## **UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-KSB**

 
| **ý**                            | ** ** | **Annual  report pursuant to section 13 or 15(d) of the Securities Exchange  Act of 1934. For the fiscal year ending June 30, 2005.**                                                                                                                 |
|---------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                  |       |                                                                                                                                                                                                                                                                 |
| **o**                                 | ** ** | **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 000-25839** |

 

**IMPLANT SCIENCES CORPORATION**

(Exact name ofregistrant as specified in its charter)

 
| **Massachusetts**                         | ** ** | **04-2837126**          |
|-------------------------------------------|------------|-------------------------|
| (State or other  jurisdiction             |       | (IRS Employer           |
| of incorporation  or organization)        |       | Identification  number) |
|                                      |       |                    |
| **107  Audubon Road, #5 Wakefield, MA**   | ** ** | **01880**               |
| (Address of  Principal Executive Offices) |       | (Zip Code)              |

 

**781-246-0700**

(Registrant’s Telephone Number, Including Area Code)

 

Securities registeredpursuant to Section 12(b) of the Act:

 
| **Title of Each Class**       | ** ** | **Name of Each Exchange on Which Registered** |
|-------------------------------|------------|-----------------------------------------------|
| Common Stock, $.10 par  value |       | American  Stock Exchange                      |
| Warrants                      |       | American  Stock Exchange                      |

 

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

YES  **ý         **NOo

 

Check if there is nodisclosure of delinquent filers in response to Item 405 of Regulation S-Bcontained in this form, and no disclosure will be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or anyamendment to this Form 10-KSB.

No Disclosure   ý

 

Indicate by checkmarkwhether the Registrant is a shell company (as defined in Rule 12B-2 of theExchange Act)     o

 

State issuer’s revenuesfor its most recent fiscal year: $12,286,000

 

The aggregate marketvalue of the voting stock held by non-affiliates of the registrant wasapproximately $49,925,000 as of September 30, 2005 (based on the closingprice for such stock as of September 30, 2005).

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock:

 

| **Class**                     | ** ** | **Outstanding  at September 30, 2005** |
|-------------------------------|------------|---------------------------------------------|
| Common Stock,  $.10 par value |       | 10,782,493                                  |

 

 

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**PART 1**

 

**SPECIAL NOTE ON FORWARD LOOKING STATEMENTS**

 

*Inaddition to historical information, this Annual Report on Form 10-KSBcontains forward looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. The words “believe,” “expect,” “anticipate,” “project,” “estimate,” “forecast,”and similar expressions, among others, identify forward lookingstatements.  The forward-lookingstatements are subject to certain risks and uncertainties that could causeactual results to differ materially from those reflected in suchforward-looking statements.  Factors thatmight cause such a difference include, but are not limited to, those discussedin the sections entitled “Business,” “Risk Factors,” and “ManagementsDiscussion and Analysis of Financial Condition and Results of Operations.”  Readers are cautioned not to place unduereliance on these forward-looking statements, which reflect management’sopinions only as of the date thereof.  Weundertake no obligation to revise or publicly release the results of anyrevision of these forward-looking statements. Readers should carefully review the risk factors described in the AnnualReport and in other documents that we file from time to time with theSecurities and Exchange Commission.*

 

**ITEM 1.****                                                               OURBUSINESS**

 

Over the past twenty oneyears, Implant Sciences Corporation (the “Company”), incorporated in August 1984,has both developed and acquired technologies using ion implantation and thinfilm coatings for medical device applications and semiconductor waferprocessing and has proprietary processes and equipment for the manufacture ofmedical devices for radiation therapy and for the modification of orthopedicjoint implant surfaces to reduce polyethylene wear generation.  This technology has further evolved toinclude new applications in the area of trace explosives detection equipment.

 

One of the greatestadvances in our ion beam technology has been in the area of temporarybrachytherapy products.  In May 1999,we received Food and Drug Administration 510(k) clearance to market our I-PlantTMIodine-125 radioactive seed for the treatment of prostate cancer and in 2001recognized our first sale. The transition from research and development of theradioactive prostate seeds to FDA approval and commercialization of thisproduct represented a critical stage in our growth from a provider of ionimplantation services for semiconductor and orthopedic applications to amanufacturer and seller of product in the form of radioactive prostate seeds.

 

 We continue to expand our radiation therapyproducts.  We are currently developing aradioactive source to be used in a delivery system designed to provide breastcancer treatment.  This treatment calledaccelerated partial breast irradiation therapy following lumpectomy can becompleted in five days rather than seven weeks of daily treatments usingexternal beam radiation.  We believe thissystem will become the treatment of choice for women following lumpectomy.  The Company is also developing a new devicefor the treatment of ocular melanoma using brachytherapy. We believe this newproduct, funded by the National Cancer Institute, will provide a betterdistribution of radiation within the tumor while providing less discomfort forthe patient.  The Company also has otherradiation therapy devices in various stages of development including devicesfor biliary duct cancer and dural irradiation.

 

Our semiconductorbusiness has recently experienced substantial growth.  This growth came through the acquisition of twoCalifornia semiconductor companies, Core Systems and Accurel Systems.  Through these acquisitions, we have more thandoubled our semiconductor capacity and are now able to offer diagnostic andsemiconductor equipment refurbishment services to semiconductor manufacturers,research laboratories and universities.

 

We currently havetwenty-three issued United States patents and eight United States patentspending covering our semiconductor and medical technologies and processes.

 

Since May 1999, wehave been performing research to develop a trace explosives detector, whichcould be used to detect hidden bombs in airports and other public places.  This technology is yet another application ofour ion source technology.  At present,we have developed both portable and bench-top systems for use in airports andDepartment of Defense facilities.  Infiscal 2005, we made significant investments in our facility to support the manufacturingand selling of our explosives detection products.  As we sell and deliver our first commercialunits, 

 

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we continue to work closelywith various government agencies to fine tune our products and develop newones.  We currently have four issuedUnited States patents and six United States patents pending covering ourexplosives detection technologies and processes.

 

**Technologies**

 

*General. *We use two coretechnologies, ion implantation and thin film coatings.  With respect to each core technology, we havedeveloped proprietary processes and equipment for the purpose of improving oraltering the surfaces of medical implants and semiconductor wafers.

 

Ion implantation and thinfilm coatings are techniques first developed in the 1970’s to improve thefunctional surface properties of metals, ceramics and polymers, such asfriction, wear, wetability and hardness. Ion implantation was initially developed as a means to dopesemiconductors in the fabrication of integrated circuits.  The accuracy, cleanliness and controllabilityof this process have made it the standard for semiconductor manufacturing.  Ion implantation is generally preferred overother surface modification methods because it does not delaminate, does notrequire high temperatures and does not deform or alter the dimensions of thetreated surface.

 

Thin film coatings wereinitially developed to interconnect transistors on semiconductor chips.  Thin films modify surfaces by layering adesired metal or ceramic coating on the substrate material.  Common thin film coating techniques includechemical vapor deposition and physical vapor deposition.

 

*IonImplantation. *Ionimplantation is a process by which ions (electrically charged atoms) areaccelerated to high velocity in a vacuum and directed toward a substrate ortarget material.  The atoms becomeembedded just below the surface of the material producing an alloy composed ofthe atoms and the substrate material in the near-surface region of the targetmaterial.  This surface alloy may havenew mechanical, electrical, chemical, optical and other properties.  We believe our proprietary technology,including high current ion sources and specialized component holding fixtures,provides higher ion implant doses and higher beam power and yields superiorsurface characteristics at lower cost than commercially available equipment.

 

Ion implantation can beused to embed single isotopes of radioactive or non-radioactive elements intocomponents.  We are using our proprietaryequipment to manufacture radioactive seed implants for the treatment ofprostate cancer and other carcinomas which can be manufactured withoutexpensive cyclotrons or linear accelerators and without hazardous radioactivewet chemistry, the methods currently employed by existing suppliers.

 

*Thin FilmCoating.*A thin film coating is grown upon a substrate in avacuum by the gradual deposition of atoms on the substrate.  Our proprietary unbalanced magnetronsputtering process results in coatings that are extremely dense and free ofvoids, yielding good contrast and sharp edges under x-ray or fluoroscopicexamination. These coatings usually consist of gold or platinum for radiopaqueapplications.  Our proprietarymanufacturing process allows for efficient utilization of precious metals andfor cost effective recovery and recycling of these precious metals.  We are also developing processes to coatstents, guidewires and catheters used in interventional cardiology procedureswith substances, usually gold or platinum, that allow those stents, guidewiresand catheters to be visible under x-ray observation during a procedure.  We believe other techniques for applying thinfilm coatings are less desirable for medical device applications because oftheir inability to apply a dense coating, while continuing to be flexible and adheringto the substrate.

 

*TraceExplosives Detection.*We have developed an instrument, whichcan detect the vapor from trace amounts of explosive compounds includingplastic explosives such as RDX, the compound commonly found in C4explosives.  The system works by ionizingexplosive molecules in an air sample and then detecting the ionized moleculesof the explosive using ion mobility spectrometry.  The instrument has successfully detectedmolecules of five different types of explosives in the air at the parts pertrillion concentrations.  We believe thistechnology will provide commercial systems with improved sensitivity andcapabilities than equipment presently available.

 

We have twenty-sevenUnited States patents and fourteen United States patents pending on ourprocesses.

 

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**Medical Products**

 

*Permanent Implants for theTreatment of Prostate Cancer*

 

*General. *The alternatives generallypresented to patients diagnosed with early stage prostate cancer are surgicalremoval of the prostate (radical prostatectomy) or external beamradiation.  Both techniques frequentlyhave significant side effects including impotence and incontinence.  Brachytherapy has been an increasinglypopular treatment technique whereby radioactive seeds (each of which isapproximately half the size of a grain of rice) are permanently implanted intothe prostate.  This technique allows thedelivery of highly concentrated yet confined doses of radiation directly to theprostate. Surrounding healthy tissues and organs are spared significantradiation exposure.  Advances intransrectal ultrasound and computed tomography imaging equipment providedetailed and precise measurements of prostate size and shape, for seeddistribution and placement.

 

*ProstateSeeds. *We havedeveloped, and been granted two United States patents covering radioactiveseeds, implants and methods of manufacturing radioactive seed implants by aproprietary process.  We have receivedFood and Drug Administration 510(k) clearance to market our I-PlantTMIodine-125 radioactive seed for the treatment of prostate cancer.  Our 510(k) clearance permits treatment of anylocalized tumors treatable by temporary or permanent brachytherapy.  A twelve-year study conducted by the NorthwestHospital, Seattle, Washington shows that this treatment has a twelve-yeardisease-free survival rate equal to surgical removal of the prostate and may besuperior to other early stage treatments, with a substantial reduction in thenegative side effects of impotence and incontinence, frequently associated withsurgery and external beam radiation treatment. The National Cancer Institute and American Cancer Society have reportedthat sexual potency after implantation of radioactive seeds has been 86% to92%, which compares with rates of 10% to 40% for radical prostatectomies and40% to 60% for external beam radiation therapy. Our production method, involving a proprietary dry fabrication process,does not use radioactive wet chemistry. On July 28, 1999 we received our Radioactive Sealed SourceRegistration Certificate, a Nuclear Regulatory Commission requirementadministered by the Commonwealth of Massachusetts as a Nuclear RegulatoryCommission Agreement State.  These seedshave been on sale in the U.S. for five years.

 

*Manufacturing. *Management believes thatthe Company’s manufacturing process results in lower capital equipment andmanufacturing assembly costs and is less hazardous than the manufacturingprocesses used by our competitors.  Otherradioactive prostate seed manufacturers use radioactive wet chemistry duringseed assembly for Iodine-125 products. Our dry process, for which we have two patents issued, uses a dryfabrication process, and we believe it requires fewer personnel and yields fasterthroughput.  Following seed core ionimplantation, we send these cores to a nuclear reactor for activation. Usingthis dry fabrication process, seed cores can be fabricated and inventoried inlarge quantities and activated only when ordered.  Due to the short half-life of Iodine-125(approximately 60 days), the competition must assemble and ship seeds on atight schedule so they can be implanted into the patient at theappropriate radioactive strength.  Wemaintain multiple source vendors for our raw materials supplies in theconstruction of our radioactive prostate seeds, including Trace SciencesInternational, Specialty Glass Products, Alfa Aesar, Mick Radio Nuclear, QuartzPlus and Braxton Manufacturing.

 

*Sales.*  SinceAugust 2003, the Company has used its own direct sales force to sellprostate seeds to many different customers.

 

*Treatment Planning Software*

 

*General. *In May 2005, ImplantSciences acquired proprietary treatment planning technology from Rosses MedicalSystems, Inc. and further enhanced it into the present I-PlantTMTPS product.  In its latest version, theCompany has developed a new module which aids the physician in making 2 and 3dimensional maps of the stage, grade and location of cancer within the prostategland.  This “Pathology Mapping ModuleTM”is in addition to the standard treatment planning function used for prostatebrachytherapy and will provide for image guided, focal treatment for thedisease.

 

*Sales. *This product is presentlybeing sold by our direct medical sales force.  The Company is presently in discussions with aradiation therapy equipment company to also distribute the product.  This product will have many differentcustomers.

 

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*Breast Cancer Radiation Treatment*

 

*General*.  Early state breast cancer is commonly treatedby lumpectomy followed by a course of 35 sessions of external beam radiation tothe whole breast over a seven week term. Over the past several years, Accelerated Partial Breast Irradiation(APBI) has been increasing in popularity with patients because it can becompleted in four to five days on an outpatient basis and has shown equalefficacy with good cosmetic outcomes. Approximately 600 to 1,000 patients have already been treated using thisnew temporary brachytherapy technique. Currently this treatment is performed using a conventional HDR (HighDose Radiation) system using an iridium -192 radioactive source.  A significant drawback of the currently usediridium -192 source is that the treatments must be performed in a heavilyconcrete shielded room to prevent the very penetrating iridium -192 gamma raysirradiating people in hallways and adjacent rooms.  Approximately 10% of the U.S. hospitalscurrently have such dedicated HDR concrete shielded rooms forbrachytherapy.  The Company has developeda new lower energy source, ytterbium -169 which can deliver the sametherapeutic dose to the lumpectomy cavity and does not require a concreteshielded treatment room.  The procedurecan be done in an ordinary treatment room with some portable shielding aroundthe patient using a conventional afterloader system.  This source assembly has received a 510(k)pre-market clearance from the FDA and does not require clinical trials prior tocommercial sales.

 

*Manufacturing.*           The Company willmanufacture the ytterbium -169 source material in-house using several nuclearreactors as subcontractors.  Versions ofthe Yb-169 source assembly will be designed to fit all afterloader systemspresently on the market.

 

*Sales.*                We expect that thesource wires will be sold by the manufacturers of the afterloaders or throughdirect selling efforts.  This new productwill be purchased by the Radiation Oncology Department of hospitals which isthe same customer our existing prostate seed salesmen call on.

 

*OrthopedicTotal Joint Replacements*

 

*General. *We provide surface engineering technology to manufacturers oforthopedic hip and knee total joint replacements.  The majority ofexisting hip and knee joint replacements are made of a cobalt chromium femoralcomponent that articulates against a polyethylene component.  Whileoffering excellent biocompatibility and superior wear resistance over prioralloys and designs and potentially longer average life than prior alloys,cobalt chromium devices still suffer from particle generation where themetal and polyethylene components articulate against each other.  This particle generationhas been identified as the primary cause of implant loosening due to osteolysisrequiring repeat surgery.

 

*Orthopedics. *We implant cobalt chromium components of total jointreplacements manufactured by our customers with nitrogen ions.  Nitrogenion implantation of these components reduces polyethylene wear by modifying thenative oxide present in cobalt chromium alloys.  Laboratory tests andclinical studies have shown that nitrogen ion implanted cobalt chromiumcomponents offer superior performance over untreated components, significantlyreducing wear and slowing the incidence of osteolysis which ultimately leads torevision surgery.

 

*Manufacturing. *We believe we now operate one of the highest beam-current ionimplanters used in the medical field.  This equipment has higherthroughput and lower cost than equipment with a lower beam-current.  Forour new second-generation orthopedic coating, this equipment can provide aceramic coating with superior characteristics due to its patented “blendedinterface” process.  We maintain multiple source vendors for our gassupplies, the primary raw material used in the ion implantation process inproviding this service, including Praxair and Matheson.

 

*Sales. *We currently implant cobalt chromium components of totaljoint replacements made by our customers with nitrogen ions and are developingceramic ion beam synthesis techniques for total joint replacements.  Wereceive untreated cobalt chromium total joint replacements from our customersand implant them at our facility.  We then invoice and ship the implantedtotal joint replacements to our customers.  We maintain one major customerwhich accounted for 13% and 19% of total revenues in the year ended June 30,2005 and 2004, respectively.

 

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*Markets. *Osteoarthritis is a natural result of the aging process andis the predominant cause of the need for joint replacement.  We believethat longer life expectancy as well as the growth in the number of people overage 50 will cause the demand for total joint replacement to increase. According to the American Academy of Orthopedic Surgeons, the hip and kneetotal joint replacement market was estimated to be 650,000 procedures in theUnited States.  We treat approximately 60,000 units each year using ourion implantation process for the Stryker-Orthopaedics Division of Stryker Corporation. Our research has shown that our ceramic coatings can decrease wear debrisgeneration by two-thirds, which we believe will reduce osteolysis and therebyreduce the need for revision surgery.

 

*RadiopaqueCoatings. *We have developed proprietary methods forapplying radiopaque coatings onto a variety of medical devices manufactured byour customers in order to increase the visibility of such devices duringinterventional cardiology and other catheter-based procedures.  Thesebiocompatible coatings are deposited using a proprietary unbalanced magnetronsputtered coating process.  The resulting coating is extremely dense andfree of voids yielding good contrast and sharp edges under x-ray orfluoroscopic examination.  We use this process to coat guidewires and catheters.

 

**SecurityProducts**

 

*TraceExplosives Detection Equipment*

 

*General. *We are developing severalexplosive detection systems that could be used in airports, public andgovernment buildings, and sporting event facilities.  The systems use our proprietary technology,which includes the use of laser beams in combination with ion mobilityspectrometry, to electronically detect minute quantities of explosive vapormolecules in the air.

 

This research has beenongoing since May 1999.  Thisproject was undertaken in response to the interest in ion beam phenomena by ourresearch personnel who are constantly researching new applications for thistechnology.  The development of newapplications is typically funded through government grants or internal funding.

 

The Department ofTransportation has stated that the U.S. could spend between $1.9 billion and$2.5 billion on equipment for the detection of bulk and trace amounts ofexplosives.  However, we do not know howmuch will be allocated to each of trace and bulk equipment or how muchallocated to equipment for the detection of trace amounts of explosives will beallocated to devices like ours.

 

In June 2000, wedeveloped our first experimental device, which demonstrated sensitivity to theexplosive TNT.  In June 2001, wedeveloped a second-generation prototype with increased sensitivity andselectivity.  This device was able todetect and specify an increasing number of compounds within various explosivematerials.  The explosives that have beentested to date are TNT, RDX, PETN, EGDN, and DNT. RDX is the primary componentof C3 and C4 explosives, such as Datasheet and Semtex, as well as certain typesof black powder explosives.  We believethese explosives represent the majority of the explosives presently used interrorist activities.  During the yearended June 30, 2005 the Company has begun taking orders for, and shipping,product previously under development.

 

The electronic detectionsystem detects microscopic quantities of explosive molecules in the air.  The device does not use any radioactivematerials and does not produce a danger to personnel operating the device orscanned by the device.  The device is asensor that receives signals that are already in the environment.  Our electronic detection system uses a sensorthat does not require physical contact to screen the article to detecttrace residues.  Since our device doesnot use a radioactive source, management believes it is safer than traceexplosives residue detection systems currently in use.

 

Consistent with ourpolicy to protect our proprietary technologies, we have been awarded four (4) patentsand submitted six (6) additional patent applications to the United StatesPatent and Trademark Office.  Thesepatent applications will cover specific design configurations that areresponsible for our improved vapor detection sensitivity.  The Company manufactures its explosivesdetection products in its manufacturing facility.

 

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**Semiconductor Products**

 

*Semiconductor Ion Implantation*

 

*General. *We supply ion implantation andanalytical services to numerous semiconductor manufacturers, researchlaboratories, and research universities. Ion implantation of electronic dopants into silicon, the process bywhich silicon is turned into a semiconductor, is an integral part of theintegrated circuit fabrication process. While many of our customers have theirown ion implantation equipment, they often use our services and specializedexpertise for research and new product development because they do not want tointerfere with production or because they are unable to perform the servicesthemselves.

 

In October 2004, weacquired Core Systems and doubled our semiconductor ion implantation equipmentand capacity.  This acquisition alsoenabled us to expand our revenue base by offering semiconductor refurbishingequipment and services which were unavailable to us before.  We further expanded our semiconductor base throughthe acquisition of Accurel Systems in March 2005.  We are now able to offer analytical andfailure analysis diagnostic services to the manufacturers of semiconductorproducts.  The Company believes thatthrough the consolidation of our processing efforts and complimentary servicesthese acquisitions provide, we will be able to expand our semiconductorimplantation services to include high volume production customers as well asthe existing R & D and pilot production customers, both domesticallyand internationally.

 

**Marketing and Sales**

 

Our marketing and salesmethods vary according to the characteristics of each of our main businessareas.  Sales and marketing to themedical device markets are through our own direct sales force.  Our semiconductor segment includes implantservices and implant diagnostic services. Our Vice President, General Manager of Core Systems, along with aninside sales staff and several independent sales representatives, isresponsible for semiconductor ion implantation services, including diskrefurbishment and source conditioner sales. The President of Accurel Systems is responsible for sales of oursemiconductor analytical services.  OurVice President of Explosives Detection Sales and Marketing is responsible forsales and marketing of our trace explosives technology, assisted by an insidesales staff and international sales reps. In March 2005, the Company entered into an agreement with Rapiscan,a division of OSI Systems Inc. to distribute our products through a privatelabel arrangement.  Sales of ourbrachytherapy products are the responsibility of our Director of BrachytherapyProducts. The Company uses both inside direct sales personnel and independentsales representatives to sell our products. The solicitation and proposal process for research and developmentcontracts and grants are conducted by our President, our Chief Scientist, andour scientific staff.  Foreign sales havecomprised less than five percent of our total revenues.

 

*Medical Sales and Marketing*

 

To promote sales of ourradioactive prostate seeds and treatment planning systems, we exhibit atvarious medical trade shows, including the American Association of Physicistsin Medicine (AAPM) show and the American Society for Therapeutics Radiology andOncology (ASTRO) show, which are attended by the vast majority of our potentialcustomers.  Sales are then concluded byour Director of Brachytherapy Products and direct sales force.

 

In the business of ionimplantation for total joint replacements, we concentrate on identifying andserving leading manufacturers.  Wherepossible, we attempt to become the sole provider of devices or surfaceengineering services to each such manufacturer. Our marketing and sales efforts require considerable direct contact andtypically involve a process of customer education in the merits of ourtechnology.  We accomplish this by firstresearching customer needs, delivering scientific papers at orthopedic andbiomaterial conferences, and through presentations at customer sites.  Our internal research and government researchgrants, as well as our patent portfolio, are an integral part of the marketingprocess.

 

To promote sales of ourradiopaque coatings, we attend trade shows, use press releases and callcustomers who we believe have an application for our technology.  Once a customer’s interest is established,the sales process proceeds with an initial demonstration project funded by thecustomer.  A set of developmental runsare then performed to determine project feasibility and to roughly optimize aparameter set for deposition.  After testingthe 

 

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samples generated, andconsidering cost estimates for production quantities, the customer mayauthorize us to proceed to pilot production.

 

In pilot production,typically, several hundred units are produced in a manner equivalent to theenvisioned full production method.  Pilotproduction may be done on an existing piece of equipment with customer/devicespecific fixturing, or a prototype machine depending on the complexity of theprocess and device.  Samples made inpilot production are fabricated into complete devices and used by the customerfor further testing, clinical studies, FDA submissions, and marketing and salesefforts.

 

*Semiconductor Sales and Marketing*

 

Since semiconductor ionimplantation is a standard process in all integrated circuit fabrication,customers usually know what they want and little education is necessary.  Our services are promoted and sold throughtrade shows, advertising in trade magazines, direct mailings and press releases.  Most of our specialty implant sales arebetween $600 and $2,500 per order and take less than one day to complete.  The entire sales effort is often conducted bytelephone.  Our sales range fromproduction customers to outsourced customer-specified ion implantationservices, which the customer’s own ion implantation department is unable orunwilling to perform, to small research projects.  Production implant sales are usually throughlong-term blanket purchase orders where our services are integrated seamlesslyinto our customer’s production line.

 

Semiconductor analyticalservices are promoted through Accurel Systems, our wholly owned subsidiary.  These sales are promoted through trade shows,and our direct sales force dedicated to this product line.

 

*Government Contracts*

 

Research and developmentcontracts from the U.S. government must be won through a competitive proposalprocess which undergoes peer review.  Weare in frequent contact with the National Institutes of Health, the Departmentof Defense, the Department of Homeland Security and other agencies at technicalconferences to stay informed of the government’s needs.  We believe our management and seniorscientific staff have earned a strong reputation with these and otheragencies.  To date we have been awardedresearch and development contracts by the National Institute of Health, theDepartment of Defense, the National Science Foundation, the NationalAeronautics and Space Administration, the Environmental Protection Agency andthe Department of Homeland Security.

 

**Research and Development**

 

Our technical staffconsists of 39 scientists and engineers, including six with Ph.D. degrees, and 33with Bachelor Degrees or with expertise in physical sciences andengineering.  All of our existing andplanned products rely on proprietary technologies developed in our research anddevelopment laboratories.  Our researchand development efforts may be self-funded, funded by corporate partners or byawards under the Small Business Innovative Research and other programs of theU.S. government.  Under the SmallBusiness Innovative Research program, we retain the right to patent anythingdeveloped pursuant to the program, however, the U.S. government retains aroyalty free license to use the technology. We have obtained over $12 million in U.S. government grants andcontracts over the past 17 years.  Eachresearch and development agreement with our corporate partners defines therights to these agreements.

 

We spent approximately $3,633,000and $3,841,000 on research and development in the fiscal years ended June 30,2005 and 2004, respectively. Approximately $1,691,000 and $2,210,000 of these research anddevelopment activities represents research and development costs that weredirectly sponsored by customers primarily in the form of government contractsand grants during 2005 and 2004, respectively.

 

**Patents and ProprietaryTechnology**

 

It is our policy toprotect our proprietary position by, among other methods, filing United Statesand foreign patent applications. We currently have twenty-seven issued UnitedStates patents and fourteen United States patent applications pending.  Of the twenty-seven patents issued, four areof material importance to us and are in the 

 

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explosivesdetection.  These four (4) materialpatents expire in the years 2021 through 2022.

 

We intend to seek furtherpatents on our technologies, if appropriate. However, there can be no assurance that patents will be issued for anyof our pending or future applications or that any claim allowed from suchapplications will be of sufficient scope or strength, or be issued in allcountries where we sell our products and services, to provide meaningfulprotection or any commercial advantage to us.

 

We also rely onunpatented proprietary technology, trade secrets and know-how and we do notknow if others will independently develop substantially equivalent proprietaryinformation, techniques or processes, that such technology or know-how will notbe disclosed or that we can meaningfully protect our rights to such unpatentedproprietary technology, trade secrets or know-how.  Although we have entered into non-disclosureagreements with our employees and consultants, we cannot be sure such non-disclosureagreements will provide adequate protection for our trade secrets or otherproprietary know-how.

 

**Government Regulation andEnvironmental Matters**

 

Medical devicesincorporating our technologies, such as radioactive prostate seeds andinterventional cardiology devices, are subject to FDA regulation.  The burden of securing FDA clearance orapproval for these core business medical devices rests with our medical devicemanufacturers or licensees.  We havereceived Food and Drug Administration 510(k) clearance to market our I-PlantTMIodine-125 radioactive seed for the treatment of prostate cancer.

 

In the 510(k) clearanceprocedure, a company must show that its new product is “substantiallyequivalent” to a medical device that is currently approved for use.  This process requires an application to theFDA.  If the FDA determines that aproduct is in fact substantially equivalent to a product that has already beenapproved for use, the FDA grants 510(k) clearance for the sale of the newproduct.  This process is quicker andless expensive than obtaining approval for an entirely new product.  We obtained 510(k) clearance for our I-PlantTMprostate seed product in May 1999. All of our presently contemplated new medical products require a 510(k)clearance only.

 

Our medical devicemanufacturing facility operates under the FDA Quality Control Regulations.  Our facility, located in Wakefield,Massachusetts, was registered with the FDA in July 2000 prior to theintroduction and commercial sales of our radioactive prostate seedproduct.  Our facility is subject to theFDA’s inspection at any time. The FDA has inspected Implant Sciences’ medicalmanufacturing facilities and found its Quality System to meet theirrequirements.  The FDA regulates themedical device industry and has the authority to demand corrective action(s)for any deficiencies in adherence to Quality System Regulations, order productrecalls, and can require that a factory cease operations until it is broughtinto compliance with these regulations. Implant Sciences’ Quality Systems Manager ensures adherence to the FDA’sQuality System Regulations as well as to the ISO 9001 standard.

 

In addition to FDAregulation, certain of our activities are regulated by, and require approvalsfrom, other federal and state agencies such as the Massachusetts Department ofPublic Health.

 

In order to ship ourradioactive prostate seed product from our facility, we are required to obtaina radioactive sealed source registration from the Massachusetts Department of PublicHealth.  We obtained this certificate prior to the commencement of thecommercial sales of our radioactive prostate seed product in the first half offiscal 2001.  This certificate requires no maintenance or renewal as longas the design of the radioactive prostate seed is not changed.  TheMassachusetts Department of Public Health can, however, terminate thiscertification in the event of an accident that would require a redesign of theproduct.  On July 28, 1999, we received our Radioactive Sealed SourceRegistration Certificate, a Nuclear Regulatory Commission requirement,administered by the Commonwealth of Massachusetts as a Nuclear RegulatoryCommission Agreement State.

 

The State RadiationControl Program issued to us a license to manufacture and distribute ourradioactive prostate seed product.  The State Radiation Control Programperforms periodic inspections of our facility.  Since the commencement ofcommercial sales of our radioactive prostate seed product in the first half offiscal 2001, the State Radiation Control Program has performed two (2) annualinspections of the facility and identified no violations or deficiencies.

 

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Furthermore, our use,management, transportation, and disposal of certain chemicals and wastes aresubject to regulation by several federal and state agencies depending on thenature of the chemical or waste material. Certain toxic chemicals and products containing toxic chemicals requirespecial reporting to the United States Environmental Protection Agency and/orits state counterparts.  We are not awareof any specific environmental liabilities that we could incur.  Our future operations may require additionalapprovals from federal and/or state environmental agencies, the cost andeffects of which cannot be determined at this time.

 

**Competition**

 

In radioactive products,such as prostate seed implants, radioactive brachytherapy devices and coronarystents, we expect to compete with Oncura Corp., Theragenics Corp., and NorthAmerican Scientific, Inc., all of which serve substantially the entireradioactive prostate seed market.  Thenumber and types of procedures being performed on the prostate are increasinglydrawing new entrants into the market.  Webelieve that competition, and, in turn, pricing pressures, may increase.  Many of our competitors have substantiallygreater financial, technical and marketing resources than we do.

