |  |      | (2,542,644 | ) |            |  
|                                                                            |  |      |            |   |            |  
|Cash flows from investing activities:                                       |  |      |            |   |            |  
|Purchase of property and equipment                                          |  |      | (848,116   | ) |            |  
|Net cash used in investing activities                                       |  |      | (848,116   | ) |            |  
|                                                                            |  |      |            |   |            |  
|Cash flows from financing activities:                                       |  |      |            |   |            |  
|Proceeds from issuance of demand promissory notes                           |  |      | 5,000,001  |   |            |  
|Proceeds from issuance of 10% convertible preferred stock, net              |  |      | -          |   |            |  
|Issuance of common stock, net of expenses                                   |  |      | -          |   |            |  
|Proceeds from short term notes                                              |  |      | -          |   |            |  
|Repayments of convertible debt                                              |  |      | (772,500   | ) |            |  
|Repayment of revolving credit agreement                                     |  |      | (466,000   | ) |            |  
|Repayment of short term notes                                               |  |      | -          |   |            |  
|Net cash provided by financing activities                                   |  |      | 3,761,501  |   |            |  
|                                                                            |  |      |            |   |            |  
|Net increase in cash                                                        |  |      | 370,741    |   |            |  
|Cash and cash equivalents at beginning of period                            |  |      | 1,982,772  |   |            |  
|Cash and cash equivalents at end of period                                  |  | $    | 2,353,513  |   |            | $
|                                                                            |  |      |            |   |            |  
|Supplemental disclosures of cash flow information:                          |  |      |            |   |            |  
|Cash paid for interest                                                      |  | $    | 133,549    |   |            | $
|Conversion of 10% convertible preferred stock and debt                      |  |      | 262,500    |   |            |  
|Dividends on 10% convertible preferred stock                                |  |      | 348,524    |   |            |  
|Fair value of warrants issued on reset of 10% convertible preferred stock   |  |      | 1,875,463  |   |            |  
|Amortization of conversion feature of 10% convertible preferred stock       |  |      | 474,680    |   |            |  
|Redeemable common stock reclassified to permanent equity                    |  |      | 242,500    |   |            |  
|Bonus warrants granted                                                      |  |      | 57,034     |   |            |  



(See accompanying notes to the unaudited
condensed consolidated financial statements.)



7







AXION INTERNATIONAL HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

JUNE 30, 2012

(Unaudited)



Note 1 - Summary of Significant Accounting
Policies



(a)         Business
and Basis of Financial Statement Presentation



Our predecessor company was formed in 1981
under the name Analytic Surveys, Inc. On March 20, 2008, Analytic Surveys, Inc. consummated an Agreement and Plan of Merger (or
the Merger) with Axion International, Inc. In the Merger, the stockholders of Axion International, Inc. succeeded to approximately
90.7% of Analytic Survey, Inc.’s issued and outstanding common stock and Analytics Survey changed its name to Axion International
Holdings, Inc. The Merger has been accounted for as a reverse merger in the form of a recapitalization with Axion as the successor.



We develop, manufacture, market and sell
composite rail ties and structural building products, such as pilings, I-beams, T-beams and boards, which, based upon patented
technology developed at Rutgers University, are fully derived from common recycled plastics and high-density polymers, such as
polyethylene, polystyrene and polypropylene. These recycled plastics, which are combined with recycled plastic composites containing
encapsulated fiberglass, achieve structural thickness and strength and are resistant to changing shape under constant stress. Our
products, manufactured through an extrusion process, are eco-friendly, non-corrosive, moisture impervious, non-chemical leaching
and insect and rot resistant. Our products possess superior lifecycles and generally have greater durability and require less maintenance
than competitive products made from wood, steel or concrete. We market our products in two lines, the first being ECOTRAXTM,
our line of rail ties, and the second being STRUXURETM, our line of structural building products.



Our consolidated financial statements include
the accounts of our wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.



The accompanying unaudited condensed consolidated
financial statements of the Company have been prepared in accordance with Rule S-X of the Securities and Exchange Commission and
with the instructions to Form 10-Q, and accordingly, they do not include all of the information and footnotes which may be required
by generally accepted accounting principles for complete financial statements.



In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair presentation have been included. However, the results
from operations for the six months ended June 30, 2012, are not necessarily indicative of the results that may be expected for
the year ending December 31, 2012. The unaudited condensed consolidated financial statements should be read in conjunction with
the consolidated December 31, 2011 financial statements and footnotes thereto included in the Company's Form 10-K/A filed with
the SEC.





(b)         Cash
and Cash Equivalents



For purposes of the statement of cash flows,
we consider all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.



(c)         Property
and Equipment



Property and equipment are recorded at
cost and are depreciated and amortized using the straight-line method over estimated useful lives of two to twenty years.  Costs
incurred that extend the useful life of the underlying asset are capitalized and depreciated over the remaining useful life. Repairs
and maintenance are charged directly to operations as incurred.



8







Our property and equipment is comprised
of the following:



|                                                          |  | June 30, 2012 |           |   | December 31, 2011 |  
|--------------------------------------------------------- |  | ------------- | --------- | - | ----------------- | -
|Property, equipment, and leasehold improvements, at cost: |  |               |           |   |                   |  
|Equipment                                                 |  | $             | 13,754    |   |                   | $
|Machinery and equipment                                   |  |               | 2,400,620 |   |                   |  
|Purchased software                                        |  |               | 123,551   |   |                   |  
|Furniture and fixtures                                    |  |               | 13,090    |   |                   |  
|                                                          |  |               | 2,551,015 |   |                   |  
|Less accumulated depreciation                             |  |               | (728,954  | ) |                   |  
|Net property and leasehold improvements                   |  | $             | 1,822,061 |   |                   | $



Depreciation expense included as a charge
to costs of sales and general and administrative expenses for the three months ended June 30, 2012 and 2011 was $38,947 and $29,620,
respectively and for the six months ended June 30, 2012 and 2011 was $73,191 and $69,704, respectively.



(d)         Allowance
for Doubtful Accounts



We accrue a reserve on a receivable when,
based upon the judgment of management, it is probable that a receivable will not be collected and the amount of any reserve may
be reasonably estimated.  During the three months ended June 30, 2012, we reserved $100,415 for receivables we determined
we may not collect in full. As of June 30, 2012 and December 31, 2011, we provided an allowance of $133,146 and $32,731, respectively
for doubtful accounts.



(e)        Revenue
and Cost Recognition



In accordance with FASB ASC 605 “Revenue
Recognition”, revenue is recognized when persuasive evidence of an agreement with the customer exists, products are shipped
or title passes pursuant to the terms of the agreement with the customer, the amount due from the customer is fixed or determinable,
collectability is reasonably assured, and there are no significant future performance obligations.



We recognize revenue when a fixed commitment
to purchase the products is received, title or ownership has passed to the customer and we do not have any specific performance
obligations remaining, such that the earnings process is complete. In most cases, we receive a purchase order from our customer
specifying the products requested and delivery instructions. We recognize revenue upon our delivery of the products as specified
in the purchase order.



In other cases where we have a contract
which provides for a large number of products and few actual deliveries, the revenues are recorded each month as the products are
produced and the risk of ownership passes to the customer upon pre-delivery acceptance. Prior to deliveries, our customer’s
products are segregated from our inventory and not available for fulfilling other orders.



Under our third-party contract manufacturing
arrangements, our costs of sales are predominately comprised of the cost of raw materials and the costs and expenses associated
with the third-party manufacturer producing the finished product. Under one arrangement, we purchase and supply the raw materials
to the third-party manufacturer who we pay a per-pound cost to produce the finished product. Under our other arrangement the third-party
manufacturer sources and pays for the raw materials and we purchase the finished product from them at a cost per unit. In addition,
for that arrangement, we are responsible for any costs of raw materials purchased by the third-party manufacturer in excess of
the arrangement’s reference prices and we share any savings for purchases below the reference prices.  Our costs of
sales may vary significantly as a result of the variability in the cost of our raw materials and the efficiency with which we plan
and execute our manufacturing processes.



Historically, we have not had
significant warranty replacements, and do not believe we will in the future.



9







(f)          Income
Taxes



We use the asset and liability method of
accounting of income taxes pursuant to the provisions of FASB ASC 740 “Income Taxes”, which establishes deferred tax
assets and liabilities to be recognized for the future tax consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.



(g)         Impairment
of Long-Lived Assets Other Than Goodwill



We assess the potential for impairment
in the carrying values of our long-term assets whenever events or changes in circumstances indicate such impairment may have occurred.  An
impairment charge to current operations is recognized when the estimated undiscounted future net cash flows of the asset are less
than its carrying value. Any such impairment is recognized based on the differences in the carrying value and estimated fair value
of the impaired asset.



(h)         Derivative
Instruments



For derivative instruments that are accounted
for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date,
with changes in fair value recognized in earnings each reporting period. We use the Black-Scholes model to value the derivative
instruments at inception and subsequent valuation dates and the value is re-assessed at the end of each reporting period, in accordance
with FASB ASC Topic 815, “Derivatives and Hedging”. Derivative instrument liabilities are classified in the balance
sheet as current or non-current based on whether or not the net-cash settlement of the derivative instrument could be required
within twelve months of the balance sheet date.



10







(i)          Share-Based
Compensation



We record share-based
compensation for transactions in which we exchange our equity instruments for services of employees, consultants and others
based on the fair value of the equity instruments issued at the date of grant or other measurement date.  The fair
value of common stock awards is based on the observed market value of our stock.  We calculate the fair value of options
and warrants using the Black-Scholes option pricing model.  Expense is recognized, net of expected forfeitures, over
the period of performance.  When the vesting of an award is subject to performance conditions, no expense is
recognized until achievement of the performance condition is deemed to be probable. Options issued to consultants are
remeasured as they vest each reporting period and the resulting value is recognized as an adjustment against our net loss
over the period during which the services are received.



(j)         Earnings
(Loss) Per Share



Basic earnings (loss) per share are computed
by dividing earnings (loss) available to common shareholders by the weighted average number of common shares outstanding for the
period.  Diluted earnings (loss) per share include the effects of the potential dilution of outstanding options, warrants,
and convertible debt on our common stock as determined using the treasury stock method. For the three and six months ended June
30, 2012 and 2011, there were no dilutive effects of such securities because we incurred a net loss in each period.  As of
June 30, 2012, we have approximately 23.4 million potential common shares issuable under our convertible instruments, warrant and
stock option agreements.



(k)         Fair
Value of Financial Instruments



Fair value is defined as an exit price, which is
the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market
participants at the measurement date.  The degree of judgment utilized in measuring the fair value of assets and liabilities
generally correlates to the level of pricing observability.  Financial assets and liabilities with readily available,
actively quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more
pricing observability and require less judgment in measuring fair value.  Conversely, financial assets and liabilities
that are rarely traded or not quoted have less price observability and are generally measured at fair value using valuation models
that require more judgment.  These valuation techniques involve some level of management estimation and judgment, the
degree of which is dependent on the price transparency of the asset, liability or market and the nature of the asset or liability.  We
have categorized our financial assets and liabilities that are recurring at fair value into a three-level hierarchy in accordance
with these provisions.



(l)          Concentration
of Credit Risk



We maintain our cash within two major U.S.
domestic banks. The amount held within one of these banks exceeds the insured limit of $250,000 from time to time and was approximately
$2.1 million at June 30, 2012.  We have not incurred losses related to these deposits.  Our accounts receivable balance
as of June 30, 2012 of approximately $1.0 million consists of amounts due from a limited number of customers.



(m) Use
of Estimates



The preparation of our financial statements
in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the
amounts reported in these financial statements and accompanying notes. Actual results could differ from those estimates.



11







(n)         Redeemable
Common Stock



We account for redeemable common stock
in accordance with ASC 480-10-S99-3A “Classification and Measurement of Redeemable Securities,” which provides
that securities that are redeemable for cash or other assets are classified outside of permanent equity if they are redeemable
at the option of the holder. Accordingly, 250,000 shares of common stock issued during the year ended December 31, 2011, as a commitment
fee pursuant to the revolving credit agreement were classified outside of permanent equity at redemption value, when issued. If
circumstances would have indicated it was probable the holder may redeem these shares of common stock, we would have recognized
changes in the redemption value in the period they occurred and adjusted the carrying value of the redeemable common stock to equal
its redemption value at the end of that reporting period. During the three months ended June 30, 2012, the revolving credit agreement
was terminated and the related redemption value of the shares of common stock was reclassified to permanent equity.



(o)       Going Concern



The accompanying financial statements have
been prepared in conformity with generally accepted accounting principles in the United States of America, which contemplates our
continuation as a going concern.  At June 30, 2012, we had a working capital deficit of $1.9 million, a stockholders’
deficit of $5.9 million and have accumulated losses to date of $32.8 million.  This raises substantial doubt about our
ability to continue as a going concern.  In view of these matters, realization of certain of the assets in the accompanying
balance sheet is dependent upon our ability to meet our financing requirements, raise additional capital, and the success of our
business plan and future operations.  We continue to seek additional means of financing to fund our business plan, but
there is no assurance that we will be successful in raising sufficient funds to assure our eventual profitability.  We
believe that actions planned and presently being taken to revise our operating and financial requirements provide us the opportunity
to continue as a going concern. The financial statements do not include any adjustments that might result from these uncertainties.



