U.S.
SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549




Form
10-K




(Mark
      One)x
            
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
      EXCHANGE ACT OF 1934For
      the fiscal year ended June 30, 2008o
            
            TRANSITION
      REPORT UNDER SECTION 13 OR 15(d) OF THESECURITIES
      EXCHANGE ACT OF 1934For
      the transition period
      from                      to







Commission
File No. 000-25839




Implant
Sciences Corporation


(Name of
small business issuer in its charter)




Massachusetts
              (State
      or other jurisdiction of
              incorporation
      or organization)
            04-2837126
              (I.R.S.
      Employer Identification No.)107
      Audubon Road, Wakefield, Massachusetts
              (Address
      of principal executive offices)
            01880
              (Zip
      Code)







Issuer’s
telephone number (781)
246-0700




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




Title
      of each class
              Common
      Stock, $0.10 par value per share
            Name
      of each exchange on which registered
              American
      Stock Exchange


€




Securities
registered pursuant to Section 12(g) of the Act: None




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




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




Indicate
by check mark whether the registrant (1) filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes x  No q




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




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




q  Large
Accelerated
Filer                                                                                                                 q  Accelerated
Filer




q  Non-accelerated
Filer                                                                                                                          x  Smaller
reporting company




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




As of
October 6, 2008, 14,135,737 shares of the registrant’s Common Stock were
outstanding.  As of December 31, 2007, the aggregate market value of
the registrant’s Common Stock held by non-affiliates of the registrant (without
admitting that any person whose shares are not included in such calculation is
an affiliate) was $8,008,000 based on the last sale price as reported by the
American Stock Exchange on such date.







IMPLANT SCIENCES
CORPORATION


FORM
10-K


FOR
THE YEAR ENDED JUNE 30, 2008





INDEX





PART IItem
      1.
            
            Description
      of Business
            
            3Item
      1A.
            
            Risk
      Factors
            
            11Item
      1B.
            
            Unresolved
      Staff Comments
            
            19Item
      2.
            
            Description
      of Properties
            
            19Item
      3.
            
            Legal
      Proceedings
            
            19Item
      4.
            
            Submission
      of Matters to a Vote of Security Holders
            
            19PART IIItem
      5.
            
            Market
      Information for Registrant’s Common Equity, Related Stockholder
      Matters
              and
      Issuer Purchases of Equity Securities
            
            20Item
      6.
            
            Selected
      Consolidated Financial Data
            
            21Item
      7.
            
            Management’s
      Discussion and Analysis or Plan of Operations
            
            22Item
      8.
            
            Financial
      Statements and Supplementary Data
            
            29Item
      9.
            
            Changes
      In and Disagreements With Accountants on Accounting and Financial
      Disclosure
            
            29Item
      9A.
            
            Controls
      and Procedures
            
            29Item
      9B.
            
            Other
      Information
            
            30PART IIIItem
      10.
            
            Directors,
      Executive Officers and Corporate Governance
            
            31Item
      11.
            
            Executive
      Compensation
            
            31Item
      12.
            
            Security
      Ownership of Certain Beneficial Owners and Management
              and
      Related Stockholder Matters
            
            31Item
      13.
            
            Certain
      Relationships and Related Transactions,  and Director
      Independence
            
            31Item
      14.
            
            Principal
      Accounting Fees and Services
            
            31PART IVItem
      15.
            
            Exhibits,
      Financial Statement Schedules
            
            32Index
      to Financial Statements
            
            F-1









-2-


PART I




Item 1.
            Business




Cautionary
      Note Regarding Forward Looking
Statements




This
Annual Report on Form 10-K contains certain statements that are
“forward-looking” within the meaning of the Private Securities Litigation Reform
Act of 1995 (the “Litigation Reform Act”).  These forward looking
statements and other information are based on our beliefs as well as assumptions
made by us using information currently available.




The words
“anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and
similar expressions, as they relate to us, are intended to identify
forward-looking statements.  Such statements reflect our current views
with respect to future events and are subject to certain risks, uncertainties
and assumptions, and are not guaranties of
future performance.  Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual results may vary materially from those described herein as anticipated,
believed, estimated, expected, intended or using other similar
expressions.




In
accordance with the provisions of the Litigation Reform Act, we are making
investors aware that such forward-looking statements, because they relate to
future events, are by their very nature subject to many important factors that
could cause actual results to differ materially from those contemplated by the
forward-looking statements contained in this Annual Report on Form
10-K.  Important factors that could cause actual results to differ
from our predictions include those discussed under “Risk Factors,” “Management’s
Discussion and Analysis” and “Business.”  Although we have sought to
identify the most significant risks to our business, we cannot predict whether,
or to what extent, any of such risks may be realized, nor can there be any
assurance that we have identified all possible issues which we might
face.  In addition, assumptions relating to budgeting, marketing,
product development and other management decisions are subjective in many
respects and thus susceptible to interpretations and periodic revisions based on
actual experience and business developments, the impact of which may cause us to
alter our marketing, capital expenditure or other budgets, which may in turn
affect our financial position and results of operations.  For all of
these reasons, the reader is cautioned not to place undue reliance on
forward-looking statements contained herein, which speak only as of the date
hereof.  We assume no responsibility to update any forward-looking
statements as a result of new information, future events, or otherwise except as
required by law.  We urge readers to review carefully the risk factors
described in this Annual Report and in the other documents that we file with the
Securities and Exchange Commission.  You can read these documents atwww.sec.gov.




Where we
say “we,” “us,” “our,” “Company” or “Implant Sciences” we mean Implant Sciences
Corporation and its subsidiaries.




General




Overview




We
develop, manufacture and sell sophisticated sensors and systems for the
Security, Safety and Defense (“SS&D”) industries.  A variety of
technologies are currently used worldwide in security and inspection
applications.  In broad terms, these technologies focus on detection
in two major categories: (i) the detection of “bulk” contraband, which includes
materials that would be visible to the eye, such as weapons, explosives,
narcotics and chemical agents; and (ii) the detection of “trace” amounts of
contraband, which includes trace particles or vapors of explosives, narcotics
and chemical agents.  Technologies used in the detection of “bulk”
materials include computed tomography, transmission and backscatter x-ray, metal
detection, trace detection and x-ray, gamma-ray, passive millimeter wave, and
neutron analysis.  Trace detection techniques used include mass
spectrometry, gas chromatography, chemical luminescence, or ion mobility
spectrometry.