 

Many medical devicemanufacturers have developed or are engaged in efforts to develop internalsurface modification technologies for use on their own products.  Most companies that market surfacemodification to the outside marketplace are divisions of organizations withbusinesses in addition to surface modification. Many of our existing and potential competitors (including medical devicemanufacturers pursuing coating solutions through their own research anddevelopment efforts) have substantially greater financial, technical andmarketing resources than we do.

 

With respect to ionimplantation of orthopedic implants, we primarily compete with SpireCorporation.  Competition within theorthopedic implant industry is primarily conducted on the basis of service andproduct design.  Price competition hasabated somewhat in the case of first time and more youthful patients wherehigher-cost and more durable reconstructive devices are preferred.  We attempt to differentiate ourselves fromour competition by providing what we believe are high value-added solutions tosurface modification.  We believe thatthe primary factors customers consider in choosing a particular surfacemodification technology are performance, ease of manufacturing, ability toproduce multiple properties from a single process, compliance withmanufacturing regulations, customer service pricing, turnaround time, and theability to work with a variety of materials. We believe that our process competes favorably with respect to thesefactors. We believe that the cost and time required to acquire equipment andtechnical engineering talent, as well as to obtain the necessary regulatoryapprovals, significantly reduces the likelihood of a manufacturer changing thecoating process it uses after a device has been approved for marketing.

 

Our competition in thesemiconductor industry consists primarily of one company:  Innovion Corporation.  This company is located in San Jose,California and primarily serves the silicon wafer production needs ofsemiconductor factories in their local area. We serve both east and west coast factories with silicon production andresearch and development laboratories worldwide.

 

In the trace explosivesdetection industry, Ion Track Division of General Electric and the BarringerDivision of Smiths Plc. are our two primary competitors.  These two companies also use ion mobility spectrometry;however, they use a radioactive Nickel-63 source to ionize the explosivemolecules.  This technology differs fromour technology because we do not use a radioactive source to ionize theexplosive molecules in the air.  We believeour technology provides our device with greater capabilities and lessregulatory restrictions.

 

Many of our competitorsand potential competitors have substantially greater capital resources than wedo and also have greater resources and expertise in the areas of research anddevelopment, obtaining regulatory approvals, manufacturing and marketing.  There can be no assurance that ourcompetitors and potential competitors will not succeed in developing, marketingand distributing technologies and products that are more effective than thosedeveloped and marketed by us or that would render our technology and productsobsolete or noncompetitive. Additionally, there is no assurance that we will be able to compete effectivelyagainst such competitors and potential competitors in terms of manufacturing,marketing and sales.

 

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**Product Liability and Insurance**

 

Our business entails therisk of product liability claims. Although we have not experienced any product liability claims to date,there can be no assurance that such claims will not be asserted or that we willhave sufficient resources to satisfy any liability resulting from suchclaims.  We have acquired product liabilityinsurance coverage.  There can be noassurance that product liability claims will not exceed such insurance coveragelimits, that such insurance will continue to be available on commerciallyreasonable terms or at all, or that a product liability claim would notmaterially adversely affect the business, financial condition or our results ofoperations.

 

**Employees**

 

As of June 30, 2005,we had 112 full time employees.  Webelieve we maintain good relations with our employees.  None of our employees are represented by aunion or covered by a collective bargaining agreement.

 

**ITEM 2.****                             PROPERTIES**

 

We operate out of threeseparate locations.  Our corporateoffices are located in an approximately 51,000 square foot leased facility inWakefield, Massachusetts.  The facilityis located approximately 15 miles north of Boston in a modern and wellmaintained business park.  Our currentlease expires in December 2008.  Inaddition to our corporate offices, this facility houses all of our research anddevelopment, explosives detection systems and brachytherapy manufacturing, aswell as semiconductor wafer processing and semiconductor equipmentmanufacturing.

 

Our second location is inSunnyvale, California, just outside of San Jose.  This is where our Core Systems division islocated.  We conduct our semiconductorwafer processing and semiconductor equipment refurbishing services and sales inan approximately 35,000 square foot leased facility.  This facility, specifically designed toperform semiconductor services, is well maintained to ensure the integrity ofthe product produced.  This lease expiresin December 2009.

 

Our third location, alsolocated in Sunnyvale, CA, is Accurel Systems. This location, in a modern and well maintained business park, consistsof a total of approximately 20,000 square feet and expires in September 2010.  We conduct our semiconductor analyticalservices at this location.

 

I**TEM 3.****                             LEGALPROCEEDINGS**

 

From time to time, we aresubject to various claims, legal proceedings and investigations covering a widerange of matters that arise in the ordinary course of our businessactivities.  Each of these matters issubject to various uncertainties.  On thebasis of information presently available, we are not currently aware of anylegal proceedings or claims that we believe are likely to have a materialeffect on our financial position or results of operations.

 

**ITEM 4.****                             SUBMISSIONOF MATTERS TO A VOTE TO SECURITY HOLDERS**

 

No matters were submittedto a vote of security holders during the fourth quarter of fiscal year ended June 30,2005.

 

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**PART II**

 

**ITEM 5.****                             MARKETFOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

 

**Market Price**

 

As of June 30,2005, our common stock, $0.10 par value, was traded on the American StockExchange under the symbol IMX.  Thefollowing sets forth the range of high and low closing sales prices on theAmerican Stock Exchange

 
| ** **                                 | ** ** | **High**   | ** ** | **Low**    | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|
| **Fiscal Year Ended June 30,  2004:** |       |       |       |       |       |
| Quarter ended September 30            |       | $          | 8.17       |       | $          | 5.10 |   |
| Quarter ended December 31             |       | 9.33       |       | 6.72       |       |
| Quarter ended March 31                |       | 14.95      |       | 9.49       |       |
| Quarter ended June 30                 |       | 16.54      |       | 10.24      |       |
|                                       |       |       |       |       |       |
| **Fiscal Year Ended June 30,  2005:** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Quarter ended September 30            |       | 11.99      |       | 7.45       |       |
| Quarter ended December 31             |       | 11.30      |       | 8.85       |       |
| Quarter ended March 31                |       | 10.75      |       | 5.60       |       |
| Quarter ended June 30                 |       | 5.97       |       | 2.45       |       |
|                                            |            |            |            |            |            |  |  |

 

At September 30,2005, the closing sales price of our common stock was $5.64.

 

**EquityCompensation Plan Disclosure**

 

The following table setsforth certain information as of June 30, 2005 regarding securitiesauthorized for issuance under our equity compensation plans.

 
| **Plan  Category**                                          | ** ** | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
|                                                        |       |                                                                                               |       |                                                                               |       |                                                                                                 |       |
| Equity  Compensation Plans Approved by Security Holders     |       | 1,908,331                                                                                          |       | $                                                                                  | 5.66       |                                                                                                 | 119,077    |   |
|                                                        |       |                                                                                               |       |                                                                               |       |                                                                                                 |       |
| Equity  Compensation Plans Not Approved by Security Holders |       | —                                                                                             |       | —                                                                             |       | —                                                                                               |       |
|                                                        |       |                                                                                               |       |                                                                               |       |                                                                                                 |       |
| Total                                                       |       | 1,908,331                                                                                          |       | $                                                                                  | 5.66       |                                                                                                 | 119,077    |   |

 

**Dividends**

 

We have never declared orpaid any cash dividends on our common stock. We currently anticipate that we will retain all future earnings for theexpansion and operation of our business, and do not anticipate paying cashdividends in the foreseeable future.

 

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**Sales ofUnregistered Securities**

 

On March 8, 2005 the Company issued 1,080,780 shares ofcommon stock at $7.22, in a private placement with fifteen investors.  The Company received $7,803,000 in grossproceeds, less placement agent fees and related transaction costs ofapproximately $433,000.  In connectionwith the transaction, the Company issued warrants to the investors to purchase270,195 shares of common stock at an exercise price of $9.35, which areexercisable anytime between September 4, 2005 and September 4,2010.  In addition, the investors haverights to purchase up to 588,235 shares of common stock at a price of $8.50 pershare, which are exercisable for a period commencing (i) anytime on orafter September 4, 2005 and (ii) on or prior to the later of the 6month anniversary of the effective date of the registration statement filed on April 12,2005, or March 4, 2006.  The Companyalso issued warrants to the placement agent to purchase 43,231 shares of commonstock at an exercise price of $9.35 per share, which are exercisable until March 4,2010.  Should the investors exercisethese additional investment rights, the placement agent will receive anadditional warrant for 23,529 shares at an exercise price of $9.35 per share.  The Company utilized the proceeds from thesale of the securities for the acquisition of businesses and assets and workingcapital purposes

 

On March 9, 2005, the Company acquired all of the stockof Accurel Systems, from existing shareholders.  The aggregate purchaseprice of Accurel is estimated to be $12,176,000, which consists of the issuanceof 418,194 shares of the Company’s common stock with a fair value of $3,520,000based upon a value per share of $8.42, $6,036,000 in cash, $1,650,000 in a notepayable to the former Accurel shareholders and estimated direct acquisitioncosts of $970,000.  The shareholder notepayable was due in 120 days from the closing, July 9, 2005 and earnedinterest at 5%. The note was secured by all of the equipment of Accurel.  The purchase is subject to a holdback of$500,000 subject to the settlement of any and all liabilities not reflected inthe closing balance sheet.  The sharesissued were also subject to adjustment if the Company’s average stock priceduring the twenty trading days prior to the end of a three month lock-up is 25%higher or lower than the price on the closing date.  The effect of this adjustment is to limit theselling shareholders’ gain or loss on the Company’s common stock to 25% duringthe lock-up period ending June 9, 2005. The average stock price for the twenty day period ending June 9,2005 was $2.97.  An additional 504,144shares of the Company’s stock were issued as a result of this adjustment.  The shares issued were determined based onthe average market price of the securities over a twenty-day period ending March 8,2005. The share price for valuation purposes was determined by the averageshare price for the period just prior to the date of the merger agreementannouncement, pursuant to the guidance in EITF Issue No. 99-12.

 

On May 6, 2005, theCompany purchased software technology from Rosses Medical Systems with anaggregate purchase price of $300,000, consisting of $100,000 in cash and 43,197shares of the Company’s common stock with a fair value of $200,000.  In conjunction with this asset acquisition, theCompany entered into consulting agreements with the former owners and a formeremployee of Rosses Medical and granted 181,426 non-qualified stock options tothem, in total.  These options are fullyvested, have a zero exercise price and are exercisable upon achieving certainsales milestones, commencing November 6, 2005.  The value of these options, if any, will berecorded as additional purchase price in the period earned.

 

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**ITEM 6.****            MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**OVERVIEW**

 

Over the past 21 years,Implant Sciences Corporation has developed core technologies using ionimplantation and thin film coatings for medical device applications and hasproprietary processes and equipment for the manufacture of medical devices forradiation therapy.  This technology hasbeen applied to the manufacture of our I-Plant radioactive prostate seeds usinga dry fabrication process which we believe is more cost-effective and lesshazardous than conventional processes which use radioactive wet chemistry.  We are currently developing a radioactive sourceto be used in a delivery system designed to provide breast cancertreatment.  The treatment, calledaccelerated partial beast irradiation therapy, following lumpectomy can becompleted in five days rather than seven weeks of daily treatments usingexternal beam radiation.  We believe thissystem will become the treatment of choice for women following lumpectomy.  The Company is also developing a new devicefor the treatment of ocular melanoma using brachytherapy, which we believe willprovide a better distribution of radiation within the tumor while providingless discomfort for the patient.  TheCompany also has numerous other radiation therapy devices in various stages ofdevelopment including devices for biliary duct cancer and dural irradiation.

 

We are also applying ourion implantation technologies to modify the surfaces of orthopedic jointimplants, manufactured by the Stryker-Orthopaedics Division of StrykerCorporation, to reduce polyethylene wear generation.  We provide ion implantation and analytical servicesto numerous semiconductor manufacturers, research laboratories anduniversities.  In October 2004 and March 2005,we acquired two California semiconductor companies.  These acquisitions have significantlyincreased our revenue base and expanded the products and services we can offerto our semiconductor customers.

 

Since May 1999, wehave been performing research to develop a trace explosives detector, whichcould be used to detect hidden bombs in airports and other public places.  This technology is yet another application ofour ion source technology.  At present,we are developing both portable and bench-top systems for use in airports andDepartment of Defense facilities. Prototype units have been delivered to the Department of Defense andDepartment of Transportation facilities for demonstration and evaluation.  We have sold units to both domestic andinternational government agencies.  Wecurrently have four issued United States patent and six United States patentspending covering our explosives detection technologies and processes.

 

On October 15, 2004the Company acquired Core Systems. On March 9, 2005 the Company acquiredAccurel Systems International.   The resultsof operations, of the acquired companies, are part of the Company’s semiconductorbusiness segment.  The results ofoperations for the acquired companies are included in the Company’s results ofoperations since the date of their respective acquisition.  As such, the results of operations and thebalance sheets of the years ended June 30, 2005 and 2004 are notcomparable.

 

On March 23, 2005, the Company entered into a Development,Distribution and Manufacturing Agreement with Rapiscan Systems.  The agreement provides for: the manufactureand sale of the Company’s existing explosives detection equipment on a privatelabel basis; the funding by Rapiscan of up to $1,000,000 for the development ofa trace explosives detection subsystem to be integrated with Rapiscan’s X-raybaggage screening device technology; and up to $2,000,000 for the developmentof other trace explosives detection subsystems. The agreement includes various manufacturing, selling and distributionrights.  No revenue has been recordedrelated to this agreement.

 

On May 6, 2005, theCompany purchased certain software technology assets from Rosses MedicalSystems.  This treatment planningsoftware compliments our prostate seed products and as such we believe willprovide new sales opportunities for seed sales. For the year ended June 30, 2005 revenues from this treatmentplanning software were immaterial.

 

In March 2004 theCompany entered into an Exchange & Venture Agreement with CardioTechInternational, Inc. (“CardioTech”), a public company and related party ofthe Company, and CorNova, Inc. (“CorNova”) (Note 9).  CorNova is a start-up company incorporated asa Delaware corporation on October 12, 2003. CorNova is developing a seriesof coronary stents used in angioplasty procedures.  The ultimate goal is tomarket and sell a new drug eluting stent based on proprietary technologyprovided by the Company and CardioTech. All stents are primarily to bedistributed in the non-US markets.  The first part of the plan is tomarket a new Cobalt-Chrome 

 

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stent which has beendeveloped and is scheduled to be released early in calendar 2006.  Thedrug eluting version which is based upon the Cobalt-Chrome base is scheduledfor release in 2007.

 

The Company manages its businessand reports results from operations for three business segments: Medical, whichincludes radioactive seeds, orthopedic coatings, medical related governmentcontracts and other related activities; Explosives Detection, which includes developmentcontracts and products sales related to the Company’s trace explosivesdetection devices; and Semiconductor, which includes ion implantation, diskrefurbishment, source conditioning equipment and semiconductor analysisservices.

 

**RESULTSOF OPERATIONS**

 

The following is adiscussion and analysis of the financial condition and results of operation ofthe Company for the years ended June 30, 2005 and 2004.  It should be read in conjunction with thefinancial statements and notes thereto appearing elsewhere herein.

 

*YearEnded June 30, 2005 vs. June 30, 2004*

 

*Revenues.* Total revenues for the year ended June 30, 2005 were$12,286,000 as compared to $8,566,000 for the comparable prior year period, anincrease of $3,720,000 or 43%.   Ourrevenues by business segment are as follows:

 

| **Year Ended June 30, 2005** | ** ** |
|-----------------------------------|------------|
| **Medical**                       | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** |
| $                                 | 4,146,000  |   | $ | 6,630,000 |   | $ | 1,510,000 |   |
|                                   |            |  |  |  |  |  |  |  |

 

| **Year Ended June 30, 2004** | ** ** |
|-----------------------------------|------------|
| **Medical**                       | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** |
| $                                 | 4,957,000  |   | $ | 1,022,000 |   | $ | 2,587,000 |   |
|                                   |            |  |  |  |  |  |  |  |

 

 Theincrease is primarily attributable to revenues from Core Systems and AccurelSystems since their acquisitions on October 15, 2004 and March 9,2005 respectively, which were not included in the previous year.   Revenues from Core and Accurel totaledapproximately $5,838,000 and are included in our semiconductor segment.  Semiconductor revenues were $6,630,000 ascompared to $1,022,000 in the prior year period, an increase of $5,608,000, or549%.

 

Seeds revenues were $1,684,000 as compared to$2,744,000 for the prior year, a decrease of $1,060,000, or 39%.  The decrease in revenues from seeds was primarilydue from a pattern of decreasing volumes that started last year.  Management believes the seed volumes have nowstabilized and are taking steps to achieve higher seed volumes in the comingyear, including the benefits of selling our recently acquired treatmentplanning software to our customers.

 

Revenues from medical and industrial coatingswere $2,018,000 as compared to $1,707,000 for the prior year, an increase of $287,000,or 17%.   While revenue from orthopedicrelated coatings remains virtually unchanged from the prior year period, werecognized a $247,000, or nearly 500% increase, in our non-orthopedic relatedmedical coatings.  This increase wasrelated to certain new customers transitioning from research and developmentprojects to the beginning stages of production. We expect to see continued growth in this area.  Medical contract sales decreased $62,000 to$444,000 as compared to $506,000 in the prior year due to the completion ofcertain contracts.

 

Revenues from the Company’s explosivesdetection business declined to $1,510,000 as compared to $2,587,000 for theprior year, a decrease of $1,077,000 or 42%. This decrease is attributable to the completion of certain governmentcontracts.  Explosives detection contractrevenues were $1,294,000 and $2,463,000 for the years ended June 30, 2005and 2004, respectively. The Company is transitioning the explosives businessfrom primarily a 

 

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contracts/development business to a product sales business.  To that extent we have established strategicsales and distribution relationships both domestically and internationally. Forthe year ended June 30, 2005, the Company has deferred $328,000 ofexplosives product revenues, pending final customer acceptance.   TheCompany recently announced a major order for its explosives detection productfrom its distributor in China. Explosives detection product revenues were$216,000 and $0 for the years ended June 30, 2005 and 2004, respectively.

 

*Cost ofRevenues*.  Cost ofrevenues for the year ended June 30, 2005 was $12,056,000 as compared to$6,186,000 for the comparable prior year period, an increase of $5,870,000, or95%.  The cost of revenues by businesssegment is as follows:

 

| **Year Ended June 30, 2005** | ** ** |
|-----------------------------------|------------|
| **Medical**                       | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** |
| $                                 | 3,821,000  |   | $ | 6,316,000 |   | $ | 1,919,000 |   |
|                                   |            |  |  |  |  |  |  |  |

 

| **Year Ended June 30, 2004** | ** ** |
|-----------------------------------|------------|
| **Medical**                       | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** |
| $                                 | 3,822,000  |   | $ | 1,280,000 |   | $ | 1,084,000 |   |
|                                   |            |  |  |  |  |  |  |  |

 

The overall increase incost of revenues is primarily a result of costs attributable to Core andAccurel since their acquisition on October 15, 2004 and March 9, 2005,respectively.  Cost of revenues at Coreand Accurel totaled $4,807,000. Core and Accurel are included in oursemiconductor segment.  In addition, ourcost of revenues also increased due to our efforts to ramp up our explosives detectionmanufacturing capability as we transition from primarily contract revenues tohigher volumes of product sales related to the explosives detection businesssegment.  The cost of our explosives detectionrevenues were $1,919,000 compared to $1,084,000 in the prior year, an increaseof $835,000 or 77%.  During the yearended June 30, 2005, we wrote off $342,000 to cost of revenues, ofequipment, that was determined by management, to have no future value.  This equipment was originally purchased orbuilt for very specific applications or technologies that in management’sjudgment no longer justify additional expenditure and no other use for thisequipment exists.  Most of the equipmentwrite offs were attributable to the medical segment.

 

Overall gross marginswere 2% of revenues in the year ended June 30, 2005 as compared to 28% ofrevenues in the prior year.  The decreasein the gross margin percentage is attributable to relatively high fixed costsin our medical products segment that cannot be easily adjusted for the decreasein revenues, which the Company experienced. Medical segment gross margins were$325,000, or 8% of revenues, for the year ended June 30, 2005 as comparedto $1,135,000, or 23% of revenues, for the prior year period.  We have reviewed our inventory valuations andhave determined that the valuations do not need to be adjusted.  In addition, the transition fromcontract/development work in the explosives detection segment created asituation in which the Company had declining revenues due to completion ofmajor contracts, at the same time the Company is building its productmanufacturing capability. The result of this transition was a gross margin loss$409,000, or 27%, of sales for the explosives detection segment, for the yearended June 30, 2005 as compared to gross margins of $1,507,000, or 58%, inthe prior year period.  Semiconductormargins were 5% of revenues as compared to a gross margin loss of 25% in theprior year period. This turnaround is attributable to Accurel since itsacquisition by the Company on March 9, 2005.  Management expects a significant improvementin semiconductor margins once Accurel is included in the results for a fulltwelve months.

 

*Researchand Development*. Research and development expense for the year ended June 30, 2005was $1,942,000 as compared to $1,631,000 for the comparable prior year period,an increase of $311,000, or 19%.  Theseexpenses include $241,000 and $300,000 of stock-based compensation expense,respectively. The Company continues to expend funds to further the developmentof new products in the areas of explosives and toxic substance detection and temporarybrachytherapy areas.

 

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*Selling,General and Administrative*. Selling, general and administrative expenses for the year ended June 30,2005 were $5,524,000 as compared to $4,599,000 for the comparable prior yearperiod, an increase of $925,000, or 20%.  This increase is primarily related to $1,260,000 of additional selling,general and administrative expenses incurred since the acquisition of Core Systemsand Accurel Systems on October 15, 2004 and March 9, 2005, combinedwith increased spending for legal, accounting and consulting services.  This increase was offset by a $1,144,000 or89% reduction of non-cash, stock based compensation, to $135,000 in the twelvemonth period ending June 30, 2005, as compared with $1,279,000 during thetwelve month period ended June 30, 2004. Additional increases in selling, general and administrative expensesincluded an increase of $339,000 related to salaries and employee related expenses,  reflecting new hires during the year; anincrease in rent expense of $171,000 due to expansion of floor space and; anincrease in audit and tax fees of $153,000.

 

* Other Income and Expenses, Net*.  For the year ended June 30, 2005, werecorded other expense, net, of $169,000 as compared to $162,000, in thecomparable prior year period.

 

*Net Loss.*  Net loss for the year ended June 30,2005 was $7,405,000 as compared with $4,012,000 for the comparable prior yearperiod, an increase in net loss of $3,393,000, or 85%.  The increase in net loss is primarily due tolosses in the explosives detection business due to the completion of certaingovernment contracts early in the year and costs related to increasing ourmanufacturing capability ahead of expected product orders.  Our acquisition of Core Systems on October 15,2004 was expected to have a positive impact on earnings because of expectedoperating efficiencies and increased revenues when combined with the Company’sexisting semiconductor operations.  Thesebenefits have been slow to develop and Core has experienced losses since it wasacquired.  Management continues to focuson opportunities for Core that could have significant profit potential. TheCompany continually reviews its goodwill assets for potential impairment.  The Company contracted an independentappraiser to do the annual assessment of this asset. The results of this assessmentconclude that the goodwill is not impaired. However, if events should occur and an impairment charge is warranted itcould have a significant impact on the Company’s financial results for theperiod then reported.   Preferreddistribution, dividends and accretion were $1,183,000 in the year ended June 30,2005 as compared to $2,527,000 in the year ended June 30, 2004.  This decrease is attributable to theconversion of preferred stock to common stock during the periods shown.  All outstanding preferred stock had beenconverted as of June 30, 2005.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

As of June 30, 2005,the Company had approximately $1,549,000 in the form of cash and cashequivalents.  During the year ended June 30,2005 the Company acquired Core Systems and Accurel Systems International.  The balance sheet items of these acquisitionsare included in the June 30, 2005 consolidated balance sheet but not inthe June 30, 2004 balance sheet.  Assuch the balance sheets as of June 30, 2005 and 2004, are notcomparable.  The cash flows representchanges since the companies were acquired. During the year ended June 30,2005, operating activities used cash of approximately $3,329,000.  Net cash used by operating activitiesprimarily reflects the $7,405,000 net loss offset by $3,010,000 in depreciationand other non-cash expenses.  In additionthe Company invested $549,000 in inventory as it begins its production of theexplosives detection product and paid down its liability to Med-Tec by$258,000.  The Company realized cash of $433,000by lowering its accounts receivables due to timely payments from governmentcontracts and $59,000 from reduced prepaid expenses.  Accounts payables and accruals increased $435,000reflecting the increase in operating activities. Cash flows from deferredrevenues increased by $714,000 primarily due to payments received by theCompany, for products and services not recognized by the Company as revenues,until final acceptance by the customer.   During the year ended June 30,****2005, investing activities used cash of approximately $8,217,000,which was primarily attributable to $8,829,000 used in the acquisition of Coreand Accurel offset by $1,400,000 realized from the sale of acquiredassets.  During the year ended June 30,2005, financing activities provided approximately $6,189,000 in cash.  Net cash provided by financing activitiesprimarily includes net proceeds from a private placement of $7,289,000 and $1,036,000from the exercise of options and warrants. Net cash provided by financing was offset by payments on our long termdebt of $2,082,000 including $1,170,000 of debt paid off by the Companyassociated with the acquired assets that were sold

 

On September 30,2005, the Company executed a $5,000,000 preferred stock instrument with LaurusMaster Fund, Ltd., and issued 500,000 shares of Series D CumulativeConvertible Preferred Stock.  The termsof the agreement state that repayment can be made in cash or converted into theCompany’s common stock at a fixed 

 

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conversion price equal to$6.80 per common share, up to a maximum of approximately 735,000 shares, over athirty-six (36) month period.  Thepreferred stock has a dividend equal to the prime rate plus one percent (1%)and provides for monthly redemptions of approximately $152,000 to be paid incash or common shares, at the option of the Company, subject to certainrestrictions, commencing on January 1, 2006.  In addition, Laurus was granted a warrant topurchase 50,000 shares of the Company’s common stock exercisable at a price of$10.20 per share.  The Company utilizedthe proceeds to repay the $3 million term note signed on July 7, 2005,plus accrued interest, and for working capital. As part of the financing, theCompany paid Laurus Capital Management, LLC, the manager of Laurus, a closingpayment equal to $90,000, plus due diligence and legal expenses of $27,000.

 

On July 6, 2005, the Company executed a $3,000,000secured term note from Laurus Master Fund, Ltd. Net proceeds from the financingare to be used for increasing the capacity of the Quantum Sniffer productionline, increasing unit inventories and the repayment of certain indebtedness dueand owing by the Company to the former shareholders of Accurel SystemsInternational.  As part of the financing,the Company paid Laurus Capital Management, LLC, the manager of Laurus, aclosing payment equal to $135,000, plus due diligence and legal expenses of$12,000.   The term note is secured bysubstantially all of the Company’s assets, has a 4-month term and bearsinterest at a rate equal to prime plus 1% per annum.  In connection with the financing, on September 30,2005, the Company issued Laurus a common stock purchase warrant to purchase upto 250,000 shares of the Company’s common stock at a price equal to $3.75 pershare.

 

On June 8, 2005,the Company executed a revolving credit facility for $1,500,000 with SiliconValley based Bridge Bank, N.A.  Therevolving credit facility has a one year term, provides for advances of up toeighty percent (80%) of the Company’s eligible accounts receivable, bearsinterest at the prime rate plus one-half percent (1/2%), and is secured by certainassets of the Company.  The creditfacility is also subject to various financial covenants.  As of June 30, 2005 no funds have beendrawn on this credit facility.

 

On March 8, 2005 the Company issued 1,080,780 shares ofcommon stock at $7.22, in a private placement with fifteen investors.  The Company received $7,803,000 in grossproceeds, less placement agent fees and related transaction costs ofapproximately $433,000.  In connectionwith the transaction, the Company issued warrants to the investors to purchase270,195 shares of common stock at an exercise price of $9.35, which areexercisable anytime between September 4, 2005 and September 4,2010.  In addition, the investors haverights to purchase up to 588,235 shares of common stock at a price of $8.50 pershare, which are exercisable for a period commencing (i) anytime on orafter September 4, 2005 and (ii) on or prior to the later of the 6month anniversary of the effective date of the registration statement, filed onApril 12, 2005, or March 4, 2006. We also issued warrants to the placement agent to purchase 43,231 sharesof common stock at an exercise price of $9.35 per share, which are exercisableuntil March 4, 2010.  Should theinvestors exercise these additional investment rights, the placement agent willreceive an additional warrant for 23,529 shares at an exercise price of $9.35per share.  The Company utilized theproceeds from the sale of the securities for the acquisition of businesses andassets and working capital purposes

 

On July 22, 2004,  the Board authorized the Company to repurchaseup to 300,000 shares of the outstanding shares of common stock, from time-time,in the open market, privately negotiated transactions, block transactions or attime and prices deemed appropriate by management.  In July 2004, the Company repurchased6,000 shares ranging in price from $8.91 to $9.02 per share, having an averageshare price of $8.97.  As of June 30,2005, the maximum allowed to be repurchased is 294,000 shares.

 

Since May 1999, wehave been developing several explosive detection systems that could be used inairports, public and government buildings, and sporting event facilities.  The systems use our proprietary Laser IMStechnology, which includes the use of laser beams in combination with ionmobility spectrometry, to electronically detect minute quantities of explosivevapor molecules in the air.

 

This project is currentlybeing undertaken by both our internal scientists and outside contractors.  The development of new applications istypically funded through government grants or internal funding.  Since March 2000, we have receivedtwelve contracts totaling over $14 million for detection of toxic chemicals orexplosives from agencies such as the Departments of the Army, Air Force, MarineCorps, Navy and the Department of Homeland Security.

 

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In June 2000, wedeveloped our first generation device, which demonstrated sensitivity to theexplosive TNT.  In June 2001, wedeveloped a second generation prototype with increased sensitivity andselectivity.  This device can detect andspecify an increasing number of compounds within various explosivematerials.  The explosives that have beentested to date are TNT, RDX, PETN, EGDN, and DNT.  RDX is the primary component of C3 and C4explosives, such as Datasheet and Semtex, as well as certain types of blackpowder explosives.  We believe theseexplosives represent the majority of the explosives presently used in terroristactivities.

 

We are developing severalversions of our explosives detection systems, including: (i) a table-topunit, which can be used to screen passengers and carry-on baggage in airports; (ii) aportable system, which can be used to clear buildings, aircrafts, or shipswhere hidden bombs are believed to exist and (iii) a walk-throughpassenger portal.  We are currentlyselling certain of these products internationally and plan to market these systemsto U.S. government agencies for use in airports, government buildings and facilities.

 

We are currentlyexpending significant resources to set up our explosives detection manufacturingfacility in anticipation of our explosives detection system orders.  Although we continue to fund as much researchand development as possible through government grants and contracts inaccordance with the provisions of the respective grant awards we will requireadditional funding in order to continue the advancement of the commercialdevelopment and manufacturing of the explosives detection system.  We will attempt to obtain such financing by: (i) governmentgrants, (ii) the exercise of the redeemable common stock purchasewarrants, (iii) private financing, or (iv) strategicpartnerships.  However, there can be noassurance that we will be successful in our attempts to raise such additionalfinancing.

 

Consistent with ourpolicy to protect our proprietary technologies, we have been awarded fourpatents and have submitted an additional six patent applications to the UnitedStates Patent and Trademark Office. These patents and applications will cover specific design configurationsthat are responsible for our improved vapor detection sensitivity.