Note 2 – Restatements





Current Report on Form 8-K, Dated May 14, 2011





On May 14, 2011, we filed with
the Securities and Exchange Commission (“SEC”) a Current Report on Form 8-K, to report our determination that our
consolidated financial statements for the year ended December 31, 2011, included in our Annual Report on Form 10-K filed with
the SEC on March 6, 2012 (the “2011 Form 10-K”), and the interim unaudited condensed consolidated financial
statements included in our September 30, 2011 Quarterly Report on Form 10-Q filed with the SEC on November 14, 2011 (the
“September 30, 2011 Form 10-Q”) should not be relied upon because we failed (i) to initially record and
subsequently fair value our derivative warrant liabilities in connection with the issuances of our 10% Convertible Preferred
Stock (the “Preferred Stock”) on March 22, 2011, April 1, 2011, April 13, 2011 and April 21, 2011 and (ii) to
recalculate the fair value of the beneficial conversion feature embedded in the Preferred Stock upon determination that the
conversion price of the Preferred Stock was required to be reset. We determined that the historical consolidated
financial statements for the year ended December 31, 2011 included in our 2011 Form 10-K and the interim unaudited condensed
consolidated financial statements for the period ended September 30, 2011, included in our September 30, 2011 10-Q required
restatement (i) to record the change in fair value of our derivative warrant liability and (ii) to recalculate the fair value
of the beneficial conversion feature and the amortization thereon in our Consolidated Statement of Stockholder Deficit.



On May 21, 2012, we filed our Form 10-K/A
for the year ended December 31, 2011 and Form 10-Q/A for the period ended September 30, 2011 restating our financial statements
and other disclosures where necessary, to properly account for these issues.





Current Report on Form 8-K Dated August 15, 2012





On August 15, 2012, we filed with
the Securities and Exchange Commission (“SEC”) a Current Report on Form 8-K, to report our determination that our consolidated
financial statements for the interim periods ended March 31, 2011, June 30, 2011, September 30, 2011, the year ended December 31,
2011, and the interim period ended March 31, 2012, should not be relied upon because in connection with the terms of the amendment
of our 10% convertible debentures (the “Debentures”) on January 14, 2011 we failed (i) to initially record and subsequently
fair value our derivative liabilities for the bonus warrants and (ii) to properly account for the loss on extinguishment of the
Debentures upon amendment. We determined that the historical consolidated financial statements for the interim periods ended
March 31, 2011, June 30, 2011, September 30, 2011, for the year ended December 31, 2011 and for the interim period ended March
31, 2012 require restatement (i) to record the initial fair value upon amendment and the subsequent change in fair value of our
derivative bonus warrant liability and (ii) to properly account for the loss on extinguishment of the Debentures upon amendment.



Our 10% convertible debentures (the “Debentures”)
were issued under purchase agreements during the fiscal year ended September 30, 2009, together with warrants, for aggregate proceeds
of $600,000. The total of the fair value of the warrants, as determined using the Black-Scholes pricing model, and the value of
the beneficial conversion features contained in the debentures, representing the difference between the fair value of common stock
issuable upon conversion at the date of purchase and the amount of proceeds allocated to the note, exceeded the proceeds received. 
Accordingly, we recorded a discount on the debentures equal to the principal amount of the debentures.  This recorded discount
on these debentures was amortized to interest expense on the interest method through their originally scheduled maturity dates
in February and March 2011.



Effective January 14, 2011,
the holders of our Debentures, agreed to extend the maturity dates to June 30, 2012 and to the elimination of the prohibition
of paying dividends or distributions on any of our equity securities. We agreed to amend the interest rate to 15% if paid
in cash and to 18% (from 12%) if paid with shares of our common stock at the rate of one share of common stock for each
$0.60 (from $0.90) of interest. We also agreed to reduce the conversion price, as defined, to $0.60, from $0.90 and to amend
the volume weighted average trading price at which we could force conversion to $2.50 from $2.00. In addition, for each
calendar month after February or March 2011 that these debentures remained outstanding, we agreed to issue a bonus warrant
exercisable for three years for a number of shares of our common stock equal to the 5% of the outstanding principal, divided
by $0.90. These bonus warrants are exercisable at $0.90 per share.



Even though these modifications
to our Debentures resulted in less than a ten percent difference in the present value of cash flows between the original
terms and the modified terms, the fair value of the conversion options was substantially greater than ten percent. We
have therefore, accounted for the modification of these Debentures as an extinguishment of the original debt and the
establishment of new debt. The difference between the reacquisition price of the new debt and the net carrying amount of the
extinguished debt was  $1.4 million and was recognized as a loss in our statement of operations during the three months ended
March 31, 2011, the period of amendment.





12







In addition, since it was probable that
we would issue the bonus warrants which were part of the reacquisition costs of the new debt, at each month-end through the amended
maturity date, we calculated the fair value of the bonus warrants using the Black-Scholes pricing model and recorded a derivative
liability of approximately $797,000 on the date of amendment and recognized the amount as a loss in our statement of operations
during the three months ended March 31, 2011, the period of amendment. The bonus warrant derivative liability does not qualify
as a fair value or cash flow hedge under ASC 815, accordingly, changes in the fair value of the derivative liability are immediately
recognized in earnings and classified as a gain or loss on the derivative liability in the accompanying statements of operations.
(See Note 7.)



This Quarterly Report on Form 10-Q for
the three and six months ended June 30, 2012 incorporates corrections made in response to the accounting errors described above
by restating our consolidated balance sheet as of December 31, 2011 and our consolidated financial statements presented herein
for the comparative periods of June 30, 2011. We anticipate filing our Form 10-Q/A for the interim periods ended September 30,
2011 and March 31, 2012 and our Form 10-K/A #2 for the year ended December 31, 2011, as soon as is practical.





The following tables show the effects
of the restatement on our consolidated balance sheet as of December 31, 2011 and consolidated statements of operations and cash
flows for the three and six months ended June 30, 2011:



|Effect on Consolidated Balance Sheet                                                                                                                             
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------
|December 31, 2011                                                                                                                                                
|                                                                                                                                                                 
|                                                                                                                                                                 
|                                                                                                                                                                 
|                                                                                                                                                                 
|                                                                                                                                                                 
|LIABILITIES AND STOCKHOLDERS' DEFICIT                                                                                                                            
|Current liabilities:                                                                                                                                             
|Accounts payable                                                                                                                                                 
|Accrued liabilities                                                                                                                                              
|Convertible revolving credit facility, net of discounts                                                                                                          
|Derivative liability - conversion option                                                                                                                         
|Derivative liability - warrants                                                                                                                                  
|                                                                                                                                                                 
|Derivative liability - bonus warrants                                                                                                                            
|                                                                                                                                                                 
|                                                                                                                                                                 
|                                                                                                                                                                 
|Convertible debt                                                                                                                                                 
|                                                                                                                                                                 
|                                                                                                                                                                 
|Total current liabilities                                                                                                                                        
|                                                                                                                                                                 
|Convertible debt, net of discount                                                                                                                                
|Fair value of 10% convertible preferred stock warrants                                                                                                           
|Total liabilities                                                                                                                                                
|                                                                                                                                                                 
|Commitments and contingencies                                                                                                                                    
|                                                                                                                                                                 
|10% Convertible preferred stock, no par value; authorized 880,000 shares;  752,273 issued and outstanding at December 31, 2011, net of discount                  
|Redeemable common stock, no par value; 250,000 shares issued and outstanding at December 31, 2011                                                                
|                                                                                                                                                                 
|Stockholders' deficit:                                                                                                                                           
|Common stock, no par value; authorized, 100,000,000 shares;  25,007,261 and 23,305,704 shares issued and outstanding  at December 31, 2011 and 2010, respectively
|                                                                                                                                                                 
|                                                                                                                                                                 
|                                                                                                                                                                 
|                                                                                                                                                                 
|Accumulated deficit                                                                                                                                              
|                                                                                                                                                                 
|                                                                                                                                                                 
|                                                                                                                                                                 
|                                                                                                                                                                 
|                                                                                                                                                                 
|Total stockholders' deficit                                                                                                                                      
|Total liabilities and stockholders' deficit                                                                                                                      



|(a) - to reverse the improper recording of debt discount.                                                                                                         
|------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(b) - to reverse the improper recording of and amortization of debt discount.                                                                                     
|(c) - to reverse the impact of the improper recording of the fair value of the bonus warrants upon issuance.                                                      
|(d) - to record the difference between the reacquisition price of the new debt and the net carrying amount of the extinguished debt at the amendment date.        
|(e) - to record the fair value of the bonus warrants as of the amendment date as a component of the reacquisition price of the new debt.                          
|(f) - to recognize the gain on the change in the fair value of the derivative liability associated with the bonus warrants for the six months ended June 30, 2011.
|(g) - to record the fair value of bonus warrants at date of issuance.                                                                                             
|(h) - to reverse incorrect recording of the fair value of bonus warrants at issuance.                                                                             





Effect on Consolidated Statement of Operations

for the Three Months Ended June 30, 2011



|                                                                       |  | As Previously |            |   |             |   |            |          | 
|---------------------------------------------------------------------- |  | ------------- | ---------- | - | ----------- | - | ---------- | -------- | 
|                                                                       |  | Reported      |            |   | Adjustments |   |            | Restated | 
|                                                                       |  |               |            |   |             |   |            |          | 
|Loss from operations                                                   |  | $             | (2,412,954 | ) |             | $ | -          |          | 
|                                                                       |  |               |            |   |             |   |            |          | 
|Other expenses:                                                        |  |               |            |   |             |   |            |          | 
|Interest expense                                                       |  |               | 67,024     |   |             |   | -          |          | 
|Amortization of debt discounts                                         |  |               | 465,909    |   |             |   | (102,858   | )(a)     | 
|                                                                       |  |               |            |   |             |   | (114,049   | )(b)     | 
|                                                                       |  |               |            |   |             |   |            |          | 
|Change in fair value of derivative liabilities                         |  |               | -          |   |             |   | (48,187    | )(c)     | 
|Total other expenses                                                   |  |               | 532,933    |   |             |   | (265,094   | )        | 
|                                                                       |  |               |            |   |             |   |            |          | 
|Loss before provision for income taxes                                 |  |               | (2,945,887 | ) |             |   | 265,094    |          | 
|Provision for income taxes                                             |  |               | -          |   |             |   | -          |          | 
|Net loss                                                               |  |               | (2,945,887 | ) |             |   | 265,094    |          | 
|Accretion of preferred dividends and beneficial
    conversion feature |  |               | (203,697   | ) |             |   | -          |          | 
|Net loss attributable to common shareholders                           |  | $             | (3,149,584 | ) |             | $ | 265,094    |          | 
|                                                                       |  |               |            |   |             |   |            |          | 
|Weighted average common shares - basic and diluted                     |  |               | 24,082,234 |   |             |   | 24,082,234 |          | 
|Basic and diluted net loss per share                                   |  | $             | (0.13      | ) |             | $ | 0.01       |          | 



| | (a) - | to reverse the improper amortization of debt discount.
| | ----- | ------------------------------------------------------

| | (b) - | to reverse the impact of the improper recording of the fair value of the bonus warrants upon issuance.
| | ----- | ------------------------------------------------------------------------------------------------------

| | (c) - | to recognize the gain on the change in the fair value of the derivative liability associated with
the bonus warrants for the period.
| | ----- | ------------------------------------------------------------------------------------------------------------------------------------