We have
developed proprietary technologies used in explosives trace detection (“ETD”)
applications and market and sell handheld and benchtop ETD systems which use our
proprietary ETD technologies.  Our products are marketed and sold to a
growing number of locations domestically and internationally.  These
systems are used by private companies and government agencies to screen baggage,
cargo, vehicles, people and other objects, for the detection of trace amounts of
explosives.




-3-


History




Since our
incorporation in August 1984, we have operated as a multi-faceted company
engaged in the development of ion-based technologies and providing commercial
services and products to the semiconductor, medical device and security
industries.  Beginning
in March 2007, we undertook steps to divest our semiconductor and medical
business activities in order to focus on our security
business.




SemiconductorBusiness
Unit




Our
business began as a result of the development of our proprietary ion-beam
technology and application of this technology in services to the semiconductor
industry.  At the outset, our initial business was to provide ion
implantation services to the semiconductor industry for surface modification of
silicon wafers.  Our services were provided to semiconductor
companies, universities and research facilities as an outsource provider of
these ion implantation services.  These services were performed at our
Massachusetts facility, where we maintained and operated several ion
implanters.




In
October 2004, we acquired Core Systems Inc., a privately-held semiconductor
wafer processing company located in Sunnyvale, California for $7,486,000
in cash and common stock of the Company.  In February 2008, our
Board approved a formal plan to sell Core Systems as part of our strategic
initiative to focus on our security business.  As of June 30, 2008 and
2007, the assets and liabilities of Core have been recorded on our balance sheet
as held-for-sale.  For the years ended June 30, 2008 and 2007, the
operations of Core have been recorded in our statements of operations as
discontinued operations.




In
March 2005, we acquired Accurel Systems International Corporation, a
privately-held semiconductor wafer analytical services company located in
Sunnyvale, California for $12,176,000 in cash and common
stock.  In March 2007, our Board approved a formal plan to sell
Accurel Systems as part of our strategic initiative to focus on our
security business. In May 2007, we completed the sale of Accurel
Systems to Evans Analytical Group LLC, in exchange
for $12,705,000 in cash of which $1,000,000 was placed in escrow (See
Note 18 to our consolidated financial statements).  For the year ended
June 30, 2007, the operations of Accurel Systems and loss on sale of
Accurel Systems have been recorded in our statements of operations as
discontinued operations.




In
February 2008, Evans filed suit requesting rescission of the acquisition
agreement, plus damages, based on claims of misrepresentation and
fraud.  In March 2008, Evans filed a claims notice with the
escrow agent prohibiting release of any portion of the escrowed funds pending
resolution of the lawsuit.  As a result we have classified the
$1,000,000 of escrowed funds as a long term asset.  We have
retained legal counsel in defense of these claims.  Please see the
more detailed discussions of the Evans litigation matter in Note 22 to our
consolidated financial statements and in Item 1A, Risk Factors - Risks Related
to our Liquidity.




Medical Business
Unit




We also
used our ion beam technology to develop ion implantation and thin film coatings
applications for medical devices.  As a result of these technologic
advancements, which were in part funded by government research grants and
awards, we were able expand our business and provide services and products to
the medical industry.  The primary medical related businesses in which
we engaged were (i) providing services to medical device companies for surface
modification of implantable devices, (ii) the development of brachytherapy
products, and (iii) the manufacture and sales of our proprietary radioactive
seeds for the treatment of prostate cancer.




We
provided ion implantation services to modify orthopedic joint implant surfaces,
resulting in reduced polyethylene wear and increased implant life, through the
second quarter of fiscal 2007.  In the second quarter of fiscal 2007,
the customer discontinued their product line using our ion implantation
services.  We did not provide services to implant ions into orthopedic
devices to any other customers.  Using similar technology, we
developed applications for coatings of cardiovascular devices, such as coronary
stents.  In May 1999, we received Food and Drug Administration 510(k)
clearance to market our radioactive seed for the treatment of prostate
cancer.  We began commercial sales of our radioactive seed in fiscal
2001.




In
further support of our strategic initiative to focus on our security business,
in June 2007, we sold certain assets associated with our prostate seed business
and discontinued the manufacturing of brachytherapy
products.  Management currently has plans in place to sell the
remaining medical segment assets and discontinue the surface modification
services provided to the medical device marketplace by the end of calendar
2008.  As of June 30, 2008 and 2007, the assets and liabilities of the
Medical Business Unit have been recorded on our balance sheet as
held-for-sale.  For the years ended June 30, 2008 and 2007, the
operations of the Medical Business Unit have been recorded in our statements of
operations as discontinued operations.






-4-




Security Business
Unit




Since May
1999, we have been performing research to improve ETD technology, and
development of ETD products which can be used for detection of trace amounts of
explosives.  At present, we have developed both portable and benchtop
systems, which have been marketed and sold both domestically and
internationally.  In order to reduce manufacturing costs and be
responsive to large quantity orders, we use a contract
manufacturer.  As we continue to sell and deliver our security
products, we work both independently and in conjunction with various government
agencies, to develop the next generation of trace explosives detectors and to
identify new applications for our proprietary technology.




In April 2008,weacquiredall of the capital stock
of Ion Metrics, Inc.,located in San
Diego,California.Ion Metrics' develops mass sensor systems to
detect and analyze chemical compounds such as explosives, chemical warfare
agents, narcotics, and toxic industrial chemicals for the homeland defense,
forensic, environmental, and safety/security markets.  Ion
Metrics' miniaturized devices and system designs provide high performance
and reliability in combination with low manufacturing costs.The operating
results of Ion Metrics have been included in the our
consolidated statement of operations commencing on April 10,
2008.Please refer
to Note 17 to our consolidated financial statements for further information
relating to the acquisition of Ion Metrics.




Industry
Overview




We
believe that the market for security and inspection products will continue to be
affected by the threat of terrorist incidents and by new government mandates and
appropriations for security and inspection products in the United States and
internationally.