 

We will requiresubstantial funds for further research and development, regulatory approvalsand continued expansion of commercial-scale manufacturing capabilities, and themarketing of our products.  Our capitalrequirements depend on numerous factors, including but not limited to, theprogress of our research and development programs; the cost of filing, prosecuting,defending and enforcing any intellectual property rights; competingtechnological and market developments; changes in our development ofcommercialization activities and arrangements; and the purchase of additionalfacilities and capital equipment.

 

As of June 30, 2005,we were conducting our operations with approximately $1,549,000 in cash andcash equivalents.  We estimate we willneed additional sources of cash combined with our cash flow from operations tofund our working capital in the next twelve months.  Future expenditures for research and productdevelopment, especially relating to outside testing, are discretionary and,accordingly, can be adjusted, as can certain selling, general andadministrative expenses, based on the availability of cash.  Subsequent to year end, the Company’sfinancing activites generated approximately $3,086,000 in additional cash.

 

Since the end ofour fiscal year ended June 30, 2005, the Company has taken several steps tomitigate the risk of its ability to continue as a going concern.  In terms of improving its cash and workingcapital position, the Company i) raised an additional $5,000,000 on September30, 2005 through the issuance of a Series D Cumulative Convertible PreferredStock (see Note 25 of the Footnotes to the Financial Statements) and ii)extended the termination date of its $1,500,000 line of credit with a bank fromJune 30, 2006 to December 31, 2006.  OnAugust 31, 2005, the Company was awarded a contract from the TransportationSecurity Administration in the approximate amount of $2,200,000 to develop a“next-generation” passenger portal within a twelve (12) month period.  This funding by the TSA will support ourcurrent explosives research and development efforts.

 

During the courseof fiscal 2005 the Company made significant investments in the growth of itssemiconductor business and in the development and commercialization of itsexplosives detection technology and equipment. The growth in the semiconductor business was realized through the acquisitionof Core Systems Inc. in October 2004 and Accurel International System Inc. inMarch 2005.  Management believes that ithas substantially completed its transition and integration efforts and can nowfocus on the organic growth of revenues and continue to work towardsimprovements in the operational efficiencies of this business unit.  Management believes that its explosivesdetection business unit has transgressed from a “development stage” operationover the past several years to an operating entity with establishedmanufacturing, distribution and service capabilities.  Recently, the Company accepted an order forthe delivery of 123 units of its handheld explosives detection equipment to theChinese government having a manufacturer’s suggested retail price (“MSRP”) ofapproximately $3.7 million.  The Companyprovides its distributor a discount from the MSRP and will recognize thediscounted portion of the revenue from this order upon shipment, with periodicshipments expected to begin in October 2005. Through its direct and indirect distribution network, the Company hasquotes to several domestic and international government agencies and commercialcompanies and believes that a substantial backlog could be achieved.

 

Based on thecurrent sales, expense and cash flow projections, the Company believes that thecurrent level of cash and cash-equivalents on hand, and the net proceeds fromthe financings and government awards mentioned above would be sufficient tofund operations until the Company achieves profitability.  However, because there can be no assurancesthat sales will materialize as forecasted, management will continue to closelymonitor and attempt to control costs at the Company and will continue to activelyseek the needed capital through government grants and awards, strategicalliances, private financing sources, and through its lending institutions.

 

The Company'sconsolidated financial statements have been presented on the basis that it is agoing concern, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business. The Company hassuffered recurring losses from operations and has a working capital and   stockholders' deficits as of June 30, 2005.  The Company raised net proceeds aggregatingapproximately $8,326,000 during the year ended June 30, 2005 from the sale ofcommon stock in connection with a private placement and the exercise of optionsand warrants.  Since the end of ourfiscal year ended June 30, 2005, the Company has taken several steps tomitigate the risk of its ability to continue as a going concern.  In terms of improving its cash and workingcapital position, the Company i) raised an additional $5,000,000 on September30, 2005 through the issuance of a Series D Cumulative Convertible PreferredStock (see Note 25) and ii) extended the termination date of its $1,500,000line of credit with a bank from June 30, 2006 to December 31, 2006.  Approximately $3,000,000 of the Series Dpreferred stock was issued for the purpose of converting a previously issued$3,000,000 short term note into this Series D preferred stock.  The Series D preferred stock containsmandatory redemptions on a monthly basis beginning in January 2006.  These mandatory redemptions are redeemable incash or shares of the Company’s common stock, at the Company’s option so longas the price of the Company’s stock does not fall below 110% of the fixedconversion price.  There can be noassurances that forecasted results will be achieved or that the Company’s stockprice will remain at a level to allow the Company to redeem the outstandingshares of Series D preferred and accrued dividends with shares of its commonstock.

 

During the courseof fiscal 2005 the Company made significant investments in the growth of its semiconductorbusiness and in the development and commercialization of its explosivesdetection technology and equipment.  Thegrowth in the semiconductor business was realized through the acquisition ofCore Systems Inc. in October 2004 and Accurel International System Inc. inMarch 2005.  Management believes that ithas substantially completed its transition and integration efforts and can nowfocus on the organic growth of revenues and continue to work towards improvementsin the operational efficiencies of this business unit.  Management believes that its explosivesdetection business unit has transgressed from a “development stage-like”operation over the past several years to an operating entity with established manufacturing,distribution and service capabilities. Recently, the Company accepted an order for the delivery of 123 units ofits handheld explosives detection equipment to the Chinese government having amanufacturers suggested retail price (“MSRP”) of approximately $3.7million.  The Company provides itsdistributor a discount from the MSRP and will recognize the discounted portionof the revenue from this order upon shipment, with periodic shipments expectedto begin in October 2005.  Through itsdirect and indirect distribution network, the Company has quotes to severaldomestic and international government agencies and commercial companies andbelieves that a substantial backlog could be achieved.  Additionally, on August 31, 2005, the Companywas awarded a contract from the Transportation Security Administration in theapproximate amount of $2,200,000 to develop a “next-generation” passengerportal within a twelve (12) month period. This funding by the TSA will support our current explosives research anddevelopment efforts.  The Company has ahistory of being active in submitting proposals for government sponsored grantsand contracts and successful in being awarded grants and contracts fromgovernment agencies.  Management willcontinue to pursue government grants and contracts to support its research anddevelopment efforts in the areas of semiconductor, medical device andexplosives and toxic substances detection.

 

Based on thecurrent sales, expense and cash flow projections, the Company believes that thecurrent level of cash and cash-equivalents on hand, and the net proceeds fromthe financings and government awards mentioned above would be sufficient tofund operations until the Company achieves profitability.  However, because there can be no assurancesthat sales will materialize as forecasted, management will continue to closelymonitor and attempt to control costs at the Company and will continue toactively seek the needed capital through government grants and awards,strategic alliances, private financing sources, and through its lendinginstitutions.  The financial statementsdo not include any adjustments relating to the recoverability andclassification of asset amounts or the amounts and classification ofliabilities that might be necessary should the Company be unable to continue asa going concern.

 

The Company’s futureminimum payments under contractual obligations related to capital leases,operating leases and term notes as of June 30, 2005 are as follows:

 

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| ** **                | ** ** | **Debt and  Capital  Leases (1)** | ** ** | **Operating  Lease** | ** ** | **MED-TEC (2)** | ** ** | **Total** | ** ** |
|---------------------------|------------|-----------------------------------|------------|----------------------|------------|-----------------|------------|-----------|------------|
| Year ending June 30: |       |                              |       |                 |       |            |       |      |       |
| 2006                      |       | $                                 | 2,052,000  |                 | $          | 1,620,000       |       | $         | 348,000    |   | $ | 4,020,000 |   |
| 2007                      |       | 386,000                           |       | 1,673,000            |       |            |       | 2,059,000 |       |
| 2008                      |       | 377,000                           |       | 1,713,000            |       |            |       | 2,090,000 |       |
| 2009                      |       | 131,000                           |       | 1,454,000            |       |            |       | 1,585,000 |       |
| 2010                      |       | 3,000                             |       | 838,000              |       |            |       | 841,000   |       |
|                      |       |                              |       |                 |       |            |       |      |       |
| Total                     |       | $                                 | 2,949,000  |                 | $          | 7,298,000       |       | $         | 348,000    |   | $ | 10,595,000 |   |

 

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(1)  Includes$1,650,000 in short term notes payable to Accurel shareholders  (See Notes 19 and 25 of the consolidatedfinancial statements).

 

 (2)  Relates to MED-TEC paymentobligation (See Note 15 of the consolidated financial statements).

 

On June 30, 2004, the Company entered into anemployment agreement with Dr. Anthony J. Armini, the Company’s Presidentand CEO, with an initial term of three years and an automatic renewal for asuccessive period of three years, unless the Company or Dr. Armini givethe other party not less than three months written notice of non-renewal.  Under this employment agreement, Dr. Arminiserves as the Company’s president and chief executive officer at a base salaryof up to $210,000.  In addition, Dr. Arminimay participate in the Company’s employee fringe benefit plans or programsgenerally available to employees of comparable status and position.  The Company is entitled to terminate hisemployment for any material breach of his employment agreement at any time uponat least 30 days written notice.  In theevent the Company terminates Dr. Armini’s employment without cause, the Companywill pay him 12 months salary.  Under hisemployment agreement, he is subject to restrictive covenants, includingconfidentiality provisions.  Also, duringhis employment and for a period of two years after the term of the employmentagreement, Dr. Armini is subject to a non-competition provision.

 

On June 30, 2004, theCompany entered into an employment agreement Dr. Stephen Bunker, theCompany’s Vice President and Chief Scientist, with an initial term of threeyears and an automatic renewal for a successive period of three years, unlessthe Company or Dr. Bunker give the other party not less than three monthswritten notice of non-renewal.  Underthis employment agreement, Dr. Bunker serves as the Company’s vicepresident and chief executive scientist at a base salary of up to$150,000.  In addition, Dr. Bunkermay participate in the Company’s employee fringe benefit plans or programsgenerally available to employees of comparable status and position.  The Company is entitled to terminate hisemployment for any material breach of his employment agreement at any time uponat least 30 days’ written notice.  In theevent the Company terminates Dr. Bunker’s employment without cause, theCompany will pay him 12 months salary. Under his employment agreement, he is subject to restrictive covenants,including confidentiality provisions. Also, during his employment and for a period of two years after the termof the employment agreement, Dr. Bunker is subject to a non-competitionprovision.

 

On October 15, 2004,the Company entered into an employment agreement Walter J. Wriggins, theCompany’s Vice President and General Manager of Core Systems, with an initialterm of one year and an automatic renewal for a successive period of one year,unless the Company or Mr. Wriggins give the other party not less thanthirty days written notice of non-renewal. Under this employment agreement, Mr. Wriggins serves as our Vice President of BusinessDevelopment/Operations and general manager of Core Systemsat a base salary of $140,000.  Inaddition, Mr. Wriggins may participate in the Company’s employee fringebenefit plans or programs generally available to employees of comparable statusand position.  The Company is entitled toterminate his employment for any material breach of his employment agreement atany time upon at least 30 days’ written notice. In the event the Company terminates Mr. Wriggins’ employmentwithout cause, the Company will pay him the balance of the salary due for theterm of the agreement.  Under his employmentagreement, he is subject to restrictive covenants, including confidentialityprovisions.  Also, during his employmentand for a period of two years after the term of the employment agreement, Mr. Wrigginsis subject to a non-competition provision

 

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*CriticalAccounting Policies*

 

Our significantaccounting policies are described in Note 2 to the consolidated financialstatements included in Item 7 of our Form 10-KSB as of June 30, 2005.  Our discussion and analysis of our financialcondition and results of operations are based upon the consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America.  The preparation of these consolidated financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities.  Onan on-going basis, we evaluate our estimates, including those related to baddebts, product returns, inventories, investments, intangible assets andwarranty obligations.  We base ourestimates on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources.  In the past, actual results have not beenmaterially different from our estimates. However, results may differ from these estimates under differentassumptions or conditions.  During theyear ended June 30, 2005, the Company adopted Statement of FinancialAccounting Standards (“SFAS”) No. 141 “Goodwill and Other IntangibleAssets.”

 

The Company has identified the following as criticalaccounting policies, based on the significant judgments and estimates used indetermining the amounts reported in its financial statements:

 

•                  *Revenue Recognition –Product and Government Contract Revenues*

 

The Company recognizes revenue when there is persuasive evidence of anarrangement with the customer which states a fixed and determinable price andterms, delivery of the product has occurred or the service performed inaccordance with the terms of the sale, and collectibility of the sale isreasonably assured.

 

Government contractrevenue under cost-sharing research and development agreements is recognized aseligible research and development expenses are incurred.  The Company’s obligation with respect tothese agreements is to perform the research on a best-efforts basis.  For government contracts with a deliverable,revenue is recognized on a percentage of completion basis.

 

Revenues for which theCompany has received payment, but has not yet recognized the revenues, pendingfulfilling its obligations under the sales agreement, are reflected on thebalance sheet as deferred revenues.

 

Revenues relating tosoftware licenses, computer hardware and software maintenance agreements will berecognized as defined in Statement of Position (“SOP”) 97-2.  Revenues related to such sales generatedduring the year ended June 30, 2005 were immaterial and there were no suchrevenues generated during the year ended June 30, 2004.

 

•                  *Accounts Receivable and Allowance for DoubtfulAccounts*

 

The Company maintains allowances for estimated lossesresulting from the inability of its customers to make required payments.  Judgments are used in determining theallowance for doubtful accounts and are based on a combination of factors.  Such factors include historical collectionexperience, credit policy and specific customer collection issues.  In circumstances where the Company is awareof a specific customer’s inability to meet its financial obligations to us(e.g., bankruptcy filings), we record a specific reserve for bad debts againstamounts due to reduce the net recognized receivable to the amount we reasonablybelieve will be collected.  We performongoing credit evaluations of our customers and continuously monitorcollections and payments from our customers. While actual bad debts have historically been within our expectationsand the provisions established, we cannot guarantee that we will continue toexperience the same bad debt rates that we have in the past.  A significant change in the liquidity orfinancial position of any of our customers could result in the uncollectibilityof the related accounts receivable and could adversely impact our operatingcash flows in that period.

 

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•                  *Sales Returns and Allowances*

 

The Company records reductions to revenue forestimated customer returns and allowances. We record estimated allowancesagainst revenues in the same period the revenue is recorded.  These estimates are based upon historicalanalysis of our credit memo data and other known factors for pricing anddisputes that arise in the normal course of business.  To date, allowances have not beensignificant.  Actual returns may differsignificantly from our estimates if factors such as economic conditions orcompetitive conditions differ from our expectations.

 

•                  *Inventories*

 

We value our inventories at lower of cost ormarket.  Cost is determined by thefirst-in, first-out (FIFO) method, including material, labor and factoryoverhead.  In assessing the ultimaterealization of inventories, management judgment is required to determine thereserve for obsolete or excess inventory. Inventory on hand may exceed future demand either because the product isexcess, or because the amount on hand is more than can be used to meet futureneed.  We provide for the total value ofinventories that we determine to be obsolete or excess based on criteria suchas customer demand and changing technologies.

 

•                  *Warranties*

 

We provide for the estimated cost of productwarranties at the time revenue is recognized. We record an estimate for warranty related costs at the time of salebased on our actual historical return rates and repair costs.  While our warranty costs have historicallybeen within our expectations and the provisions established, we cannotguarantee that we will continue to experience the same warranty return rates orrepair costs that we have in the past.  Asignificant increase in warranty return rates or costs to repair our productscould have a material adverse impact on our operating results for the period orperiods in which such returns or additional costs materialize.

 

•                  *Valuation of Certain Marketable Equity Securities*

 

The Company currently classifies its investmentsecurities as available-for-sale securities. Pursuant to SFAS No. 115, “Accountingfor Certain Investments in Debt and Equity Securities,” such securities aremeasured at fair market value in the financial statements with unrealized gainsor losses recorded in accumulated other comprehensive income until thesecurities are sold or otherwise disposed of. However, in accordance with SFAS No. 115, a decline in fair marketvalue below cost that is other than temporary is accounted for as a realized loss.  To date, we have not experienced any realizedlosses.

 

•                  *Income Taxes*

 

The income tax accounting process involves estimatingour actual current exposure together with assessing temporary differencesresulting from differing treatment of items for tax and accountingpurposes.  These differences result inthe recognition of deferred tax assets and liabilities.  We must then record a valuation allowance toreduce our deferred tax assets to the amount that is more likely than not to berealized.

 

Significant management judgment is required indetermining our provision for income taxes, our deferred tax assets andliabilities and any valuation allowance recorded against deferred taxassets.  We have recorded a full valuationallowance against our deferred tax assets of $6,890,000 as of June 30, 2005,due to uncertainties related to our ability to utilize these assets.  The valuation allowance is based on ourestimates of taxable income and the period over which our deferred tax assetswill be recoverable.  In the event thatactual results differ from these estimates or we adjust these estimates infuture periods we may need to adjust our valuation allowance which couldmaterially impact our financial position and results of operations.

 

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•                  *Goodwill and IntangibleAssets*

 

SFAS No. 142, “Goodwilland Other Intangible Assets,” requires that goodwill and intangible assets withindefinite lives no longer be amortized but instead be measured for impairmentat least annually or whenever events indicate that there may be an impairment.In order to determine if an impairment exists, management compares thereporting unit’s carrying value to the reporting unit’s fair value. Determiningthe reporting unit’s fair value requires management to make estimates based onmarket conditions and operational performance. Absent an event that indicates aspecific impairment may exist, management has selected August 31st as thedate of performing the annual goodwill impairment test Future events couldcause management to conclude that impairment indicators exist and that goodwillassociated with the Company’s acquired businesses is impaired. Any resultingimpairment loss could have a material adverse impact on the Company’s financialcondition and results of operations.

 

Intangible assets with finite lives consist of acquired customer base, technology and trademarks and are valued according to the future cash flows they are estimated to produce. These assigned values are amortized on a basis which matches the periods in which those cash flows are estimated to be produced, or straight line over the estimated useful lives, if no other method provides a better result. The Company continually evaluates whether events or circumstances have occurred that indicate that the estimated remaining useful life of our intangible assets may warrant   revision or that the carrying value of these assets may be impaired. To compute whether intangible assets with finite lives been impaired, the estimated undiscounted future cash flows for the estimated remaining useful life of the assets are compared to the carrying value. To the extent that the future cash flows are less than the carrying value, the assets are written down to the estimated fair value of the asset.

 

•                  Equity*Transactions*

 

In many of our financingtransactions, warrants have been issued. Additionally, we issue options and warrants to non-employees from timeto time as payment for services.  In allof these cases, we apply the principles of SFAS No. 123 “Accounting forStock-based Compensation” to value these awards, which inherently include anumber of estimates and assumptions including stock price volatilityfactors.  The Company records financingand certain offering costs associated with its capital raising efforts in itsstatements of operations.  These includeamortization of debt issue costs such as cash, warrants and other securitiesissued to finders and placement agents, and amortization of preferred stock discountcreated by in-the-money conversion features on convertible debt accounted forin accordance with Emerging Issues Task Force (“EITF”) Issue 98-5, “Accountingfor Convertible Securities with Beneficial Conversion Features or ContingentlyAdjustable Conversion Ratios,” and Issue 00-27, “Application of Issue 98-5 toCertain Convertible Instruments,” by other securities issued in connection withpreferred stock as a result of allocating the proceeds amongst the securitiesin accordance with Accounting Principles Board (“APB”) Opinion No. 14, “Accountingfor Convertible Debt and Debt Issued with Stock Purchase Warrants,” based ontheir relative fair values.  We based ourestimates and assumptions on the best information available at the time ofvaluation, however, changes in these estimates and assumptions could have amaterial effect on the valuation of the underlying instruments.

 

*Recent Accounting Pronouncements*

 

In November 2004, the Financial Accounting Standards Board (“FASB”) issued, SFAS No. 151, “Inventory Costs-an Amendment of ARB No. 43, Chapter 4” (“FAS 151”). FAS 151 amends ARB 43, Chapter 4, to clarify that, abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges.  In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of the provision of FAS 151 is not expected to have a material impact on the Company’s financial position or results of operations.

 

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*  *In December 2004, the FASB issued SFAS No. 153, “Exchanges of Non-monetary Assets”, which eliminates the exception of fair value measurement for non-monetary exchanges of similar productive assets in existing accounting literature and replaces it with an exception for exchanges that do not have commercial substance. SFAS No. 153 specifies that a non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The provisions of SFAS No. 153 are effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Adoption of this statement is not expected to have a material impact on the Company’s financial position or results of operations.

 

  In December 2004, the FASB issued Statement No. 123-R, “Share-Based Payments.” SFAS 123-R is a revision of SFAS 123, “Accounting for Stock-Based Compensation.” The Company is required to adopt the provisions of SFAS 123-R as of the beginning of its third fiscal quarter of 2006, beginning January1, 2006.  This statement establishes standards for and requires the recognition of the cost of employment-related services settled in share-based payment.  The provisions of this statement are effective for all employee equity awards granted on or after the required effective date and to any unvested awards outstanding as of the required effective date. Retrospective application is permitted. The Company has not yet assessed the impact of adopting this new standard.  The Company does expect the impact of adopting this new standard to be of a material nature.

 

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**ITEM 7.****                             CONSOLIDATEDFINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

Our consolidated financialstatements and related report of independent registered public accounting firmare appended to the end of this Form 10-KSB for the fiscal year ended June 30,2005 and contain the following:

 
|                                                                                                                                             |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Report of Independent  Registered Public Accounting Firm                                                                                         |   |
| Consolidated Balance  Sheets as of June 30, 2005 and 2004                                                                                   |   |
| Consolidated  Statements of Operations for the years ended June 30, 2005 and 2004                                                           |   |
| Consolidated  Statements of Changes in Stockholders’ Equity and Comprehensive Income(Loss)  for the years ended June 30, 2005 and 2004 |   |
| Consolidated  Statements of Cash Flows for the years ended June 30, 2005 and 2004                                                           |   |
| Notes to  Consolidated Financial Statements                                                                                                      |   |

 

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Report of IndependentRegistered Public Accounting Firm

 

To the Board of Directorsand Stockholders of

Implant SciencesCorporation:

 

We have audited the accompanyingconsolidated balance sheet of Implant Sciences Corporation and subsidiaries(the “Company”) as of June 30, 2005 and 2004 and the related consolidatedstatements of operations, stockholders’ equity and comprehensive income (loss)and cash flows for each of the two years in the period ended June 30,2005.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

 

We conducted ouraudits in accordance with the standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor werewe engaged to perform, an audit of its internal controls over financialreporting.  Our audits includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no suchopinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Implant Sciences Corporation andsubsidiaries at June 30, 2005 and 2004, and the results of theiroperations and their cash flows for each of the two years in the period ended June 30,2005, in conformity with accounting principles generally accepted in the UnitedStates of America.

 

The accompanying consolidatedfinancial statements have been prepared assuming that the Company will continueas a going concern. As discussed in Note 1 to the consolidated financialstatements, the Company has suffered recurring losses from operations and hasworking capital and stockholder deficits as of June 30, 2005. These mattersraise substantial doubt about its ability to continue as a going concern.  Management’s plans in regard to these mattersare also described in Note 1. The consolidated financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.

 
|                  | /s/ BDO Seidman, LLP |   |
|-----------------------|----------------------|--------|
|                  |                 |
|                  |                 |
| Boston, Massachusetts |                 |
| October 10, 2005 |                 |

 

26

----

 

**IMPLANT SCIENCES CORPORATION**

**CONSOLIDATDBALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                     | ** ** | **June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|------------|
| ** **                                                                                                                                                                                                                                     | ** ** | **2005**     | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                                                                                                     |       |         |       |   |   |
| Current assets:                                                                                                                                                                                                                                |       |         |       |   |   |
| Cash and cash  equivalents (Note 2)                                                                                                                                                                                                            |       | $            | 1,549,000  |   | $ | 6,906,000 |   |
| Accounts  receivable, less allowance of $147,000 and $89,000, respectively (Note 2)                                                                                                                                                            |       | 3,003,000    |       | 709,000 |   |
| Accounts  receivable, unbilled (Notes 2 and 7)                                                                                                                                                                                                 |       | 298,000      |       | 1,434,000 |   |
| Inventories  (Notes 2 and 3)                                                                                                                                                                                                                   |       | 1,204,000    |       | 481,000 |   |
| Investments -  available for sale securities (Notes 2 and 9)                                                                                                                                                                                   |       | 204,000      |       | 419,000 |   |
| Prepaid expenses  and other current assets                                                                                                                                                                                                     |       | 224,000      |       | 140,000 |   |
| Total current  assets                                                                                                                                                                                                                          |       | 6,482,000    |       | 10,089,000 |   |
|                                                                                                                                                                                                                                           |       |         |       |   |   |
| Property and  equipment, net (Notes 2, 4 and 10)                                                                                                                                                                                               |       | 10,434,000   |       | 4,308,000 |   |
| Amortizable  intangible assets, net (Notes 15 and 20)                                                                                                                                                                                          |       | 2,057,000    |       | 625,000 |   |
| Investment in  unconsolidated subsidiary (Note 6)                                                                                                                                                                                              |       | 531,000      |       | 63,000 |   |
| Other  non-current assets (Note 24)                                                                                                                                                                                                            |       | 511,000      |       | 139,000 |   |
| Goodwill (Note  20)                                                                                                                                                                                                                            |       | 12,213,000   |       | — |   |
| Total assets                                                                                                                                                                                                                                   |       | $            | 32,228,000 |   | $ | 15,224,000 |   |
|                                                                                                                                                                                                                                           |       |         |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                 |       |         |       |   |   |
| Current  liabilities:                                                                                                                                                                                                                          |       |         |       |   |   |
| Current  maturities of long-term debt and obligations under capital lease (Notes 10  and 15)                                                                                                                                                   |       | $            | 2,052,000  |   | $ | 101,000 |   |
| Payable to  Med-Tec (Note 15)                                                                                                                                                                                                                  |       | 348,000      |       | 394,000 |   |
| Accrued expenses  (Note 5)                                                                                                                                                                                                                     |       | 2,445,000    |       | 740,000 |   |
| Accounts payable                                                                                                                                                                                                                               |       | 1,526,000    |       | 578,000 |   |
| Current portion  of long term lease liability (Note 19)                                                                                                                                                                                        |       | 102,000      |       |   |   |
| Deferred revenue                                                                                                                                                                                                                               |       | 773,000      |       | 23,000 |   |
| Total current  liabilities                                                                                                                                                                                                                     |       | 7,246,000    |       | 1,836,000 |   |
|                                                                                                                                                                                                                                           |       |         |       |   |   |
| Long-term  liabilities:                                                                                                                                                                                                                        |       |         |       |   |   |
| Long-term debt  and obligations under capital lease, net of current maturities (Notes 10 and  15)                                                                                                                                              |       | 897,000      |       | 6,000 |   |
| Long-term lease  liability (Note 19)                                                                                                                                                                                                           |       | 701,000      |       | — |   |
| Payable to  Med-Tec, net of current amount (Note 15)                                                                                                                                                                                           |       | —       |       | 212,000 |   |
| Total  liabilities                                                                                                                                                                                                                             |       | 8,844,000    |       | 2,054,000 |   |
|                                                                                                                                                                                                                                           |       |         |       |   |   |
| Commitments and  contingencies (Note 10)                                                                                                                                                                                                       |       |         |       |   |   |
|                                                                                                                                                                                                                                           |       |         |       |   |   |
| Convertible  preferred stock (Note 12): 5,000,000 shares authorized 5% Series C Cumulative  Redeemable Convertible Preferred Stock; $10 stated value; 250,000 shares  designated; 0 shares 131,875 shares issued and outstanding, respectively |       | —       |       | 670,000 |   |
|                                                                                                                                                                                                                                           |       |         |       |   |   |
| Stockholders’  equity (Notes 13 and 16):                                                                                                                                                                                                  |       |         |       |   |   |
| Common stock,  $0.10 par value; 20,000,000 shares authorized; 10,756,842 and 8,370,338  shares issued and outstanding, respectively                                                                                                            |       | 1,075,000    |       | 837,000 |   |
| Additional  paid-in capital                                                                                                                                                                                                                    |       | 50,995,000   |       | 31,360,000 |   |
| Accumulated  deficit                                                                                                                                                                                                                           |       | (28,115,000  | )          | (19,527,000 | ) |
| Deferred  compensation (Note 2 and 13)                                                                                                                                                                                                         |       | (349,000     | )          | (449,000 | ) |
| Accumulated  other comprehensive income (loss)                                                                                                                                                                                                 |       | (5,000       | )          | 313,000 |   |
| Treasury stock,  22,449 and 3,103 common shares, respectively, at cost (Note 6)                                                                                                                                                                |       | (217,000     | )          | (34,000 | ) |
| Total  stockholders’ equity                                                                                                                                                                                                               |       | 23,384,000   |       | 12,500,000 |   |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                               |       | $            | 32,228,000 |   | $ | 15,224,000 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

27

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**IMPLANT SCIENCES CORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
| ** **                                                                                     | ** ** | **Years Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                     | ** ** | **2005**                 | ** ** | **2004** | ** ** |
| Revenues (Notes 7 and 8):                                                                      |       |                     |       |   |   |
| Medical                                                                                        |       | $                        | 4,146,000  |   | $ | 4,957,000 |   |
| Semiconductor                                                                                  |       | 6,630,000                |       | 1,022,000 |   |
| Explosives  detection                                                                          |       | 1,510,000                |       | 2,587,000 |   |
| Total revenues                                                                                 |       | 12,286,000               |       | 8,566,000 |   |
|                                                                                           |       |                     |       |   |   |
| Cost of revenues:                                                                              |       |                     |       |   |   |
| Cost of medical  revenues                                                                      |       | 3,821,000                |       | 3,822,000 |   |
| Cost of  semiconductor revenues                                                                |       | 6,316,000                |       | 1,280,000 |   |
| Cost of  explosives detection revenues                                                         |       | 1,919,000                |       | 1,084,000 |   |
| Total cost of  revenues                                                                        |       | 12,056,000               |       | 6,186,000 |   |
|                                                                                           |       |                     |       |   |   |
| Gross margin                                                                                   |       | 230,000                  |       | 2,380,000 |   |
|                                                                                           |       |                     |       |   |   |
| Operating expenses:                                                                            |       |                     |       |   |   |
| Research and  development                                                                      |       | 1,942,000                |       | 1,631,000 |   |
| Selling, general  and administrative                                                           |       | 5,524,000                |       | 4,599,000 |   |
| Total operating  expenses                                                                      |       | 7,466,000                |       | 6,230,000 |   |
|                                                                                           |       |                     |       |   |   |
| Loss from operations                                                                           |       | (7,236,000               | )          | (3,850,000 | ) |
|                                                                                           |       |                     |       |   |   |
| Other income (expenses):                                                                       |       |                     |       |   |   |
| Interest income                                                                                |       | 48,000                   |       | 23,000 |   |
| Interest expense                                                                               |       | (142,000                 | )          | (135,000 | ) |
| Equity losses in  unconsolidated subsidiaries (Note 6)                                         |       | (75,000                  | )          | (50,000 | ) |
| Total other  expense, net                                                                      |       | (169,000                 | )          | (162,000 | ) |
|                                                                                           |       |                     |       |   |   |
| Net loss                                                                                       |       | (7,405,000               | )          | (4,012,000 | ) |
|                                                                                           |       |                     |       |   |   |
| Preferred distribution, dividends and accretion  (Note 12)                                     |       | (1,183,000               | )          | (2,527,000 | ) |
|                                                                                           |       |                     |       |   |   |
| Net loss applicable to common shareholders                                                     |       | $                        | (8,588,000 | ) | $ | (6,539,000 | ) |
|                                                                                           |       |                     |       |   |   |
| Net per share applicable to common shareholders,  basic and diluted                            |       | $                        | (0.91      | ) | $ | (0.89 | ) |
|                                                                                           |       |                     |       |   |   |
| Weighted average common shares outstanding used in  computing basic and diluted loss per share |       | 9,412,548                |       | 7,317,677 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