13







Effect on Consolidated Statement of Operations

for the Six Months Ended June 30, 2011



|                                                                   |  | As Previously |            |   |             |   |            |          | 
|------------------------------------------------------------------ |  | ------------- | ---------- | - | ----------- | - | ---------- | -------- | 
|                                                                   |  | Reported      |            |   | Adjustments |   |            | Restated | 
|                                                                   |  |               |            |   |             |   |            |          | 
|Loss from operations                                               |  | $             | (4,108,625 | ) |             | $ | -          |          | 
|                                                                   |  |               |            |   |             |   |            |          | 
|Other expenses:                                                    |  |               |            |   |             |   |            |          | 
|Interest expense                                                   |  |               | 97,104     |   |             |   | -          |          | 
|Amortization of debt discounts                                     |  |               | 670,049    |   |             |   | (188,572   | )(a)     | 
|                                                                   |  |               |            |   |             |   | (114,049   | )(b)     | 
|                                                                   |  |               |            |   |             |   |            |          | 
|Loss on debt extinguishment                                        |  |               | -          |   |             |   | 1,350,000  | (c)      | 
|Fair value of bonus warrants at debt extinguishment                |  |               | -          |   |             |   | 797,185    | (d)      | 
|Change in fair value of derivative liabilities                     |  |               | -          |   |             |   | (359,561   | )(e)     | 
|Total other expenses                                               |  |               | 767,153    |   |             |   | 1,485,003  |          | 
|                                                                   |  |               |            |   |             |   |            |          | 
|Loss before provision for income taxes                             |  |               | (4,875,778 | ) |             |   | (1,485,003 | )        | 
|Provision for income taxes                                         |  |               | -          |   |             |   | -          |          | 
|Net loss                                                           |  |               | (4,875,778 | ) |             |   | (1,485,003 | )        | 
|Accretion of preferred dividends and beneficial conversion feature |  |               | (207,556   | ) |             |   | -          |          | 
|Net loss attributable to common shareholders                       |  | $             | (5,083,334 | ) |             | $ | (1,485,003 | )        | 
|                                                                   |  |               |            |   |             |   |            |          | 
|Weighted average common shares - basic and diluted                 |  |               | 23,773,725 |   |             |   | 23,773,725 |          | 
|Basic and diluted net loss per share                               |  | $             | (0.21      | ) |             | $ | (0.06      | )        | 



| | (a) - | to reverse the improper amortization of debt discount.
| | ----- | ------------------------------------------------------

| | (b) - | to reverse the impact of the improper recording of the fair value of the bonus warrants upon issuance.
| | ----- | ------------------------------------------------------------------------------------------------------

| | (c) - | to record the difference between the reacquisition price of the new debt and the net carrying amount
of the extinguished debt at the amendment date.
| | ----- | ----------------------------------------------------------------------------------------------------------------------------------------------------

| | (d) - | to record the fair value of the bonus warrants as of the amendment date as a component of the reacquisition
price of the new debt.
| | ----- | ----------------------------------------------------------------------------------------------------------------------------------

| | (e) - | to recognize the gain on the change in the fair value of the derivative liability associated with
the bonus warrants for the six months ended June 30, 2011.
| | ----- | ------------------------------------------------------------------------------------------------------------------------------------------------------------





14







Effect on Consolidated Statement of Cash
Flows

for the Six Months Ended June 30, 2011



|                                                                            |  | As Previously |            |   |             |   |            |          | 
|--------------------------------------------------------------------------- |  | ------------- | ---------- | - | ----------- | - | ---------- | -------- | 
|                                                                            |  | Reported      |            |   | Adjustments |   |            | Restated | 
|                                                                            |  |               |            |   |             |   |            |          | 
|Cash flow from operating activities:                                        |  |               |            |   |             |   |            |          | 
|Net loss                                                                    |  | $             | (4,875,778 | ) |             | $ | (1,485,003 | )        | 
|Adjustments to reconcile net loss to net cash used in operating activities: |  |               |            |   |             |   |            |          | 
|Amortization of convertible debt discount                                   |  |               | 486,972    |   |             |   | (188,572   | )(a)     | 
|Loss on debt extinguishment                                                 |  |               | -          |   |             |   | 1,350,000  | (c)      | 
|Fair value of bonus warrants at debt extinguishment                         |  |               | -          |   |             |   | 797,185    | (d)      | 
|Fair value of bonus warrants at grant date                                  |  |               | -          |   |             |   | (114,049   | )(b)     | 
|Change in fair value of derivative liabilities - Bonus Warrants             |  |               | -          |   |             |   | (359,561   | )(e)     | 
|                                                                            |  |               |            |   |             |   |            |          | 
|Net cash used in operating activities                                       |  | $             | (3,435,727 | ) |             | $ | -          |          | 



| | (a) - | to reverse the improper amortization of debt discount.
| | ----- | ------------------------------------------------------

| | (b) - | to reverse the impact of the improper recording of the fair value of the bonus warrants upon issuance.
| | ----- | ------------------------------------------------------------------------------------------------------

| | (c) - | to record the difference between the reacquisition price of the new debt and the net carrying amount
of the extinguished debt at the amendment date.
| | ----- | ----------------------------------------------------------------------------------------------------------------------------------------------------

| | (d) - | to record the fair value of the bonus warrants as of the amendment date as a component of the reacquisition
price of the new debt.
| | ----- | ----------------------------------------------------------------------------------------------------------------------------------

| | (e) - | to recognize the gain on the change in the fair value of the derivative liability associated with
the bonus warrants for the six months ended June 30, 2011.
| | ----- | ------------------------------------------------------------------------------------------------------------------------------------------------------------





15







Note 3 – Inventories



Inventories are priced at the lower of
cost or market and consist primarily of raw materials and finished products. No material adjustment has been made to the cost
of finished products inventories as of June 30, 2012 and December 31, 2011.



|                     |  | June 30, 2012 |           |  | December 31, 2011 |  
|-------------------- |  | ------------- | --------- |  | ----------------- | -
|                     |  |               |           |  |                   |  
|Finished products    |  | $             | 2,152,193 |  |                   | $
|Production materials |  |               | 205,575   |  |                   |  
|Total inventories    |  | $             | 2,357,768 |  |                   | $



Since we engage third-party contract manufacturers
to produce our finished products, and in certain situations we provide them the raw materials, our inventories at June 30, 2012
and December 31, 2011 are located at the third-party contract manufacturing locations. We carry adequate insurance for loss on
this inventory.



Note 4 - Accrued Liabilities



The components of accrued liabilities are:



|                           |  | June 30, 2012 |         |  | December 31, 2011 |  
|-------------------------- |  | ------------- | ------- |  | ----------------- | -
|Royalties                  |  | $             | 254,007 |  |                   | $
|Payroll                    |  |               | 58,161  |  |                   |  
|Sales tax payable          |  |               | 36,740  |  |                   |  
|Insurance premiums payable |  |               | 55,543  |  |                   |  
|Interest                   |  |               | 67,408  |  |                   |  
|Miscellaneous              |  |               | 16,829  |  |                   |  
|Total accrued liabilities  |  | $             | 488,688 |  |                   | $



Note 5 – Demand Promissory Notes



During the three months ended June 30,
2012 we entered into a Memorandum of Understanding (the “MOU”) with Melvin Lenkin, Samuel Rose and others (collectively  the “Investors”).
Pursuant to the MOU, we issued to the Investors demand promissory notes (collectively, the “Demand Notes”)
in the aggregate principal amount of $5,000,001.  Interest accrues on the unpaid principal balance of the Demand Notes
at a rate of 8.00% per annum. The principal balance of the Demand Notes, together with accrued and unpaid interest, is due and
payable at any time after June 30, 2012 on demand.



For the three months ended June 30, 2012, we recognized $67,408
of interest expense in connection with the Demand Notes.



Note 6 - Convertible Revolving Credit Agreement



During the year ended December 31, 2011,
we entered into a convertible revolving credit agreement (the “Agreement”) with a private lender (“Lender”).
Under the terms of the Agreement, Lender had agreed to lend us up to $2,000,000 on a revolving basis (the “Loan”).
The Loan carried interest at 12% per annum on any outstanding principal amount. In consideration for the Loan, we issued to
Lender 250,000 shares of our restricted common stock and initially accounted for this redeemable common stock outside of permanent
equity at redemption value.



The fair value at issuance of the
shares given as consideration and the fair value of the beneficial conversion feature were recorded as a discount to the
outstanding Loan, and the discount was scheduled to be amortized over the contractual term of the Agreement through September
30, 2012. Since we repaid the outstanding principal and terminated the Agreement during the three months ended June 30, 2012,
which was earlier then the scheduled maturity date, we amortized the remaining discounts during the period. During the three and
six months ended June 30, 2012, we amortized $203,471 and $305,206 of the discount to other expenses in our statement
of operations.



Upon termination of the Agreement,
the 250,000 shares of common stock were reclassified to permanent equity.



16







Note 7 - Derivative Liabilities



Conversion Option



The convertible revolving credit agreement,
see Note 6 (the “Agreement”) entered into during the year ended December 31, 2011 met the definition of a hybrid instrument, as defined
in ASC Topic 815 “Derivatives and Hedging”. The hybrid instrument was comprised of a (i) a debt instrument, as the
host contract and (ii) an option to convert the debt outstanding under the revolving credit agreement into shares of our common
stock, as an embedded derivative. The embedded derivative derives its value based on the underlying fair value of the shares of
our common stock. The embedded derivative is not clearly and closely related to the underlying host debt instrument since the economic
characteristics and risk associated with this derivative are based on the common stock fair value.



We determined the fair value of the embedded
derivative and recorded it as a discount to the debt and a derivative liability on the date of issue. As disclosed in Note
5, the discount was amortized to other expenses over the initial term of the Agreement and the unamortized discount at repayment
of principal of the Agreement was charged to our statement of operations during the three months ended June 30, 2012.



The embedded derivative did not
qualify as a fair value or cash flow hedge under ASC 815. Accordingly, changes in the fair value of the embedded derivative
were immediately recognized in earnings and classified as a gain or loss on the embedded derivative financial instrument in
the accompanying statements of operations. For the three and six months ended June 30, 2012, we recognized a gain on the
change in fair value of this derivative liability of $127,071 and $113,271, respectively.



Upon termination of the Agreement during
the three months ended June 30, 2012, the fair value of the derivative liability of $127,071 was charged to our statement of operations.



17







Warrants



The 10% convertible preferred stock (see
Note 9) issued during the year ended December 31, 2011 meets the definition of a hybrid instrument, as defined in ASC Topic 815
“Derivatives and Hedging” (”ASC 815”). The hybrid instrument is comprised of a (i) a preferred stock, as
the host contract, (ii) a warrant to purchase shares of our common stock to be issued if a certain revenue milestone was not achieved
(the “Make Good Warrant”), as an embedded derivative liability and (iii) an option to convert the preferred stock into
shares of our common stock (the “Conversion Option”). Since, at issuance the number of shares of common stock which
the Make Good Warrant would be exercisable into, was not known, ASC 815 requires the fair value of the Make Good Warrants be recorded
as a derivative liability at issuance and any change in fair value be recognized in current earnings. The Conversion Option derives
its value based on the underlying fair value of the shares of our common stock as does the Preferred Stock, and therefore is clearly
and closely related to the underlying host contract.



The Make Good Warrant derivative
liability does not qualify as a fair value or cash flow hedge under ASC 815. Accordingly, changes in the fair value of the
derivative liability are immediately recognized in earnings and classified as a gain or loss on the derivative liability in
the accompanying statements of operations. At the date of issuance in March and April 2011, we determined the fair value of
the Make Good Warrant derivative to be insignificant and did not record a charge to Common Stock and a credit to the
derivative liability. Subsequently in 2011, since it became probable that the revenue milestone would not be met, we recorded
the derivative liability at fair value of $1.9 million. Since we did not achieve the revenue milestone for the year ended
December 31, 2011, we were required to issue the Make Good Warrants, and accordingly once issued, the derivative liability
associated with the Make Good Warrants was satisfied and the related derivative liability was reduced to zero. During the
three months ended March 31, 2012, we credited Common Stock for the issuance of these warrants for the fair value of the
derivative liability of approximately $1.9 million.



Bonus Warrants



Effective January 14, 2011, the
holders of our Debentures, agreed to extend the maturity dates to June 30, 2012 and to the elimination of the prohibition of
paying dividends or distributions on any of our equity securities. In addition to other amendments, we agreed that for each
calendar month after the original maturity dates that these Debentures remained outstanding, we would issue a bonus warrant exercisable for three years for a number of shares of our common stock equal to the 5% of
the outstanding principal, divided by $0.90. These bonus warrants are exercisable at $0.90 per share.



Since it was probable that we
would issue the bonus warrants which were part of the reacquisition costs of the new debt, at each month-end through the
amended maturity date, we calculated the fair value of the bonus warrants using the Black-Scholes pricing model and recorded
a derivative liability of approximately $797,000 on the date of amendment and recognized the amount as a loss in our
statement of operations during the three months ended March 31, 2011, the period of amendment. The bonus warrant derivative
liability does not qualify as a fair value or cash flow hedge under ASC 815, accordingly, changes in the fair value of the
derivative liability are immediately recognized in earnings and classified as a gain or loss on the derivative liability in
the accompanying statements of operations. During the three and six months ended June 30, 2012, we recorded approximately
$2,500 and $13,300, respectively of the gain in the fair value of the derivative liability. Upon issuance of the bonus
warrants during the six months ended June 30, 2012 and year ended December 31, 2011, we credited additional paid-in capital for
approximately  $57,000, and $234,700, respectively.