The
September 11, 2001 terrorist attacks on the World Trade Center and the Pentagon
using hijacked airliners led to nationwide shifts in transportation and
facilities security policies.  Shortly following these attacks, the
U.S.Congress passed the Aviation and Transportation Security Act and integrated
many U.S. security-related agencies, including the Federal Aviation
Administration, into the U.S. Department of Homeland Security
(“DHS”).  Under its directive from Congress, DHS has undertaken
numerous initiatives to prevent terrorists from entering the country, hijacking
airliners, and obtaining and trafficking in weapons of mass destruction and
their components, to secure sensitive U.S. technologies and to identify and
screen high-risk cargo containers before they are loaded onto vessels destined
for the United States, among others.  These initiatives, more fully
described in the Strategic Border Initiative, the Customs-Trade Partnership
Against Terrorism and the U.S. Customs and Border Protection Container Security
Initiative, have resulted in an increased demand for security and inspection
products both in the United States and other nations.




These
government sponsored initiatives  have also stimulated security
programs in other areas of the world as the U.S initiatives call on other
nations to bolster their port security strategies, including acquiring or
improving their security and inspection equipment.  As a result, the
international market for non-intrusive inspection equipment continues to expand
as countries that ship goods directly to the United States are required to
improve their security infrastructure.




The U.S.
Congress recently passed legislation that mandated the inspection of
international maritime cargo destined for the United States, domestic civil
aviation cargo, and for radiological and nuclear threats in cargo entering the
United States.  In addition, following recommendations outlined in the
“9/11 Commission Report,” issued by the National Commission on Terrorist Attacks
Upon the United States, DHS will require the screening of all cargo carried
on passenger airlines by 2010.




Furthermore,
DHS’s Science and Technology Directorate has supported the development of new
security inspection technologies and products.  We participate in a
number of such research and development efforts, including projects to develop
new technologies for improving the accuracy of detection of trace amounts of
explosives, narcotics and chemical agents; and improved sampling techniques for
the application of trace detection to aviation and cargo
screening.  The Science and Technology Directorate has also initiated
programs for the development of technologies capable of protecting highways,
railways and waterways from terrorist attack.




In
addition, the U.S. Department of Defense has also begun to invest more heavily
in technologies and services that screen would-be attackers before they are able
to harm U.S. and allied forces.




Similar
initiatives by international organizations such as the European Union have also
resulted in a growing worldwide demand for airline, cargo, port and border
inspection technologies.  For example, the European Union is expected
to issue uniform performance standards for people, cargo, mail and parcel and
hold baggage screening systems as well as new directives related specifically to
maritime security.  We anticipate that the promulgation of these new
standards will establish performance baselines against which we will be able to
direct certain of our research and development spending and market our products
to customers located in the European Union.






-5-




As a
result of these and other changes, sales of our security products have
improved.  Major projects recently installed or currently underway
include system installations at airports, ports and border crossings, government
and military facilities and other locations, primarily in the international
marketplace.  We anticipate that there may be growing demand from
governments and commercial enterprises for increasingly sophisticated screening
solutions in the future.




Technology




Since May
1999, we have performed research and development in the area of explosives trace
detection (“ETD”).  We have developed several proprietary technologies
in key areas of ETD which we believe improve the harvesting, collection and
detection of trace particles and vapors of explosives substances.  In
addition, we continue our development efforts to adapt this technology for the
detection of narcotics and other chemical agents.  Our intellectual
property portfolio contains 17 security-related patents and patents
pending:  six issued United States patents, 10 United States patents
pending, and one licensed patent.  We believe that our portfolio of
patents and patents pending provides extensive protection in sample
harvesting and detection.  A key to our past and future success
is our ability to innovate and offer differentiation in these
areas.




We
compartmentalize ETD into four major areas: (i) harvest, (ii) transport, (iii)
analysis, and (iv) reporting.  These technologies, which are
incorporated into our handheld detector, are discussed in detail in the
following sections.




Harvest
- Aerosol Particle Release




Tiny
particles of explosives and narcotics are “sticky” and generally adhere to
surfaces.  Particles could be transferred if an object, such as
fingers or clothing, comes in contact with a particle.  It is common
knowledge that a person touching an explosives material can transfer
explosives particles to numerous other objects leaving a trail of particles
behind.




Our
competitors commonly swipe a surface to be interrogated for explosives particles
with a cloth or paper material.  We believe that this “contact”
methodology provides an effective, but costly and time
consuming method, of harvesting sample as compared to an automated,
non-contact collection of the trace sample.  Human portals, which can
be seen in certain airports, use air puffs to blow particles off of
people.  While somewhat effective for clothing and cardboard, we do
not believe the method performs well for most other surfaces.  We have
developed a patented method, which we believe to be more efficient, using an
aerosol of fine dry ice particles mixed into an air puff.  This
technique, which is surprisingly inexpensive to use, could increase collection
sensitivity substantially as compared to the method of simply “puffing” with
air.  Our aerosol technology functions as a very gentle version of
“sandblasting” and is safe for almost all surfaces.  Since dry ice
sublimes into gas, no residue is left behind, and the aerosol may be used
indoors.  We have two patents pending on this
methodology.




Transport




Vortex
Sampling




Once the
trace particle has been released from a surface, it has to be transported to a
collection point.  Vortex sampling was the first of our sampling
innovations.  We have three patents issued and two patents pending in
the area of vortex sampling methodology.




Our
vortex is similar to a miniature tornado.  There is a spinning
cylinder of air flowing outward which surrounds and protects an inner vacuum
drawing the sample inward.  It is this vortex sampling technology that
enables particles released within the vortex, or blown into it, to be
transported with high efficiency to a collection filter.




Long-Life Sample
Trap




Once
particles have been liberated from the surface being interrogated for the
presence of trace amounts of explosives, the particles are transported to our
innovative trapping filter, which is an ultra-fine stainless steel woven
mesh.  The trapping filter has a long usable life, which could span
several years, requiring inexpensive, routine maintenance.  We believe
the trapping filter provides an innovative solution to the more costly
consumables used by several of our competitors engaged in ETD using contact
methodology for sampling and detection.






-6-




Analysis




Flash
Desorption




Flash
desorption is an optical method for converting the chemistry of a particle, such
as the chemicals composing explosives or narcotics, into a vapor that can be
subjected to analyses for the discrimination of chemical
properties.  In conventional trace chemical detectors, a sample is
slowly warmed in an oven producing diluted vapor with low chemical
concentrations.  Optical flash vaporization heats a sample almost
instantaneously, producing a high sample concentration for
detection.  Our spectrometers can be as much as 10 times more
sensitive when optical flash vaporization is employed.