28

----

 

**IMPLANT SCIENCES CORPORATION**

**STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME (LOSS)**

**FOR THE YEARS ENDED JUNE 30, 2004 AND 2005**

 
| ** **                                                                                                                                           | ** ** | ** **        | ** ** | ** **          | ** ** | ** **  | ** ** | ** **      | ** ** | ** **             | ** **  | ** **        | ** ** | ** **          | ** ** | ** **     | ** ** | **Notes**              | ** ** | ** **        | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|---------------------|------------|-------------|------------|-----------------|------------|------------------------|-------------|-------------------|------------|---------------------|------------|----------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                                                                           | ** ** | **Common  Stock** | ** ** | **Additional**      | ** ** | ** **  | ** ** | ** **      | ** ** | **Accumulated  Other** | ** **  | ** **        | ** ** | ** **          | ** ** | **Receivable** | ** ** | **Total**              | ** ** | ** **        | ** ** |
| ** **                                                                                                                                           | ** ** | **Number  of**    | ** ** | ** **          | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Deferred**           | ** **  | **Comprehensive** | ** ** | **Treasury  Stock** | ** ** | **from**       | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                                                                           | ** ** | **shares**        | ** ** | **$.10 par  value** | ** ** | **Capital** | ** ** | **Deficit**     | ** ** | **Compensation**       | ** **  | **Income**        | ** ** | **Shares**          | ** ** | **Cost**       | ** ** | **Employees**          | ** ** | **Equity**        | ** ** | **Loss**   | ** ** |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Balance at June  30, 2003                                                                                                                            |       | 6,650,156         |       | $                   | 665,000    |        | $          | 16,064,000      |       | $                      | (12,988,000 | )                 | $          | (7,000              | )          | $              | 117,000    |                   | —     |              | $          | —     |       | $ | (223,000 | ) | $ | 3,628,000 |   |   |   |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Issuance of  common stock pursuant to exercise of stock options                                                                                      |       | 138,635           |       | 14,000              |       | 516,000     |       |            |       |                   |        |              |       |                |       |           |       |                   |       | 530,000           |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Issuance of  common stock pursuant to exercise of warrants                                                                                           |       | 186,120           |       | 19,000              |       | 1,083,000   |       |            |       |                   |        |              |       |                |       |           |       |                   |       | 1,102,000         |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Issuance of  common stock pursuant to employee stock purchase plan                                                                                   |       | 7,135             |       | 1,000               |       | 28,000      |       |            |       |                   |        |              |       |                |       |           |       |                   |       | 29,000            |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Issuance of  common stock pursuant to private financing agreement, net of issuance costs  of $310,000                                                |       | 468,604           |       | 47,000              |       | 4,642,000   |       |            |       |                   |        |              |       |                |       |           |       |                   |       | 4,689,000         |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Conversion of 7%  Series A Cumulative Convertible Preferred Stock and related accrued dividends  into common stock                                   |       | 301,143           |       | 30,000              |       | 1,501,000   |       | (32,000         | )          |                   |        |              |       |                |       |           |       |                   |       | 1,499,000         |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Conversion of 5%  Series B Cumulative Convertible Preferred Stock and related accrued dividends  into common stock                                   |       | 371,336           |       | 37,000              |       | 2,057,000   |       | (63,000         | )          |                   |        |              |       |                |       |           |       |                   |       | 2,031,000         |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Issuance of  common stock to consultants in exchange for services                                                                                    |       | 11,205            |       | 1,000               |       | 109,000     |       |            |       |                   |        |              |       |                |       |           |       |                   |       | 110,000           |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Accretion and  dividends on 7% Series A Cumulative Convertible Preferred Stock                                                                       |       |              |       |                |       |        |       | (532,000        | )          |                   |        |              |       |                |       |           |       |                   |       | (532,000          | )          |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Accretion of the  beneficial conversion feature and common stock warrants in connection with  the 5% Series B Cumulative Convertible Preferred Stock |       |              |       |                |       | 1,009,000   |       | (1,224,000      | )          |                   |        |              |       |                |       |           |       |                   |       | (215,000          | )          |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Accretion of the  beneficial conversion feature and common stock warrants in connection with  the 5% Series C Cumulative Convertible Preferred Stock |       |              |       |                |       | 1,005,000   |       | (638,000        | )          |                   |        |              |       |                |       |           |       |                   |       | 367,000           |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Conversion of 5%  Series C Cumulative Convertible Preferred Stock and related accrued dividends  into common stock                                   |       | 175,000           |       | 17,000              |       | 1,164,000   |       |            |       |                   |        |              |       |                |       |           |       |                   |       | 1,181,000         |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Repayment of  notes receivable from employees                                                                                                        |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       | 223,000                |       | 223,000           |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Investment in  unconsolidated subsidiaries (Note 6)                                                                                                  |       | 10,344            |       | 1,000               |       | 112,000     |       |            |       |                   |        | (6,000            | )          | 3,103               |       | (34,000        | )          |                   |       | 73,000            |       | (6,000     | )          |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Fair value  associated with warrants and nonqualified stock options issued to  nonemployees                                                          |       | —            |       | —              |       | 992,000     |       |            |       | 2,000                  |        |              |       |                |       |           |       |                   |       | 994,000           |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Stock-based  compensation associated with warrants and nonqualified stock options issued  to employees below fair market value                       |       | 50,660            |       | 5,000               |       | 1,040,000   |       |            |       | (444,000               | )           |              |       |                |       |           |       |                   |       | 601,000           |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Unrealized gain  on available for sale securities                                                                                                    |       |              |       |                |       |        |       |            |       |                   |        | 202,000           |       |                |       |           |       |                   |       | 202,000           |       | 202,000    |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Value of  underwriter IPO unit warrant extension (Note 13)                                                                                           |       |              |       |                |       | 38,000      |       | (38,000         | )          |                   |        |              |       |                |       |           |       |                   |       | —            |       |       |       |
|                                                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |           |       |                   |       |              |       |       |       |
| Net loss                                                                                                                                             |       |              |       |                |       |        |       | (4,012,000      | )          |                   |        |              |       |                |       |           |       |                   |       | (4,012,000        | )          | (4,012,000 | )          |
| Balance at June  30, 2004                                                                                                                            |       | 8,370,338         |       | $                   | 837,000    |        | $          | 31,360,000      |       | $                      | (19,527,000 | )                 | $          | (449,000            | )          | $              | 313,000    |                   | 3,103      |              | $          | (34,000    | )          | $ | — |   | $ | 12,500,000 |   | $ | (3,816,000 | ) |
|                                                                                                                                                      |            |                   |            |                     |            |             |            |                 |            |                        |             |                   |            |                     |            |                |            |                        |            |                   |            |            |            |  |  |  |  |  |  |  |  |  |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

29

----

 
| ** **                                                                                                           | ** ** | **Common  Stock** | ** ** | **Additional**      | ** ** | ** **  | ** ** | ** **      | ** ** | **Accumulated  Other** | ** **  | ** **        | ** ** | ** **          | ** ** | **Total**              | ** ** | ** **        | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|---------------------|------------|-------------|------------|-----------------|------------|------------------------|-------------|-------------------|------------|---------------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                                                           | ** ** | **Number  of**    | ** ** | ** **          | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Deferred**           | ** **  | **Comprehensive** | ** ** | **Treasury  Stock** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                                           | ** ** | **shares**        | ** ** | **$.10 par  value** | ** ** | **Capital** | ** ** | **Deficit**     | ** ** | **Compensation**       | ** **  | **Income**        | ** ** | **Shares**          | ** ** | **Cost**               | ** ** | **Equity**        | ** ** | **Loss** | ** ** |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Balance at June  30, 2004                                                                                            |       | 8,370,338         |       | $                   | 837,000    |        | $          | 31,360,000      |       | $                      | (19,527,000 | )                 | $          | (449,000            | )          | $                      | 313,000    |              | 3,103      |   | $ | (34,000 | ) | $ | 12,500,000 |   |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Issuance of  common stock pursuant to exercise of stock options                                                      |       | 153,160           |       | 15,000              |       | 856,000     |       |            |       |                   |        |              |       |                |       |                   |       | 871,000           |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Issuance of  common stock pursuant to exercise of warrants                                                           |       | 42,810            |       | 4,000               |       | 137,000     |       |            |       |                   |        |              |       |                |       |                   |       | 141,000           |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Issuance of  common stock pursuant to employee stock purchase plan                                                   |       | 3,075             |       | —              |       | 25,000      |       |            |       |                   |        |              |       |                |       |                   |       | 25,000            |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Issuance of  common stock pursuant to private financing agreement, net of issuance costs                             |       | 1,080,780         |       | 108,000             |       | 7,181,000   |       |            |       |                   |        |              |       |                |       |                   |       | 7,289,000         |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Conversion of 5%  Series C Cumulative Convertible Preferred Stock and related accrued dividends  into common stock   |       | 208,289           |       | 21,000              |       | 1,417,000   |       | (55,000         | )          |                   |        |              |       |                |       |                   |       | 1,383,000         |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Accretion and  dividends on 5% Series C Cumulative Convertible Preferred Stock                                       |       | —            |       | —              |       | —      |       | (649,000        | )          |                   |        |              |       |                |       |                   |       | (649,000          | )          |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Investment in  unconsolidated subsidiaries (Note 6)                                                                  |       | 76,687            |       | 8,000               |       | 742,000     |       |            |       |                   |        | (78,000           | )          | 13,346              |       | (129,000               | )          | 543,000           |       | (78,000 | ) |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Issuance of  common stock pursuant to investment in Core Systems                                                     |       | 311,437           |       | 31,000              |       | 3,219,000   |       |            |       |                   |        | —            |       | —              |       | —                 |       | 3,250,000         |       | — |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Issuance of  common stock in exchange for the retirement of debt in connection with the  acquisition of Core Systems |       | 48,875            |       | 5,000               |       | 505,000     |       |            |       |                   |        |              |       |                |       |                   |       | 510,000           |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Issuance of  common stock warrants in connection with the acquisition of Core Systems                                |       |              |       |                |       | 1,122,000   |       |            |       |                   |        |              |       |                |       |                   |       | 1,122,000         |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Issuance of  common stock pursuant to investment in Accurel Systems International                                    |       | 418,194           |       | 42,000              |       | 3,478,000   |       |            |       |                   |        |              |       |                |       |                   |       | 3,520,000         |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Fair value  associated with warrants and nonqualified stock options issued to  nonemployees (Note 13)                |       | —            |       | —              |       | 228,000     |       |            |       | (129,000               | )           |              |       |                |       |                   |       | 99,000            |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Value ascribed to  stock options issued to employees below fair market value                                         |       | —            |       | —              |       | 144,000     |       | —          |       | (144,000               | )           |              |       |                |       |                   |       | —            |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Purchase of  treasury stock                                                                                          |       |              |       |                |       |        |       |            |       |                   |        |              |       | 6,000               |       | (54,000                | )          | (54,000           | )          |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Amortization of  deferred compensation                                                                               |       |              |       |                |       | (94,000     | )          |            |       | 373,000                |        |              |       |                |       |                   |       | 279,000           |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Issuance of  common stock for assets acquired from Rosses Medical                                                    |       | 43,197            |       | 4,000               |       | 196,000     |       |            |       |                   |        |              |       |                |       |                   |       | 200,000           |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Unrealized gain  on available for sale securities                                                                    |       |              |       |                |       |        |       |            |       |                   |        | (240,000          | )          |                |       |                   |       | (240,000          | )          | (240,000 | ) |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Value of  underwriter IPO unit warrant extension (Note 13)                                                           |       |              |       |                |       | 479,000     |       | (479,000        | )          |                   |        |              |       |                |       |                   |       | —            |       |   |   |
|                                                                                                                 |       |              |       |                |       |        |       |            |       |                   |        |              |       |                |       |                   |       |              |       |   |   |
| Net loss                                                                                                             |       |              |       |                |       |        |       | (7,405,000      | )          |                   |        |              |       |                |       |                   |       | (7,405,000        | )          | (7,405,000 | ) |
|                                                                                                                 |       | 10,756,842        |       | $                   | 1,075,000  |        | $          | 50,995,000      |       | $                      | (28,115,000 | )                 | $          | (349,000            | )          | $                      | (5,000     | )                 | 22,449     |   | $ | (217,000 | ) | $ | 23,384,000 |   | $ | (7,723,000 | ) |
|                                                                                                                      |            |                   |            |                     |            |             |            |                 |            |                        |             |                   |            |                     |            |                        |            |                   |            |  |  |  |  |  |  |  |  |  |  |

 

Theaccompanying notes are an integral part of these consolidated financialstatements

 

30

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**IMPLANT SCIENCES CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                                                                                               | ** ** | **Years Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                                               | ** ** | **2005**                 | ** ** | **2004** | ** ** |
| **Cash  flows from operating activities:**                                                                               |       |                     |       |   |   |
| Net loss                                                                                                                 |       | $                        | (7,405,000 | ) | $ | (4,012,000 | ) |
|                                                                                                                     |       |                     |       |   |   |
| Adjustments to  reconcile net loss to net cash used in operating activities:                                             |       |                     |       |   |   |
| Depreciation and  amortization                                                                                           |       | 1,611,000                |       | 881,000 |   |
| Amortization of  intangible assets                                                                                       |       | 589,000                  |       | 382,000 |   |
| Stock-based  compensation expense                                                                                        |       | 378,000                  |       | 1,668,000 |   |
| Equity loss in  unconsolidated subsidiaries                                                                              |       | 75,000                   |       | 50,000 |   |
| Loss on  equipment write down                                                                                            |       | 357,000                  |       | — |   |
| Changes in  operating assets and liabilities:                                                                            |       |                     |       |   |   |
| Accounts  receivable                                                                                                     |       | 433,000                  |       | (1,365,000 | ) |
| Inventories                                                                                                              |       | (549,000                 | )          | (8,000 | ) |
| Prepaid expenses  and other current assets                                                                               |       | 59,000                   |       | (102,000 | ) |
| Accounts payable                                                                                                         |       | (19,000                  | )          | (171,000 | ) |
| Accrued expenses                                                                                                         |       | 454,000                  |       | (6,000 | ) |
| Deferred revenue                                                                                                         |       | 714,000                  |       | 36,000 |   |
| Long-term lease  liability                                                                                               |       | (26,000                  | )          | — |   |
| Net cash used in  operating activities                                                                                   |       | (3,329,000               | )          | (2,647,000 | ) |
|                                                                                                                     |       |                     |       |   |   |
| **Cash  flows from (for) investing activities:**                                                                         |       |                     |       |   |   |
| Purchase of  property and equipment                                                                                      |       | (688,000                 | )          | (355,000 | ) |
| Proceeds from  sale of equipment                                                                                         |       | 1,400,000                |       | — |   |
| (Investment in)  proceeds from - available for sale securities                                                           |       | (25,000                  | )          | (40,000 | ) |
| Investment in  Core Systems, net of cash received                                                                        |       | (2,404,000               | )          | — |   |
| Investment in  Accurel Systems International, net of cash received                                                       |       | (6,425,000               | )          | — |   |
| Increase in  other non-current assets                                                                                    |       | (75,000                  | )          | (105,000 | ) |
| Net cash used in  investing activities                                                                                   |       | (8,217,000               | )          | (500,000 | ) |
|                                                                                                                     |       |                     |       |   |   |
| **Cash  flows from financing activities:**                                                                               |       |                     |       |   |   |
| ** **                                                                                                               |       |                     |       |   |   |
| Proceeds from  issuance of common stock in connection with the exercise of options and the  Employee Stock Purchase Plan |       | 896,000                  |       | 559,000 |   |
| Proceeds from  warrant exercise                                                                                          |       | 141,000                  |       | 1,102,000 |   |
| Proceeds from  issuance of 5% Series B Cumulative Convertible Preferred Stock, net of  issuance costs                    |       | —                   |       | 1,818,000 |   |
| Proceeds from  issuance of 5% Series C Cumulative Convertible Preferred Stock, net of  issuance costs                    |       | —                   |       | 2,282,000 |   |
| Repayments of  long-term debt and capital lease obligations                                                              |       | (2,083,000               | )          | (1,579,000 | ) |
| Acqusition of  treasury shares                                                                                           |       | (54,000                  | )          | — |   |
| Repayments of  notes receivable from employees                                                                           |       | —                   |       | 223,000 |   |
| Proceeds from  issuance of common stock in connection with private placement, net of  issuance costs                     |       | 7,289,000                |       | 4,689,000 |   |
| Net cash  provided by financing activities                                                                               |       | 6,189,000                |       | 9,094,000 |   |
| Net (decrease)  increase in cash and cash equivalents                                                                    |       | (5,357,000               | )          | 5,947,000 |   |
| Cash and cash  equivalents, beginning                                                                                    |       | 6,906,000                |       | 959,000 |   |
| Cash and cash  equivalents, ending                                                                                       |       | $                        | 1,549,000  |   | $ | 6,906,000 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

31

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| ** **                                                                                                               | ** ** | **Years ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                                               | ** ** | **2005**                 | ** ** | **2004** | ** ** |
| **Supplemental  Disclosure of Cash Flow Information:**                                                                   |       |                     |       |   |   |
| Interest paid in  cash                                                                                                   |       | $                        | 167,000    |   | $ | 135,000 |   |
|                                                                                                                     |       |                     |       |   |   |
| **Noncash  Investing and Financing Activity:**                                                                           |       |                     |       |   |   |
| Value of IPO  warrant extension                                                                                          |       | $                        | 479,000    |   | $ | 38,000 |   |
| Issuance of  Series B warrants                                                                                           |       | $                        | —     |   | $ | 184,000 |   |
| Noncash  beneficial conversion feature - Series B                                                                        |       | $                        | —     |   | $ | 826,000 |   |
| Issuance of  Series C warrants                                                                                           |       | $                        | —     |   | $ | 305,000 |   |
| Noncash  beneficial conversion feature - Series C                                                                        |       | $                        | —     |   | $ | 700,000 |   |
| Conversion of  Series A Cumulative Convertible Preferred stock and accrued dividends into  common stock                  |       | $                        | —     |   | $ | 1,531,000 |   |
| Conversion of  Series B Cumulative Convertible Preferred stock and accrued dividends into  common stock                  |       | $                        | —     |   | $ | 2,064,000 |   |
| Conversion of  Series C Cumulative Convertible Preferred stock and accrued dividends into  common stock                  |       | $                        | 1,438,000  |   | $ | 1,181,000 |   |
| Accretion of 7%  Series A Cumulative Convertible Preferresd Stock dividends, beneficial  conversion feature and warrants |       | $                        | —     |   | $ | 564,000 |   |
| Accretion of 5%  Series B Cumulative Convertible Preferred Stock dividends, beneficial  conversion feature and warrants  |       | $                        | —     |   | $ | 1,287,000 |   |
| Accretion of 5%  Series C Cumulative Convertible Preferred Stock dividends, beneficial  conversion feature and warrants  |       | $                        | 704,000    |   | $ | 638,000 |   |
| Value of  intangible asset acquired in exchange for long-term note payable                                               |       | $                        | —     |   | $ | 1,007,000 |   |
| Value of  software technology acquired in exchange for cash and shares of common stock  (Note 24)                        |       | $                        | 300,000    |   | $ | — |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

32

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**Supplemental Disclosure of Cash FlowInformation**

 

**On October 15, 2004, the Company acquired Core SystemsIncorporated -**

 
| **Fair  value of assets:**                                    |   |       |      |
|---------------------------------------------------------------|--------|------------|-----------|
| Accounts  receivable                                          |   | $          | 518,000   |   |
| Inventory                                                     |   | 174,000    |      |
| Property, plant  and equipment                                |   | 3,422,000  |      |
| Intangible  assets                                            |   | 335,000    |      |
| Goodwill                                                      |   | 4,647,000  |      |
| Other assets                                                  |   | 74,000     |      |
| **Liabilities assumed:**                                      |   |       |      |
| Accounts payable  and accrued expenses                        |   | (1,063,000 | )         |
| Debt and capital  leases                                      |   | (621,000   | )         |
| **Purchase price:**                                           |   |       |      |
|                                                          |   |       |      |
| Cash paid for  purchase of Core Systems, net of cash acquired |   | (2,604,000 | )         |
| Fair value of  warrants issued                                |   | (1,122,000 | )         |
|                                                          |   |       |      |
| Fair value of  common stock issued                            |   | $          | 3,760,000 |   |

 

**On March9, 2005, the Company acquired Accurel Systems International Corporation -**

 
| **Fair  value of assets:**                               |   |       |      |
|----------------------------------------------------------|--------|------------|-----------|
| Accounts  receivable                                     |   | $          | 1,073,000 |   |
| Property, plant  and equipment                           |   | 3,957,000  |      |
| Assets held for  sale                                    |   | 1,400,000  |      |
| Other intangible  assets                                 |   | 1,670,000  |      |
| Goodwill                                                 |   | 7,566,000  |      |
| Other assets                                             |   | 183,000    |      |
| **Liabilities assumed:**                                 |   |       |      |
| Accounts payable  and accrued expenses                   |   | (557,000   | )         |
| Long-term lease  liability                               |   | (829,000   | )         |
| Debt and capital  leases                                 |   | (2,440,000 | )         |
| **Purchase price:**                                      |   |       |      |
| Debt issued to  selling shareholders                     |   | (1,650,000 | )         |
| Cash paid for  purchase of Accurel, net of cash acquired |   | (6,853,000 | )         |
|                                                     |   |       |      |
| Fair value of  common stock issued                       |   | $          | 3,520,000 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

33

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**IMPLANT SCIENCES CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**1.****                                      Description ofBusiness**

 

ImplantSciences Corporation (the “Company”) develops products for the medical deviceand explosives detection industry.  Itscore technology involves ion implantation and thin film coatings of radioactiveand non-radioactive materials.  TheCompany has received Food and Drug Administration 510(k) clearance to marketboth its I-Plantä Iodine-125radioactive seed for the treatment of prostate cancer and its Ytterbium-192source for breast cancer therapy.  TheCompany also modifies the surface characteristics of orthopedic joint implantsto reduce polyethylene wear and thereby increasing the life of theimplant.  The Company also provides ionimplantation and analytical services to the semiconductor industry andsemiconductor equipment.  The Companycontinues to make significant investments in developing new applications of itsexplosives detection systems while ramping up its manufacturing capabilities inanticipation of order fulfillment.

 

While the Companystrives to bring new products to market, it is subject to a number of riskssimilar to other technology-based companies, including risks related to: (a)its dependence on key individuals and collaborative research partners; (b)competition from substitute products and larger companies; (c) its ability todevelop and market commercially usable products and obtain regulatory approvalfor its products under development; and (d) its ability to obtain thesubstantial additional financing necessary to adequately fund the development,commercialization and marketing of its products.  For the year ended June 30, 2005, the Companyreported a net loss of $7,405,000 and used $3,329,000 in cash fromoperations.  As of June 30, 2005, theCompany had an accumulated deficit of approximately $28,115,000 and a workingcapital deficit of $764,000.  Managementcontinually evaluates plans to reduce its operating expenses and increase itscash flow from operations.  Failure ofthe Company to achieve its projections may require the Company to seekadditional financing.  Subsequent to June30, 2005 the Company executed a $3.0 million secured term note from LaurusMaster Fund, Ltd. Net proceeds from the financing were used to pay a $1.65million note due and owing by the Company to the former shareholders of AccurelSystems International. On September 30, 2005, the Company executed a $5.0million preferred stock instrument with Laurus Master Fund, Ltd., and issued500,000 shares of Series D Cumulative Convertible Preferred Stock.  The Company utilized the proceeds to repaythe $3 million term note from Laurus signed on July 7, 2005 plus accruedinterest, and for working capital.

 

Managementhas prepared operating plans which would indicate the Company has sufficientfinancial resources, based upon this financing, to sustain operations for atleast the next twelve months. These plans depend heavily on the successfulincrease in explosives detection product revenue.  Management has also developed plans whichprovide for cost cutting measures should projected revenues not be met.  Management believes that these cost cuttingmeasures will be sufficient to allow the Company to continue as a going concernshould revenue projections not be met.

 

The Company'sconsolidated financial statements have been presented on the basis that it is agoing concern, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business. The Company hassuffered recurring losses from operations and has a working capital and   stockholders' deficits as of June 30,2005.  The Company raised net proceedsaggregating approximately $8,326,000 during the year ended June 30, 2005 fromthe sale of common stock in connection with a private placement and theexercise of options and warrants.  Sincethe end of their fiscal year ended June 30, 2005, the Company has taken severalsteps to mitigate the risk of its inability to continue as a goingconcern.  In terms of improving its cashand working capital position, the Company i) raised an additional $5,000,000 onSeptember 30, 2005 through the issuance of a Series D Cumulative ConvertiblePreferred Stock (see Note 25) and ii) extended the termination date of its$1,500,000 line of credit with a bank from June 30, 2006 to December 31,2006.  Approximately $3,000,000 of theSeries D preferred stock was issued for the purpose of converting a previouslyissued $3,000,000 short term note into this Series D preferred stock.  The Series D preferred stock containsmandatory redemptions on a monthly basis beginning in January 2006.  These mandatory redemptions are redeemable incash or shares of the Company’s common stock, at the Company’s option so longas the price of the Company’s stock does not fall below 110% of the fixedconversion price.  There can be noassurances that forecasted results will be achieved or that the Company’s stockprice will remain at a level to allow the Company to redeem the outstandingshares of Series D preferred and accrued dividends with shares of its commonstock.  These matters raise substantialdoubt about the ability of the Company to operate as a going concern.

 

During the course offiscal 2005 the Company made significant investments in the growth of itssemiconductor business and in the development and commercialization of itsexplosives detection technology and equipment. The growth in the semiconductor business was realized through theacquisition of Core Systems Inc. in October 2004 and Accurel InternationalSystem Inc. in March 2005.  Managementbelieves that it has substantially completed its transition and integration effortsand can now focus on the organic growth of revenues and continue to worktowards improvements in the operational efficiencies of this businessunit.  Management believes that itsexplosives detection business unit has transgressed from a “developmentstage-like” operation over the past several years to an operating entity withestablished manufacturing, distribution and service capabilities.  Recently, the Company accepted an order forthe delivery of 123 units of its handheld explosives detection equipment to theChinese government having a manufacturers suggested retail price (“MSRP”) ofapproximately $3.7 million.  The Companyprovides its distributor a discount from the MSRP and will recognize thediscounted portion of the revenue from this order upon shipment, with periodicshipments expected to begin in October 2005. Through its direct and indirect distribution network, the Company hasquotes to several domestic and international government agencies and commercialcompanies and believes that a substantial backlog could be achieved.  Additionally, on August 31, 2005, the Companywas awarded a contract from the Transportation Security Administration in theapproximate amount of $2,200,000 to develop a “next-generation” passengerportal within a twelve (12) month period. This funding by the TSA will support their current explosives researchand development efforts.  The Company hasa history of being active in submitting proposals for government sponsoredgrants and contracts and successful in being awarded grants and contracts fromgovernment agencies.  Management willcontinue to pursue government grants and contracts to support its research anddevelopment efforts in the areas of semiconductor, medical device andexplosives and toxic substances detection.

 

Based on the currentsales, expense and cash flow projections, the Company believes that the currentlevel of cash and cash-equivalents on hand, and the net proceeds from thefinancings and government awards mentioned above would be sufficient to fundoperations until the Company achieves profitability.  However, because there can be no assurancesthat sales will materialize as forecasted, management will continue to closelymonitor and attempt to control costs at the Company and will continue toactively seek the needed capital through government grants and awards,strategic alliances, private financing sources, and through its lendinginstitutions.  The financial statementsdo not include any adjustments relating to the recoverability and classificationof asset amounts or the amounts and classification of liabilities that might benecessary should the Company be unable to continue as a going concern.

 

**2.****                                      Summary ofSignificant Accounting Policies**

 

*Principlesof Consolidation*

 

Theaccompanying consolidated financial statements include the accounts of theCompany and its wholly owned subsidiaries. All intercompany balances have been eliminated in consolidation*.*

 

*Reclassifications*

 

Certainamounts in the prior year’s financial statements have been reclassified toconform with the current year’s presentation.

 

*Use of Estimates*

 

Thepreparation of these financial statements in conformity with accountingprinciples generally accepted in the United States of America, requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting periods. Some of the more significant estimates include allowance for doubtfulaccounts, allowance for sales returns, inventory valuation, and warrantyreserves.  Management’s estimates arebased on the facts

 

34

----

 

and circumstancesavailable at the time estimates are made, past historical experience, risk ofloss, general economic conditions and trends and management’s assessments ofthe probable future outcome of these matters. Consequently, actual results could differ from such estimates.

 

*Cash,Cash Equivalents, and Investments*

 

The Company considers anysecurities with original maturities of 90 days or less at the time ofinvestment to be cash equivalents.

 

The Company accounts forinvestments in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”  Under SFAS No. 115, securities purchased inorder to be held for indefinite periods of time and not intended at the time ofpurchase to be held until maturity are classified as available-for-salesecurities.  At June 30, 2005, thesesecurities consisted of common stock in CardioTech, a related party (See Note9).  This common stock is recorded atfair market value with any unrealized gains and losses reported as a separatecomponent of equity in other accumulated comprehensive income (loss).

 

*ComprehensiveIncome (Loss)*

 

The Company hasaccumulated other comprehensive losses resulting from the unrealized losses onan investment in marketable securities of CardioTech International Inc. (Note9) and the recognition of the unrealized loss of the Company’s share ofCardioTech stock owned by CorNova (Note 6), which is recorded as a separatecomponent of equity in other accumulated comprehensive income (loss).

 

*FinancialInstruments*

 

The estimated fair valuesof the Company’s financial instruments, which at June 30, 2005 include cashequivalents, investments in available for sale securities, accounts receivable,accounts payable and long-term debt approximates their carrying values due totheir short-term nature or market variable rates of interest.

 

*Inventories*

 

Inventories consist ofraw materials, work-in-process and finished goods.  Work-in-process and finished goods includeslabor and overhead, and are stated at the lower of cost (first in, first out)or market.

 

*Property and Equipment and Capital Lease*

 

Equipmentand leasehold improvements are stated at cost. Equipment is depreciated using the straight-line method over theestimated useful lives of the assets, ranging from three to seven years.  Capitalized leases and leasehold improvementsare amortized based upon the lesser of the term of the lease or the useful lifeof the asset and such expense is included in depreciation expense.  Expenditures for repairs and maintenance arecharged to expense as incurred.

 
| ** **                                                 | ** ** | **Estimated Lives**                                                              | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| Machinery and equipment                                    |       | 5 - 7 years                                                                      |       |
| Computers and software                                     |       | 3 - 5 years                                                                      |       |
| Leasehold improvements and equipment under capital  leases |       | Lesser of the remaining life of the lease or the  useful life of the improvement |       |
| Furniture and fixtures                                     |       | 5 - 7 years                                                                      |       |
| Motor vehicles                                             |       | 7 years                                                                          |       |

 

*WarrantyCosts*

 

The Company accrueswarranty costs in the period the related revenue is recognized.  Warranty costs and related accruals for theyear ended June 30, 2005 were $60,000, all of which remain on the balance sheetas a reserve.  For the year ended June30, 2004 the warranty reserve was $2,000.