Fair Value Measurements



We are required to disclose the fair value
measurements required by Accounting for Fair Value Measurements. The derivative liability recorded at fair value in the balance
sheet as of June 30, 2012 and December 31, 2011 is categorized based upon the level of judgment associated with the inputs used
to measure its fair value. Hierarchical levels, defined by Accounting for Fair Value Measurements are directly related to the amount
of subjectivity associated with the inputs to fair valuation of the liability is as follows:



| | Level 1 - | Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date;
| | --------- | -------------------------------------------------------------------------------------------------------------------



| | Level 2 - | Inputs other than Level 1 inputs that are either directly or indirectly observable; and
| | --------- | ---------------------------------------------------------------------------------------



| | Level 3 - | Unobservable inputs, for which little or no market data exist, therefore requiring an entity to develop its own assumptions.
| | --------- | ----------------------------------------------------------------------------------------------------------------------------



The following table summarizes the financial
liabilities measured at fair value on a recurring basis as of June 30, 2012 and December 31, 2011, segregated by the level of the
valuation inputs within the fair value hierarchy utilized to measure fair value:



|                         |  | As of June 30, 2012 |  
|------------------------ |  | ------------------- | -
|                         |  | Level 1             |  
|Placement agent warrants |  |                     | -
|Total                    |  | $                   | -



|                                         |  | As of December 31, 2011 (Restated) |  
|---------------------------------------- |  | ---------------------------------- | -
|                                         |  | Level 1                            |  
|Derivative liability – conversion option |  | $                                  | -
|Derivative liability – warrants          |  |                                    | -
|Derivative liability – bonus warrants    |  |                                    | -
|Placement agent warrants                 |  |                                    | -
|Total                                    |  | $                                  | -



18







The following tables are a reconciliation
of the derivative liability for which Level 3 inputs were used in determining fair value:



|                                                   |  | Conversion Option |          |   | Warrants |   |            | Bonus
    Warrants |  |   | Placement
Agent
Warrants |  
|-------------------------------------------------- |  | ----------------- | -------- | - | -------- | - | ---------- | ------------------ |  | - | ------------------------ | -
|                                                   |  |                   |          |   |          |   |            |                    |  |   |                          |  
|Beginning balance as of January 1, 2012            |  | $                 | 113,271  |   |          | $ | 1,875,463  |                    |  | $ | 70,343                   |  
|Change in fair value                               |  |                   | (113,271 | ) |          |   | -          |                    |  |   | (13,309                  | )
|Credited to common stock upon issuance of warrants |  |                   | -        |   |          |   | (1,875,463 | )                  |  |   | (57,034                  | )
|Ending balance as of June 30, 2012                 |  | $                 | -        |   |          | $ | -          |                    |  | $ | -                        |  



|                                                   |  | Conversion Option |         |   | Warrants |   |           | Bonus Warrants |  |   | Placement Agent Warrants |  
|-------------------------------------------------- |  | ----------------- | ------- | - | -------- | - | --------- | -------------- |  | - | ------------------------ | -
|                                                   |  |                   |         |   |          |   |           |                |  |   |                          |  
|Beginning balance as of January 1, 2011            |  | $                 | -       |   |          | $ | -         |                |  | $ | -                        |  
|Fair value of derivative liability                 |  |                   | 118,663 |   |          |   | -         |                |  |   | 797,185                  |  
|Change in fair value                               |  |                   | (5,392  | ) |          |   | 1,875,463 |                |  |   | (492,111                 | )
|Credited to common stock upon issuance of warrants |  |                   | -       |   |          |   | -         |                |  |   | (234,731                 | )
|Ending balance as of December 31, 2011             |  | $                 | 113,271 |   |          | $ | 1,875,463 |                |  | $ | 70,343                   |  



19







Note 8 - Convertible Debt



The components of debt are summarized as follows.



|                            |  | Due          |  |  | June 30, 2012 |   |   | December 31,
    2011
(Restated) |  
|--------------------------- |  | ------------ |  |  | ------------- | - | - | -------------------------------- | -
|10% convertible debentures  |  | June 2012    |  |  | $             | - |   |                                  | $
|8.75% convertible debenture |  | January 2012 |  |  |               | - |   |                                  |  
|Total                       |  |              |  |  |               |   | - |                                  |  



10% Convertible Debentures



Our 10% convertible debentures (the “Debentures”)
were issued under purchase agreements during the fiscal year ended September 30, 2009, together with warrants, for aggregate proceeds
of $600,000. The total of the fair value of the warrants, as determined using the Black-Scholes pricing model, and the value of
the beneficial conversion features contained in the debentures, representing the difference between the fair value of common stock
issuable upon conversion at the date of purchase and the amount of proceeds allocated to the note, exceeded the proceeds received. 
Accordingly, we recorded a discount on the Debentures equal to the principal amount of the Debentures.  This recorded discount
on these Debentures was amortized to interest expense on the interest method through their originally scheduled maturity dates
in February and March 2011.



Effective January 14, 2011, the
holders of our Debentures, agreed to extend the maturity dates to June 30, 2012 and to the elimination of the prohibition of
paying dividends or distributions on any of our equity securities. We agreed to amend the interest rate to 15% if paid in
cash and to 18% (from 12%) if paid with shares of our common stock at the rate of one share of common stock for each $0.60
(from $0.90) of interest. We also agreed to reduce the conversion price, as defined, to $0.60, from $0.90 and to amend the
volume weighted average trading price at which we could force conversion to $2.50 from $2.00. In addition, for each calendar
month after February or March 2011 that these Debentures remained outstanding, we agreed to issue a bonus warrant exercisable for three years for a number of shares of our common stock equal to the 5% of the
outstanding principal, divided by $0.90. These bonus warrants are exercisable at $0.90 per share.



Even though these modifications to
our Debentures resulted in less than a ten percent difference in the present value of cash flows between the original terms
and the modified terms, the fair value of the conversion options was substantially greater than ten percent. We have
therefore, accounted for the modification of these Debentures as an extinguishment of the original debt and the establishment
of new debt. The difference between the reacquisition price of the new debt and the net carrying amount of the extinguished
debt was $1.4 million and was recognized as a loss in our statement of operations during the three months ended March 31,
2011, the period of amendment.



In addition, since it was probable that we would issue the bonus
warrants which were part of the reacquisition costs of the new debt, at each month-end through the amended maturity date, we calculated
the fair value of the bonus warrants using the Black-Scholes pricing model and recorded a derivative liability of approximately
$797,000 on the date of amendment and recognized the amount as a loss in our statement of operations during the three months ended
March 31, 2011, the period of amendment. The bonus warrant derivative liability does not qualify as a fair value or cash flow hedge
under ASC 815, accordingly, changes in the fair value of the derivative liability are immediately recognized in earnings and classified
as a gain or loss on the derivative liability in the accompanying statements of operations. (See Note 7.)



During the three and six months ended June 30, 2012, we recorded
approximately $2,500 and $13,300, respectively of the gain in the fair value of the derivative liability.



The principal of $600,000 and accrued interest were repaid during
the three months ended June 30, 2012, upon maturity.



20







8.75% Convertible Debenture



At maturity on January 31, 2012, we repaid
the full principal plus accrued interest on our 8.75% convertible debenture.



Note 9 - 10% Convertible Redeemable
Preferred Stock



We designated 880,000 shares of preferred
stock as 10% convertible redeemable preferred stock (the “Preferred Stock”). The Preferred Stock has a stated value
(the “Stated Value”) of $10.00 per share. The Preferred Stock and any dividends thereon may be converted into shares
of our common stock at any time by the holder at a conversion rate, as adjusted (the “Conversion Rate”). The holders
of the Preferred Stock are entitled to receive dividends at the rate of ten percent (10%) per annum payable quarterly. Dividends
shall not be declared, paid or set aside for any series or other class of stock ranking junior to the Preferred Stock, until all
dividends have been paid in full on the Preferred Stock. The dividends on the Preferred Stock are payable, at our option, in cash,
if permissible, or in additional shares of common stock. The Preferred Stock is not subject to any anti-dilution provisions other
than for stock splits and stock dividends or other similar transactions. The holders of the Preferred Stock shall have the right
to vote with our stockholders in any matter. The number of votes that may be cast by a holder of our Preferred Stock shall equal
the Stated Value of the Preferred Stock purchased divided by the Conversion Rate. The Preferred Stock shall be redeemable for cash
by the holder any time after the three (3) year anniversary from the initial purchase. The Preferred Stock may be converted by
us, provided that the variable weighted average price of our common stock has closed at $4.00 per share or greater, for sixty (60)
consecutive trading days and during such sixty (60) day period, the shares of common stock issuable upon conversion of the Preferred
Stock have either been registered for resale or are issuable without restriction pursuant to Rule 144 of the Securities Act of
1933, as amended.



Pursuant to the terms of the
Preferred Stock, since our net revenues for the twelve months ended December 31, 2011 were less than $10 million as reported
in our audited financial statements, (i) the holders of our Preferred Stock received a warrant to purchase approximately 3.8
million shares of our common stock (the “Make Good Warrants”) and (ii) the Conversion Rate of the Preferred Stock
was adjusted to $1.00, subject to adjustments for stock splits and stock dividends (the issuance of the Make Good Warrants
and the adjustment to the Conversion Rate is referred to as the “Make Good Adjustment”). The Make Good Warrants
are still outstanding at June 30, 2012, expire December 31, 2015 and have an initial exercise price of $1.00 per share
and provide for cashless exercise at any time the underlying shares of common stock have not been registered for resale under
the Securities Act of 1933 or are issuable without restriction pursuant to Rule 144 of the Securities Act.



21







During March and April 2011, we sold 759,773
shares of Preferred Stock at a price per share of $10, for gross proceeds of $7,597,730. We paid commissions, legal fees and other
expenses of issuance of $828,340, which has been recorded as a discount and deducted from the face value of the Preferred Stock.
At issuance of the Preferred Stock, we attributed a beneficial conversion feature to the Preferred Stock based upon the difference
between the Conversion Rate at the time of issuance and the closing price of our common stock on the date of issuance, which was
recorded as a discount and deducted from the face value of the Preferred Stock. Pursuant to the Make Good Adjustment of the Conversion
Rate to $1.00, at December 31, 2011 the beneficial conversion feature was recalculated as if the $1.00 Conversion Rate was in affect
at issuance, and the amortization of the related discount was adjusted for the year ended December 31, 2011. These discounts are
amortized over three years consistent with the initial redemption terms, as a charge to additional paid-in capital, due to a deficit
in retained earnings and during the three and six months ended June 30, 2012, we amortized $300,904 and $474,680, respectively
to additional paid-in capital. At June 30, 2012, the unamortized Preferred Stock discount balance was $1.6 million.



During the three and six months ended June
30, 2012, we issued 200,000 and 262,500 shares of our common stock, respectively upon conversion of 20,000 and 26,250 shares of
our Preferred Stock, respectively.



As of June 30, 2012, we may be required
to issue 7.3 million shares of our common stock if the remaining holders of our Preferred Stock elect to convert.



Since the Preferred Stock may ultimately
be redeemed at the option of the holder, the carrying value of the shares, net of unamortized discount and accumulated dividends,
has been classified as temporary equity at June 30, 2012.



As of June
30, 2012 we accrued dividends on the Preferred Stock in the amount of $176,773. The accrued dividends
were paid with approximately 392,800 shares of common stock, which were issued in lieu of cash. The common
stock issued in payment of the accrued dividends as of June 30, 2012, were issued subsequent to June 30, 2012.



The components of our Preferred Stock are
summarized as follows:



|                                            |  | June 30, |            |   | December 31, |  
|------------------------------------------- |  | -------- | ---------- | - | ------------ | -
|                                            |  | 2012     |            |   | 2011         |  
|Redeemable preferred stock - face value     |  | $        | 7,260,230  |   |              | $
|Accrued dividends                           |  |          | 176,773    |   |              |  
|Unamortized discount                        |  |          | (1,636,068 | ) |              |  
|Redeemable preferred stock, net of discount |  | $        | 5,800,935  |   |              | $



Placement Agent Warrants



We issued warrants to the placement agents
for the sale of our 10% convertible preferred stock, to purchase 58,352 shares of 10% convertible preferred stock at $10 per share.
Since the underlying 10% convertible preferred stock is redeemable by the holder after three years from the date of purchase, we
recorded the fair value of the warrants at issuance, as a liability on our balance sheet and we re-value this warrant liability
at each reporting date, with changes in fair value recognized in earnings each reporting period. The fair value of the warrant
liability at June 30, 2012 was $140,458, and we recognized the change in fair value of the warrant liability during the three and
six months ended June 30, 2012 of $104,539 and $347,097, respectively.



Note 10 - Stockholder’s Equity



We are authorized to issue up to 100,000,000
shares of common stock, no par value, and up to 2,500,000 shares of preferred stock, no par value. There were 26,188,550 and 25,257,261
shares of common stock issued and outstanding at June 30, 2012 and December 31, 2011, respectively.  During the year
ended December 31, 2011, we designated 880,000 shares of preferred stock as 10% convertible preferred stock and had outstanding
726,023 and 752,273 shares of 10% convertible preferred stock at June 30, 2012 and December 31, 2011, respectively. We may issue
additional shares of preferred stock, with dividend requirements, voting rights, redemption prices, liquidation preferences and
premiums, conversion rights and other terms without a vote of the shareholders.