This
method is not appropriate with conventional sample collection methods, such as
paper wipes, because the paper is white, and the light from the bright flash
reflects off, producing little heating.  However, by using our
trapping filter, a very fast desorption response can be
achieved increasing sensitivity.  We have two patents issued and
one patent pending in the area of flash desorption methodology.  The
first product under development to take advantage of our flash desorption
technology is our air cargo screening system described under “Products”
below.




Photonic
Ionization




The most
widely used conventional method of turning molecules into ions that can be
analyzed is to use a radioactive beta source.  While ETD equipment
using radioactive sources are simple, effective, and need no electricity in the
ionization process, there are important issues involving safety, licensing,
regular verification of source integrity, and disposal.  Some markets,
such as Japan and Australia, are known to reject instruments with radioactive
sources.  We believe that most markets would prefer not to have to
address the issues surrounding ETD equipment with radioactive
sources.




We have
developed two types of photonic, non-radioactive ion sources for our instruments
for applications requiring either the ionization of positive ions or negative
ions.  These ion sources may be found individually or in combination
within our products, depending on the application for which the ETD equipment is
to be used.  We have two patents pending in the area of photonic
ionization.




Reporting




Reporting
is the portion of the cycle that displays and stores information generated
during the analysis phase.  It is the information an operator sees and
indicates if an alarm condition exists or if the test is
clear.  Information can be displayed in both graphical and tabular
formats.  The reporting also indicates when the instrument is ready
for the next sample as well as displaying built-in system
diagnostics.




Intellectual
      Property




It is our policy to
protect our proprietary position by, among other methods, filing United States
patent applications.Our intellectual property portfolio
contains 17 security-related patents and patents pending:  six patents
have been issued and are active, 10 patents are pending and we license one
patent.  The six issued patents expire in the years 2021 through
2024.  We believe our patent portfolio provides extensive
protection.  We also rely on unpatented proprietary technology, trade
secrets and know how.




Manufacturing




We
manufacture our security products primarily through a sole source contract
manufacturer located locally in Worcester, Massachusetts.  We believe
our strategy to outsource manufacturing should reduce manufacturing costs,
improve scheduling flexibility, and allow us to focus our internal resources and
management on product development, marketing, sales and
distribution.  We also maintain an internal production group at our
corporate headquarters in Wakefield, Massachusetts responsible for
pre-production logistics, oversight of contract manufacturing, quality control
and inventory management.




Products




We have
developed several explosives detection systems designed for use in aviation and
transportation security, high-threat facilities and infrastructure, military
installations, customs and border protection, and mail and cargo
screening.  The systems use our proprietary Quantum SnifferTM technologies,
including photon-based, non-radioactive ion source in combination with ion
mobility spectrometry (a classic detection tool sensitive to the unique speeds
with which ions of various substances move through air) (“IMS”), to
electronically detect minute quantities of explosives vapor and
particles.




-7-




Current
Products




Quantum SnifferTMQS-H150 Portable Explosives
Detector




The
Quantum Sniffer QS-H150 Portable Explosives Detector employs a patented vortex
collector for the simultaneous detection of explosives particulates and vapors
with or without physical contact and in real-time.  We believe our
advanced QS-H150 to be more sensitive than other detection
devices.  The QS-H150 can detect parts-per-trillion levels of
explosives vapor and nanogram quantities of explosives particulates for most
explosives substances considered to be threats.  Such substances
include, but are not limited to, military and commercial explosives, improvised
and homemade explosives, and propellants and taggants.




The
QS-H150 has automatic and continuous self-calibration.  It monitors
its environment, senses changes that would affect its accuracy, and
re-calibrates accordingly.  The system requires no user intervention
and no calibration consumables.  The detection process begins with the
collection of a sample with our patented vortex collector.  After
collection, the sample is ionized photonically and analyzed using IMS
technology.  The presence of a threat substance is indicated by a
visible and audible alarm.  The threat substance is then identified
and displayed on the integrated LCD screen.  Optionally, and at any
time, a monitor and keyboard may be connected for convenient access to
spectrogram display and analysis tools, administrative tools, and
diagnostics.




When
detecting a threat substance, the QS-H150 rapidly alarms.  This
real-time detection limits equipment contamination and allows for fast
clear-down.  Operation and maintenance are
cost-effective.  Since there is no requirement for dopants,
calibration consumables or verification consumables, the overall cost of
consumables are minimized.  Routine maintenance consists only of care
and cleaning using common supplies, and desiccant replacement as
required.  There is no radioactive material used in the QS-H150, so
there are no associated certifications, licenses, inspections, or end-of-life
disposal issues.




Quantum SnifferTMQS-B200 Benchtop Explosives
Detector




The
QS-B200 Benchtop Explosives Detector uses dual IMS with non radioactive
ionization for the detection and identification of a wide range of military,
commercial, and improvised explosives.  The QS-B200 has automatic and
continuous self-calibration.  It monitors its environment, senses
changes that would affect its accuracy, and re-calibrates
accordingly.  For detection, the sample is collected with a standard
trap, ionized, and analyzed via IMS.  The presence of a threat is
indicated by a visible and audible alarm, and the substance is identified and
displayed on the integrated touch screen display.  Users may save data
locally, print via built-in thermal printer, or send data through standard
interfaces (USB, LAN, etc.).  Multi-level password protected data
security is standard.  We believe that the operation and maintenance
of the QS-B200 are extremely cost-effective.  Routine maintenance
consists only of care and cleaning using common supplies, and desiccant
replacement as required.  There is no radioactive material used in the
QS-B200, so there are no associated certifications, licenses, inspections, or
end-of-life disposal issues.




Products
Under Development




Quantum SnifferTMQS-H300Air Cargo Screening
System




With the
assistance of funding from DHS, we have developed a hand sampler detector which
utilizes our proprietary jetted vortex collector for non-contact collection of
trace particulate materials.  We believe the hand sampler, which will
be a compact, lightweight device, could significantly improve explosives
detection capabilities while also being very user friendly.  Our
non-contact method could prove to be more effective than traditional contact
sample collection methods, and at a much lower cost to users.  This
improved sampling process has applicability for use in detecting trace amounts
of explosives found on a wide range of objects such as carry-on luggage,
parcels, packages and cargo.  In addition, multiple handheld sampling
units could be systematically deployed in concert with a centralized trace
explosives detection system to improve efficiency and increase the volume of
articles screened.  We believe this product could usher in a new
way of thinking about how cargo and other items can be properly examined in a
cost effective and user friendly manner.