 

35

----

 

*Income Taxes*

 

The liability method isused to account for income taxes. Deferred tax assets and liabilities are determined based on differencesbetween the financial reporting and income tax bases of assets and liabilitiesas well as net operating loss and tax credit carry forwards and are measuredusing the enacted tax rates and laws that will be in effect when thedifferences reverse.  Deferred tax assetsmay be reduced by a valuation allowance to reflect the uncertainty associatedwith their ultimate realization.

* *

*Patent Costs*

 

As of June 30, 2005,there were 27 patents issued.  TheCompany expenses patent costs as incurred.

* *

*Impairmentof Long-Lived Assets*

 

In accordance with SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” theCompany reviews the carrying values of its long-lived assets for possibleimpairment whenever events or changes in circumstances indicate that thecarrying amounts of the assets may not be recoverable.

 

During the twelve monthperiod ended June 30, 2005 the Company wrote off equipment with a net bookvalue of $357,000 that was determined by management to have no further value tothe Company.  $342,000 of this charge wasreported as cost of revenues and $15,000 was reported as selling, general andadministrative expense.

 

*Goodwill and Intangible Assets*

 

At June 30, 2005, theCompany had goodwill and intangible assets of $14,270,000.  SFAS No. 142, “Goodwill and Other IntangibleAssets”, requires that goodwill and intangible assets with indefinite lives nolonger be amortized but instead be measured for impairment at least annually orwhenever events indicate that there may be an impairment. In order to determineif impairment exists, management continually compares the reporting unit’scarrying value to the reporting unit’s fair value. The Company has fourreporting units, medical, explosives detection, semiconductor wafer processingand semiconductor analytical services. All of the Company’s goodwill isallocated to the semiconductor wafer processing and the semiconductor analyticalservices reporting units.  Determiningthe reporting unit’s fair value requires management to make estimates based onmarket conditions and operational performance. Absent an event that indicates aspecific impairment may exist, management has selected August 31st as the dateof performing the annual goodwill impairment test and has concluded thegoodwill is not impaired. Future events could cause management to conclude thatimpairment indicators exist and that goodwill associated with the Company’sacquired businesses is impaired. Any resulting impairment loss could have amaterial adverse impact on the Company’s financial condition and results ofoperations.

 

Intangible assets withfinite lives consist of acquired customer base, technology and trademarks andare valued according to the future cash flows they are estimated to produce.These assigned values are amortized on a basis which matches the periods inwhich those cash flows are estimated to be produced. The Company continuallyevaluates whether events or circumstances have occurred that indicate that theestimated remaining useful life of its intangible assets may warrant revisionor that the carrying value of these assets may be impaired. To compute whetherintangible assets with finite lives been impaired, the estimated undiscountedfuture cash flows for the estimated remaining useful life of the assets arecompared to the carrying value. To the extent that the future cash flows areless than the carrying value, the assets are written down to the estimated fairvalue of the asset.

 

*Concentration of Credit Risk and Major Customers*

 

The Company grants creditto its customers, primarily large corporations in the medical device andsemiconductor industries and the U.S. government.  The Company performs periodic creditevaluations of customer financial conditions and generally does not requirecollateral.  Receivables are generallydue within thirty days.  Credit losseshave historically been minimal, which is consistent with management’sexpectations.  Reserves are provided forestimated amounts of accounts receivable which may not be collected.  Financial instruments that potentiallysubject the Company to concentration of credit risk consist of tradereceivables.

 

36

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TheCompany has three major customers with revenues in excess of 10% of theCompany’s total revenues for the year ended June 30, 2004 and two in 2005, thataccounted for the following annual revenue:

 
| ** ** | ** ** | **Years Ended June 30,** | ** ** |
|------------|------------|--------------------------|------------|
| ** ** | ** ** | **2005**                 | ** ** | **2004** | ** ** |
| ** ** | ** ** | **Revenues**             | ** ** | **% of Total  Revenue** | ** ** | **Revenues** | ** ** | **% of Total  Revenues** | ** ** |
|       |       |                     |       |   |   |   |   |   |   |
| Company A  |       | $                        | 2,020,000  |   | 16 | % | $ | 2,969,000 |   | 35 | % |
| Company B  |       | 1,586,000                |       | 13 | % | 1,585,000 |   | 19 | % |
| Company C  |       | —                   |       | — |   | 883,000 |   | 10 | % |
|            |            |                          |            |  |  |  |  |  |  |  |  |

 

At June 30, 2005 and 2004, these customers accountedfor the following amounts of accounts receivable:

 
| ** ** | ** ** | **June 30,**                 |
|------------|------------|------------------------------|
| ** ** | ** ** | **2005**                     | ** ** | **2004** | ** ** |
| ** ** | ** ** | **Accounts  Receivable (1)** | ** ** | **% of  Total A/R** | ** ** | **Accounts  Receivable (1)** | ** ** | **% of  Total A/R** | ** ** |
| Company A  |       | $                            | 843,000 |   | 26 | % | — |   | — |   |
| Company B  |       | 206,000                      |   | 6 | % | $ | 222,000 |   | 10 | % |
| Company C  |       | —                       |   | — |   | 1,534,000 |   | 72 | % |
|            |            |                              |  |  |  |  |  |  |  |  |  |

 

----

(1) Containsbilled and unbilled revenue

 

**Thefollowing table details the changes in the Company’s reserve for uncollectibleaccounts:**

 
| Reserve for  uncollectible accounts receivable as of June 30, 2004 |   | $       | 89,000  |   |
|--------------------------------------------------------------------|--------|---------|---------|--------|
| Additional reserves related to acquisitions                        |   | 24,000  |    |
| Additional accruals during the year ended June 30,  2005           |   | 54,000  |    |
| Charges against the reserve for the year ended June  30, 2005      |   | (20,000 | )       |
|                                                               |   |    |    |
| Reserve for uncollectible accounts receivable as of  June 30, 2005 |   | $       | 147,000 |   |

 

*EmployeeStock-Based Compensation*

 

The Company accounts forits employee stock-based compensation arrangements under the provisions ofAccounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issuedto Employees,” rather than the alternative fair value accounting methodprovided for under SFAS No. 123, “Accounting for Stock-Based Compensation.”  Under APB 25, when the exercise price ofoptions granted to employees and non-employee directors under these plansequals the market price of the underlying stock on the date of the grant, nocompensation expense is recorded.

 

The Company haselected to use the disclosure-only provisions of SFAS No. 123 and SFAS No. 148,“Accounting for Stock-Based Compensation-Transition and Disclosure.”  Had compensation expense for stock optiongrants to employees been determined based on the fair value method at the grantdates for awards under the stock option plans consistent with the methodprescribed by SFAS No. 123, the Company’s net loss would have increased to thepro forma amounts indicated as follows:

 

37

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| ** **                                                                                                                       | ** ** | **Years Ended June 30,** | ** **  |
|----------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|-------------|
| ** **                                                                                                                       | ** ** | **2005**                 | ** **  | **2004** | ** ** |
| Net loss applicable to common shareholders, as  reported                                                                         |       | $                        | (8,588,000  | ) | $ | (6,539,000 | ) |
| Add: Stock-based  employee compensation expense included in reported net loss applicable to  common shareholders, net of tax     |       | 279,000                  |        | 295,000 |   |
| Deduct: Total  stock-based employee compensation expense determined under the fair value  based method of all awards, net of tax |       | (1,901,000               | )           | (856,000 | ) |
|                                                                                                                             |       |                     |        |   |   |
| Pro forma net loss applicable to common shareholders                                                                             |       | $                        | (10,210,000 | ) | $ | (7,100,000 | ) |
|                                                                                                                             |       |                     |        |   |   |
| Net loss per  share applicable to common shareholders, basic and diluted:                                                        |       |                     |        |   |   |
| As reported                                                                                                                      |       | $                        | (0.91       | ) | $ | (0.89 | ) |
| Pro forma                                                                                                                        |       | $                        | (1.08       | ) | $ | (0.97 | ) |
|                                                                                                                             |       |                     |        |   |   |
| Weighted average  common shares outstanding, basic and diluted                                                                   |       | 9,412,548                |        | 7,317,677 |   |

 

The Company has computedthe pro forma disclosures for stock options granted to employees using theBlack-Scholes option pricing model prescribed by SFAS No. 123.  In addition, deferred compensation has beenrecorded relating to stock options issued below fair market value.  The assumptions used during each of the twoyears ended June 30, 2005 were as follows:

 
| ** **                                   | ** ** | **June 30,** | ** ** |
|----------------------------------------------|------------|--------------|------------|
| ** **                                   | ** ** | **2005**     | ** ** | **2004** | ** ** |
| Risk free interest rate                      |       | 4.10%-4.73%  |       | 2.87%-6.69% |   |
| Expected dividend yield                      |       | 0%           |       | 0% |   |
| Expected lives (years)                       |       | 5 - 10 years |       | 5 - 10 years |   |
| Expected volatility                          |       | 62% - 68%    |       | 47% - 68% |   |
| Weighted-average fair value of option grants |       | $5.91        |       | $6.75 |   |

 

In December 2003 and 2004,the Company issued stock options below fair market value. The compensationexpense related to these options is being amortized over the vesting periods ofthe options which averages 3 years. During the years ended June 30, 2005 and 2004, the Company recorded $279,000and $295,000 respectively in compensation expense related to this transaction.

 

*Revenue Recognition*

 

The Company recognizesrevenue when there is persuasive evidence of an arrangement with the customerwhich states a fixed or determinable price and terms, delivery of the producthas occurred or the service performed in accordance with the terms of the sale,and collectibility of the sale is reasonably assured.  The Company provides for estimated returns atthe time of shipment based on historical data.

 

Contract revenue undercost-sharing research and development agreements is recognized as eligibleresearch and development expenses are incurred. The Company’s obligation with respect to these agreements is to performthe research on a best-efforts basis. For contracts with a deliverable, revenue is recognized on a percentageof completion basis.

 

Deferred revenues arerecorded when the Company receives payments for product or services for whichit has not yet completed its obligation to deliver product or has not completedservices required by agreements.

 

38

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*Accounts Receivable*

 

Contract revenue undercost sharing research and development agreements is recognized as eligibleexpenses are incurred.  Invoicing ofresearch and development contracts occurs in accordance with the terms of thecontract.  Revenue recognized butunbilled is recorded as unbilled accounts receivable.  At June 30, 2005 and 2004 unbilled accountsreceivable represented approximately 9% and 67% of total accountsreceivable.  Generally, there are noprerequisites necessary to bill.

 

*Research and Development Costs*

 

All costs of research anddevelopment activities are expensed as incurred.  The Company performs research and developmentfor itself and under contracts with others, primarily the U.S. government.  In addition, periodically, the Company maycontinue its research on such projects at its own expense.  These costs are considered Company fundedresearch and development. Customer funded research and development areconsidered cost of revenues.

 

The Company funded andcustomer reimbursed research and development costs were as follows:

 
| ** **                     | ** ** | **Years ended June 30,** | ** ** |
|--------------------------------|------------|--------------------------|------------|
| ** **                     | ** ** | **2005**                 | ** ** | **2004** | ** ** |
|                           |       |                     |       |   |   |
| Company funded                 |       | $                        | 1,942,000  |   | $ | 1,631,000 |   |
| Customer funded                |       | 1,691,000                |       | 2,210,000 |   |
|                           |       |                     |       |   |   |
| Total research and development |       | $                        | 3,633,000  |   | $ | 3,841,000 |   |

 

*Earnings (Loss) per Share*

 

Basic earnings (loss) pershare is computed based only on the weighted average number of common sharesoutstanding during the period. Diluted earnings per share is computed by usingthe weighted average number of common shares outstanding during the period,plus the dilutive effects of shares issuable through the exercise of stockoptions (common stock equivalents) unless their inclusion would beantidilutive.  In calculating dilutedearnings per share, the dilutive effect of stock options and warrants iscomputed using the average market price for the period.  Basic and diluted net loss per shareavailable for common shareholders is the same for all periods presented asoutstanding common stock options and warrants have been excluded because theyare antidilutive.

 

The Company had thefollowing potential dilutive securities outstanding on June 30, 2005: optionsand warrants to purchase 1,908,331 and 2,324,389 shares, respectively, of theCompany’s common stock at weighted average exercise prices of $5.66 and $9.52per share, respectively. Such potential dilutive securities were not includedin the calculation of diluted loss per share in 2005 because the inclusionthereof would be antidilutive.

 

The Company had thefollowing potential dilutive securities outstanding on June 30, 2004: (i)options and warrants to purchase 1,162,065 and 1,876,803 shares, respectively,of the Company’s common stock at weighted average exercise prices of $5.55 and$9.72 per share, respectively, and (ii) Series C Preferred Stock convertibleinto an aggregate of 195,370 shares of the Company’s common stock.  Such potential dilutive securities were notincluded in the calculation of diluted loss per share in 2004 because theinclusion thereof would be antidilutive.

 

39

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*Recent Accounting Pronouncements*

 

In November 2004, the FASB issued, FASB Statement No. 151, “Inventory Costs-an Amendment of ARB No. 43, Chapter 4” (“FAS 151”). FAS 151 amends ARB 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges.  In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of the provision of FAS 151 is not expected to have a material impact on the Company’s financial position or results of operations.

 

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets,” which eliminates the exception of fair value measurement for nonmonetary exchanges of similar productive assets in existing accounting literature and replaces it with an exception for exchanges that do not have commercial substance. SFAS No. 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The provisions of SFAS No. 153 are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Adoption of this statement is not expected to have a material impact on the Company’s financial position or results of operations.

 

InDecember 2004, the FASB issued Statement No. 123-R, “Share-Based Payments.”SFAS 123-R is a revision of SFAS 123, “Accounting for Stock-Based Compensation.”The Company is required to adopt the provisions of SFAS 123-R as of thebeginning of its third fiscal quarter of 2006, beginning January 1, 2006.  This statement establishes standards for andrequires the recognition of the cost of employment-related services settled inshare-based payment.  The provisions ofthis statement are effective for all employee equity awards granted on or afterthe required effective date and to any unvested awards outstanding as of therequired effective date. Retrospective application is permitted. The Companyhas not yet assessed the impact of adopting this new standard.  The Company does expect the impact ofadopting this new standard to be of a material nature.

 

**3.****                                      Inventories**

 

Inventories consist ofthe following:

 
| ** **       | ** ** | **June 30,** | ** ** |
|------------------|------------|--------------|------------|
| ** **       | ** ** | **2005**     | ** ** | **2004** | ** ** |
| Raw materials    |       | $            | 548,000    |   | $ | 308,000 |   |
| Work-in-progress |       | 416,000      |       | 97,000 |   |
| Finished goods   |       | 240,000      |       | 76,000 |   |
|             |       | $            | 1,204,000  |   | $ | 481,000 |   |
|                  |            |              |            |  |  |  |  |  |

 

Thereserve for excess and obsolete inventory was $204,000 and $81,000 as of June30, 2005 and 2004, respectively.

 

**Thefollowing table summarizes changes in the reserve for obsolete inventory:**

 
| Reserve for  obsolete inventory as of June 30, 2004 |   | $       | 81,000  |   |
|-----------------------------------------------------|--------|---------|---------|--------|
| Additions to the reserve during the year            |   | 204,000 |    |
| Charges against the reserve                         |   | (81,000 | )       |
| Reserve for obsolete inventory as of June 30, 2005  |   | $       | 204,000 |   |
|                                                     |        |         |         |        |  |

 

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**4.****             Property and Equipment**

 

Property andequipment consists of the following**:**

 
| ** **                                      | ** ** | **June 30,** | ** ** |
|-------------------------------------------------|------------|--------------|------------|
| ** **                                      | ** ** | **2005**     | ** ** | **2004** | ** ** |
| Machinery and equipment                         |       | $            | 14,286,000 |   | $ | 7,269,000 |   |
| Computers and software                          |       | 648,000      |       | 452,000 |   |
| Leasehold improvements                          |       | 356,000      |       | 322,000 |   |
| Furniture and fixtures                          |       | 212,000      |       | 161,000 |   |
| Motor vehicles                                  |       | —       |       | 33,000 |   |
| Equipment under capital lease                   |       | 122,000      |       | 32,000 |   |
| Total Property and Equipment                    |       | 15,624,000   |       | 8,269,000 |   |
| Less: Accumulated depreciation and amortization |       | (5,190,000   | )          | (3,961,000 | ) |
|                                            |       |         |       |   |   |
|                                            |       | $            | 10,434,000 |   | $ | 4,308,000 |   |
|                                                 |            |              |            |  |  |  |  |  |

 

TheCompany recorded depreciation expense of approximately $1,580,000 and $866,000for the years ended June 30, 2005 and 2004, respectively.  Capitalized leases and leasehold improvementsare amortized based upon the lesser of the term of the lease or the useful lifeof the asset and such expense is included in depreciation expense.

 

**5.****             Accrued Expenses**

 

Accrued expenses consistof the following:  

 
| ** **                            | ** ** | **June 30,** | ** ** |
|---------------------------------------|------------|--------------|------------|
| ** **                            | ** ** | **2005**     | ** ** | **2004** | ** ** |
| Accrued costs related to acquisitions |       | $            | 794,000    |   | — |   |
| Accrued compensation and benefits     |       | 730,000      |       | $ | 397,000 |   |
| Other accrued liabilities             |       | 435,000      |       | 65,000 |   |
| Accrued legal and accounting          |       | 199,000      |       | 80,000 |   |
| Warranty reserve                      |       | 62,000       |       | — |   |
| Subcontractor costs                   |       | 170,000      |       | 118,000 |   |
| Accrued utilities                     |       | 55,000       |       | 17,000 |   |
| Accrued dividends                     |       | —       |       | 63,000 |   |
|                                  |       | $            | 2,445,000  |   | $ | 740,000 |   |

 

**6.****             Investment in Unconsolidated Subsidiaries**

 

InMarch 2004 the Company entered into an Exchange & Venture Agreement withCardioTech International, Inc. (“CardioTech”), a public company and relatedparty of the Company, and CorNova, Inc. (“CorNova”) (Note 9).  CorNova is a start-up company incorporated asa Delaware corporation on October 12, 2003. CorNova’s focus is the development and marketing of innovativeinterventional cardiology products.  TheCompany has determined that its technology may have applications in CorNova’sproducts. In connection with the agreement, in March 2004, the Company andCardioTech issued 10,344 and 12,931 shares, respectively, of their respectivecommon stock (the “Contributory Shares”) bearing an aggregate fair market valueof $113,000 and $76,000, respectively, as of the date of the issuance.  In exchange, the Company and CardioTech eachreceived 1,500,000 shares of CorNova’s common stock, which represented a 30%ownership position for each party.  InFebruary 2005, upon CorNova’s securing of an additional $3,000,000 in financing(“Series A”), CardioTech and the Company each issued additional shares of theircommon stock (the “Investment Shares”), which was equal in value to twenty-fivepercent (25%) of the gross proceeds of the Series A Financing, or$750,000.  The Company and CardioTechissued an additional

 

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76,687 and 308,642 sharesof their common stock, respectively.  Asof June 30, 2005, the Company’s shares represent a 19% ownership position inCorNova, and had a position on the Board of Directors.

 

Boththe Contributory Shares and the Investment Shares (collectively, the “Securities”)are restricted securities within the meaning of Rule 144 of the Securities andExchange Commission under the Securities Act of 1933, as amended (the “SecuritiesAct”) and none of the Securities may be sold except pursuant to an effectiveregistration statement under the Securities Act or under the securities laws ofany state, or in a transaction exempt from registration under the SecuritiesAct.

 

TheCompany is accounting for this investment under the equity method under APBOpinion No. 18, “The Equity Method of Accounting for Investments in CommonStock.”  As of June 30, 2005, 87,031shares have been issued to CorNova by the Company, 16,449 of which have beencategorized as treasury stock in the accompanying balance sheet.  These shares represent 19% of the sharesissued. The Company’s Chief Executive Officer is one of the directors ofCorNova. For the years ended June 30, 2005 and 2004, the Company recognizedapproximately $75,000 and $50,000, respectively, of equity losses inunconsolidated subsidiaries, representing the Company’s portion of CorNova’snet loss.  The Company also recordedapproximately $78,000 and $6,000 as an unrealized loss, which is included inaccumulated other comprehensive income for the years ended June 30, 2005 and2004, respectively, which relates to the Company’s portion of the decline invalue of the Securities issued to CorNova. CorNova’s unaudited results for the twelve month period ended June 30,2005 were:  revenues of $34,000, expensesof $646,000, income tax benefit of $240,000 and a net loss of $372,000. CorNova’sunaudited results for the 12-month period ending June 30, 2004 were: revenuesof $0 and expenses of $45,000.

 

CorNovais developing a series of coronary stents used in angioplasty procedures. The ultimate goal is to market and sell a new drug eluting stent based onproprietary technology provided by the Company and CardioTech. All stents areprimarily to be distributed in the non-US markets.  The first part of theplan is to market a new Cobalt-Chrome stent which has been developed and isscheduled to be released early in calendar 2006.  The drug eluting versionwhich is based upon the Cobalt-Chrome base is scheduled for release in 2007.

 

**7.****             Researchand Development Arrangements**

 

The Company is therecipient of several grants under the U.S. Government’s Small BusinessInnovative Research (SBIR) Program. These grants from the National Institute of Health are firm-fixed pricedcontracts and generally range in length from six to twenty-four months.  Contracts received from the Department ofDefense are both firm-fixed price and cost-plus type programs and also rangefrom six to twenty-four months.  Revenuesunder such arrangements were approximately $2,022,000 and $2,969,000 for theyears ended June 30, 2005 and 2004, respectively.  Revenues earned under these contracts arerecognized in the appropriate business segment. Unbilled accounts receivable relating to such arrangements wasapproximately $298,000 and $1,434,000 at June 30, 2005 and 2004, respectively.

 

**8.****             Cooperative Research and DevelopmentAgreement**

 

In August 2002, theCompany executed a Cooperative Research and Development Agreement with anagency of the Department of Homeland Security (TSA) for its trace explosivesdetection prototypes.  Under the agreement,the Company will submit these prototypes for testing and evaluation.  In addition, the TSA will supply the Companywith test protocols and current and anticipated performance criteria needed forcommercial approval and as a mechanism for future funding from the TSA.  The Company is accounting for the revenuesrelated to this agreement under the percentage of completion method ofaccounting and has recognized approximately $154,000 and $846,000 during theyears ended June 30, 2005 and 2004, respectively.  At June 30, 2005, the contract was complete.

 

**9.****             Related Party Transactions**

 

SFAS No. 57, “RelatedParty Disclosures,” specifies the nature of information that should bedisclosed in financial statements regarding related party transactions.  CardioTech, a publicly traded company whose

 

42

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common stock trades under the symbol CTE on theAmerican Stock Exchange, is a related party with the Company by virtue of itssignificant business relationships.

 

Certain directors of theCompany hold positions as directors of CardioTech.  The CEO and Chairman of the Board ofDirectors of the Company is also a director of CardioTech.  The CEO and Chairman of the Board ofDirectors of CardioTech is also a director of the Company.

 

InMarch 2000, the Company entered into a joint research agreement with CardioTechto develop a proprietary porous polymer biocompatible coating technology as aplatform for the Company’s proprietary radioactive brachytherapytechnology.  In consideration for thisagreement, the Company agreed to pay $150,000 in cash and purchase 100,000shares of CardioTech stock at a price of $1.00 per share.  As of June 30, 2005, the Company haspurchased these shares, the fair market value of which is $204,000 and isrecorded as investments in available for sale securities in the accompanyingconsolidated balance sheet.  Theunrealized holding gains and losses are recorded as accumulated othercomprehensive income (loss) within stockholders’ equity.

 

In March 2004 the Companyentered into an Exchange & Venture Agreement with CardioTech and CorNova(Note 6).  The Company’s CEO and the Company’sChairman of the Nominating Committee are also on the Board of Directors ofCorNova.

 

**10.****          Commitments and Contingencies**

 

(a)          Capital and OperatingLeases

 

TheCompany has an operating lease for its manufacturing, research and office spacein Wakefield, MA which expires on December 31, 2008.  The Company has an option to extend the leasefor five additional years.  Under the termsof the lease, the Company is responsible for its proportionate share of realestate taxes and operating expenses relating to this facility.  The Company also has leases for both of itsfacilities in Sunnyvale, CA.  The leasesexpire in December 2009 and September 2010. The Company has an option to extend each lease for five additionalyears. Under the terms of the leases, the Company is responsible for itsproportionate share of real estate taxes and operating expenses relating tothese facilities. Total rental expense, including maintenance and real estatetax expenses, for the fiscal years ended June 30, 2005 and 2004 was $1,352,000and $644,000, respectively.

 

Inconjunction with the acquisition of Accurel, the Company recorded a leaseliability of $829,000. This liability reflects managements estimate of theexcess of payments required under the Accurel facility lease, at the date ofacquisition, versus the fair market value of lease payments that would havebeen required, if the lease had been negotiated under current marketconditions. The balance of the lease liability on June 30, 2005 is $803,000, ofwhich $102,000 is current

 

Includedin property and equipment at June 30, 2005 is equipment recorded under acapital lease with a net book value of $55,000. Amortization of assets under capital lease obligations is included indepreciation expense.

 

Futureminimum rental payments required under capital leases and operating leases withnon-cancelable terms in excess of one year at June 30, 2005, together with thepresent value of net minimum lease payments are as follows:

 

43

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| ** **                  | ** ** | **Capital Lease** | ** ** | **Operating Lease** | ** ** |
|-----------------------------|------------|-------------------|------------|---------------------|------------|
|                        |       |              |       |                |       |
| Year ending June 30:        |       |              |       |                |       |
| 2006                        |       | $                 | 52,000     |                | $          | 1,620,000 |   |
| 2007                        |       | 37,000            |       | 1,673,000           |       |
| 2008                        |       | 28,000            |       | 1,713,000           |       |
| 2009                        |       | 14,000            |       | 1,454,000           |       |
| 2010                        |       | 1,000             |       | 838,000             |       |
| Net minimum  lease payments |       | 132,000           |       | $                   | 7,298,000  |   |
|                        |       |              |       |                |       |
| Less: current portion       |       | 52,000            |       |                |       |
| Long term portion           |       | $                 | 80,000     |                |       |   |

 

(b)   Employment Agreements

 

On June 30, 2004, the Company entered into an employment agreement withDr. Anthony J. Armini, the Company’s President and CEO, with an initial term ofthree years and an automatic renewal for a successive period of three years,unless the Company or Dr. Armini give the other party not less than threemonths written notice of non-renewal. Under this employment agreement, Dr. Armini serves as the Company’spresident and chief executive officer at a base salary of up to $210,000.  In addition, Dr. Armini may participate inthe Company’s employee fringe benefit plans or programs generally available toemployees of comparable status and position. The Company is entitled to terminate his employment for any materialbreach of his employment agreement at any time upon at least 30 days’ writtennotice.  In the event the Companyterminates Dr. Armini’s employment without cause, the Company will pay him 12months salary.  Under his employmentagreement, he is subject to restrictive covenants, including confidentialityprovisions.  Also, during his employmentand for a period of two years after the term of the employment agreement, Dr.Armini is subject to a non-competition provision.

 

On June 30, 2004, the Company entered into an employment agreement withDr. Stephen Bunker, the Company’s Vice President and Chief Scientist, with aninitial term of three years and an automatic renewal for a successive period ofthree years, unless the Company or Dr. Bunker give the other party not lessthan three months written notice of non-renewal.  Under this employment agreement, Dr. Bunkerserves as the Company’s vice president and chief executive scientist at a basesalary of up to $150,000.  In addition,Dr. Bunker may participate in the Company’s employee fringe benefit plans orprograms generally available to employees of comparable status andposition.  The Company is entitled toterminate his employment for any material breach of his employment agreement atany time upon at least 30 days’ written notice. In the event the Company terminates Dr. Bunker’s employment withoutcause, the Company will pay him 12 months salary.  Under his employment agreement, he is subjectto restrictive covenants, including confidentiality provisions.  Also, during his employment and for a periodof two years after the term of the employment agreement, Dr. Bunker is subjectto a non-competition provision.

 

On October 15,2004, the Company entered into an employment agreement Walter J. Wriggins, theCompany’s Vice President and General Manager of Core Systems, with an initialterm of one year and an automatic renewal for a successive period of one year,unless the Company or Mr. Wriggins give the other party not less than thirtydays written notice of non-renewal. Under this employment agreement, Mr. Wriggins serves as the Company’s Vice President of BusinessDevelopment/Operations and general manager of Core Systemsat a base salary of $140,000.  Inaddition, Mr. Wriggins may participate in the Company’s employee fringe benefitplans or programs generally available to employees of comparable status andposition.  The Company is entitled toterminate his employment for any material breach of his employment agreement atany time upon at least 30 days’ written notice. In the event the Company terminates Mr. Wriggins’ employment withoutcause, the Company will pay him the balance of the salary due for the term ofthe agreement.  Under his employmentagreement, he is subject to restrictive covenants, including confidentialityprovisions.  Also, during his employmentand for a period of two years after the term of the employment agreement, Mr.Wriggins is subject to a non-competition provision

 

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(c)   Litigation

 

From time to time, theCompany is subject to various claims, legal proceedings and investigationscovering a wide range of matters that arise in the ordinary course of itsbusiness activities.  Each of thesematters is subject to various uncertainties. On the basis of information presently available, the Company is notcurrently aware of any legal proceedings or claims that the Company believesare likely to have a material effect on the Company’s financial position orresults of operations.

 

(d)   Salestax contingency

 

Accurel has undergone aCalifornia sales tax audit for the period of October 2001 to September 2004.  This period of time is prior to the Company’sacquisition of Accurel.  The Companybelieves that any claims as a result of this audit, estimated to beapproximately $275,000, are the responsibility of third parties or will besatisfied from $500,000 of acquisition funds withheld from the previous ownersof Accurel to satisfy undisclosed liabilities. Upon resolution of this contingency, any amounts not paid for by others,if any, would be allocated by the Company as part of the Accurel purchaseprice.

 

**11.****          Income Taxes**

 

A reconciliation of the federal statutory rate to the Company’seffective tax rate for the years ended June 30, 2005 and 2004 are as follows:

 
| ** **                                                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Income tax provision (benefit) at federal statutory  rate                              |       | (34.0    | )%         | (34.0    | )%         |
| Increase  (decrease) in tax resulting from State tax provision, net of federal benefit |       | (8.5     | )%         | (8.0     | )%         |
| Non-deductible  expenses                                                               |       | 1.9      | %          | (3.6     | )%         |
| Credits and  other, net                                                                |       | (—  | )%         | (.3      | )%         |
| Change in  valuation allowance                                                         |       | 40.6     | %          | 45.9     | %          |
| Effective income tax rate                                                              |       | —   | %          | —   | %          |

 

Significant components ofthe Company’s net deferred tax asset are as follows:

 
| *** ***                                     | ** ** | **June 30,** | ** ** |
|--------------------------------------------------|------------|--------------|------------|
| ** **                                       | ** ** | **2005**     | ** ** | **2004** | ** ** |
| ***Deferred Tax Components***                    |       |         |       |   |   |
| Deferred tax assets:                             |       |         |       |   |   |
| Net operating  loss and tax credit carryforwards |       | $            | 9,774,000  |   | $ | 6,181,000 |   |
| Accrued expenses                                 |       | 589,000      |       | 134,000 |   |
| Book over tax  patent costs                      |       | —       |       | 71,000 |   |
| Stock-based  compensation                        |       | 4,000        |       | 545,000 |   |
| Depreciation                                     |       | —       |       | (590,000 | ) |
| Equity  investments                              |       | —       |       | 18,000 |   |
| Total deferred tax assets                        |       | 10,367,000   |       | 6,359,000 |   |
|                                             |       |         |       |   |   |
| Deferred tax liabilities:                        |       |         |       |   |   |
| Tax over  financial statement depreciation       |       | 2,787,000    |       | — |   |
| Tax over  financial statement amortization       |       | 466,000      |       | — |   |
| Investment in  affiliates                        |       | 224,000      |       | — |   |
| Total deferred tax liabilities                   |       | 3,477,000    |       | — |   |
|                                             |       |         |       |   |   |
| Net deferred tax  assets                         |       | 6,890,000    |       | 6,359,000 |   |
| Valuation  allowance                             |       | (6,890,000   | )          | (6,359,000 | ) |
| Net deferred tax asset                           |       | $            | —     |   | $ | — |   |

 

45

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Avaluation allowance has been established for the Company’s tax assets as theiruse is dependent on the generation of sufficient future taxable income, whichcannot be predicted at this time. Included in the valuation allowance is approximately $1,384,000 relatedto certain operating loss carryforwards resulting from the exercise of employeestock options, the tax benefit of which, when recognized, will be accounted foras a credit to additional paid in capital rather than a reduction in incometax.