22









As of June 30, 2012, we had outstanding
options, warrants and other convertible securities that, when exercised or converted, could result in the issuance of up to approximately
23.4 million shares of common stock.



Common Stock Issuances for the Six
Months Ended June 30, 2012



During January 2012, we issued 125,000
shares of common stock with a fair value on the date of issuance of $90,000, to a consultant pursuant to the terms of an agreement
to provide services.



We paid the December 31, 2011 accrued dividend
on our 10% convertible preferred stock with 247,538 shares of our common stock, with a fair value on the effective date of issuance
of $176,620.



During March 2012, we issued 62,500 shares
of common stock upon conversion of 6,250 shares of our 10% convertible preferred stock, with a value of $62,500.



We paid the March 31, 2012 accrued dividend
on our 10% convertible preferred stock with 286,251 shares of our common stock, with a fair value on the effective date of issuance
of $171,751.



Upon termination, and pursuant to an employment
agreement, we issued 10,000 shares of our common stock during May 2012, to an employee, with a fair value on the date of issuance
of $6,400.



During May 2012, we issued 200,000 shares of our common stock
upon conversion of 20,000 shares of our 10% convertible preferred stock, with a value of $200,000.



Warrants - Common Stock



From time to time, we compensate consultants,
advisors and investors with warrants to purchase shares of our common stock, in lieu of cash payments. Net share settlement is
available to warrant holders. Such warrants are marked to market at each reporting period.



The following table sets forth our warrant
activity during the period presented.



|                              |  | Six Months Ended |          
|----------------------------- |  | ---------------- | ---------
|                              |  | June 30, 2012    |          
|                              |  |                  |          
|                              |  | Number           |          
|                              |  | of Shares        |          
|                              |  | Issuable         |          
|Outstanding – January 1, 2012 |  |                  | 5,452,141
|Granted during the period     |  |                  | 3,928,040
|Exercised during the period   |  |                  | -        
|Outstanding – June 30, 2012   |  |                  | 9,380,181
|                              |  |                  |          
|Exercisable at end of period  |  |                  | 9,164,181



For the warrants granted during the six
months ended June 30, 2012, we estimated the fair value of each warrant at the grant date by using the Black-Scholes option pricing
model with the following range of assumptions for the warrants granted during the three months ended June 30, 2012 - (i) no dividend
yield, (ii) expected volatility of between 83% and 100%, (iii) risk-free interest rates of between 0.3% and 0.6%, and (iv) expected
lives of approximately three years.



During the three and six months
ended June 30, 2012, we issued warrants to purchase 100,005 and 166,675 shares of our common stock, respectively at a
weighted average exercise price of $0.60 to the holders of our 10% convertible debentures pursuant to their amended terms.
These warrants had a fair value of approximately $18,900 and $57,000, respectively at the date of grant which was charged to
common stock upon issuance.



Of the warrants to purchase shares of our
common stock granted during the six months ended June 30, 2012, we issued warrants to purchase 3,761,365 shares of our common stock
at an exercise price of $1.00 to the holders of our 10% convertible preferred stock pursuant to the Make Good Adjustment. The warrants
had a fair value at date of grant of $1,875,463 which was based on the Black-Scholes pricing model.



In addition, certain
previously issued warrants are amortized over a service period spanning multiple reporting periods. During the three and six
months ended June 30, 2012, we amortized $2,866 and $21,799, respectively of fair value of these previously granted warrants,
to our statement of operations.



Warrants - 10% Convertible Preferred
Stock



We issued warrants to the placement agents
for the sale of our 10% convertible preferred stock, to purchase 58,352 shares of 10% convertible preferred stock at $10 per share.
Since the underlying 10% convertible preferred stock is redeemable by the holder after three years from the date of purchase, we
recorded the fair value of the warrants at issuance, as a liability on our balance sheet and we re-value the warrant liability
at each reporting date, with any changes in fair value recognized in earnings each reporting period. The fair value of the warrant
liability at June 30, 2012 was $140,458, and we recognized the change in fair value of the warrant liability during the three and
six months ended June 30, 2012 of $104,539 and $347,097, respectively.



Options – Common Stock



We have two nonqualified stock option plans
approved by shareholders with an aggregate of approximately 1.2 million shares remaining available for grant as of June 30, 2012.  The
exercise price of the options are established by the Board of Directors on the date of grant and are generally equal to the market
price of the stock on the grant date.  The Board of Directors may determine the vesting period for each new grant. Options
issued are exercisable in whole or in part for a period as determined by the Board of Directors of up to ten years from the date
of grant.



23







For the six months ended June
30, 2012, we estimated the fair value of each option award at the grant date by using the Black-Scholes option pricing
model based on the following assumptions for the awards - (i) no dividend yield, (ii) expected volatility of 125%, (iii)
risk-free interest rate of 0.8%, and (iv) expected life of five years. No options were awarded during the three months ended June
30, 2012.



In prior periods, we awarded options
which provide the optionee with the right to exercise certain of these options based on the optionee’s achievement of
specific performance conditions. During the three months ended June 30, 2012, we concluded that it was more probable
then not, that certain of these performance condition options would be met at the end of an estimated service period. The
fair value of the option is determined on the date the option was granted using the Black-Scholes option pricing model and
amortized over the service period to operating expenses. During the three and six months ended June 30, 2012, we amortized
$105,980 and $138,385, respectively of the fair values of these performance condition options to operating expenses.



In
addition to options awarded during the three and six months ended June 30, 2012, options awarded in prior periods are
being amortized over a service period encompassing multiple reporting periods. During the three and six months ended June 30,
2012, we recognized in operating expenses $45,537 and $240,457, respectively.Compensation expense to be recognized in
periods subsequent to June 30, 2012 is approximately $71,800.



The following table summarizes our stock
option activity for the period presented:



|                              |  | Six Months Ended |          
|----------------------------- |  | ---------------- | ---------
|                              |  | June 30,2012     |          
|                              |  |                  |          
|                              |  | Number           |          
|                              |  | of Shares        |          
|                              |  | Issuable         |          
|Outstanding – January 1, 2012 |  |                  | 5,886,261
|Granted during the period     |  |                  | 300,000  
|Exercised during the period   |  |                  | -        
|Cancelled during the period   |  |                  | -        
|Outstanding – June 30, 2012   |  |                  | 6,186,261
|                              |  |                  |          
|Exercisable at  June 30, 2012 |  |                  | 3,734,703



24







The following table summarizes options
outstanding at June 30, 2012:



|                                    |  | Number of Shares Issuable |           |  | Weighted- Average Exercise Price |   |      | Weighted- Average Remaining Term
    (Years) |  |  | Aggregate Intrinsic Value | 
|----------------------------------- |  | ------------------------- | --------- |  | -------------------------------- | - | ---- | -------------------------------------------- |  |  | ------------------------- | 
|Total shares issuable upon exercise |  |                           | 6,186,261 |  |                                  | $ | 1.10 |                                              |  |  | 3.4                       | 
|Options exercisable                 |  |                           | 3,734,703 |  |                                  |   | 1.05 |                                              |  |  | 3.1                       | 
|Options not vested                  |  |                           | 2,451,558 |  |                                  |   | 1.19 |                                              |  |  | 3.8                       | 



Note 11 - Income Taxes



Due to our substantial operating losses
and the valuation allowance applied against our deferred tax assets, we have not recorded any income tax expense or benefit. Income
tax benefit attributable to loss before income taxes differed from the amounts computed by applying the United States of America
federal tax rate of 40% to loss before income taxes as a result of the following:



|                                        |  | June 30, |            |   | December 31, |  
|--------------------------------------- |  | -------- | ---------- | - | ------------ | -
|                                        |  | 2012     |            |   | 2011         |  
|                                        |  |          |            |   |              |  
|Current:                                |  |          |            |   |              |  
|Federal                                 |  | $        | -          |   |              | $
|State                                   |  |          | -          |   |              |  
|                                        |  |          | -          |   |              |  
|Increase in valuation allowance         |  |          | (1,480,000 | ) |              |  
|Benefit of operating loss carry forward |  |          | 1,480,000  |   |              |  
|Provision for income taxes, net         |  | $        | -          |   |              | $



|                                  |  | June 30, |       |    | December 31, | 
|--------------------------------- |  | -------- | ----- | -- | ------------ | 
|                                  |  | 2012     |       |    | 2011         | 
|Statutory federal income tax rate |  |          | 40.0  | %  |              | 
|                                  |  |          |       |    |              | 
|Increase in valuation allowance   |  |          | (40.0 | )% |              | 
|Effective tax rate                |  |          | 0.0   | %  |              | 



Deferred income taxes result from temporary
differences in the recognition of income and expenses for the financial reporting purposes and for tax purposes. At June 30, 2012,
we had available net operating loss carry forwards of approximately $16.6 million that expire through 2032. Our ability to
utilize our net operating loss carry forwards is uncertain and thus a valuation allowance has been provided against our net deferred
tax asset. Due to the changes in ownership over the prior periods from debt conversions, equity financings and the merger transaction,
we may have triggered a Section 382 limitation on the utilization of such net operating loss carry forwards. In addition, we have
not remained current with our federal and state tax returns. The net deferred tax assets and liabilities are comprised of the following:



|                              |  | June 30, |            |   | December 31, |  
|----------------------------- |  | -------- | ---------- | - | ------------ | -
|                              |  | 2012     |            |   | 2011         |  
|Deferred tax assets:          |  |          |            |   |              |  
|Current                       |  | $        | -          |   |              | $
|Non-current                   |  |          | 6,640,000  |   |              |  
|                              |  |          | 6,640,000  |   |              |  
|Less valuation allowance      |  |          | (6,640,000 | ) |              |  
|Net deferred income tax asset |  | $        | -          |   |              | $



25







Note 12 - Business Concentration



During the three and six months ended June
30, 2012, we sold our products to 13 and 22 customers, respectively with sales of our ECOTRAX rail ties to one customer representing
approximately 47% and 63%, respectively of our total revenue.



Purchases of raw materials and contract
manufacturing services and products from our two contract manufacturers were approximately 51% and 49% of our total purchases for
the three and six months ended June 30, 2012, respectively.



Note 13 - Commitments and Contingencies



Operating leases



We lease office space in New Providence,
New Jersey pursuant to a three-year lease agreement for office space which provides for initial monthly lease payments of approximately
$3,400 with customary annual increases.  These premises serve as our corporate headquarters. The initial term of the
lease expires on October 31, 2012 and the lease provides one renewal option for an additional three-year term.  Facility
rent expense for this facility totaled approximately $11,300 and $22,600 for the three and six months ended June 30, 2012, respectively.
Future minimum rental payments for the remainder of the initial lease term totals approximately $15,100.



Rutgers License



In February 2007, we acquired an exclusive,
royalty-bearing license in specific but broad global territories to make, have made, use, sell, offer for sale, modify, develop,
import, and export products made using patent applications owned by Rutgers University (Rutgers”).  We are using
these patented technologies in the production of our composite rail ties and structural building products. The term of the License
Agreement runs until the expiration of the last-to-expire issued patent within the Rutgers’ technologies licensed under the
License Agreement, unless terminated earlier.



We are obligated to pay Rutgers royalties
ranging from 1.5% to 3.0% on various product sales, subject to certain minimum payments each year and to reimburse Rutgers for
certain patent defense costs in the case of patent infringement claims made against the Rutgers patents.  We also pay annual
membership dues to Rutgers Center for Advanced Materials via Immiscible Polymer Processing, or AIMPP, a department of Rutgers.  The
membership allows us to use AIMPP for basic research and development at no additional cost, with access to more comprehensive R&D
services available to us for fees determined on a per-project basis.



Litigation



In April 2006, we commenced an action against
Tonga Partners, L.P. (Tonga”), Cannell Capital, L.L.C. and J. Carlo Cannell in the United States District Court of New York,
for disgorgement of short-swing profits pursuant to Section 16 of the Securities Exchange Act of 1934, as amended.  On
November 10, 2004, Tonga converted a convertible promissory note into 1,701,341 shares of Common Stock, and thereafter, between
November 10 and November 15, 2004, sold such shares for short-swing profits.  In September 2008, the District Court granted
us summary judgment against Tonga for disgorgement of short-swing profits in the amount of $5.0 million.  The defendants
appealed the order granting the summary judgment to the U.S. Court of Appeals for the 2nd Circuit. The three judge panel
held in our favor. The defendants have petitioned the Court for a full judge review. Their petition is currently pending.



From time to time, we are subject to various
other routine litigation incidental to our business. We do not believe that any of these routine legal proceedings would have a
material adverse effect on our financial condition or results of operations.