Miniature Mass
Spectrometer




We
initially developed our proprietary ion mobility spectrometer
(IMS).  We believe that as market demand grows for greater precision
of substance identification and the list of substances to be detected increases,
more advanced detectors will be required.






-8-




Our
acquisition of Ion Metrics enabled us to obtain miniaturized quadrupole mass
spectrometry (“QMS”) detector technology.  The QMS detector is roughly
the size of an AA battery ands has low manufacturing costs.  The QMS
detector senses the mass of a molecular ion resulting in an “orthogonal”
detection method in which a different unique characteristic of a substance is
sensed.  We believe that, because it is unlikely that two substances
would share the same mass and the same ion mobility in air, QMS detector
technology improves the accuracy of detection and minimizes false
alarms.  We are currently developing interfaces for using the QMS
detector in our advanced equipment.




Hyphenated
Detectors




Depending
on the application and the number of “interfering” background chemicals, it may
be necessary to incorporate additional “orthogonal” detection
methods.  The combination of these sensors in series is commonly known
as employing “hyphenated” detection methods.  A hyphenated system is
one in which a sequence of different types of detectors all must agree that an
alarm has occurred before a valid alarm is declared.




Our
acquisition of Ion Metrics also provided us miniature differential mobility
spectrometer (“DMS”) detector technology.  We are currently developing
a fully hyphenated system employing IMS, DMS, and QMS for DHS.  In
addition, we have developed and applied for patents on miniaturized pumping
support hardware.




We
believe detection systems incorporating hyphenated detection methods could
accelerate the expansion of our product line to more effectively address the
needs of the security, safety and defense sector, as well as accelerate our
entry into the narcotics, chemical warfare and toxic industrial chemical
detection marketplaces.  Combining these technologies with our other
innovative products could enhance our competitive position while improving sales
volumes and product margins in the future.  We expect hyphenated systems to
appear in our future product offerings.




Marketing
      and Sales




We market
and sell our products through  direct sales and marketing staff
located in the United States and China, in addition to using an expansive global
network of independent and specialized sales representatives and
distributors.  This sales staff is supported by a sales organization
located primarily in the United States, as well as a global network of
independent distributors.




We have
not experienced, and do not expect to experience, in any material respect,
seasonality in sales of our products.




Contracts
      and Material Relationships




Government
Contracts




Research
and development contracts from the U.S. government must be won through a
competitive proposal process which undergoes peer review.  We are in
contact with the Department of Defense, DHS and other agencies at technical
conferences to stay informed of the government's needs.  We believe
our management and senior scientific staff have earned a strong reputation with
these and other agencies. To date we have been awarded research and development
contracts by the Department of Defense, the National Science Foundation, the
National Aeronautics and Space Administration, the Environmental Protection
Agency and DHS.




Competition




In the
trace explosives detection industry, General Electric (GE Security) and Smiths
Detection are our two primary competitors.  These two companies also
use ion mobility spectrometry; however, they use a radioactive 63Ni
source to ionize the explosive molecules.  We believe our technology
differs from the competition in that we do not have a radioactive ion source, we
have lower operating costs, and can do “real time” detection.  We
believe our patented technology provides our device with greater operating
advantages and fewer regulatory restrictions.




Research
      and Development




Our
technical staff consists of 16 scientists and engineers, including three of whom
hold Ph.D. degrees.  All of our existing and planned products rely on
proprietary technologies developed in our research and development
laboratories.  Our research and development efforts may be
self-funded, funded by corporate partners or by awards under the Small Business
Innovative Research and other programs of the U.S. government.  Under
the Small Business Innovative Research program, we retain the right to patent
any technology developed pursuant to the program, subject to the retention by
the U.S. government of a royalty-free license to use the
technology.  We have obtained over $20 million in U.S. government
grants and contracts over the past 19 years.




We spent
approximately $3,097,000 and $1,662,000 on internally funded research and
development in the fiscal years ended June 30, 2008 and 2007,
respectively.






-9-




Government
      Regulation and Environmental
Compliance




From time
to time, legislation is drafted and introduced in Congress that could
significantly change the statutory provisions governing the approval,
manufacturing and marketing of security products.




Furthermore,
our use, management, transportation, and disposal of certain chemicals and
wastes are subject to regulation by several federal and state agencies depending
on the nature of the chemical or waste material.  Certain toxic
chemicals and products containing toxic chemicals require special reporting to
the U.S. Environmental Protection Agency and/or its state counterparts. We are
not aware of any specific environmental liabilities to which we are likely to be
subject.  Our future operations may require additional approvals from
federal and/or state environmental agencies, the cost and effects of which
cannot be determined at this time.




Employees




As of
June 30, 2008, we had 58 full-time employees at our Massachusetts facility and
37 full-time employees in California.




None of
these employees are covered by a collective bargaining agreement, and management
considers its relations with its employees to be good.




Geographic
Areas




Our
revenues are derived from both domestic and international
sales.  During the fiscal year ended June 30, 2008, foreign sales
represented 78% of our revenue with two customers from China
representing 55% and 15%, respectively, of our revenue.  For the
fiscal year ended June 30, 2007, foreign sales represented 39% of our
revenue with one customer from China representing 15% of our
revenue.


-10-


Item 1A.
            Risk
      Factors




An
investment in our common stock involves a high degree of risk. Investors should
carefully consider the following risk factors in evaluating our Company and our
business.  If any of these risks, or other risks not presently known
to us or that we currently believe are not significant, develops into an actual
event, then our business, financial condition and results of operations could be
adversely affected.  If that happens, the market price of our common
stock could decline.




Risks
Related to our Liquidity




We
will be required to redeem our Series D Preferred Stock on October 24,
2008.




We will
be required to redeem the remaining shares of Series D Redeemable Convertible
Preferred Stock held by Laurus Master Fund, Ltd. on October 24,
2008.  Management does not believe that we will meet the conditions
necessary for us to redeem the Series D Preferred Stock by issuing shares of our
common stock and that we will be required to redeem such preferred stock for
cash.  Our obligations to Laurus are secured by a security interest in
substantially all of our assets.  As of June 30, 2008, the outstanding
balance due to Laurus was approximately $2,269,000.  We made a payment
of $250,000 to Laurus, inclusive of $22,000 of dividends, on October 2,
2008, and upon application of this payment, the balance expected to be
paid to Laurus on October 24, 2008 is approximately
$1,893,000.  If we are unable to redeem the Series D Preferred Stock
as required, refinance our obligations to Laurus, or negotiate a further
extension of the obligation to redeem the Series D Preferred Stock, Laurus may
seize our assets and we may be forced to curtail or discontinue operations
entirely.