 

AtJune 30, 2005, the Company has the following unused net operating loss and taxcredit carryforwards available to offset federal and state taxable income, bothof which expire at various times through 2025.

 
| ** ** | ** ** | **Net Operating  Loss** | ** ** | **Investment Amt  and R&D Credits** | ** ** | **Expiration Dates** | ** ** |
|------------|------------|-------------------------|------------|-----------------------------------------|------------|----------------------|------------|
|       |       |                    |       |                                    |       |                 |       |
| Federal    |       | $                       | 23,065,000 |                                    | $          | 276,000              |       | 2019 to 2025 |   |
|       |       |                    |       |                                    |       |                 |       |
| State      |       | $                       | 23,771,000 |                                    | $          | 303,000              |       | 2006 to 2010 |   |

 

The Company’s federal netoperating loss carryforwards are subject to review and possible adjustment bythe Internal Revenue Service and are subject to certain limitations in theevent of cumulative changes in the ownership interest of significantstockholders over a three-year period in excess of 50%.

 

**12.****          ConvertiblePreferred Stock**

 

OnNovember 25, 2003, the Company issued 250,000 shares of Series C 5%Cumulative Convertible Preferred Stock (“Series C”) having a stated value of$10 per share, pursuant to a Securities Purchase Agreement executed on November25, 2003 with the Laurus Master Fund, Ltd. (Laurus). The Company received$2,500,000 in gross proceeds, less a management and placement agent fee ofapproximately $125,000, and related transaction costs of approximately$86,000.  The terms of the Series Cprovide for repayment with shares of the Company’s common stock or in cash,pursuant to an amortization schedule. Repayment of the Series C commenced on March 31, 2004.  The Company had the sole option to determinewhether to satisfy payment of the monthly amount in full on each repayment dateeither in cash or in shares of common stock, or a combination of both, unlessthe closing price of the Company’s common stock for any of the eleven tradingdays preceding a repayment date was less than $7.35, wherein the Company wasrequired to pay such monthly amount in cash. If the payment of the monthly amount is made in common stock, the fixedconversion price is $6.75.  The Companyalso issued to Laurus a warrant to purchase 50,000 shares of common stock at$8.44 per share and 50,000 shares of common stock at $10.13 per share.  The Securities Purchase Agreement alsoprovided for a security interest in substantially all of the Company’s assetsand provided Laurus a right of first refusal on future financing arrangementsduring the Term of the agreement.  In theevent Laurus declines to exercise its right of first refusal, it agreed toenter into such documentation as shall be reasonable requested by the Companyin order to subordinate its rights under the Series C to the subsequentfinancier.  The Company utilized theproceeds of this financing to purchase an ion implanter and for general workingcapital purposes.

 

In accordance with theprovisions of Emerging Issues Task Force (EITF) Issue 00-27, “Application ofEITF Issue No. 98-5 ‘Accounting for Convertible Securities with BeneficialConversion Features of Contingently Adjustable Conversion Ratios’, to CertainConvertible Securities”, which became effective in November 2000, the allocatedvalue of the Series C contained a beneficial conversion feature calculated

 

46

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based on the difference between the effectiveconversion price of the proceeds allocated to the Series C and the fair marketvalue of the common stock at the date of issuance.  The discount arising from the beneficialconversion feature aggregated $700,000. The discount was being amortized and recorded as a preferred dividendduring the period from the issuance of the preferred stock to March 7, 2005 theactual conversion date, using the effective interest method.

 

The Company valued the SeriesC at issuance to be $1,284,000 based on the relative fair market values of thefinancial instruments issued in connection with this placement, net of offeringcosts and the beneficial conversion feature. The amounts recorded in the financial statements represent the amountsattributed to the sale of the preferred stock, net cash proceeds of $2,289,000($211,000 of issuance costs incurred), the amount allocated to warrants of$305,000, and the amount of the discount related to the value of beneficial conversionfeature of $700,000.  The Companyaccreted these discounts on the carrying value of the preferred stock to itsredemption value of $2,500,000 at the actual conversion date.  The accretion of these amounts was recordedas a preferred dividend in the period of accretion. As of June 30, 2005, allamounts were fully amortized and the principal balance of the Series C has beenfully converted.

 

During the years endedJune 30, 2005 and 2004, Laurus redeemed 131,875 and 118,125 shares of Series Cinto 208,289 and 175,000 shares, respectively, of common stock at a conversionprice of $6.75 per share and redeemed approximately $87,000 and $125,000 ofaccrued dividends into 12,919 shares of common stock.  The conversion of accrued dividends intocommon stock resulted in additional dividends of approximately $33,000, inexcess of its 5% stated value.  AllSeries C shares and related accrued dividends had been converted into 383,289shares of common stock.

 

**13.****          Stockholders’Equity**

 

(a)   IPOUnits

 

InJune 1999, the Company issued 1,138,000 Units, consisting of one share ofcommon stock and one redeemable common stock purchase warrant (the “IPOWarrants”), in connection with its initial public offering.  Each Unit carries the right to purchase oneshare of common stock at $9.00, and is redeemable by the Company at $0.20 perwarrant if the closing bid price of the common stock averages in excess of$10.50 for a period of 20 consecutive trading days.  On April 15, 2003, the Company extended theexpiration date of the IPO Warrants from June 30, 2003 to June 30, 2005.  The Company did not receive any considerationfrom the holders of the warrants; accordingly, the Company recognized the valueof this transaction as a preferred distribution based upon the estimated fairvalue of the extension of approximately $195,000.  On March 14, 2005, the Company again extendedthe expiration date of the IPO Warrants from June 30, 2005 to March 31,2006.  The Company did not receive anyconsideration from the holders of the warrants; accordingly, the Companyrecognized the value of this transaction as a preferred distribution based uponthe estimated fair value of the extension of approximately $479,000.  As of June 30, 2005, 1,064,700 IPO Warrantsremain outstanding.

 

(b)   OptionActivity

 

InSeptember 1998, the Company adopted the 1998 Stock Option Plan (the “1998 Plan”).  The 1998 Plan provides for the grant ofincentive stock options and nonqualified stock options to employees andaffiliates.  The exercise price of theoptions equals 100% or 110% of the fair market value on the date of thegrant.  Options expire ten years from thedate of the option grant and vest ratably over a three-year period commencingwith the second year.  A total of 280,000options were reserved for issuance under the 1998 Plan.  Upon adoption of the 1998 Plan, the 1992Stock Option Plan was terminated.  InDecember 2000, the Company adopted the 2000 Incentive and Non Qualified StockOption Plan (the “2000 Plan”).  The 2000Plan provides for the grant of incentive stock options and nonqualified stockoptions to employees and affiliates.  Theexercise price of the options equal 100% of the fair market value on the dateof the grant or 110% of the fair market value for greater than 5% beneficialowners of the Company stock.  Optionsexpire between five and ten years from the date of the option grant and havevariable vesting periods.  A total of1,000,000 options were reserved for issuance under the 2000 Plan. As of June30, 2004 a total of 8,503 and

 

47

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0 stock options wereavailable for issuance under the 1998 and 2000 stock options Plans,respectively.  As of June 30, 2004, theCompany’s Board of Directors approved the issuance of 500,000 options toemployees under the 2000 Plan.  Duringthe year ended June 30, 2004, 38,800 options were granted by the Company priorto shareholder approval.  These grantswere subject to shareholder approval. Shareholder approval fixes the measurement date at which time theCompany may record deferred compensation related to the difference between thefair market value of the options upon approval and the exercise price of theoptions.  These amounts, if any, will beexpensed over the related vesting period.

 

InDecember 2003, the stockholders of the Company approved an increase in the 2000Incentive and Non-Qualified Stock Option Plan from 600,000 shares to 1,000,000shares. Prior to approval of this increase, the Company granted options toemployees, subject to shareholder approval. The Company recorded approximately$739,000 of deferred compensation expense relating to these stock options,which represents the difference between the exercise price of the options andthe fair market value of the stock on the date of shareholder approval.  This deferred compensation is being amortizedas compensation expense over the related vesting period, $237,000 and 295,000of which was recorded as non-cash compensation during the years ended June 30,2005 and 2004, respectively.

 

InDecember 2004, the stockholders of the Company approved an increase in the 2000Incentive and Non-Qualified Stock Option Plan from 1,000,000 shares to1,500,000 shares.  Prior to the approvalof this increase, the Company granted options to employees, subject to shareholderapproval.  The Company recordedapproximately $144,000 of deferred compensation expense relating to these stockoptions, which represents the difference between the exercise price of theoptions and the fair market value of the stock on the date of shareholderapproval. This deferred compensation is being amortized as compensation expenseover the related vesting period, $42,000 and $295,000 of which was recorded asnon-cash compensation during the years ended June 30, 2005 and 2004,respectively.

 

In December2004, the Company adopted the 2004 Stock Option Plan.  The 2004 Plan provides for the grant ofincentive stock options and nonqualified stock options to employees andaffiliates.  The exercise price of theoptions equa1 100% of the fair market value on the date of the grant or 110% ofthe fair market value for greater than 10% beneficial owners of the Companystock.  Options expire between five andten years from the date of the option grant and have variable vestingperiods.  As of June 30, 2005, a total of11,503, 64,000 and 43,574 shares are available for issuance under the 1998,2000 and 2004 stock option plans, respectively.

 

InSeptember 1998, the Company adopted the 1998 Employee Stock Purchase Plan (the “Plan”).  The Plan provides a method whereby employeesof the Company will have an opportunity to acquire an ownership interest in theCompany through the purchase of shares of common stock of the Company throughpayroll deductions.  After 12 months of employment,an employee is eligible to participate and can defer up to 10% of their wagesinto this Plan, with a maximum of $25,000 in any calendar year.  The purchase price of the common stock iscalculated at the lower of 85% of the closing price of the stock on the firstday of the plan period or the last day of the plan period.  The periods are January 1 to June 30 and July1 to December 31.  Fractional shares arenot issued.  Participants may withdraw atany time by giving written notice to the Company and will be credited theamounts of deferrals in their account. The maximum number of shares eligible to be issued under the Plan is141,000.  As of June 30, 2005, a total of119,681 shares are available for issuance under the Plan.

 

Thefollowing table presents the activity of the 1992, 1998, 2000 and 2004 StockOption Plans for the years ended June 30, 2005, and 2004:

 

48

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| ** **                                                      | ** ** | **2005**   | ** ** | **2004**                                | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|
| ** **                                                      | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Outstanding  at beginning of period                             |       | 1,162,065  |       | $                                       | 5.55       |   | 953,500 |   | $ | 5.55 |   |
|                                                            |       |       |       |                                    |       |   |   |   |   |
| Granted                                                         |       | 973,726    |       | 5.91                                    |       | 352,200 |   | 6.75 |   |
| Exercised                                                       |       | (153,160   | )          | 5.69                                    |       | (138,635 | ) | 3.77 |   |
| Canceled                                                        |       | (74,300    | )          | 8.74                                    |       | (5,000 | ) | 7.74 |   |
|                                                            |       |       |       |                                    |       |   |   |   |   |
| Outstanding  at end of period                                   |       | 1,908,331  |       | $                                       | 5.66       |   | 1,162,065 |   | $ | 5.55 |   |
|                                                            |       |       |       |                                    |       |   |   |   |   |
| Options  exercisable at end of period                           |       | 1,016,362  |       | $                                       | 4.51       |   | 665,560 |   | $ | 4.90 |   |
|                                                            |       |       |       |                                    |       |   |   |   |   |
| Weighted-average  fair value of options granted during the year |       |       |       | $                                       | 5.91       |   |   |   | $ | 6.75 |   |

 

Thefollowing table presents weighted average price and life information aboutsignificant options groups outstanding at June 30, 2005:

 
| ** **                    | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                                        | ** ** |
|-------------------------------|------------|-------------------------|------------|----------------------------------------------------------------|------------|
| **Range  of Exercise Prices** | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Remaining  Contractual Life  (in years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.00 - 2.31                  |       | 299,391                 |       | 2.29                                                           |       | $ | 0.70 |   | 299,391 |   | $ | 0.70 |   |
| $3.07 - $5.25                 |       | 596,740                 |       | 7.32                                                           |       | 4.03 |   | 372,671 |   | 4.10 |   |
| $6.00 - $7.89                 |       | 473,200                 |       | 8.35                                                           |       | 6.50 |   | 130,100 |   | 6.82 |   |
| $8.00 - $9.97                 |       | 407,000                 |       | 6.05                                                           |       | 9.17 |   | 160,400 |   | 8.65 |   |
| $10.00 - $14.00               |       | 132,000                 |       | 8.61                                                           |       | 10.50 |   | 53,800 |   | 10.53 |   |
| ** **                    | ** ** | **1,908,331**           | ** ** | **6.61**                                                       | ** ** | **$** | **5.66** | ** ** | **1,016,362** | ** ** | **$** | **4.51** | ** ** |

 

(c)  Warrants

 

Duringthe year ended June 30, 2004, the Company issued a warrant to an investorrelations company to purchase 250,000 shares of common stock at an exerciseprice of $14.00, in exchange for services. This warrant was fully vested and expired on June 30, 2004.  The fair value of this warrant wasapproximately $230,000 and was recorded as compensation expense in theaccompanying statement of operations for the year ended June 30,2004.  In June 2004, the Companyissued this investor relations company another warrant to purchase 150,000shares of the common stock at an exercise price of $14.00, in exchange forcontinued services. These warrants were fully vested upon issuance and expire 3years from the date of grant. The fair market value of these warrants wasapproximately $638,000 and was recorded as compensation expense in theaccompanying statement of operations during the year ended June 30, 2004.

 

Duringthe year ended June 30, 2004, the Company issued other warrants to variousadvisors and individuals in exchange for services to purchase a total of 10,000shares of common stock at exercise prices ranging from $9.95 to $10.25. Thefair value of these warrants was approximately $58,000 and was recorded ascompensation expense in the accompanying statement of operations during theyear ended June 30, 2004.

 

49

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In October 2004,the Company issued 200,000 common stock warrants, at an exercise price of$9.75, to a consultant in connection with the Core acquisition.  The warrants were fully vested upon issuanceand expire 5 years from the date of grant. The Company recorded the fair valueof these warrants, of approximately $1,122,000, as additional costs associatedwith the Core acquisition and included this value in the total purchase priceof the acquisition.

 

In March 2005,in connection with a private placement (Note 17), the Company issued warrantsto the investors to purchase 270,195 shares of common stock, and warrants toplacement agents to purchase 43,231 shares of common stock, at an exerciseprice of $9.35, which are exercisable anytime between September 4, 2005and September 4, 2010.

 

Duringthe year ended June 30, 2005, the Company issued other warrants to variousadvisors and individuals in exchange for services, to purchase a total of46,000 shares of common stock at exercise prices ranging from $3.68 to $11.89and vesting periods of 1 to 3 years.  TheCompany recorded the fair value of these warrants of approximately $228,000,ofwhich approximately $99,000 was recorded as stock based compensation expenseand approximately $140,000 of this was recorded as deferred compensation forcertain warrants with 3-year vesting terms, and will be expensed over thevesting period.

 

TheCompany estimated the fair value of the warrants issued during 2004 and 2005using the Black-Scholes option-pricing model. The Company estimated the fairvalue of the warrants using the following input assumptions:

 
| ** **              | ** ** | **2005**              | ** ** | **2004**            | ** ** |
|-------------------------|------------|-----------------------|------------|---------------------|------------|
| Volatility              |       | 62.0% - 65.0%         |       | 63.0% - 67.5%       |       |
| Dividend yield          |       | 0%                    |       | 0%                  |       |
| Risk-free interest rate |       | 3.47% - 4.17%         |       | .94% - 4.50%        |       |
| Expected lives          |       | 1 year – 5 years |       | 3 months - 5  years |       |

 

Thefollowing table presents the weighted average exercise price of warrantsoutstanding at June 30, 2005:

 

WarrantsOutstanding and Exercisable

 

| **Range  of Exercise  Prices** | ** ** | **Number of  Warrant Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|--------------------------------|------------|-------------------------------|------------|--------------------------------------|------------|
|                           |       |                          |       |                                 |       |
| $3.20 - $6.88                  |       | 160,500                       |       | $                                    | 4.99       |   |
|                           |       |                          |       |                                 |       |
| $8.25 - $9.95                  |       | 1,683,126                     |       | $                                    | 8.96       |   |
|                           |       |                          |       |                                 |       |
| $10.13 - $14.43                |       | 480,763                       |       | $                                    | 13.00      |   |
|                           |       |                          |       |                                 |       |
| Total                          |       | 2,324,389                     |       | $                                    | 9.52       |   |

 

Thefollowing table presents the warrant activity for the years ended June 30,2005 and 2004:

 

50

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| ** **                                                       | ** ** | **2005**   | ** ** | **2004**                              | ** ** |
|------------------------------------------------------------------|------------|------------|------------|---------------------------------------|------------|
| ** **                                                       | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Outstanding  at beginning of period                              |       | 1,876,803  |       | $                                     | 9.72       |   | 1,651,775 |   | $ | 8.80 |   |
|                                                             |       |       |       |                                  |       |   |   |   |   |
| Granted                                                          |       | 559,426    |       | 9.01                                  |       | 723,088 |   | 12.65 |   |
| Exercised                                                        |       | 42,810     |       | 3.28                                  |       | 186,120 |   | 6.06 |   |
| Canceled                                                         |       | 69,030     |       | 14.40                                 |       | 311,940 |   | 13.84 |   |
| Warrants  Outstanding at end of period                           |       | 2,324,389  |       | $                                     | 9.53       |   | 1,876,803 |   | $ | 9.72 |   |
|                                                             |       |       |       |                                  |       |   |   |   |   |
| Warrants  exercisable at end of period                           |       | 2,293,389  |       | $                                     | 9.01       |   | 1,876,803 |   | $ | 12.65 |   |
|                                                             |       |       |       |                                  |       |   |   |   |   |
| Weighted-average  fair value of warrants granted during the year |       |       |       | $                                     | 9.01       |   |   |   | $ | 12.65 |   |

 

**14.****                               401k Plan**

 

TheCompany has a defined contribution retirement plan which contains a 401(k)plan.  The Company maintains separateplans for each of its employee groups in Massachusetts and Sunnyvale,California.  Although all of the plansare 401(k), plan eligibility requirements vary from location to location.  All employees who meet the age requirement,either 18 or 21, and who have completed the minimum service requirement areeligible for participation in the plan. The Company may make discretionary contributions to the 401(k)plan.  During the years ended June 30,2005 and 2004, the Company made no contributions to the plan.

 

**15.****                               Long-term Debt**

 

*MED-TEC Payment Obligation*

 

On July 31,2003, the Company entered into an agreement with its former exclusivedistributor of prostate seeds, to release each other from further obligationsunder the original Distributor Agreement.  The new agreement conveys tothe Company direct marketing and sales capabilities to sell its I-Plant Seedbrachytherapy seeds for use in the treatment of prostate cancer.  Inconnection with this, the Company’s former exclusive distributor agreed to workcooperatively to transition customers and marketing materials directly to theCompany.  The distributor also agreed not to compete with the Company fora period of three years.  The agreement requires the Company to pay thedistributor an average of approximately $39,000 per month over the 28 months, beginningSeptember 1, 2003.  The present value of this payment obligation wasrecorded as approximately $1,007,000, using a rate of 10.24%.  This amount was recorded as an intangibleasset and is being amortized over its estimated useful life of 29 months. During the years ended June 30, 2005 and 2004, approximately $417,000 and$383,000, respectively, of amortization expense was recognized, which isincluded in selling, general and administrative expenses in the accompanyingconsolidated statements of operations. As of June 30, 2005, the outstanding principal balance isapproximately $348,000, which becomes due during the year ended June 30,2006.  For the years ended June 30, 2005 and 2004, the Companyrecorded approximately $46,000 and $68,000, respectively, of interest expenserelating to this transaction.

 

*Installment Note*

 

AccurelSystems has a $1,400,000 fixed rate installment note with a bank. The notecalls for monthly payments of $29,000 plus interest at a rate of 6.84%, throughSeptember 1, 2008.  As of June 30,2005 the note balance is $1,167,000, of which approximately $350,000 becomesdue during the year ending June 20, 2006.

 

51

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The note is secured bysubstantially all assets of Accurel.  Thebank has consented to continue the note under the same terms after theacquisition.  During the year ended June 30,2005, the Company recorded interest expense of approximately $25,000 inconnection with this note

 

TheLoan Agreement requires Accurel to report monthly financial results to the bankand for Accurel to comply with certain financial covenants.  As of June 30, 2005 Accurel was incompliance with the covenants.

 

Futureprincipal payments on this note are as follows:

 
| **Year  ending June 30,** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------|------------|
| 2006                           |       | $          | 350,000    |   |
| 2007                           |       | $          | 350,000    |   |
| 2008                           |       | $          | 350,000    |   |
| 2009                           |       | $          | 117,000    |   |

 

**16.****                              ****Private Placement**

 

On March 8,2005 the Company issued 1,080,780 shares of common stock at $7.22, in a privateplacement with fifteen investors.  TheCompany received $7,803,000 in gross proceeds, less placement agent fees andrelated transaction costs of approximately $433,000.

 

Inconnection with the transaction, the Company issued warrants to the investorsto purchase 270,195 shares of common stock at an exercise price of $9.35, whichare exercisable anytime between September 4, 2005 and September 4,2010.  In addition, the investors haverights to purchase up to 588,235 shares of common stock at a price of $8.50 pershare, which are exercisable for a period commencing (i) anytime on orafter September 4, 2005 and (ii) on or prior to the later of the 6month anniversary of the effective date of the registration statement or March 4,2006.  The Company also issued warrantsto the placement agent to purchase 43,231 shares of common stock at an exerciseprice of $9.35 per share, which are exercisable until March 4, 2010.  Should the investors exercise theseadditional investment rights, the placement agent will receive an additionalwarrant for 23,529 shares at an exercise price of $9.35 per share.

 

**17.****                               FinancialInformation by Segment**

 

UnderSFAS No. 131, “Disclosures aboutSegments of an Enterprise and Related Information,” operating segmentsare defined as components of an enterprise about which separate financialinformation is available that is evaluated regularly by the chief operatingdecision maker, or decision making group, in deciding how to allocate resourcesand in assessing performance.  TheCompany’s chief operating decision making group is composed of the chiefexecutive officer and members of senior management. The Company’s reportablesegments are:  Medical, Semiconductor andExplosives.

 

Grossmargin is the measure that management uses when evaluating the Company’ssegments, therefore, operating expenses are excluded from the financialinformation below.

 

Therevenues and expenses related to these segments for the years ended June 30,2005 and 2004, respectively, are:

 

52

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| ** **   | ** ** | **Year Ended June 30, 2005** | ** ** |
|--------------|------------|-----------------------------------|------------|
| ** **   | ** ** | **Medical**                       | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| ** **   | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue      |       | $                                 | 4,146,000  |   | $ | 6,630,000 |   | $ | 1,510,000 |   | $ | 12,286,000 |   |
| COGS         |       | (3,821,000                        | )          | (6,316,000 | ) | (1,919,000 | ) | (12,056,000 | ) |
| Gross Margin |       | $                                 | 325,000    |   | $ | 314,000 |   | $ | (409,000 | ) | $ | 230,000 |   |

 
| ** **   | ** ** | **Year Ended June 30, 2004** | ** ** |
|--------------|------------|-----------------------------------|------------|
| ** **   | ** ** | **Medical**                       | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| ** **   | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue      |       | $                                 | 4,957,000  |   | $ | 1,022,000 |   | $ | 2,587,000 |   | $ | 8,566,000 |   |
| COGS         |       | (3,822,000                        | )          | (1,280,000 | ) | (1,084,000 | ) | (6,186,000 | ) |
| Gross Margin |       | $                                 | 1,135,000  |   | $ | (258,000 | ) | $ | 1,503,000 |   | $ | 2,380,000 |   |

 

**18.****                              ****Acquisition ofCore Systems Incorporated**

 

On October 15,2004, the Company completed the acquisition of Core Systems (“Core”), aprivately held semiconductor wafer processing company.  The transaction was structured as areorganization of Core with and into a newly formed, wholly-owned subsidiary ofthe Company.  The operating results ofCore Systems have been included in the Company’s statement of operationsbeginning October 15, 2004.

 

Theaggregate purchase price of Core was $7,486,000, which consisted of $2,000,000in cash; 311,437 shares of the Company’s common stock with an aggregate fairvalue of $3,250,000; direct acquisition costs of approximately $1,726,000 andthe payment of approximately $510,000 of debt and other obligations coincidentwith the closing which were paid by issuing 48,875 shares of the Company’s common stock. The number of shares issuedwas initially determined by the average price of the Company’s stock over atwenty day period ending October 8, 2004. The share price was subject to adjustment limiting the gain or loss inthe value of the Company stock, over a twenty day period at the end of a sixmonth lock-up, ending April 15, 2005, to 25% from the initial value.  The twenty day average price of the stock forthe period ending April 15, 2005 was $5.75 which resulted in the need toissue of an additional 112,475 shares. As of June 30, 2005, these shares were not issued andoutstanding.  These shares will be issuedpending approval of the American Stock Exchange. The fair value of the Company’scommon stock was determined based on the average market price of the Company’scommon stock over a period of time before October 15, 2004, the date fairvalue is to be determined, pursuant to Emerging Issues Task Force (“EITF”) IssueNo. 99-12, “Determination of the Measurement Date for the Market Price ofAcquirer Securities Issued in a Purchase Business Combination.”  In addition the purchase is subject to anearn out payable in Company stock which will be accounted for as additionalpurchase price when and if earned.  Theearn out period is the twelve month period ending October 14, 2005.  There are no maximum or minimum earnoutprovisions As of June 30, 2005 no earn out payments have been made.

 

| **Core Purchase Price**     | ** ** |
|-----------------------------|------------|
|                        |       |   |   |
| Cash                        |       | $ | 2,000,000 |   |
| Equity                      |       | 3,250,000 |   |
| Equity used to retire  debt |       | 510,000 |   |
| Warrant                     |       | 1,122,000 |   |
| Direct Costs                |       | 604,000 |   |
|                        |       | $ | 7,486,000 |   |

 

53

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Thefollowing table summarizes the allocation of the purchase price to the fairvalue of the assets acquired and liabilities assumed at the date ofacquisition:

 
| ** **                             | ** ** | **October 15, 2004** | ** ** |
|----------------------------------------|------------|---------------------------|------------|
|                                   |       |                      |       |
| Accounts receivable                    |       | $                         | 518,000    |   |
| Inventory                              |       | 174,000                   |       |
| Property, plant and  equipment         |       | 3,422,000                 |       |
| Other intangible assets                |       | 335,000                   |       |
| Goodwill                               |       | 4,647,000                 |       |
| Other assets                           |       | 74,000                    |       |
| Accounts payable and  accrued expenses |       | (1,063,000                | )          |
| Debt and capital leases                |       | (621,000                  | )          |
|                                   |       |                      |       |
|                                   |       | $                         | 7,486,000  |   |

 

Theallocation of purchase price is the responsibility of management. The Companyhas considered a number of factors, including professional appraisals, for thevaluation of equipment acquired, in making its purchase price allocation determination.The acquisition of Core resulted in goodwill of $4,647,000.  The Company believes the amount of goodwillis appropriate based on operating efficiencies expected as the Wakefieldsemiconductor and Core operations are integrated, added opportunities forrevenue growth as the semiconductor industry serviced by Core continues torecover and additional revenue opportunities from providing a broad range ofservices to the industry.  The Companyalso identified $335,000 of intangible assets with finite lives.  The intangible assets will be amortized overa period of sixty months, the estimated useful lives of the assets, from thedate of acquisition, October 15, 2004. Amortization expense for the year ended June 30, 2005 related tothese intangible assets was $47,000.

 

Theacquisition of Core is accounted for as a purchase under SFAS No. 141, “BusinessCombinations.” Accordingly, the operating results of Core are included in theaccompanying consolidated financial statements since the acquisition date aspart of the Company’s semiconductor reporting segment.

 

**19.****                              ****Acquisition ofAccurel Systems International Corporation**

 

On March 9,2005, the Company acquired all of the stock of Accurel Systems InternationalCorporation (“Accurel”), a California S Corporation, from existingshareholders.  The aggregate purchase price of Accurel is estimated to be$12,176,000, which consists of the issuance of 418,194 shares of the Company’scommon stock with a fair value of $3,520,000 based upon a value per share of$8.42, $6,036,000 in cash, $1,650,000 note payable to the former Accurelshareholders and estimated direct acquisition costs of $970,000.  The shareholder notes payable due in 120 daysfrom the closing and earns interest at 5%. The note is secured by all of theequipment of Accurel. The notes have been paid in full on July 8,2005.  The shares issued were determinedbased on the average market price of the securities over a twenty day periodending March 8, 2005. The share price for valuation purposes wasdetermined by the average share price for the period just prior to the date ofthe merger agreement announcement, pursuant to the guidance in EITF Issue No. 99-12. Thepurchase is subject to a 12-month holdback of $500,000 subject to thesettlement of any and all pre-acquisition contingencies not specificallyidentified in the closing balance sheet. The shares issued were also subject to adjustment if the Company’saverage stock price during the twenty trading days prior to the end of a threemonth lock-up is 25% higher or lower than the price on the closing date.  The effect of this adjustment is to limit theselling shareholders’ gain or loss on the Company’s common stock to 25% duringthe lock-up period ending June 9, 2005. The average stock price for the twenty day period ending June 9,2005 was $2.97.  An additional 504,144shares of Company stock were issued as a result of this adjustment. As of June 30,2005, these shares were not issued and outstanding. The shares will be issuedpending authorization of the American Stock Exchange.  Accurel’s

 

54

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results from operationsare included in the Company’s consolidated statement of operations beginning March 9,2005, the date of acquisition.