26







Note 14 - Related Party Transactions



Michael Dodd



Mr. Dodd, who was a member of our board
of directors from September 2010 until his resignation in August 2012, is currently serving as the Chief Executive Officer of 3D
Global Solutions Inc. (3D).  3D provides professional program management services to governments, corporations and
global organizations. During the year ended December 31, 2011, 3D purchased approximately $102,200 of our composite rail ties
on terms similar to our other customers and which remains uncollected at June 30, 2012.



Samuel G. Rose



Samuel G. Rose beneficially owns in excess
of 5% of our outstanding stock.



Convertible Revolving Credit Agreement.During the year ended December 31, 2011, we entered into a convertible revolving credit agreement (the Agreement”)
with Mr. Rose. Under the terms of the Agreement, Mr. Rose had agreed to lend us up to $2,000,000 on a revolving basis (the Loan”).
The Loan carried interest at 12% per annum on the outstanding principal amount. The Loan had an original maturity date of September
30, 2012. In consideration for the Loan, we paid all legal and accounting costs associated with the documentation of the Loan and
issued to Mr. Rose 250,000 shares of our restricted common stock. We have agreed to register the common stock issued to Mr. Rose
within six months from date of closing provided, however, if such common stock is not registered we will redeem all of Mr. Rose’s
unregistered stock in cash at a price equal to the greater of (a) the average VWAP for the thirty days ending one trading day prior
to the date of issuance or (b) $0.90 per share.



We gave Mr. Rose a security interest in
our inventory and accounts receivable pursuant to terms of a security agreement. During the year ended December 31, 2011, we borrowed
$466,000 under the Agreement.



During the three months ended June 30,
2012 we repaid the outstanding principal and accrued interest and the Agreement was cancelled.



Demand Promissory Notes.Effective
April 25, 2012 we entered into a Memorandum of Understanding (the
“MOU”) with Mr. Rose and several other investors. Pursuant to the MOU, we issued to Mr. Rose a demand promissory
note (the “Note”) in the principal amount of $1,666,667.  Interest accrues on the unpaid principal
balance of the Note at a rate of 8.00% per annum. The principal balance of the Note, together with accrued and unpaid
interest, is due and payable at any time after June 30, 2012 on demand.



Melvin Lenkin



Melvin Lenkin beneficially owns in excess
of 5% of our outstanding stock.



Demand Promissory Notes.Effective
April 25, 2012 we entered into a Memorandum of Understanding (the “MOU”) with Mr. Lenkin and
several other investors. Pursuant to the MOU, we issued to Mr. Lenkin a demand promissory note (the “Note”) in the
principal amount of $1,426,667.  Interest accrues on the unpaid principal balance of the Note at a rate of 8.00% per
annum. The principal balance of the Note, together with accrued and unpaid interest, is due and payable at any time after June
30, 2012 on demand.



27







Item 2.  Management’s
Discussion and Analysis of Financial Condition and Results of Operations



The discussion of our financial condition
and results of operations set forth below should be read in conjunction with the consolidated financial statements and related
notes thereto included elsewhere in this Form 10-Q. This Form 10-Q contains forward-looking statements that involve risk and uncertainties.
The statements contained in this Form 10-Q that are not purely historical are forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, as amended, and the
Private Securities Litigation Reform Act of 1995. When used in this Form 10-Q, or in the documents incorporated by reference into
this Form 10-Q, the words “anticipate,” “believe,” “estimate,” “intend”, “expect”,
“may”, “will” and similar expressions are intended to identify such forward-looking statements. Such forward-looking
statements include, without limitation, statements relating to competition, management of growth, our strategy, future sales, future
expenses and future liquidity and capital resources. All forward-looking statements in this Form 10-Q are based upon information
available to us on the date of this Form 10-Q, and we assume no obligation to update any such forward-looking statements. Our actual
results, performance and achievements could differ materially from those discussed in this Form 10-Q. Factors that could cause
or contribute to such differences (“Cautionary Statements”) include, but are not limited to, those discussed in Item
1A. “Risk Factors” and elsewhere in our Annual Report on Form 10-K.  All subsequent written and oral forward-looking
statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by the Cautionary Statements.



Basis of Presentation



The financial information presented in
this Form 10-Q is not audited and is not necessarily indicative of our future consolidated financial position, results of operations
or cash flows. Our fiscal year-end is December 31, and our fiscal quarters end on March 31, June 30 and September 30. Unless otherwise
stated, all dates refer to our fiscal year and fiscal periods.



Overview



Our predecessor company was formed in 1981
under the name Analytic Surveys, Inc. On March 20, 2008, Analytic Surveys, Inc. consummated an Agreement and Plan of Merger (or
the Merger) with Axion International, Inc. In the Merger, the stockholders of Axion International, Inc. succeeded to approximately
90.7% of Analytic Survey, Inc.’s issued and outstanding common stock and Analytics Survey changed its name to Axion International
Holdings, Inc. The Merger has been accounted for as a reverse merger in the form of a recapitalization with Axion as the successor.



We develop, manufacture, market and sell
composite rail ties and structural building products, such as pilings, I-beams, T-beams and boards, which, based upon patented
technology developed at Rutgers University, are fully derived from common recycled plastics and high-density polymers, such as
polyethylene, polystyrene and polypropylene. These recycled plastics, which are combined with recycled plastic composites containing
encapsulated fiberglass, achieve structural thickness and strength and are resistant to changing shape under constant stress. Our
products, manufactured through an extrusion process, are eco-friendly, non-corrosive, moisture impervious, non-chemical leaching
and insect and rot resistant. Our products possess superior lifecycles and generally have greater durability and require less maintenance
than competitive products made from wood, steel or concrete. We market our products in two lines, the first being ECOTRAXTM,
our line of rail ties, and the second being STRUXURETM, our line of structural building products.



Sources of Revenues



We derive our revenues through the sale
of our ECOTRAX rail ties and STRUXURE building products. Our strategic focus to date has been to advance rapidly the sale of our
ECOTRAX rail ties and to create a broad-based market for our STRUXURE building products. We have been undertaking strategic initiatives,
including the ongoing development and deployment of engineering guidance materials, such as supporting documentation, research,
testing and various publications of the structural properties and performance of our products, with the goal to educate the engineers,
developers and others who might use our products in projects for their clients, as well as our potential customers.



In late 2010, we commenced the sales and
marketing of our products. Having completed a number of commercially engineered solution projects over the past several years,
we began concentrating our activities from proof-of-concept to a strategically focused, sales-oriented growth company. Over
the past several years, our activities centered upon advancing the development of our technology and products.  As proof-of-concept,
we completed the deployment of our products across multiple customers, applications and industries. Beginning late in 2010
we began introducing our ECOTRAX rail products to mass markets globally and, late in the year ended December 31, 2011, we developed
and began implementing a sales strategy for our STRUXURE building products to other public- and private-sector buyers. In certain
markets, our sales cycle can be rather long as the customer may require an internal testing phase before placing a larger order.
Our strategic focus is on the continued growth of sales, within both the rail tie and the structural building products sectors,
the expansion of our technology within and across markets, and the expansion of our infrastructure in order to manufacture our
products and support our growing sales order pipeline.



28







Cost of Sales and Operating Expenses



Costs of Sales.  Our costs
of sales are primarily comprised of the cost of raw materials and the costs and expenses associated with our contract manufacturing
arrangements.  The price of the raw materials depends principally on the stage and source of the supply. We purchase
the raw materials in various stages, from recycled plastic containers purchased in bulk, which require further processing before
use, to ready-for-production material. Typically, the more processed raw material is more expensive, on a per-pound basis, than
less processed material. But the less processed material requires additional costs to prepare it for production. Likewise, raw
materials purchased through third-party brokers or other intermediaries are more expensive than materials purchased directly from
the source or collection point.



Our strategy to reduce our raw material
costs include broadening our raw materials sources and purchasing other low-cost, unprocessed materials, such as other scrap materials
containing our specific raw materials from unique sources and recycled materials from municipal and other recycling collection
sources. Previously, due to the limited amount of time and personnel we could devote to raw materials sourcing, we acquired our
raw materials primarily from intermediaries, and purchased production-stage material, which resulted in the acquisition of raw
materials at less-than favorable prices. But dealing in the recycled plastics market, whether through intermediaries or bulk purchases,
we encountered and will continue to encounter increasing and decreasing prices typically seen in a commodities market. But since
the cost of our raw materials is the single largest determinant of our costs of sales, we continue to seek out (i) agreements with
sources of cheaper raw materials, while ensuring those materials meet or exceed our quality standards as well as (ii) expanding
our research and development effort of different raw materials which may provide a cost and/or performance advantage over existing
materials.



We are continuing to take steps to reduce
our production costs and expenses, while increasing capacity. During the second half of the year ended December 31, 2011, we significantly
increased production capacity, both through a focused joint effort with our existing contract manufacturer, as well as adding a
second contract manufacturer. This situation has allowed us to shift certain production to one or the other contract manufacturer,
or allows us to increase or decrease our production as the situation dictates. Our existing contract manufacturing arrangements
allow for the production of our products utilizing our manifolds, molds and controllers. Under one arrangement, we source, purchase
and supply the contract manufacturer with the raw materials and pay a per pound manufacturing cost to our contract manufacturer
to produce the finished products. Under the other arrangement, the contract manufacturer is responsible for sourcing and purchasing
the raw materials and producing the finished product, which we purchase from them at a predetermined cost. Pursuant to that agreement,
the predetermined cost is based on a reference price of each raw material, and we are obligated to reimburse the contract manufacturer
for any costs it incurs in excess of the reference price and we share in any savings resulting from raw material purchases below
the reference price. In addition to eliminating our cost and expense of sourcing the raw materials, we have improved our cash flow
by eliminating the need to expend funds early in the manufacturing-to-sales cycle to purchase the raw materials, and instead purchase
the finished product closer to the sale to our customer.



Additionally, we continued our efforts
in driving unnecessary costs and expenses out of our manufacturing processes through the coordinated efforts of both our contract
manufacturers and us. Each step of the manufacturing process, from raw material handling and storage through the quality control
review and inventory handling steps, we continue to jointly examine best practices and other methods to improve and streamline
the processes to eliminate unnecessary costs and expenses. We’ve made some improvements and continue to search out ways to
continue to reduce the costs of manufacturing our products.



Even with the fluctuations in the prices
in the raw materials market, the steps we have taken during the six months ended June 30, 2012, from the sourcing of our raw materials
to the relationships with our contract manufacturers, should continue to benefit us in controlling our costs of sales.



Product Development and Quality Management.
Product development and quality management expenses are incurred as we perform oversight of our contract manufacturing relationships
and ongoing evaluations of materials and processes for existing products, as well as the development of new products and processes.
Such expenses typically include costs associated with the design and the required testing procedures associated with our two product
lines. In addition to our investment in both our product development efforts and insuring the products we produce meet the high
quality specifications we’ve set, we continue to work with the scientific team at Rutgers University to enhance our product
formulations, develop innovative products and expand the reach of our existing products.



29







Marketing and Sales.  Expenses
related to marketing and sales consist primarily of compensation for our sales and marketing personnel, sales commissions and incentives,
advertising, trade shows and related travel. We have increased our marketing and sales effort and anticipate incurring significant
marketing and sales expenses in the future. The strategy we employ in reaching out to our target markets-whether through collaborative
approaches, such as joint ventures, by building our own sales and marketing infrastructure, or by sub-licensing our technology
to others-will have a significant effect on our marketing and sales expenses. We expect that in the future, marketing and sales
expenses will increase in absolute dollars.



General and Administrative.  General
and administrative expenses consist of compensation and related expenses for executive, finance, accounting, administrative, legal,
shareholder services, depreciation of general office equipment and other corporate expenses. We anticipate that we will continue
to use share-based compensation when compensating consultants and others, in certain situations. In addition, we anticipate as
we continue to grow our business, our general and administrative expenses will increase. As a result, we expect that in subsequent
periods, general and administrative expenses will increase in absolute dollars as revenue increases.



Interest Expense and Amortization of
Debt and Preferred Stock Discounts.  Interest expense primarily consists of the contractual interest rate we pay on our
debt instruments. Amortization of debt and preferred stock discounts consists of the periodic amortization of the debt discounts
associated with our debt, and the amortization of the 10% convertible preferred stock discount.



Gain or Loss from Change in Fair
Value of Derivative Liability. During January 2011, we agreed to amend the terms of our 10% convertible debentures, which
among other revisions extended the maturity dates to June 30, 2012 and that for each calendar month after the original
maturity dates that these debentures remained outstanding, required us to issue warrants. Since it was probable that we would
issue these warrants, we calculated the fair value of the warrants and recorded a derivative liability of approximately
$797,000 on the date of amendment and recognized the amount as a loss in our statement of operations. The derivative
liability does not qualify as a fair value or cash flow hedge under ASC 815, accordingly, changes in the fair value of the
derivative liability are immediately recognized in earnings and classified as a gain or loss from change in fair value in the
statements of operations.