We
have received a qualified audit opinion on our ability to continue as a going
concern.




The audit
report issued by our independent registered public accounting firm issued on our
audited financial statements for the fiscal year ended June 30, 2008 contains a
qualification regarding our ability to continue as a going
concern.  This qualification indicates there is substantial doubt on
the part of our independent registered public accounting firm as to our ability
to continue as a going concern due to the risk that we may not have sufficient
cash and liquid assets at June 30, 2008, to cover our operating capital
requirements for the next twelve-month period and if sufficient cash cannot be
obtained we would have to substantially alter our operations, or we may be
forced to discontinue operations.  Such an opinion from our
independent registered public accounting firm may limit our ability to access
certain types of financing, or may prevent us from obtaining financing on
acceptable terms.  There can be no assurance that our accounting firm
will not qualify their opinion in the future.




We
rely on a third-party credit facility to provide working capital.  If
our access to a third-party credit facility were unavailable or restricted, our
business could be adversely affected.




We
currently rely on third-party credit, private equity financing and cash
generated from our operations for working capital purposes.  If our
credit facility is no longer available at acceptable rates, we would be required
to reduce or curtail our operations and research and development
projects.  This would have a material adverse effect on our business
and results of operations.




As of
June 30, 2008, we were in violation of our minimum current ratio and minimum net
worth financial covenants (collectively, the "Financial Covenant Defaults") in
our loan agreements with Bridge Bank, N.A.  On October 10, 2008, we
received a notice of default with respect of violation of depository accounts,
financial reporting and failure to complete a sale of an asset (collectively,
the "Subsequent Covenant Defaults").  We received a waiver from Bridge
Bank with respect of the Financial Covenant Default, but cannot be certain that
the bank will continue to grant waivers in the future due to the potential for
financial covenant non-compliance.  We did not receive a waiver for
the Subsequent Covenant Defaults.  If the bank does not agree to grant us
such waivers, there is a risk that the bank may call the loan or prevent us from
taking additional advances until the default is cured.  We
havea credit
facility with the bank, which matures in January 2009, having an unpaid balance
of approximately $862,000 as of June 30, 2008, consisting of a $385,000 term
note and $477,000 of borrowings under the revolving line of credit that matures
in January 2009.




We
are engaged in litigation with Evans Analytical Group LLC, the buyer of our
Accurel Systems subsidiary.  If we are unsuccessful in defending the
claims made by Evans, our business, assets and results of operations could be
materially adversely affected.




In May
2007, we entered into an asset purchase agreement to sell substantially all of
the assets of our Accurel Systems subsidiary to Evans for approximately
$12,705,000, including $1,000,000 held by an escrow agent as security for
certain representations and warranties.  In February 2008, Evans filed
suit requesting rescission of the asset purchase agreement, plus damages, based
on claims of misrepresentation and fraud.  In March 2008, Evans filed
a claims notice with the escrow agent prohibiting release of any portion of the
escrow to us pending resolution of the lawsuit.  More
recently, Evans has filed motions that, if granted by the court, could result in
attachments against substantial portions of our assets prior to any final
judgment on the merits of Evans’ claims. If these motions are granted by the
court, we may be prevented from using our cash to operate our business. We are
vigorously defending ourselves against Evans' claims.  No
assurance can be given, however, that we will






-11-
 
  be
successful in our defense against Evans’ claims, or that Evans' motions to
attach our assets will not be granted.  The grant of these motions, or
any substantial final judgment in favor of Evans would have a material adverse
effect on our business, assets and results of operations, and require us to file
for protection under bankruptcy laws.  Moreover, we believe that our
litigation with Evans has made it extremely difficult to raise capital we
need to operate our business.




We
will require additional capital to fund operations and continue the development,
commercialization and marketing of our product.  Our failure to raise
capital could have a material adverse effect on the business.




Management
continually evaluates plans to reduce its operating expenses, increase sales and
increase its cash flow from operations.  Despite the current sales,
expense and cash flow projections, the cash available from our line of credit,
the projected cash from the sale of Core Systems and certain other assets, we
will require additional capital in the second quarter of fiscal 2009 to fund
operations and continue the development, commercialization and marketing of our
products.




Our
failure to achieve our projections, sell Core and other assets, and/or obtain
sufficient additional capital on acceptable terms, would have a material adverse
effect on our operations and could require us to file for protection under
bankruptcy laws.




Risks
Related to Our Business




We
have incurred substantial operating losses and we may never be
profitable.  There can be no assurance that our revenue will be
maintained at the current level or increase in the future.




During
the fiscal years ended June 30, 2008 and 2007, we had revenues ofapproximately $5,152,000
and $4,582,000, respectively.  During the fiscal years ended June 30,
2008 and 2007, we had losses from continuing operations ofapproximately $7,714,000
and $4,733,000, respectively.  During the fiscal years ended June 30,
2008 and 2007, we had net losses ofapproximately
$10,735,000 and $10,688,000, respectively.  There is a risk that we
will never be profitable.  We plan to further increase our
expenditures tocomplete the development
and commercialization of our new products, and to broaden our sales and
marketing capabilities.  Asa result, we believe we
will likely incur losses over the next severalquarters.  Our
ability to generate sufficient revenues to achieve profits will depend on a
variety of factors, many of which are outside our control,
including:




·
            the
      size of the markets we address;




·
            the
      existence of competition and other solutions to the problems we
      address;




·
            the
      extent of patent and intellectual property protection afforded to our
      products;




·
            the
      cost and availability of raw material and intermediate component
      supplies;




·
            changes
      in governmental (including foreign governmental) initiatives and
      requirements;




·
            changes
      in domestic and foreign regulatory
requirements;




·
            the
      costs associated with equipment development, repair and maintenance; and
      our ability to manufacture and deliver products at prices that exceed our
      costs.