 

| **Accurel Purchase Price**            | ** ** |
|---------------------------------------|------------|
|                                  |       |   |   |
| Cash                                  |       | $ | 6,036,000 |   |
| Equity                                |       | 3,520,000 |   |
| Notes payable to former  shareholders |       | 1,650,000 |   |
| Direct costs                          |       | 970,000 |   |
|                                  |       | $ | 12,176,000 |   |

 

Thefollowing table summarizes the preliminary allocation of the purchase price tothe fair value of the assets acquired and liabilities assumed at the date of acquisition:

 
| ** **                           | ** ** | **March 9, 2005** | ** ** |
|--------------------------------------|------------|------------------------|------------|
|                                 |       |                   |       |
| Cash                                 |       | $                      | 153,000    |   |
| Accounts receivable                  |       | 1,073,000              |       |
| Prepaid expenses and  other assets   |       | 183,000                |       |
| Property, plant and  equipment       |       | 3,957,000              |       |
| Intangible assets with  finite lives |       | 1,670,000              |       |
| Goodwill                             |       | 7,566,000              |       |
| Assets held for sale                 |       | 1,400,000              |       |
| Other liabilities                    |       | (1,386,000             | )          |
| Debt and capital leases              |       | (2,440,000             | )          |
|                                 |       | $                      | 12,176,000 |   |

 

Theabove allocation of the purchase price includes the value of the intangibleassets, determined to be $1,670,000 and goodwill of $7,566,000.  The intangible assets are being amortizedover periods of eighteen months to seven years, their estimated usefullives.  Amortization expense for theseassets for the year ended June 30, 2005 since the date of the Accurelacquisition on March 9, 2005, was $108,000. The allocation of the purchaseprice of Accurel is based on management estimates and assumptions and theresults of independent appraisals.  The allocation of purchase price isthe responsibility of management.  TheCompany considered a number of factors, including professional appraisals, inmaking its final determination. Included in the above allocation is anunfavorable lease obligation of $829,000, which was recorded as a long-termlease liability in accordance with SFAS 141. This liability reflects the estimated amount that Accurel’s futureobligations under its facility lease are above the fair value of the leasedfacility, based on current market conditions. The lease expires in 2010.  Duringthe year ended June 30, 2005, the Company amortized approximately $26,000related to this long-term lease liability.

 

Theacquisition of Accurel is accounted for as a purchase under SFAS No. 141  Accordingly, the operating results of Accurelare included in the accompanying consolidated financial statements since theacquisition date as part of the Company’s semiconductor reporting segment.

 

Thefollowing table presents selected unaudited financial information of theCompany including Core Systems Incorporated and Accurel Systems InternationalCorporation as if the acquisitions had occurred on July 1, 2003.  The unaudited pro forma results are notnecessarily indicative of the results that would have occurred had theacquisition of Core Systems and Accurel been consummated on July 1, 2003,or of future results.

 

55

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| ** **                                                               | ** ** | **Years Ended**   | ** ** |
|--------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                               | ** ** | **June 30,** | ** ** |
| ** **                                                               | ** ** | **2005**          | ** ** | **2004** | ** ** |
|                                                                     |       |              |       |   |   |
| Revenues                                                                 |       | $                 | 19,126,000 |   | $ | 21,100,000 |   |
|                                                                     |       |              |       |   |   |
| Loss  from operations                                                    |       | (7,356,000        | )          | (3,601,000 | ) |
|                                                                     |       |              |       |   |   |
| Net  loss                                                                |       | (7,735,000        | )          | (3,921,000 | ) |
|                                                                     |       |              |       |   |   |
| Preferred  distribution, dividends and accretion                         |       | (1,183,000        | )          | (2,527,000 | ) |
|                                                                     |       |              |       |   |   |
| Net  loss applicable to common shareholders                              |       | $                 | (8,918,000 | ) | $ | (6,448,000 | ) |
|                                                                     |       |              |       |   |   |
| Net  loss per share applicable to common shareholders, basic and diluted |       | $                 | (0.88      | ) | $ | (0.74 | ) |
|                                                                     |       |              |       |   |   |
| Weighted  average common shares outstanding, basic and diluted           |       | 10,168,743        |       | 8,663,924 |   |

 

**20.****                              ****Goodwill and Other IntangibleAssets**

 

At June 30,2005, the Company had goodwill and intangible assets of $14,270,000.  SFAS No. 142, “Goodwill and OtherIntangible Assets”, requires that goodwill and intangible assets withindefinite lives no longer be amortized but instead be measured for impairmentat least annually or whenever events indicate that there may be an impairment.  In order to determine if impairment exists,management continually estimates the reporting unit’s fair value based onmarket conditions and operational performance. The Company may employ the work of independent appraisers in making itsdetermination.  The Company will make itsannual assessment as of August 31st of each year to determine if itsgoodwill is impaired.  As of June 30,2005 the Company has determined that its goodwill and intangible assets withindefinite lives are not impaired. Future events could cause management to conclude that impairment indicatorsexist and that goodwill and intangible assets with indefinite lives associatedwith the Company’s acquired businesses are impaired.  Any resulting impairment loss could have amaterial adverse impact on the Company’s financial condition and results ofoperations.

 

Intangibleassets with finite lives are valued according to the future cash flows they areestimated to produce.  These assignedvalues are amortized over the period of time those cash flows are estimated tobe produced.  Management continuallyevaluates whether events or circumstances have occurred that indicate that theestimated remaining useful life or the carrying value of these assets has beenimpaired. As of June 30, 2005 management believes no impairment exists.

 

Thefollowing table summarizes the Company’s intangible assets as of June 30,2005:

 

| ** **       | ** ** | **Gross Carrying** | ** ** | **Accumulated**  | ** ** | **Net Carrying** | ** ** |
|------------------|------------|--------------------|------------|------------------|------------|------------------|------------|
| ** **       | ** ** | **Amount**         | ** ** | **Amortization** | ** ** | **Amount**       | ** ** |
| Non-Compete      |       | $                  | 1,057,000  |             | $          | 809,000          |       | $ | 248,000 |   |
|             |       |               |       |             |       |             |       |
| Name Recognition |       | 200,000            |       | 9,000            |       | 191,000          |       |
|             |       |               |       |             |       |             |       |
| Customer Base    |       | 1,630,000          |       | 119,000          |       | 1,511,000        |       |
|             |       |               |       |             |       |             |       |
| Technology       |       | 125,000            |       | 18,000           |       | 107,000          |       |
|             |       |               |       |             |       |             |       |
| Total            |       | $                  | 3,012,000  |             | $          | 955,000          |       | $ | 2,057,000 |   |

 

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Estimated amortization expense for intangible assets with finite liveson our balance sheet as of June 30, 2005, for the fiscal years ending June 30,is as follows:

 

| 2006       |   | $       | 621,000   |   |
|------------|--------|---------|-----------|--------|
| 2007       |   | 386,000 |      |
| 2008       |   | 380,000 |      |
| 2009       |   | 380,000 |      |
| 2010       |   | 244,000 |      |
| Thereafter |   | 46,000  |      |
|       |   | $       | 2,057,000 |   |

 

**21.****                               TreasuryStock**

 

In June 2004,the Board authorized the Company to repurchase of up to 300,000 shares of theCompany’s common stock, from time to time in the open market, privatelynegotiated transactions, block transactions or at time and prices deemed appropriateby management.  During July 2004, theCompany repurchased 6,000 shares of common stock at prices ranging from $8.91to $9.02 per share, with an average cost per share of $8.97 and a total cost ofapproximately $54,000, which is recorded as treasury stock in the accompanyingcondensed consolidated balance sheet.  Asof June 30, 2005, the maximum number of shares authorized to berepurchased are 294,000.

 

In March 2004,the Company entered into an Exchange & Venture Agreement withCardioTech International and CorNova and issued 10,344 shares of common stockbearing an aggregate fair market value of $113,000.  In February 2005, the Company issued anadditional 76,687 shares of common stock bearing an aggregate fair market valueof $750,000.  As of June 30, 2005,16,449 shares, representing a 19% ownership of Company common stock held byCorNova, have been categorized as treasury stock.

 

**22.****                               CreditArrangements**

 

At thetime of its acquisition, Accurel Systems had a $1,400,000 fixed rateinstallment note with a bank. The note calls for monthly payments of $29,000plus interest at a rate of 6.84%, through September 1, 2008.  The bank has consented to continue the noteunder the same terms after the acquisition. As of June 30, 2005, the notebalance is $1,254,000.  The note issecured by substantially all assets of Accurel.

 

TheLoan Agreement requires Accurel to report monthly financial results to the bankand for Accurel to comply with certain financial covenants.  As of June 30, 2005, Accurel was in compliancewith the covenants.

 

On June 8, 2005, the Company executeda revolving credit facility for $1,500,000 with Silicon Valley based BridgeBank, N.A.  The revolving credit facilityhas a one year term, provides for advances of up to eighty percent (80%) of theCompany’s eligible accounts receivable, bears interest at the prime rate plusone-half percent (1/2%), and is secured by certain assets of the Company and issubject to certain covenants.  As of June 30,2005, the company has not drawn down any funds on the credit facility.

 

**23.****                               RapiscanContract**

 

On March 23, 2005, Rapiscan Systems, Inc. (“Rapiscan”)and the Company entered into a Development, Distribution and ManufacturingAgreement (the “Agreement”).  TheAgreement provides for: i) the manufacture and sale of Implant’s existingQuantum SnifferTM explosives detection equipment (the “QSTMProducts to Rapiscan, on a private label basis; ii) the funding by Rapiscan ofup to $1,000,000 for the development by Implant of a trace explosives detectionsubsystem using Implant’s Quantum SnifferTM Technology (the “QSTMTechnology”) that could be integrated with Rapiscan’s X-ray baggage screeningdevice technology; iii) the funding by Rapiscan of up to $2,000,000 for thedevelopment by Implant of other trace explosives detection subsystems (the “OtherQSTM Trace Prototype”) utilizing the QSTM

 

57

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Technology; iv) the parties granting each other various rights tomanufacture and sell components of commercial products resulting from thedevelopment of the QSTM Baggage Screening Prototype and the Other QSTMTrace Prototype, certain distribution rights granted to Rapiscan and royaltypayments to the Company for products sold by Rapiscan.  No revenue has been recorded related to thisagreement.

 

**24.****                               RossesMedical**

 

On May 6,2005, the Company purchased certain software technology assets from RossesMedical Systems with an aggregate purchase price of $300,000, consisting of$100,000 in cash and 43,197 shares of the Company’s common stock with a fairvalue of $200,000.  In conjunction withthis asset acquisition, the Company entered into consulting agreements with theformer owners and a former employee of Rosses Medical and granted 181,426non-qualified stock options.  Theseoptions are fully vested, have a zero exercise price and are exercisable uponachieving certain sales milestones, commencing November 6, 2005.  The value of these options will be recordedas additional purchase price in the period earned.  Should all sales milestones be achieved, theCompany has estimated the fair value of these options using the Black Scholesoption pricing model to be $796,460.  Asof June 30, 2005, no options are exercisable.  This asset is included in other assets on theCompany’s consolidated balance sheet and is being amortized over three years ona straight line basis.

 

Revenueswill consist of software licenses, computer hardware and software maintenanceagreements.  Statement of Position (“SOP”)97-2, Software Revenue Recognition will apply to these revenues.  For the year ended June 30, 2005 theserevenues were immaterial.

 

**25.****                               SubsequentEvents**

 

On July 6,2005, the Company executed a $3.0 million secured term note from Laurus MasterFund, Ltd. Net proceeds from the financing are to be used for increasing thecapacity of the Quantum Sniffer production line, increasing unit inventoriesand the repayment of certain indebtedness due and owing by the Company to theformer shareholders of Accurel Systems International.  As part of the financing, the Company paidLaurus Capital Management, LLC, the manager of Laurus, a closing payment equalto $135,000, plus due diligence and legal expenses of $12,000.

 

Theterm note is secured by substantially all of the Company’s assets, has a 4-monthterm and bears interest at a rate equal to prime plus 1% per annum.  In connection with the financing, on September 30,2005, the Company will issue Laurus a common stock purchase warrant to purchaseup to 250,000 shares of the Company’s common stock at a price equal to $3.75per share.

 

OnJuly 8, 2005, the Company paid in full the principal and interest due onthe notes payable to the former Accurel Shareholders (Note 15).  All liens on the Company’s assets in regardsto this transaction have been removed.

 

On September 30,2005, the Company executed a $5.0 million preferred stock instrument withLaurus Master Fund, Ltd., and issued 500,000 shares of Series D CumulativeConvertible Preferred Stock.  The termsof the agreement state that repayment can be made in cash or converted into theCompany’s common stock at a fixed conversion price equal to $6.80 per commonshare, up to a maximum of approximately 735,000 shares, over a thirty-six (36)month period.  The preferred stock has adividend equal to the prime rate plus one percent (1%) and provides for monthlyredemptions in the amount of approximately $152,000 to be paid in cash orcommon shares at the option of the Company, subject to certain restrictions,commencing on January 1, 2006.  Inaddition, Laurus was granted a warrant to purchase 50,000 shares of the Company’scommon stock exercisable at a price of $10.20 per share.  The Company utilized the proceeds to repaythe $3 million term note signed on July 7, 2005 plus accrued interest, andfor working capital. As part of the financing, the Company paid Laurus CapitalManagement, LLC, the manager of Laurus, a closing payment equal to $90,000,plus due diligence and legal expenses of $27,000.

 

58

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**ITEM 8****                                                       ChangesIn and Disagreements with Accountants on Accounting and Financial Disclosure**

 

NONE

 

# ***ITEM8A.  CONTROLS AND PROCEDURES***

 

EVALUATION OF OUR DISCLOSURE CONTROLS AND INTERNAL CONTROLS

 

As of the end of the period covered by this Annual Report, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (“Disclosure Controls”) and our internal controls and procedures for financial reporting (“Internal Controls”). This evaluation (the “Controls Evaluation”) was done under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”). Rules adopted by the SEC require that in this section of the Annual Report, we present the conclusions of our CEO and the CFO about the effectiveness of our Disclosure Controls and Internal Controls based on and as of the date of the Controls Evaluation.

 

CEO AND CFO CERTIFICATIONS

 

Appearing as exhibits to this Annual Report are “Certifications” of the CEO and the CFO. The Certifications are required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (the “Section 302 Certifications”). This section of the Annual Report contains information concerning the Controls Evaluation referred to in the Section 302 Certifications and this information should be read in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented.

 

DISCLOSURE CONTROLS AND INTERNAL CONTROLS

 

Disclosure Controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 (“Exchange Act”), such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal Controls are procedures which are designed with the objective of providing reasonable assurance that (1) our transactions are properly authorized, recorded and reported; and (2) our assets are safeguarded against unauthorized or improper use, to permit the preparation of our financial statements in conformity with generally accepted accounting principles.

 

LIMITATIONS ON THE EFFECTIVENESS OF CONTROLS

 

Our management, including the CEO and CFO, has concluded that our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives and have concluded that the controls and procedures are effective at that reasonable assurance level.

 

SCOPE OF THE CONTROLS EVALUATION

 

The CEO/CFO evaluation of our Disclosure Controls and Internal Controls included a review of the controls’ objectives and design, the controls’ implementation by us and the effect of the controls on the information generated for use in this Annual Report. In the course of the Controls Evaluation, management sought to identify data errors, controls problems or acts of fraud and to confirm that appropriate corrective action, including process improvements, were being undertaken. This type of evaluation will be done on a quarterly basis so that the conclusions concerning controls effectiveness can be reported in our Quarterly Reports on Form 10-QSB and Annual Report on Form 10-KSB. The overall goals of these various review and evaluation activities are to monitor our Disclosure Controls and Internal Controls and to make 

 

59

 

modifications as necessary; our intent in this regard is that the Disclosure Controls and the Internal Controls will be maintained as dynamic systems that change (including with improvements and corrections) as conditions warrant.

 

Among other matters, management sought in its evaluation to determine whether there were any “significant deficiencies” or “material weaknesses” in our Internal Controls, or whether we had identified any acts of fraud involving personnel who have a significant role in our Internal Controls. In the professional auditing literature, “significant deficiencies” are referred to as “reportable conditions”; these are control issues that could have a significant adverse effect on the ability to record, process, summarize and report financial data in the financial statements. A “material weakness” is defined in the auditing literature as a particularly serious reportable condition where the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and not be detected within a timely period by employees in the normal course of performing their assigned functions.

 

CONCLUSIONS

 

Based upon the Controls Evaluation, our CEO and CFO have concluded that, as of the end of the period covered by this Annual Report, our Disclosure Controls are not effective to provide reasonable assurance that our financial statements are fairly presented in conformity with generally accepted accounting principles for the reasons discussed below.

 

Our independent registered public accounting firm reported to our Audit Committee certain conditions involving internal controls which they believe represent material weaknesses in our internal control environment. These matters are with regard to insufficient personnel resources and technical accounting expertise within the accounting function to effect timely financial close process and to effectively evaluate and resolve non-routine and/or complex accounting transactions. A material  weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

 

As we disclosed in our previous 10-K/A for the year ended Jiune 30, 2004 and quarterly reports thereafter management and the independent auditors have reported certain matters to the Audit Committee involving internal controls that were considered to be a reportable condition. These matters focused on the financial reporting and close process and resulted from inadequate staffing and supervision over the closing process. As management promised in previous filings it has increased its staffing by hiring a corporate controller and is committed to hiring additional accounting staff over the next six months.  These additions to the staff will continue to improve the timeliness of the close process and the help significantly reduce the number of quarter end or fourth quarter closing adjustments made by management.

 

Our management and the Audit Committee agreed with our independent registered public accounting firm on the matter raised in their report and agreed to address the material weakness.

 

To remediate this internal control material weakness, management has commenced implementation of the following measures:

 

•                  For material transactions that are unique or outside our core operations, we will continue to document our process for accounting for such transactions and we will improve our process for researching the applicable accounting literature and documenting our conclusions, by consulting with outside experts to ensure our interpretations are correct.

•                  We will prepare a standardized memorandum that is required to be completed for each transaction that is unique or outside our normal core operations that is material to our financial statements. This memo will be reviewed and approved by the Vice President of Finance and the Chief Financial Officer.

•                  We will enhance formal communication with, and approval by, our Chief Financial Officer and Audit Committee of our application of GAAP and accounting policy decisions for transactions that are outside our core operations and the advice received from outside experts.

 

**PART III**

 

**ITEM 9.****                             Directors and Executive Officers of theRegistrant**

 

SECTION 16COMPLIANCE

 

Section  16(a) ofthe Securities Exchange Act of 1934, as amended, requires our officers,directors and persons who beneficially own more than 10% of a registered classof our equity securities  (“ten percentstockholders”) to file reports of ownership and changes in ownership with theSecurities and Exchange Commission. Officers, directors and ten percent stockholders are charged by the SECregulations to furnish us with copies of all Section 16(a) forms theyfile.

 

Based solely upon areview of Forms 3, 4, and 5 and amendments thereto furnished to us during thepast fiscal year, and, if applicable, written representations that Form 5was not required, we believe that all Section 16(a) filingrequirements applicable to our officers, directors and ten percent stockholderswere fulfilled.  The following are ourexecutive officers and directors:

 
| **Name**                     | ** ** | **Age** | ** ** | **Position**                                                  | ** ** | **Position Since** |
|------------------------------|------------|---------|------------|---------------------------------------------------------------|------------|--------------------|
|                         |       |    |       |                                                          |       |               |
| Anthony J. Armini (1)        |       | 67      |       | President, Chief  Executive Officer and Chairman of the Board |       | 1984               |
|                         |       |    |       |                                                          |       |               |
| Stephen N. Bunker (1)        |       | 62      |       | Vice President and  Chief Scientist, Director                 |       | 1987               |
|                         |       |    |       |                                                          |       |               |
| John J. Munro, III  (1) |       | 56      |       | Vice President,  Brachytherapy Products                       |       | 2001               |
|                         |       |    |       |                                                          |       |               |
| Diane J. Ryan (1)            |       | 45      |       | Vice President Finance  and Chief Financial Officer           |       | 2003               |
|                         |       |    |       |                                                          |       |               |
| Walter Wriggins (1)          |       | 61      |       | Vice President and  General Manager Core Systems              |       | 2004               |
|                         |       |    |       |                                                          |       |               |
| John Traub (1)               |       | 58      |       | Vice President and  President Accurel Systems                 |       | 2005               |
|                         |       |    |       |                                                          |       |               |
| R. Erik Bates (1)            |       | 49      |       | Vice President, EDS  Manufacturing                            |       | 2005               |
|                         |       |    |       |                                                          |       |               |
| Michael Szycher (2)          |       | 66      |       | Director                                                      |       | 1999               |

 

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| David B. Eisenhaure (2) (4)    |   | 59     |   | Director |   | 2002   |
|-------------------------------------|--------|--------|--------|----------|--------|--------|
|                                |   |   |   |     |   |   |
| Gerald Entine (2) (3) (4) |   | 62     |   | Director |   | 2004   |

 

----

(1)                                  Executive Officer

(2)                                  Member of the Audit Committee for the fiscalyear ended June 30, 2005

(3)                                  Chairman of the Audit Committee

(4)                                  Member of the Compensation Committee for thefiscal year ended June 30, 2004.

 

*Dr. AnthonyJ. Armini* has been the Company’s President, Chief ExecutiveOfficer, and Chairman of the Board of Directors since the Company’sincorporation.  From 1972 to 1984, priorto the Company’s founding, Dr. Armini was Executive Vice President atSpire Corporation.  From 1967 to 1972, Dr. Arminiwas a Senior Scientist at McDonnell Douglas Corporation.  Dr. Armini received his Ph.D. in nuclearphysics from the University of California, Los Angeles in 1967.  Dr. Armini is the author of twenty twopatents and fourteen publications in this field.  Dr. Armini has over thirty years ofexperience working with cyclotrons and linear accelerators, the production andcharacterization of radioisotopes, and over twenty years experience with ionimplantation in the medical and semiconductor fields.  Since October 2000, Dr. Armini hasbeen on the Board of Directors of CardioTech International, Inc., apublicly traded company of which Dr. Szycher is President and ChiefExecutive Officer.

 

*Dr. StephenN. Bunker* has served as the Company’s Vice President andChief Scientist since 1987 and a Director since 1988.  Prior to joining the Company, from 1972 to1987, Dr. Bunker was a Chief Scientist at Spire Corporation.  From 1971 to 1972, Dr. Bunker was anEngineer at McDonnell Douglas Corporation. Dr. Bunker received his Ph.D. in nuclear physics from theUniversity of California, Los Angeles in 1969. Dr. Bunker is the author of fifteen patents in the field of ionbeam technology.

 

*John J. Munro, III* has been the Company’s Vice President ofBrachytherapy Products since 2001.  From March 2000until December 2000, he served as the Company’s Director of BrachytherapyProducts and from November 1999 until March 2000 as the Company’sProject Manager of Temporary Brachytherapy. From August 1998 until October 1999, he served as ChiefExecutive Officer of GammaMed, USA, Inc and from July 1997 until August 1998Mr. Munro was the Director of Source Operations at CIS-US, Inc.  Mr. Munro is the author of two patents.

 

*DianeJ. Ryan*has served as the Company’s Vice President of Financeand Chief Financial Officer since May 2003.  Ms. Ryan has been employed with ImplantSciences Corporation since March 1989. From March 2003 to May 2003, she was the Corporate Controllerof the Company.  Ms. Ryan graduatedfrom Salem State College with a B.S. in Business Administration and a minor inmanagement.

 

*Walter J.Wriggins*has served as the Company’s Vice President andGeneral Manager of Core Systems, since October 2004.  Prior to his career at Core Systems, Mr. Wrigginshad over 22 years experience in semiconductor industry.  His career began as a materials scientist inthe GE aircraft engine group, from which he transitioned to a sales andmarketing career at various semiconductor companies throughout thecountry.  These companies, at which heheld senior management positions, include: Axcelis (formally Eaton Corporation), Applied Materials, Varian ThinFilms, and Ion Implant Services.  Mr. Wrigginsreceived a B.A. in Applied Science, and a B.S. in Material Science andEngineering from Lehigh University and an MBA from Boston University.

 

*JohnTraub*has served as the Company’s Vice President andPresident of Accurel Systems International, since March 2005 and prior tothat as Executive Vice President and Chief Operating Officer of Accurel Systems, Inc..  Mr. Traub has held senior posts withseveral semiconductor equipment and services companies including MicrofabSystems, Align-Rite Limited, Systems Chemistry Inc. and at UltratechStepper.  John also serves on the SantaClara University Board of Fellows Executive Committee and as Chairmen of theBoard of Governors of American Theatre of San Jose.

 

*R. ErikBates*has served as the Company’s Vice President ofOperations, Explosives Detection Equipment Division, since March 2005.  Mr. Bates has over twenty five years ofexperience encompassing engineering,

 

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manufacturing,operations, and business development. The majority of his experience has been in the medical deviceindustry.  Mr. Bates has a B.S. inplastics engineering from the University of Lowell and an MBA from RivierCollege.  He is actively involved in publiceducation, and is on the Advisory Board for the College of Engineering at UMassLowell.

 

*Dr. Michael Szycher* joined the Company’s Board of Directorsin December 1999.  He has beenPresident and Chief Executive Officer and Chairman of CardioTech International, Inc.,a publicly traded manufacturer of medical devices and biocompatible polymerssince 1996.  From 1988 to 1996, Dr. Szycherwas Chairman and Chief Technology Officer of Polymedica Industries.  Dr. Szycher is a recognized authority onpolyurethanes and blood compatible polymers. He is the editor of six books on various subjects in blood compatiblematerials and devices and the author of eighty original research articles.

 

*Dr. David B. Eisenhaure* has served on the Company’s board ofdirectors since November 2002.  Hehas been the President, Chief Executive Officer and Chairman of the Board ofSatCon Technology Corporation since 1985. From 1974 until 1985, Mr. Eisenhaure was associated with theCharles Stark Draper Laboratory, Incorporated and with its predecessor, theMassachusetts Institute of Technology’s Instrumentation Laboratory, from 1967to 1974.  Dr. Eisenhaure also holdsan academic position at M.I.T., as a lecturer in the Department of MechanicalEngineering.  Mr. Eisenhaure serveson the board of directors of Mechanical Technology Incorporated and BeaconPower.  He holds a S.B., S.M. and anEngineer’s Degree in Mechanical Engineering from M.I.T.

 

*Dr. GeraldEntine* has served on the Company’s board since May 2004.He is the President of Radiation Monitoring Devices, Inc. of Watertown,Massachusetts, which he founded in 1974. RMD is a manufacturer of radiationdetectors and diagnostic instrumentation used in medical and industrialapplications. Dr. Entine, who received his Ph.D. in Physics from theUniversity of California in Berkeley, has also been the Principal Investigatoron numerous research grants from the National Institutes of Health, NASA, DOEand the National Science Foundation.

 

CODE OF ETHICS

 

TheCompany has adopted a code of ethics that applies to its directors, officersand employees and has been posted on the Company’s website:  www.implantsciences.com.

 

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**ITEM 10.****                      ExecutiveCompensation**

 

The following table setsforth the aggregate cash compensation paid by us with respect to the threefiscal years ended June 30, 2003, 2004 and 2005 to our executive officers

 

**SUMMARYCOMPENSATION TABLE**

 
| ** **                           | ** ** | **Annual Compensation** | ** ** | **Long-Term  Compensation  Awards  Shares** | ** ** |
|--------------------------------------|------------|-------------------------|------------|---------------------------------------------|------------|
| ** **                           | ** ** | ** **              | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Other Annual  Compensation ($)** | ** ** | **Underlying  Options** | ** ** |
| **Name  and Principal Position**     | ** ** | **Year**                | ** ** | **Salary($)**                               | ** ** | **Bonus ($)** | ** ** | **(1)** | ** ** | **Granted(#)** | ** ** |
| Anthony J. Armini                    |       | 2005                    |       | $                                           | 213,101    |   | — |   | $ | 15,417 |   | — |   |
| President,  Chief Executive Officer  |       | 2004                    |       | $                                           | 197,684    |   | $ | 59,700 |   | $ | 12,260 |   | 50,000 |   |
| and  Chairman of the Board           |       | 2003                    |       | $                                           | 166,693    |   | $ | 75,000 |   | $ | 14,965 |   | 62,200 |   |
|                                 |       |                    |       |                                        |       |   |   |   |   |   |   |
| Stephen N. Bunker                    |       | 2005                    |       | $                                           | 103,377    |   | — |   | $ | 1,077 |   | 30,000 |   |
| Vice  President, Chief Scientist and |       | 2004                    |       | $                                           | 114,228    |   | $ | 23,150 |   | $ | 1,049 |   | 50,000 |   |
| Director                             |       | 2003                    |       | $                                           | 82,932     |   | — |   | $ | 1,316 |   | 57,300 |   |
|                                 |       |                    |       |                                        |       |   |   |   |   |   |   |
| Diane J. Ryan                        |       | 2005                    |       | $                                           | 120,393    |   | $ | 25,000 |   | $ | 1,147 |   | 30,000 |   |
| Vice  President Finance and Chief    |       | 2004                    |       | $                                           | 93,102     |   | $ | 25,050 |   | $ | 812 |   | 50,000 |   |
| Financial  Officer                   |       | 2003                    |       | $                                           | 75,421     |   | $ | 2,750 |   | $ | 783 |   | 49,000 |   |
|                                 |       |                    |       |                                        |       |   |   |   |   |   |   |
| John J. Munro, III              |       | 2005                    |       | $                                           | 109,598    |   | $ | 13,000 |   | $ | 1,087 |   | 30,000 |   |
| Vice  President of Sales and         |       | 2004                    |       | $                                           | 118,974    |   | $ | 24,050 |   | $ | 1,103 |   | 50,000 |   |
| Marketing                            |       | 2003                    |       | $                                           | 123,841    |   | $ | 2,500 |   | $ | 942 |   | 22,700 |   |
|                                 |       |                    |       |                                        |       |   |   |   |   |   |   |
| Walter J. Wriggins (2)               |       | 2005                    |       | $                                           | 101,124    |   | — |   | — |   | 70,000 |   |
|                                 |       | 2004                    |       | —                                      |       | — |   | — |   | — |   |
|                                 |       | 2003                    |       | —                                      |       | — |   | — |   | — |   |
|                                 |       |                    |       |                                        |       |   |   |   |   |   |   |
| John Traub (3)                       |       | 2005                    |       | $                                           | 53,615     |   | — |   | — |   | 50,000 |   |
|                                 |       | 2004                    |       | —                                      |       | — |   | — |   | — |   |
|                                 |       | 2003                    |       | —                                      |       | — |   | — |   | — |   |
|                                 |       |                    |       |                                        |       |   |   |   |   |   |   |
| R. Erik Bates (3)                    |       | 2005                    |       | $                                           | 33,231     |   | — |   | — |   | 30,000 |   |
|                                 |       | 2004                    |       | —                                      |       | — |   | — |   | — |   |
|                                 |       | 2003                    |       | —                                      |       | — |   | — |   | — |   |

 

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(1)                                  Other annual compensation consists oflife and disability insurance premiums and 401(k) plan benefits paid by us onbehalf of these executive officers.

(2)                                  Joined the Company in October 2004.

(3)                                  Joined the Company in March 2005

 

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**Employment Agreements**

 

*Anthony J. Armini.*  On June 30, 2004, we entered into anemployment agreement, with an initial term of three years and an automatic renewalfor a successive period of three years, unless the we or Dr. Armini givethe other party not less than three months written notice of non-renewal.  Under this employment agreement, Dr. Arminiserves as our president and chief executive officer at a base salary of up to$210,000.  In addition, Dr. Arminimay participate in our employee fringe benefit plans or programs generallyavailable to employees of comparable status and position.  We are entitled to terminate his employmentfor any material breach of his employment agreement at any time upon at least30 days written notice.  In the event weterminate Dr. Armini’s employment without cause, we will pay him 12 monthssalary.  Under his employment agreement,he is subject to restrictive covenants, including confidentialityprovisions.  Also, during his employmentand for a period of two years after the term of the employment agreement, Dr. Arminiis subject to a non-competition provision.