During the year ended December 31, 2011, we entered into a revolving credit agreement which was terminated
during the three months ended June 30, 2012, which gave the holder the right to convert a portion of the outstanding debt into
shares of our common stock. We recognized the fair value of this beneficial conversion feature at the date we executed the agreement
and at the end of each reporting period, recognizing the change in earnings during the current period.



Pursuant to the terms of our 10% convertible
preferred stock, we were required to issue warrants to the holders of the preferred stock. At initial issuance of the 10% convertible
preferred stock, we recorded the fair value as a derivative liability and recognized the change in fair value in current earnings.
During the three months ended March 31, 2012, we issued the warrants and reclassified the fair value of the warrants as represented
by the derivative liability, upon issuance of the warrants, to common stock.



Critical Accounting Policies



Management’s Discussion and Analysis
of Financial Condition and Results of Operations are based upon our financial statements, which have been prepared in accordance
with generally accepted accounting principles (or GAAP) in the U.S. The preparation of financial statements in conformity with
GAAP requires management to make estimates, judgments and assumptions that affect the amounts reported in our consolidated financial
statements and accompanying notes. Our critical accounting policies are those that affect our financial statements materially and
involve difficult, subjective or complex judgments by management.



An accounting policy is deemed to be critical
if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate
is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably
likely to occur could materially change the financial statements.



Use of Estimates . The preparation
of financial statements in conformity with GAAP 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 the financial statements and
the reported amount of revenues and expenses during the reporting period.  Actual results could differ from those estimates.



Revenue and Cost Recognition.  We
recognize revenue when a fixed commitment to purchase our products is received, title or ownership has passed to the customer,
the amount due from the customer is fixed or determinable, collectability is reasonably assured, and we do not have any specific
performance obligations remaining, such that the earnings process is complete. In most cases, we receive a purchase order from
our customer specifying the products requested and delivery instructions. We recognize revenue upon our delivery of the products
as specified in the purchase order.



30







In other cases where we have a contract
which provides for a large number of products and few actual deliveries, the revenues are recorded each month as the products are
produced and the risk of ownership passes to the customer upon pre-delivery acceptance. Prior to deliveries, our customer’s
products are segregated from our inventory and not available for fulfilling other orders.



Share-based Compensation. We
recognize stock-based compensation for transactions in which we exchange our equity instruments for services of directors, employees,
consultants and others based on the fair value of the equity instruments issued at the date of grant or other measurement date.  The
fair value of common stock awards is based on the observed market value of our stock.  We calculate the fair value of
options and warrants using the Black-Scholes option pricing model. The Black-Scholes model requires the input of subjective
assumptions including volatility, expected term, risk-free interest rate and dividend yield. We use a measure of volatility based
on the historical volatility of our common stock over a similar period to the expected life of the award. The expected term of
an award is based on the vesting or service period.  We base the risk-free rate on the rate of U.S. Treasury obligations
with maturities similar to the expected term used in the model. Historically, we have not, and do not anticipate paying in the
foreseeable future, dividends on our common stock, and accordingly use an expected dividend yield of zero.



Derivative Instruments. For derivative
instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then
re-valued at each reporting date, with changes in fair value recognized in earnings each reporting period. We use the Black-Scholes
model to value the derivative instruments at inception and subsequent valuation dates. The classification of derivative instruments,
including whether such instruments should be recorded as a liability or as equity, is re-assessed at the end of each reporting
period, in accordance with FASB ASC Topic 815, “Derivatives and Hedging”. Derivative instrument liabilities are
classified in the balance sheet as current or non-current based on whether or not the net-cash settlement of the derivative instrument
could be required within twelve months of the balance sheet date.



Recent Accounting Pronouncements



For information regarding recent accounting
pronouncements and their effect on us, see “Recent Accounting Pronouncements” in Note 1 of the unaudited Notes to Condensed
Consolidated Financial Statements contained herein.



Results of Operations – Three
and Six Months Ended June 30, 2012 and 2011



The following discussion should be read
in conjunction with the information set forth in the unaudited condensed consolidated financial statements and the related notes
thereto appearing elsewhere in this Form 10-Q.



Revenue . For the three months ended
June 30, 2012 and 2011, we recognized revenue of $1.8 million and $1.3 million, respectively which included revenue from the sales
of our ECOTRAX, our composite rail ties of $1.5 million and $0.9 million, respectively during those periods. The remainder of our
revenue during the three months ended June 30, 2012 and 2011 was from our sales of our STRUXURE composite structural building products.
Approximately 47% and 23% of our sales during the three months ended June 30, 2012 and 2011, respectively were to one customer
pursuant to a three-year supply agreement for our ECOTRAX rail ties.



For the six months ended June 30, 2012
and 2011, we recognized revenue of $4.1 million and $1.5 million, respectively which included revenue from the sales of our ECOTRAX,
our composite rail ties of $3.6 million and $1.1 million, respectively during those periods. The remainder of our revenue during
the six months ended June 30, 2012 and 2011 was from our sales of our STRUXURE composite structural building products. Approximately
63% and 20% of our sales during the six months ended June 30, 2012 and 2011, respectively were to one customer pursuant to the
three-year supply agreement for our ECOTRAX rail ties.



The three-year supply agreement for our
ECOTRAX rail ties contains challenging pricing terms, but has provided us with the foundation to initially develop and expand our
manufacturing capacity and processes. Beginning in June 2011 and through June  2012, we’ve
recognized approximately one-third of the revenue represented in this three-year supply agreement for our ECOTRAX rail ties. Since
we continue to encounter raw material pricing pressure against the challenging pricing terms of our three-year supply agreement,
we are evaluating the timing of any future ECOTRAX rail tie production and deliveries pursuant to this agreement.



During the three months ended June 30,
2012, we continued to receive small test orders for ECOTRAX rail ties and STRUXTURE building products as we pursue re-order decisions
for these as well as orders from new and repeat customers. Our ECOTRAX rail ties are currently in track test or undergoing purchase
approval in the following regions with leading passenger and freight lines – Australia, Brazil, Chile, Mexico, New Zealand,
Russia and Singapore as well as various other countries in Europe. There can be no assurance that the results of these and other
test orders or the approval processes currently underway for other orders will materialize into additional orders for our ECOTRAX
rail ties.



Our focus will continue to be on diversifying
our customer base and the pricing of our products, as well as the continuing development of opportunities we foresee with our STRUXURE
composite structural building products. We sold products to six and nine new customers during the three and six months ended June
30, 2012, respectively out of a total of 22 customers for the six months ended June 30, 2012.



Costs of Sales. Cost of sales amounted
to $1.8 million and $1.2 million for the three months ended June 30, 2012 and 2011, respectively, resulting in gross margins of
approximately $40,100 and $92,900, respectively. The reduced gross margin for the three months ended June 30, 2012, is a result
of a larger percent of our revenue was from deliveries pursuant to our three-year supply agreement for our ECOTRAX rail ties which
contains challenging pricing. During the six months ended June 30, 2012 and 2011, our costs of sales were $4.0 million and $1.5
million, respectively with gross margins of approximately $51,200 and $8,400 for the corresponding periods.



During the six months ended June 30, 2012,
we continued to experience the challenge of sourcing raw materials at prices which would benefit our gross margins. We met with
some success in finding new and expansive sources of raw materials, either containing a higher percentage of our individual raw
material components on a per pound basis or at a significant price advantage. Even though we did experience additional costs of
preparing this less expensive raw material for use in production, we anticipate that a combination of enhanced manufacturing methods,
processes and procedures in addition to the reduced costs of raw materials, will have a positive impact on our gross margins in
subsequent periods.



Our costs of sales continued to be impacted
by our early stage of manufacturing and commercial activities and which included, among other factors, less efficient manufacturing
processes and methods and continued higher than anticipated costs and expenses of the raw materials used in production. We continue
to work to improve our manufacturing processes and procedures to remove unnecessary and inefficient costs and expenses.



Because we are in the early stages of commercial
activities, cost of sales may not be indicative of cost of sales in the future, which may vary significantly and are highly dependent
on the price of raw materials, concurrent production activities, use of subcontractors and timing and mix of the sales and services.



31







Product Development and Quality Management
.. Costs and expenses associated with our product development and quality management efforts were approximately $328,400 and $93,200
for the three months ended June 30, 2012 and 2011, respectively. For the six months ended June 30, 2012 and 2011, our product development
and quality management expenses were approximately $563,800 and $166,600, respectively.



The increases in both periods reflect the
expansion of our quality management efforts within our third-party manufacturing processes, enhancement of our product formulations,
and development of new innovative products.



Marketing and Sales.  Marketing
and sales expenses increased to approximately $248,300 for the three months ended June 30, 2012 compared to approximately $4,600
for the corresponding period in 2011. For the six months ended June 30, 2012 and 2011, our marketing and sales expenses were approximately
$387,100 and $63,700, respectively. The increases for both periods reflects an increased effort in establishing our ECOTRAX and
STRUXURE brands through effective and efficient branding strategies and the marketing efforts in support thereof. We continue to
expand the exposure of our products, and anticipate our expenses of marketing and sales to increase in the future.



General and Administrative. 
General and administrative expenses were $1.0 million and $2.4 million for the three months ended June 30, 2012 and 2011, respectively,
and $1.9 million and $3.9 million for the six months ended June 30, 2012 and 2011, respectively. During the three months ended
June 30, 2012 and 2011, we recorded approximately $160,700 and $1.8 million, respectively in charges related to the fair value
of the shares of our common stock and options and warrants providing the right to purchase shares of our common stock at a predetermined
price in the future, issued prior to and during the period. For the six month periods ended June 30, 2012 and 2011, we recorded
similar share-based charges of approximately $497,040 and $2.7 million, respectively. We anticipate we will continue to use share-based
compensation for employees, officers and directors as well as to compensate consultants.



During the three and six months ended June
30, 2012, we recognized the change in fair value of our 10% convertible preferred stock warrants liability of approximately $104,500
and $347,100, respectively. In addition, we recognized during the three months ended June 30, 2012 approximately $251,300 in expenses
associated with the preparation and filing of our registration statement.



Interest Expense. Interest
expense recognized during the three months ended June 30, 2012 and 2011, was approximately $95,600 and $67,000, respectively, and
represented the contractual interest rates payable on our debt obligations. For the six months ended June 30, 2012 and 2011, we
recognized interest expense of approximately $133,500 and $97,100, respectively.



During the three months ended June 30,
2012, we received $5 million in exchange for our 8% demand notes and repaid $1.1 of principal of our previously outstanding convertible
debentures and revolving credit agreement. We anticipate interest expense to increase in the future until the outstanding principal
on the 8% demand notes is repaid.



Amortization of Debt Discounts. During the three months ended June 30, 2012 and 2011, we recognized approximately $203,500 and $249,000, respectively
for the amortization of  debt discounts. We recognized
approximately $373,600 and $367,400 for the six months ended June 30, 2012 and 2011, respectively.



At the time of issuance, we record discounts
on our convertible securities primarily due to the embedded conversion features, the fair value of any related shares of common
stock or warrants issued in conjunction with the securities and any costs incurred in issuing the security. These discounts are
amortized over the term of the underlying convertible security, to additional paid-in capital in the case of the embedded beneficial
conversion feature and warrants issued pursuant to the convertible preferred stock and to operating expense in the case of the
shares of common stock or warrants issued and embedded beneficial conversion features pursuant to the revolving credit agreement
and convertible debentures. Any unamortized discount remaining when the security is repaid or converted is written off to additional
paid-in capital or operating expense in that period.



Loss on Debt Extinguishment.
We accounted for the amendment to our 10% convertible debentures as an extinguishment of the old debt and the issuance of new
debt. The difference between the reacquisition price of the new debt and the net carrying amount of the extinguished debt was
$1.4 million and was recognized as a loss in our statement of operations during the three months ended March 31, 2011, the
period of amendment. There was no corresponding charge in the three or six months ended June 30, 2012.



Fair Value of Bonus Warrants
at Extinguishment. Effective January 14, 2011, the holders of our 10% convertible debentures agreed to certain amendments to the
debentures. In addition to other amendments, we agreed that for each calendar month after the original maturity dates that
these debentures remained outstanding, we would issue a warrant based on a predetermined calculation. Since it was probable
that we would issue these warrants at each month-end through the amended maturity date, we calculated the fair value of the
warrants using the Black-Scholes pricing model and recorded a derivative liability of approximately $797,000 on the date of
amendment and recognized the amount as a loss in our statement of operations. This derivative liability does not qualify as a
fair value or cash flow hedge under ASC 815 accordingly, changes in the fair value of the derivative liability are
immediately recognized in earnings and classified as a gain or loss on the derivative liability in the accompanying
statements of operations.



During the six months ended June 30, 2011, we recorded the fair
value of the derivative liability of approximately $797,000 as a charge in our statement of operations.