Our
operating results have fluctuated in the past from quarter to quarter and are
likely to fluctuate significantly in the future due to a variety of factors,
many of which are beyond our control, including:




·
            changing
      demand for our products and
services;




·
            the
      timing of actual customer orders and requests for product shipment and the
      accuracy of our forecasts of future production
    requirements;




·
            the
      reduction, rescheduling or cancellation of product orders by
      customers;




·
            difficulties
      in forecasting demand for our products and the planning and managing of
      inventory levels;




·
            the
      introduction and market acceptance of our new products and changes in
      demand for our existing products;




·
            changes
      in the relative portion of our revenue represented by our various
      products, services and customers, including the relative mix of our
      business across our target markets;




-12-
 
  ·
                changes
      in competitive or economic conditions generally or in our
      markets;
 ·
                competitive
      pressures on selling prices;
 ·
                the
      amount and timing of costs associated with product warranties and
      returns;


·
            changes
      in availability or costs of materials, components or
    supplies;




·
            changes
      in our product distribution channels and the timeliness of receipt of
      distributor resale information;




·
            the
      amount and timing of investments in research and
    development;




·
            difficulties
      in integrating acquired assets and businesses into our operations;
      and




·
            charges
      to earnings resulting from the application of the purchase method of
      accounting following acquisitions.




A
substantial portion of our revenue in any quarter historically has been derived
from orders booked and shipped in the same quarter, and historically, backlog
has not been a meaningful indicator of revenues for a particular
period.  Accordingly, our sales expectations currently are based
almost entirely on our internal estimates of future demand and not from firm
customer orders.




As a
result of these factors, many of which are difficult to control or predict, as
well as the other risk factors discussed in this Annual Report, we may
experience material adverse fluctuations in our future operating results on a
quarterly or annual basis.




Our
markets are subject to technological change and our success depends on our
ability to develop and introduce new products.




The
market for our security products is characterized by:




·
            changing
      technologies;




·
            changing
      customer needs;




·
            frequent
      new product introductions and
enhancements;




·
            increased
      integration with other functions;
and




·
            product
      obsolescence.




Our
success will be dependent in part on the design and development of new
products.  To develop new products and designs for our security
market, we must develop, gain access to and use leading technologies in a
cost-effective and timely manner and continue to expand our technical and design
expertise.  The product development process is time-consuming and
costly, and there can be no assurance that product development will be
successfully completed, that necessary regulatory clearances or approvals will
be granted on a timely basis, or at all, or that the potential products will
achieve market acceptance.  Our failure to develop, obtain necessary
regulatory clearances or approvals for, or successfully market potential new
products could have a material adverse effect on our business, financial
condition and results of operations.




Our
explosives detection products and technologies may not be accepted by government
agencies or commercial consumers of security products which could harm our
future financial performance.




There can
be no assurance that our explosives detection systems will achieve wide
acceptance by government agencies, commercial consumers of security products,
and market acceptance generally.  The degree of market acceptance for
our explosives detection products and services will also depend upon a number of
factors, including the receipt and timing of regulatory approvals and the
establishment and demonstration of the ability of our proposed device to detect
trace explosives residues on personnel, baggage and other cargo.  Our
failure to develop a commercial product to compete successfully with respect to
throughput, the ability to scan personnel, baggage and other cargo, and
portability could delay, limit or prevent market
acceptance.  Moreover, the market for explosives detection systems,
especially trace detection, is largely undeveloped, and we believe that the
overall demand for explosives detection systems technology will depend
significantly upon public perception of the risk of terrorist
attacks.  There can be no assurance that the public will perceive the
threat of terrorist attacks to be substantial or that governmental agencies and
private-industry will actively pursue explosives detection systems
technology.  Long-term market acceptance of our products and services
will depend, in part, on the capabilities, operating features and price of our
products and technologies as compared to those of other available products and
services.  As a result, there can be no assurance that currently
available products, or products under development for commercialization, will be
able to achieve market penetration, revenue growth or
profitability.






-13-




If
we cannot obtain the additional capital required to fund our operations on
favorable terms, or at all, we may have to delay or reconsider our growth
strategy.




Our
growth strategy may require additional capital for, among other purposes,
completing acquisitions of companies and customers’ product lines and
manufacturing assets, integrating acquired companies and assets, acquiring new
equipment and maintaining the condition of existing equipment.  If
cash generated internally is insufficient to fund capital requirements, or if we
desire to make additional acquisitions, we will require additional debt or
equity financing.  Adequate financing may not be available or, if
available, may not be available on terms satisfactory to us.  If we
raise additional capital by issuing equity or convertible debt securities, the
additional securities will dilute the share ownership of our existing
investors.  In addition, we may grant future investors rights that are
superior to those of our existing investors.  If we fail to obtain
sufficient additional capital in the future, we could be forced to curtail our
growth strategy by reducing or delaying capital expenditures and acquisitions,
selling assets or restructuring or refinancing our indebtedness.




We
depend on outside suppliers and subcontractors, and our production and
reputation could be harmed if they are unable to meet our volume and quality
requirements and alternative sources are not available.




We have
various “sole source” suppliers who supply key components for our
products.  Our outside suppliers may fail to develop and supply us
with products and components on a timely basis, or may supply us with products
and components that do not meet our quality, quantity or cost
requirements.  If any of these problems occur, we may be unable to
obtain substitute sources of these products and components on a timely basis or
on terms acceptable to us, which could harm our ability to manufacture our own
products and components profitably or on time, and to ship products to customers
on time and generate revenues.  In addition, if the processes that our
suppliers use to manufacture products and components are proprietary, we may be
unable to obtain comparable components from alternative suppliers.




We
depend on a contract manufacturer, and our production and products could be
harmed if they are unable to meet our volume and quality requirements and
alternative sources are not available.




We rely
on a single contract manufacturer to provide manufacturing services for our
explosives detection products.  If these services become unavailable,
we would be required to identify and enter into an agreement with a new contract
manufacturer or take the manufacturing in house.  The loss of our
contract manufacturer could significantly disrupt production as well as increase
the cost of production, thereby increasing the prices of our
products.  These changes could have a material adverse effect on our
business and results of operations.




We
may not be able to protect our intellectual property rights
adequately.