 

*Stephen N. Bunker.*  On June 30, 2004, we entered into anemployment agreement, with an initial term of three years and an automaticrenewal for a successive period of three years, unless the we or Dr. Bunkergive the other party not less than three months written notice ofnon-renewal.  Under this employmentagreement, Dr. Bunker serves as our vice president and chief executivescientist at a base salary of up to $150,000. In addition, Dr. Bunker may participate in our employee fringebenefit plans or programs generally available to employees of comparable statusand position.  We are entitled toterminate his employment for any material breach of his employment agreement atany time upon at least 30 days’ written notice. In the event we terminate Dr. Bunker’s employment without cause, wewill pay him 12 months salary.  Under hisemployment agreement, he is subject to restrictive covenants, includingconfidentiality provisions.  Also, duringhis employment and for a period of two years after the term of the employmentagreement, Dr. Bunker is subject to a non-competition provision.

 

*Walter J. Wriggins.*  On October 15, 2004, we entered into anemployment agreement, with an initial term of one years and an automaticrenewal for a successive period of one year, unless we or Mr. Wrigginsgive the other party not less than thirty days written notice ofnon-renewal.  Under this employmentagreement, Mr. Wriggins serves as our Vice President of Business Development/Operations and generalmanager of Core Systems at a base salary of $140,000.  In addition, Mr. Wriggins may participatein our employee fringe benefit plans or programs generally available toemployees of comparable status and position. We are entitled to terminate his employment for any material breach ofhis employment agreement at any time upon at least 30 days’ writtennotice.  In the event we terminate Mr. Wriggins’employment without cause, we will pay him the balance of the salary due for theterm of the agreement.  Under hisemployment agreement, he is subject to restrictive covenants, includingconfidentiality provisions.  Also, duringhis employment and for a period of two years after the term of the employmentagreement, Mr. Wriggins is subject to a non-competition provision.

 

**DirectorCompensation**

 

Our directors who are ouremployees do not receive any compensation for service on the board ofdirectors.  Directors who are not ouremployees, are paid a yearly stipend of $2,500 and are reimbursed forreasonable travel expenses incurred in connection with attendance at board andcommittee meetings.

 

Under the 2004 incentiveand nonqualified stock option plan, each director who is not our employee,automatically receives an annual grant of options to purchase 10,000 shares ofour common stock at an exercise price equal to the closing price of the commonstock on that date for each year of service. Each such option will have a term of ten years and will vest in full onthe date of the grant.

 

**Stock Option and Purchase Plans**

 

In September 1998,the Company adopted the 1998 Stock Option Plan (the “1998 Plan”).  The 1998 Plan provides for the grant ofincentive stock options and nonqualified stock options to employees andaffiliates.  The exercise price of theoptions equals 100% of the fair market value on the date of the grant.  Options expire ten years from the date of theoption grant and vest ratably over a three-year period commencing with thesecond year.  A total of 280,000 optionswere reserved for issuance under the 1998 Plan. Upon adoption of the 1998 Plan, the 1992 Stock

 

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Option Plan wasterminated.  No new stock options will begranted under the 1992 Stock Option Plan, which has been superseded by the 1998Plan.  In December 2000, the Companyadopted the 2000 Incentive and Non Qualified Stock Option Plan (the “2000 Plan”).  The 2000 Plan provides for the grant ofincentive stock options and nonqualified stock options to employees andaffiliates.  The exercise price of theoptions equals 100% of the fair market value on the date of the grant or 110%of the fair market value for greater than 10% beneficial owners of the Companystock.  Options expire between five andten years from the date of the option grant and have variable vesting periods.  A total of 1,500,000 options have beenreserved for the 2000 Plan.  In December 2004,the Company adopted the 2004 Stock Option Plan. The 2004 Plan provides for the grant of incentive stock options andnonqualified stock options to employees and affiliates.  The exercise price of the options equal1 100%of the fair market value on the date of the grant or 110% of the fair marketvalue for greater than 10% beneficial owners of the Company stock.  Options expire between five and ten yearsfrom the date of the option grant and have variable vesting periods.  A total of 500,000 options were reserved forissuance under the 2004 Plan.  As of June 30,2005, a total of 11,503, 64,000 and 43,574 shares are available for issuanceunder the 1998, 2000 and 2004 stock option Plans, respectively.

 

The Board of Directorsadministers the Stock Plan. Subject to the provisions of the Stock Plan, theBoard of Directors has the authority to select the optionees or restrictedstock recipients and determine the terms of the options or restricted stockgranted, including: (i) the number of shares, (ii) option exerciseterms, (iii) the exercise or purchase price (which in the case of anincentive stock option cannot be less than the market price of the Common Stockas of the date of grant), (iv) type and duration of transfer or otherrestrictions and (v) the time and form of payment for restricted stock andupon exercise of options. Generally, an option is not transferable by theoption holder except by will or by the laws of descent and distribution. Also,generally, no option may be exercised more than 60 days following terminationof employment, 90 days in cases of retirement. However, in the event that termination is due to death or disability,the option is exercisable for a period of 180 days following such termination.

 

In September 1998,the Company adopted the 1998 Employee Stock Purchase Plan (the “Plan”).  The Plan provides a method whereby employeesof the Company will have an opportunity to acquire an ownership interest in theCompany through the purchase of shares of Common Stock of the Company throughpayroll deductions,  After 12 months ofemployment, an employee is eligible to participate and can defer up to 10% oftheir wages into this Plan.  The purchaseprice of the Common Stock is calculated at the lower of 85% of the closing priceof the stock on the first day of the plan period or the last day of the planperiod and is issued twice a year.  Theperiods are January 1 to June 30 and July 1 to December 31.  Fractional shares are not issued.  Participants may withdraw at any time bygiving written notice to the Company and will be credited the amounts ofdeferrals in their account.  The maximumnumber of shares eligible to be issued under the Plan is 141,000.  As of June 30, 2004, a total of 119,681shares are available for issuance.

 

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**OPTIONGRANTS IN FISCAL 2005**

 

The following table setsforth certain information regarding stock options held as of June 30, 2005by the executive officers.

 
| **Name  and Principal Position**                                                               | ** ** | **Number of  Securities  Underlying  Options  Granted** | ** ** | **% of Total  Granted to  Employees in  Fiscal Year** | ** ** | **Exercise  Price  ($/sh)** | ** ** | **Expiration  Date** | ** ** |
|------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------|------------|----------------------|------------|
|                                                                                           |       |                                                    |       |                                                  |       |                        |       |                 |       |
| Anthony J. Armini                                                                              |       | —                                                  |       | 0                                                     | %          | —                      |       | —               |       |
| President,  Chief Executive Office and Chairman of the Board                                   |       |                                                    |       |                                                  |       |                        |       |                 |       |
|                                                                                           |       |                                                    |       |                                                  |       |                        |       |                 |       |
| Stephen N. Bunker                                                                              |       | —                                                  |       | 0                                                     | %          | —                      |       | —               |       |
| Vice  President and Chief Scientist                                                            |       |                                                    |       |                                                  |       |                        |       |                 |       |
|                                                                                           |       |                                                    |       |                                                  |       |                        |       |                 |       |
| Diane J. Ryan                                                                                  |       | 30,000                                                  |       | 3                                                     | %          | $                           | 9.15       |                 | 07/28/14   |   |
| Vice  President Finance and Chief Financial Officer                                            |       |                                                    |       |                                                  |       |                        |       |                 |       |
|                                                                                           |       |                                                    |       |                                                  |       |                        |       |                 |       |
| John J. Munro, III                                                                        |       | 30,000                                                  |       | 3                                                     | %          | $                           | 9.15       |                 | 07/28/14   |   |
| Vice  President of Brachytherapy Products                                                      |       |                                                    |       |                                                  |       |                        |       |                 |       |
|                                                                                           |       |                                                    |       |                                                  |       |                        |       |                 |       |
| Walter J. Wriggins                                                                             |       | 50,000                                                  |       | 5                                                     | %          | $                           | 9.92       |                 | 10/15/14   |   |
| Vice  President Business Development/Operations and General Manager of Core Systems, Inc. |       | 20,000                                                  |       | 2                                                     | %          | $                           | 3.58       |                 | 04/22/15   |   |
|                                                                                           |       |                                                    |       |                                                  |       |                        |       |                 |       |
| John Traub                                                                                     |       | 50,000                                                  |       | 5                                                     | %          | $                           | 6.00       |                 | 03/11/15   |   |
| President  Accurel Systems International Corp.                                                 |       |                                                    |       |                                                  |       |                        |       |                 |       |
|                                                                                           |       |                                                    |       |                                                  |       |                        |       |                 |       |
| R. Erik Bates                                                                                  |       | 30,000                                                  |       | 3                                                     | %          | $                           | 6.30       |                 | 03/29/15   |   |
| Vice  President Operations  Explosives Detection Division                                      |       |                                                    |       |                                                  |       |                        |       |                 |       |

 

**AGGREGATEOPTIONS EXERCISABLE IN LAST FISCAL YEARAND FISCAL YEAR END OPTION VALUES**

 
| ** **                                                                                     | ** ** | **Number of Securities  Underlying Unexercised  Options at June 30, 2005** | ** ** | **Value of Unexercised  In-the-Money Options  at June 30, 2005 (1)** | ** ** |
|------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| **Name  and Principal Position**                                                               | ** ** | **Exercisable**                                                                 | ** ** | **Unexercisable**                                                         | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
|                                                                                           |       |                                                                            |       |                                                                      |       |   |   |   |   |
| Anthony J. Armini                                                                              |       | 157,040                                                                         |       | 41,160                                                                    |       | 8,052 |   | — |   |
| President,  Chief Executive Office and Chairman of the Board                                   |       |                                                                            |       |                                                                      |       |   |   |   |   |
|                                                                                           |       |                                                                            |       |                                                                      |       |   |   |   |   |
| Stephen N. Bunker                                                                              |       | 58,500                                                                          |       | 41,500                                                                    |       | — |   | — |   |
| Vice  President and Chief Scientist                                                            |       |                                                                            |       |                                                                      |       |   |   |   |   |
|                                                                                           |       |                                                                            |       |                                                                      |       |   |   |   |   |
| Diane J. Ryan                                                                                  |       | 57,206                                                                          |       | 73,594                                                                    |       | 3,480 |   | — |   |
| Vice  President Finance and Chief Financial Officer                                            |       |                                                                            |       |                                                                      |       |   |   |   |   |
|                                                                                           |       |                                                                            |       |                                                                      |       |   |   |   |   |
| John J. Munro, III                                                                        |       | 71,150                                                                          |       | 65,550                                                                    |       | 6,699 |   | — |   |
| Vice  President of Brachytherapy Products                                                      |       |                                                                            |       |                                                                      |       |   |   |   |   |
|                                                                                           |       |                                                                            |       |                                                                      |       |   |   |   |   |
| Walter J. Wriggins                                                                             |       | —                                                                          |       | 70,000                                                                    |       | — |   | — |   |
| Vice  President Business Development/Operations and General Manager of Core Systems, Inc. |       |                                                                            |       |                                                                      |       |   |   |   |   |
|                                                                                           |       |                                                                            |       |                                                                      |       |   |   |   |   |
| John Traub                                                                                     |       | —                                                                          |       | 50,000                                                                    |       | — |   | — |   |
| President  Accurel Systems International Corp.                                                 |       |                                                                            |       |                                                                      |       |   |   |   |   |
|                                                                                           |       |                                                                            |       |                                                                      |       |   |   |   |   |
| R. Erik Bates                                                                                  |       | —                                                                          |       | 30,000                                                                    |       | — |   | — |   |
| Vice  President Operations  Explosives Detection Division                                      |       |                                                                            |       |                                                                      |       |   |   |   |   |

 

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(1)          As of June 30,2005, the market value of a share of common stock was $2.97

 

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**ITEM 11.****                      SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters**

 

The following table setsforth information as of August 31, 2005, with respect to the beneficialownership of our common stock of each director and nominee for director, eachnamed executive officer in the executive compensation table above, all of ourdirectors and current officers as a group, and each person known by us to be abeneficial owner of five percent or more of our common stock.  This information is based upon informationreceived from or on behalf of the individuals named therein.

 

| **Name  of Beneficial Owner** | ** ** | ** ** | ** ** | **Number of  Shares  Beneficially  Owned (1)** | ** ** | **Percent of  Class (2)** | ** ** |
|-------------------------------|------------|------------|------------|------------------------------------------------|------------|--------------------------------|------------|
|                          |       |       |       |                                           |       |                           |       |
| Anthony J. Armini             |       | (3)        |       | 1,331,192                                      |       | 12                             | %          |
| Stephen N. Bunker             |       | (4)        |       | 730,548                                        |       | 6                              | %          |
| John J. Munro, III       |       | (5)        |       | 106,042                                        |       | 1                              | %          |
| Diane J. Ryan                 |       | (6)        |       | 111,746                                        |       | 1                              | %          |
| Walter J. Wriggins            |       |       |       | 21,300                                         |       |                           | *          |
| John Traub                    |       |       |       | 15,000                                         |       |                           | *          |
| R. Erik Bates                 |       |       |       | —                                         |       |                           | *          |
| Michael Szycher               |       | (7)        |       | 61,000                                         |       | 1                              | %          |
| David Eisenhaure              |       | (8)        |       | 56,000                                         |       |                           | *          |
| Gerald Entine                 |       | (9)        |       | 48,000                                         |       |                           | *          |

 

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| *      | Less than 1%                                                                                                                                                                                                                                                      |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                              |
| (1)    | Unless otherwise noted,  each person identified possesses sole voting and investment power over the  shares                                                                                                                                                       |
| (2)    | The calculation of  percentage of class is based on 10,782,493 shares of common stock issued and  outstanding as of September 30, 2005 plus any shares issuable upon  exercise of options, to such persons and included as being beneficially owned  by him. |
| (3)    | Includes 134,540 shares  exercisable within 60 days of the date hereof.                                                                                                                                                                                           |
| (4)    | Includes 75,000 shares  exercisable within 60 days of the date hereof.                                                                                                                                                                                            |
| (5)    | Includes 97,850 shares  exercisable within 60 days of the date hereof.                                                                                                                                                                                            |
| (6)    | Includes 83,906 shares  exercisable within 60 days of the date hereof.                                                                                                                                                                                            |
| (7)    | Includes 59,000 shares  exercisable within 60 days of the date hereof.                                                                                                                                                                                            |
| (8)    | Includes 55,000 shares  exercisable within 60 days of the date hereof.                                                                                                                                                                                            |
| (9)    | Includes 45,000 shares  exercisable within 60 days of the date hereof.                                                                                                                                                                                            |

 

**ITEM 12.****                      CertainRelationships and Related Transactions**

 

Our CEO and Chairman of theBoard of Directors is also a director of CardioTech.  The CEO and Chairman of the Board ofDirectors of CardioTech is also our director.

 

In March 2000, theCompany entered into a joint research agreement with CardioTech to develop aproprietary porous polymer biocompatible coating technology as a platform forthe Company’s proprietary radioactive brachytherapy technology.  In consideration for this agreement, theCompany agreed to pay $150,000 in cash and purchase 100,000 shares ofCardioTech stock at a price of $1.00 per share. As of June 30, 2005, the Company has purchased these shares, thefair market value of which is $179,000 and is recorded as investments inavailable for sale securities in the accompanying consolidated balance sheet.

 

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In March 2004 theCompany entered into an Exchange & Venture Agreement with CardioTechInternational, Inc. (“CardioTech”), a public company and related party ofthe Company, and CorNova, Inc. (“CorNova”).  CorNova is a start-up company incorporated asa Delaware corporation on October 12, 2003.  CorNova’s focus is the development andmarketing of innovative interventional cardiology products.  In connection with the agreement, in March 2004,the Company and CardioTech issued 10,344 and 12,931 shares, respectively, oftheir respective common stock (the “Contributory Shares”) bearing an aggregatefair market value of $113,000 and $76,000, respectively, as of the date of theissuance.  In exchange, the Company andCardioTech each received 1,500,000 shares of CorNova’s common stock, whichrepresented a 30% ownership position for each party.  In February 2005, upon CorNova’ssecuring of an additional $3,000,000 in financing (“Series A”), CardioTechand the Company each issued additional shares of their common stock, which wasequal in value to twenty-five percent (25%) of the gross proceeds of the Series AFinancing, or $750,000.  As of June 30,2005, the Company’s shares, represent a 19% ownership position.  Anthony Armini, our CEO and Michael Szycher,the Chairman of our Nominating Committee, are also on the Board of Directors ofCorNova.

 

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**ITEM 13.****                      EXHIBIT INDEX**

 

The following exhibitsare incorporate by reference filed as part of this Form 10-KSB for thefiscal year ended June 30, 2005

 
| **Exhibit  No.** | ** ** | **Ref.  No.** | ** ** | **Description**                                                                                                                           |
|------------------|------------|---------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |          |       |                                                                                                                                      |
| 3.2              |       | 1             |       | By-Laws of the Company                                                                                                                    |
| 3.3              |       | 1             |       | Articles of Amendment to the Articles of  Organization of the Company, dated June 9, 1999                                            |
| 3.4              |       | 1             |       | Restated Articles of Organization of the Company,  dated June 9. 1999                                                                |
| 3.5              |       | 5             |       | Certificate of Vote of Directors establishing Series A  7% Cumulative Convertible Preferred Stock, dated October 7, 2002        |
| 3.6              |       | 6             |       | Certificate of Vote of Directors establishing Series B  5% Cumulative Convertible Preferred Stock, dated August 26, 2003        |
| 3.7              |       | 7             |       | Certificate of Vote of Directors establishing Series C  5% Cumulative Convertible Preferred Stock, dated November 25, 2003.     |
| 4.1              |       | 2             |       | Specimen certificate for the Common Stock of the  Company                                                                                 |
| 4.2              |       | 2             |       | Specimen certificate for the Redeemable Warrants of  the Company                                                                          |
| 4.3              |       | 3             |       | Specimen certificate for the Units of the Company                                                                                         |
| 4.4              |       | 5             |       | Specimen Certificate of the Series A 7%  Cumulative Convertible Preferred Stock                                                      |
| 5.1              |       | 15            |       | Opinion of Ellenoff Grossman & Schole LLP                                                                                        |
| 10.3             |       | 1             |       | 1992 Stock Option Plan                                                                                                                    |
| 10.31            |       | 1             |       | Form of Stock Option Agreement under the 1992  Stock Option Plan                                                                     |
| 10.32            |       | 1             |       | 1998 Incentive and Nonqualified Stock Option Plan                                                                                         |
| 10.33            |       | 2             |       | Form of Incentive Stock Option under the 1998  Incentive and Nonqualified Stock Option Plan                                          |
| 10.34            |       | 2             |       | Form of Nonqualified Stock Option under the  1998 Incentive and Nonqualified Stock Option Plan                                       |
| 10.35            |       | 2             |       | Form of Nonqualified Stock Option for  Non-Employee Directors under the 1998 Incentive and Nonqualified Stock Option  Plan           |
| 10.54            |       | 4             |       | Research and Development Agreement, dated March 13,  2000, by and between Implant Sciences Corporation and Cardiotech  International |
| 10.55            |       | 4             |       | Amendment to Distributorship Agreement between  Med-Tec Iowa, Inc., and Implant Sciences Corporation dated 26 January 2000      |
| 10.69            |       | 5             |       | Securities Purchase Agreement between Implant  Sciences Corporation and Laurus Master Fund, Ltd. Dated October 7, 2002               |
| 10.69.1          |       | 6             |       | Amendment #1 to Item 10.69                                                                                                                |
| 10.70            |       | 5             |       | Security Agreement between Implant Sciences  Corporation and Laurus Master Fund, Ltd. Dated October 7, 2002.                         |
| 10.71            |       | 5             |       | Common Stock Purchase Warrant for 55,000 shares  issued to Laurus Master Fund, Ltd. Dated October 7, 2002.                           |
| 10.72            |       | 6             |       | Securities Purchase Agreement between Implant  Sciences Corporation and Laurus Master Fund, Ltd, Dated August 28, 2003.              |
| 10.73            |       | 6             |       | Security Agreement between Implant Sciences  Corporation and Laurus Master Fund, Ltd. Dated August 28, 2003.                         |
| 10.74            |       | 6             |       | Common Stock Purchase Warrant for 70,000 shares  issued to Laurus Master Fund, Ltd. Dated August 28, 2003.                           |

 

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| **Exhibit  No.** | ** ** | **Ref.  No.** | ** ** | **Description**                                                                                                                                                                  |
|------------------|------------|---------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |          |       |                                                                                                                                                                             |
| 10.75            |       | 7             |       | Securities Purchase Agreement between Implant  Sciences Corporation and Laurus Master Fund, Ltd, Dated November 25,  2003.                                                  |
| 10.76            |       | 7             |       | Security Agreement between Implant Sciences  Corporation and Laurus Master Fund, Ltd. Dated November 25, 2003.                                                              |
| 10.77            |       | 7             |       | Common Stock Purchase Warrant for 100,000 shares  issued to Laurus Master Fund, Ltd. Dated November 25, 2003.                                                               |
| 10.78            |       | 8             |       | Exchange and Venture agreement between Implant  Sciences Corporation, CardioTech International, and CorNova, Inc. dated March 5,  2004.                                |
| 10.79            |       | 9             |       | Form of Securities Purchase Agreement between  Implant Sciences and certain investors                                                                                       |
| 10.80            |       | 9             |       | Form of Warrant dated June, 17, 2004                                                                                                                                        |
| 10.81            |       | 9             |       | Form of Additional Investors Rights Agreement  dated June 17, 2004 between Implant Sciences and certain investors                                                      |
| 10.82            |       | 9             |       | Form of Registration Rights Agreement dated June 17,  2004 between Implant Sciences and certain investors                                                              |
| 10.83            |       | 10            |       | Employment Agreement with Anthony J. Armini, dated June 30,  3004                                                                                                           |
| 10.84            |       | 11            |       | Agreement and Plan of Merger and Reorganization,  dated October 13, 2004, by and among the Company, C Acquisition Corp.,  Core Systems Incoporationd and Donald W. Lindsey. |
| 10.85            |       | 12            |       | Securities Purchase Agreements, dated March 4,  2005, by and between the Company and the Purchasers thereunder, with attached  schedules.                                   |
| 10.86            |       | 12            |       | Form of Common Stock Purchase Warrant, dated March 4,  2005, by the Company in favor of Pacific Wave Partners Limited.                                                 |
| 10.87            |       | 12            |       | Form of Common Stock Purchase Warrant, dated March 4,  2005, by the Company in favor of the Purchasers.                                                                |
| 10.88            |       | 12            |       | Form of Additional Investment Right, dated March 4,  2005, by and between the Company in favor of the purchasers.                                                      |
| 10.89            |       | 12            |       | Registration Rights Agreement, dated March 4,  2005, by and between the Company and the parties thereto.                                                                    |
| 10.90            |       | 13            |       | Stock Purchase Agreement dated March 9, 2005 by  and among the Company, Accurel and the Stockholders.                                                                       |
| 10.91            |       | 13            |       | Form of the Securted Promissory Note dated March 9,  2005 made out by the Company in favor of the Stockholders.                                                        |
| 10.92            |       | 13            |       | Note and Security Agreement dated March 9, 2005,  by and among the Company, the Stockholders and the Escrow Agent thereunder.                                               |
| 10.93            |       | 13            |       | Holdback and Escrow Agreement dated March 9,  2005, by and among the Company, the Stockholders and the Escrow Agent  thereunder.                                            |
| 10.94            |       | 14*           |       | Development, Distribution and Manufacturing  Agreement dated March 23, 2005 by and between the Company and Rapiscan  Systems, Inc.                                     |
| 10.95            |       | 16            |       | Form of Business Financing Agreement dated June 1,  2005 between the Company and Bridge Bank, N.A.                                                                     |
| 10.96            |       | 16            |       | Form of Intellectual Property Security  Agreement dated June 1, 2005 between Implant Sciences Corporation and  Bridge Bank, N.A.                                       |
| 10.97            |       | 16            |       | Form of Intellectual Property Security  Agreement dated June 1, 2005 between C Acquisition Corp. and Bridge  Bank, N.A.                                                |
| 10.98            |       | 17            |       | Form of Securities Purchase Agreement, dated as  of July 6, 2005, by and between the Company and Laurus Master Fund, Ltd.                                              |

 

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| **Exhibit  No.** | ** ** | **Ref.  No.** | ** ** | **Description**                                                                                                                                                                   |
|------------------|------------|---------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |          |       |                                                                                                                                                                              |
| 10.99            |       | 17            |       | Form of Secured Term Note, dated as of July 6,  2005, by the Company in favor of Laurus Master Fund, Ltd.                                                               |
| 11.00            |       | 17            |       | Form of Subsidiary Guaranty, dated as of July 6,  2005, by the Company in favor of Laurus Master Fund, Ltd.                                                             |
| 11.01            |       | 17            |       | Form of Common Stock Purchase Warrant, by the  Company in favor of Laurus Master Fund, Ltd.                                                                                  |
| 11.02            |       | 17            |       | Form of Funds Escrow Agreement                                                                                                                                               |
| 11.03            |       | 17            |       | Form of Master Security Agreement                                                                                                                                            |
| 21.1             |       | 18            |       | Subsidiaries of the Company                                                                                                                                                       |
| 23.1             |       |          |       | Consent of BDO Seidman, LLP                                                                                                                                                       |
| 23.2             |       |          |       | Consent of Nation Smith Hermes Diamond, independent  registered public accounting firm                                                                                            |
| 23.3             |       |          |       | Consent of Ireland San Filippo, LLP, independent  certified public accounting firm                                                                                                |
| 31.1             |       |          |       | Certification of Chief Executive Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                         |
| 31.2             |       |          |       | Certification of the Chief Financial Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                     |
| 32.1             |       |          |       | Certification of the Chief Executive Officer and  Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |
|             |       |          |       |                                                                                                                                                                              |
|             |       | 1             |       | Previously filed in the Registration Statement on Form SB-2  (Registration No. 333-64499) filed on September 29, 1998, and is  incorporated herein by reference.   |
|             |       | 2             |       | Previously filed in Amendment No. 1 to the  Registration Statement, filed on December 21, 1998, and is incorporated  herein by reference.                               |
|             |       | 3             |       | Previously filed in Amendment No. 2 to the  Registration Statement, filed on February 11, 1999, and is incorporated  herein by reference.                               |
|             |       | 4             |       | Previously filed in Quarterly Report on Form 10-QSB  for the quarter ended March 31, 2001, filed on May 11, 2000, and is  incorporated herein by reference.        |
|             |       | 5             |       | Previously filed in the Annual Report on Form 10  KSB for the fiscal year ended June 30, 2002 filed on October 15,  2002 and is incorporated herein by reference   |
|             |       | 6             |       | Previously filed in the Annual Report on Form 10  KSB for the fiscal year ended June 30, 2003 filed on September 29,  2003 and is incorporated herein by reference |
|             |       | 7             |       | Previously filed on Form 8-K on December 12,  2003, and is incorporated herein by reference                                                                             |
|             |       | 8             |       | Previously filed on Form 8-K on March 18,  2004, and is incorporated herein by reference                                                                                |
|             |       | 9             |       | Previously filed on Form S-3 on July 14,  2004, and is incorporated herein by reference                                                                                 |
|             |       | 10            |       | Previously filed in the Annual Report on Form 10-KSB  for the fiscal year ended June 30, 2004, and is incorporated herein by  reference.                                |
|             |       | 11            |       | Previously filed on Form 8-K on October 19,  2004, and is incorporated herein by reference.                                                                             |
|             |       | 12            |       | Previously filed on Form 8-K or Amendment form Form 8-K  on March 9, 2005 and is incorporated herein by reference.                                                 |
|             |       | 13            |       | Previously filed on Form 8-K on March 11,  2005 and is incorporated herein by reference.                                                                                |
|             |       | 14            |       | Previously filed on an Amendment to Form 8-K on  April 7, 2005 and is incorporated herein by reference.                                                                 |
|             |       | 15            |       | Previously filed with this Registration Statement                                                                                                                                 |
|             |       | 16            |       | Previously filed on Form 8-K on June 13,  2005 and is incorporated herein by reference                                                                                  |
|             |       | 17            |       | Previously filed on Form 8-K on July 14,  2005 and is incorporated herein by reference                                                                                  |
|             |       | 18            |       | Previously filed on Form S-3 on August 3,  2005 and is incorporated herein by reference.                                                                                |
|             |       | *             |       | filed pursuant to a request for confidential  treatment                                                                                                                           |

 

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**ITEM 14.****                      PRINCIPALACCOUNTANT FEES AND SERVICES**

 

| ** **         | ** ** | **June 30,** | ** ** |
|--------------------|------------|-------------------|------------|
| ** **         | ** ** | **2005**          | ** ** | **2004** | ** ** |
| ** **         | ** ** | ** **        | ** ** | ** ** | ** ** |
| Audit fees         |       | $                 | 297,500    |   | $ | 138,000 |   |
| Audit related fees |       | 17,650            |       | 8,000 |   |
| Total              |       | $                 | 315,150    |   | $ | 146,000 |   |

 

The Company’s Audit Committee must pre-approve all audit services to beprovided to the Company, whether provided by the principal auditor or otherfirms, and all other services (review, attest and non-audit) to be provided tothe Company by the independent auditor, provided, however, that *de minimis* non-audit services may instead be approved inaccordance with applicable SEC rules. The Company’s principal financial and accounting officer communicates toboth the Chairman of the Audit Committee and the auditing services firm anyservices requested to be provided.  Afterreceiving a fee quote for services from the service provider, a letter from theChairman of the Audit Committee is prepared and submitted to the serviceprovider as evidence of approval of the requested services.

 

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**SIGNATURES**

 

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

 

 
|                         |   | Implant Sciences  Corporation        |
|------------------------------|--------|--------------------------------------|
|                         |   |                                 |
| Date: October 13,  2005 |   | /s/ Anthony J. Armini                |   |
|                         |   | Anthony J. Armini                    |
|                         |   | President, Chief  Executive Officer, |
|                         |   | Chairman of the Board  of Directors  |
|                         |   | (Principal Executive  Officer)       |

 

In accordance with theExchange Act, this report has been signed below by the following persons onbehalf of the registrant and in the capacities and on the dates indicated.

 

 
| Date: October 13,  2005      |   | /s/ Anthony J. Armini                         |   |
|-----------------------------------|--------|-----------------------------------------------|--------|
|                              |   | Anthony J. Armini                             |
|                              |   | President, Chief  Executive Officer,          |
|                              |   | Chairman of the Board  of Directors           |
|                              |   | (Principal Executive  Officer)                |
|                              |   |                                          |
|                              |   |                                          |
| Date: October 13,  2005      |   | /s/ Diane J. Ryan                             |   |
|                              |   | Diane J. Ryan                                 |
|                              |   | VP Finance and CFO                            |
|                              |   | (Principal Financial  and Accounting Officer) |
|                              |   |                                          |
|                              |   |                                          |
|  Date: October 13, 2005 |   | /s/ Stephen N. Bunker                         |   |
|                              |   | Stephen N. Bunker                             |
|                              |   | Vice President and  Chief Scientist,          |
|                              |   | Director                                      |
|                              |   |                                          |
|                              |   |                                          |
| Date: October 13,  2005      |   | /s/ Michael Szycher                           |   |
|                              |   | Michael Szycher,  Director                    |
|                              |   |                                          |
|                              |   |                                          |
| Date: October 13,  2005      |   | /s/ David Eisenhaure                          |   |
|                              |   | David Eisenhaure,  Director                   |
|                              |   |                                          |
|                              |   |                                          |
| Date: October 13,  2005      |   | /s/ Gerald Entine                             |   |
|                              |   | Gerald Entine, Director                       |

 

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