32







Gain or Loss from Change in Fair
Value of Derivative Liability. During the year ended December 31, 2011, we entered into a revolving credit agreement and
pursuant to the agreement we recognized the fair value of the embedded beneficial conversion feature as a derivative
liability. During the three and six months ended June 30, 2012, we recorded a  gain of approximately $127,100 and $113,300,
respectively due to the change in fair value of this derivative liability. There was no corresponding transaction for the
three or six months ended June 30, 2011.



Effective January 14, 2011, the
holders of our 10% convertible debentures agreed to certain amendments to the debentures. In addition to other amendments, we
agreed that for each calendar month after the original maturity dates that these debentures remained outstanding, we would
issue a warrant based on a predetermined calculation. Since it was probable that we would issue these warrants at each
month-end through the amended maturity date, we calculated the fair value of the warrants using the Black-Scholes pricing
model and recorded a derivative liability of approximately $797,000 on the date of amendment and recognized the amount as a
loss in our statement of operations. This derivative liability does not qualify as a fair value or cash flow hedge under ASC
815, accordingly changes in the fair value of the derivative liability are immediately recognized in earnings and classified
as a gain or loss on the derivative liability in the accompanying statements of operations. During the three and six months
ended June 30, 2012, we recorded a gain in the change in fair value of the derivative liability of approximately $2,500 and
$13,300, respectively as a charge in our statement of operations. During the three and six months ended June 30, 2011, we
recorded a gain in the change in fair value of the derivative liability of approximately $48,200 and $359,600, respectively
as a charge in our statement of operations.



Income Taxes . We have unused net
operating loss carry forwards, which included losses incurred from inception through June 30, 2012. Due to the uncertainty
that sufficient future taxable income will be recognized to realize associated deferred tax assets, no income tax benefit from
inception through June 30, 2012 has been recorded.



Liquidity, Capital Resources and Plan
of Operations



At June 30, 2012 we had $5.8 million in
current assets and $7.7 million in current liabilities resulting in a working capital deficit of $1.9 million. This compares to
working capital deficit of approximately $112,000 million at December 31, 2011.



We used $2.5 million in our
operating activities during the six months ended June 30, 2012. We recorded approximately $570,500 in non-cash
transactions, consisting of depreciation and amortization, amortization of debt and preferred stock discounts, changes in
fair value of derivative liabilities and share-based compensation expense during the period. To offset a scheduled shut down
of a manufacturing line at one of our contract manufacturers, we invested approximately $829,300 in additional inventory.



To increase production capacity, we purchased
property and equipment of approximately $848,100 during the six months ended June 30, 2012. We anticipate purchasing additional
property and equipment as we continue to expand our manufacturing capacity. We spend between $0.7 million and $1.0 million to have
a typical production line made, delivered and installed.



Upon maturity in January 2012, we repaid
principal of $172,500 and accrued interest on our 8.75% convertible debenture. During May 2012, the outstanding balance of $466,000
on our revolving credit agreement was repaid in full. In addition, upon maturity in June 2012, we repaid the $600,000 of principal
on our 10% convertible debentures.



Pursuant to the terms of the 10% convertible
preferred stock, to date we have elected to pay our quarterly dividends in shares of our common stock, rather than in cash. Whether
or not we make the same election for future quarters will have an impact on our cash balances.



During the three months ended June 30,
21012 we entered into a Memorandum of Understanding (the “MOU”) with certain investors. Pursuant to the MOU, we issued
the investors demand promissory notes in the aggregate principal amount of $5,000,001.  Interest accrues on the unpaid
principal balance of the demand promissory notes at a rate of 8.00% per annum. The principal balance of the demand promissory notes,
together with accrued and unpaid interest, is due and payable at any time after June 30, 2012 on demand. Pursuant to the terms
of the MOU, we agreed to use commercially reasonable efforts to negotiate and execute definitive agreements pursuant to which the
investors shall severally purchase an aggregate of $10,000,000 of convertible debt from us, $5,000,001 of which will be paid for
by converting the outstanding principal balance of the demand promissory notes, and $5,000,000 of which will be paid for in cash
on December 1, 2012.



Our ability to redeem our convertible preferred
stock when, and if, redeemed by the holders, pay principal and interest on our demand promissory notes and to fund our planned
operations, including certain minimum royalties pursuant to our license agreement with Rutgers University, depends on our future
operating performance and our ability to raise capital. The timing and amount of our financing needs will be highly dependent on
our ability to manufacture our products at a cost which provides for an appropriate return, the success of our sales and marketing
programs, our ability to obtain purchase commitments, the size of such purchase commitments and any associated working capital
requirements.



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At June 30, 2012, we had a working capital deficit of $1.9 million,
a stockholders’ deficit of $5.9 million and have accumulated losses to date of $32.8 million.  This raises substantial
doubt about our ability to continue as a going concern.  In view of these matters, realization of certain of the assets
in the accompanying balance sheet is dependent upon our ability to meet our financing requirements, raise additional capital, and
the success of our business plan and future operations.



Our current operating plans are to enhance
and expand our manufacturing capacity when necessary to meet our customer commitments, continue to expand our marketing and sales
capabilities to increase our pipeline of sales orders, and continue to develop innovative solutions for our customers. Although
we have raised additional funds through the issuance of our demand promissory notes and continue exploring other financing sources,
there can be no assurance that we will achieve our financing needs at all or upon terms acceptable to us.  Further, if we
issue additional equity or debt securities, stockholders may experience additional dilution or the new equity securities may have
rights, preferences or privileges senior to those of existing holders of our common stock.



Disclosure About Off-Balance Sheet Arrangements



We do not have any transactions, agreements
or other contractual arrangements that constitute off-balance sheet arrangements.



Item 3.  Quantitative and
Qualitative Disclosures About Market Risks.



Not applicable.



Item 4. Controls and Procedures



(a) Evaluation of disclosure controls
and procedures.



With the participation of our chief executive
officer and chief financial officer, we evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule
13a-15 under the Exchange Act. In designing and evaluating the disclosure controls and procedures, we recognize that any controls
and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control
objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints
and that we are required to apply our judgment in evaluating the benefits of possible controls and procedures relative to their
costs.



Based on our evaluation, our chief
executive officer and chief financial officer concluded that, as a result of the material weaknesses described below, as of June
30, 2012, our disclosure controls and procedures are not designed at a reasonable assurance level and are ineffective to provide
reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded,
processed, summarized, and reported within the time periods specified in SEC rules and forms, and that such information is accumulated
and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow
timely decisions regarding required disclosure.  The material weaknesses, which relate to internal control over financial
reporting, that were identified are:





| | (i) | We did not maintain sufficient personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of GAAP commensurate with our complexity and our financial accounting and reporting requirements. We have limited experience in the areas of financial reporting regarding complex financial instruments.  As a result, there is a reasonable possibility that material misstatements of the consolidated financial statements, including disclosures, will not be prevented or detected on a timely basis.  For example, on May 10, 2012, we became aware that we had failed to recognize a warrant derivative liability with respect to our 10% Convertible Preferred Stock and the subsequent measurement of fair value of the warrant derivative liability, as required by Accounting Standards Codification 815-40.  As a result, we determined that our consolidated financial statements for the year ended December 31, 2011 filed in the Annual Report on Form 10-K and our consolidated financial statements as of and for the three month period ended September 30, 2011 filed in the quarterly report on Form 10-Q (collectively, the “Reports”) should not be relied upon and needed to be restated.; and
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | (ii) | Due to our small size, we do not have a proper segregation of duties in certain areas of our financial reporting and other accounting processes and procedures. This control deficiency, results in a reasonable possibility that material misstatements of the consolidated financial statements will not be prevented or detected on a timely basis.
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We are committed to improving our financial
organization. As part of this commitment, in May 2012, we adopted additional processes and procedures over financial reporting
as a result of the failure in recognizing the warrant derivative liability issue that resulted in the amendment to our Reports.
If the issuance of any securities is contemplated, we will consult with legal counsel and appropriate accounting resources to evaluate
the financial statement impact that the issuance of such financial instruments may have prior to issuance. Additional measures
may be implemented as we evaluate the effectiveness of these efforts.  We cannot assure you that these remediation efforts
will be successful or that our internal control over financial reporting will be effective in accomplishing the control objectives.



In addition, we will continue to evaluate
the need and costs to increase our personnel resources and technical accounting expertise within the accounting function to resolve
non-routine or complex accounting matters.  As our operations are relatively small and we continue to have net cash losses
each quarter, we do not anticipate being able to hire additional internal personnel until such time as our operations are profitable
on a cash basis or until our operations are large enough to justify the hiring of additional accounting personnel. As necessary,
we may engage consultants in the future in order to ensure proper accounting for our consolidated financial statements.



We believe that engaging additional knowledgeable
personnel with specific technical accounting expertise will remedy the following material weakness: insufficient personnel with
an appropriate level of technical accounting knowledge, experience, and training in the application of GAAP commensurate with our
complexity and our financial accounting and reporting requirements.



We believe that when the circumstances
allow for the hiring of additional personnel who have the technical expertise and knowledge with the non-routine or technical issues
we have encountered in the past, will result in both proper recording of these transactions and a much more knowledgeable finance
department as a whole. Due to the fact that we have a limited internal accounting staff, additional personnel will also allow for
the proper segregation of duties and provide more checks and balances within the department. Additional personnel will also provide
the cross training needed to support us if personnel turn-over issues within the department occur. We believe this will greatly
decrease any control and procedure issues we may encounter in the future.



(b) Changes in internal control over financial reporting.



We regularly review our system of
internal control over financial reporting and make changes to our processes and systems to improve controls and increase efficiency,
while ensuring that we maintain an effective internal control environment. Changes may include such activities as implementing
new, more efficient systems, consolidating activities, and migrating processes. There were no changes in our internal control over
financial reporting that occurred during the quarter ended June 30, 2012 that have materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting.



35







PART II. OTHER INFORMATION



Item 1. Legal Proceedings.



None.



Item 2. Unregistered Sales of Securities and Use of Proceeds.



During January 2012, we issued 125,000
shares of common stock with a fair value on the date of issuance of $90,000, to a consultant pursuant to the terms of an agreement
to provide services.



In January 2012, we issued 247,538 shares
of common stock as payment of, in lieu of cash, the dividends on our 10% convertible preferred stock accrued at December 31, 2011,
with a fair value at date of issue of $176,620.



During March 2012, we issued 62,500 shares
of common stock upon conversion of 6,250 shares of our 10% convertible preferred stock, with a value of $62,500.



During the three months ended
March 31, 2012, we issued warrants to purchase 100,005 shares of our common stock at a weighted average exercise price of
$0.60 per share, to debenture holders pursuant to the amended terms of our 10% convertible debentures due in June 2012. The
warrants had a fair value of approximately $38,100 at the date of grant based on the Black-Scholes pricing model, which was
credited to common stock upon issuance.



Pursuant to the terms of our 10% convertible
preferred stock, during March 2012 we issued warrants to purchase 3,761,365 shares of our common stock at a weighted average exercise
price of $1.00 per share. The fair value of the warrants was $1.9 million, representing the fair value of the derivative liability
of the warrants immediately before issuance.



In April 2012, we issued 286,251 shares
of common stock as payment of, in lieu of cash, the dividends on our 10% convertible preferred stock accrued at March 31, 2012,
with a fair value at date of issue of $171,751.



In May 2012, we issued 10,000 shares of
common stock to an employee upon termination pursuant to terms of an employment letter, with a value on date of issue of $6,400.



During May 2012, we issued 200,000 shares
of common stock upon conversion of 20,000 shares of our 10% convertible preferred stock, with a value of $200,000.



During the three months ended June 30,
2012, we issued warrants to purchase 66,670 shares of our common stock at a weighted average exercise price of $0.60 per share,
to debenture holders pursuant to the amended terms of our 10% convertible debentures due in June 2012. The warrants had a fair
value of approximately $18,900 at the date of grant based on the Black-Scholes pricing model, which was credited to
common stock upon issuance.



We relied upon Section 4 (2) of the Securities
Act and Regulation D under the Securities Act in connection with the issuance of the above described securities.



Item 3. Defaults Upon Senior Securities.



None.



Item 4. Mine Safety Disclosures.



(Not Applicable)



Item 5. Other Information.



None.





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Item 6. Exhibits.



|Exhibits: |                                                                                 
|--------- | --------------------------------------------------------------------------------
|          |                                                                                 
|31.1      | Section 302 Certification of Chief Executive Officer                            
|          |                                                                                 
|31.2      | Section 302 Certification of Principal Financial Officer                        
|          |                                                                                 
|32.1      | Section 906 Certification of Chief Executive Officer and Chief Financial Officer



37







SIGNATURES



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



| |                       | Axion International Holdings, Inc.
| | --------------------- | ----------------------------------
| |                       |                                   
| | Date: August 20, 2012 | /s/ Steven Silverman              
| |                       | Steven Silverman                  
| |                       | Chief Executive Officer           
| |                       |                                   
| | Date: August 20, 2012 | /s/ Donald Fallon                 
| |                       | Donald Fallon                     
| |                       | Chief Financial Officer           



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