Our
ability to compete is affected by our ability to protect our intellectual
property rights.  We rely on a combination of patents, trademarks,
copyrights, trade secrets, confidentiality procedures and non-disclosure and
licensing arrangements to protect our intellectual property
rights.  Despite these efforts, we cannot be certain that the steps we
take to protect our proprietary information will be adequate to prevent
misappropriation of our technology, or that our competitors will not
independently develop technology that is substantially similar or superior to
our technology.  More specifically, we cannot assure you that any
future applications will be approved, or that any issued patents will provide us
with competitive advantages or will not be challenged by third
parties.  Nor can we assure you that, if challenged, our patents will
be found to be valid or enforceable, or that the patents of others will not have
an adverse effect on our ability to do business.  Furthermore, others
may independently develop similar products or processes, duplicate our products
or processes or design their products around any patents that may be issued to
us.




Our
success depends on our ability to obtain new patents and operate without
infringing on the proprietary rights of others.




Although
we have six United States patents issued and ten United States patent
applications pending for our explosives detection technology and processes, our
success will depend, in part, on our ability to obtain the patents applied for
and maintain trade secret protection for our technology and operate without
infringing on the proprietary rights of third parties.  The validity
and breadth of claims in technology patents involve complex legal and factual
questions and, therefore, may be highly uncertain.  No assurance can
be given that any pending patent applications or any future patent application
will issue as patents, that the scope of any patent protection obtained will be
sufficient to exclude competitors or provide competitive advantages to us, that
any of our patents will be held valid if subsequently challenged or that others
will not claim rights in or ownership of the patents and other proprietary
rights held by us.






-14-




Furthermore,
there can be no assurance that others have not or will not develop similar
products, duplicate any of our products or design around any patents issued or
that may be issued in the future to us. In addition, whether or not patents are
issued to us, others may hold or receive patents which contain claims having a
scope that covers products or processes developed by us.




Moreover,
there can be no assurances that patents issued to us will not be challenged,
invalidated or circumvented or that the rights thereunder will provide any
competitive advantage.  We could incur substantial costs in defending
any patent infringement suits or in asserting any patent rights, including those
granted to third parties.  Patents and patent applications in the
United States may be subject to interference proceedings brought by the United
States Patent & Trademark Office, or to opposition proceedings initiated in
a foreign patent office by third parties.  We may incur significant
costs defending such proceedings.  Any litigation or proceedings
relating to the intellectual property rights of any parties, whether or not
determined in our favor or settled by us, is costly and may divert the efforts
and attention of our management and technical personnel.  In addition,
we may be required to obtain licenses to patents or proprietary rights from
third parties.  There can be no assurance that such licenses will be
available on acceptable terms if at all.  If we do not obtain required
licenses, we could encounter delays in product development or find that the
development, manufacture or sale of products requiring such licenses could be
foreclosed.  Accordingly, challenges to our intellectual property,
whether or not ultimately successful, could have a material adverse effect on
our business and results of operations.




We also
rely on unpatented proprietary technology, trade secrets and know-how and no
assurance can be given that others will not independently develop substantially
equivalent proprietary information, techniques or processes, that such
technology or know-how will not be disclosed or that we can meaningfully protect
our rights to such unpatented proprietary technology, trade secrets, or
know-how.  Although we have entered into non-disclosure agreements
with our employees and consultants, there can be no assurance that such
non-disclosure agreements will provide adequate protection for our trade secrets
or other proprietary know-how.




Our
future success depends on the continued service of management, engineering and
sales personnel and our ability to identify, hire and retain additional
personnel.




Our
success depends, to a significant extent, upon the efforts and abilities of
members of senior management.  The loss of the services of one or more
of our senior management or other key employees could adversely affect our
business.  We do not maintain key person life insurance on any of our
officers, employees or consultants.




There is
intense competition for qualified employees in the security industry,
particularly for highly skilled design, applications, engineering and sales
people.  We may not be able to continue to attract and retain
technologists, managers, or other qualified personnel necessary for the
development of our business or to replace qualified individuals who could leave
us at any time in the future.  Our anticipated growth is expected to
place increased demands on our resources, and will likely require the addition
of new management and engineering staff as well as the development of additional
expertise by existing management employees.  If we lose the services
of or fail to recruit engineers or other technical and management personnel, our
business could be harmed.




Periods
of rapid growth and expansion could place a significant strain on our resources,
including our employee base.




To manage
our possible future growth effectively, we will be required to continue to
improve our operational, financial and management systems.  In doing
so, we will periodically implement new software and other systems that will
affect our internal operations regionally or globally.




Future
growth will also require us to successfully hire, train, motivate and manage our
employees.  In addition, our continued growth and the evolution of our
business plan will require significant additional management, technical and
administrative resources.  We may not be able to effectively manage
the growth and evolution of our current business.




We
are exposed to product liability which could place a substantial financial
burden on us, if we are sued.




The
development and sale of explosives detection products entails an inherent risk
of product liability.  For example, if our products fail to adequately
detect explosives, if we are unable to successfully train technicians to
properly use our products, or if the market determines or concludes that any of
our products are not safe or effective for any reason, we may be exposed to
product liability claims.  We do not currently carry product liability
insurance.  A product liability claim, whether meritorious or not,
could be time consuming, distracting and expensive to defend, could be harmful
to our reputation, could result in a diversion of management and financial
resources away from our primary business and could result in product recalls. In
any such case, there could be a material adverse effect on our business and
results of operations and our business could fail.






-15-




We
use hazardous materials in our research and manufacturing
activities.  Any liability resulting from the misuse of such hazardous
materials could adversely affect our business.




Our
research and manufacturing activities sometimes involve the use of various
hazardous materials.  Although we believe that our safety procedures
for handling, manufacturing, distributing, transporting and disposing of such
materials comply with the standards for protection of human health, safety, and
the environment, prescribed by local, state, federal and international
regulations, the risk of accidental contamination or injury from these materials
cannot be completely eliminated.  Nor can we eliminate the risk that
one or more of our hazardous material or hazardous waste handlers may cause
contamination for which, under laws imposing strict liability, we could be held
liable.  While we currently maintain insurance in amounts which we
believe are appropriate in light of the risk of accident, we could be held
liable for any damages that might result from any such event.  Any
such liability could exceed our insurance and available resources and could have
a material adverse effect on our business and results of
operations.




If
we are unable to complete our assessments as to the adequacy of our internal
controls over financial reporting as required by Section 404 of the
Sarbanes-Oxley Act of 2002, investors could lose confidence in the reliability
of our financial statements, which could result in a decrease in the value of
our common stock.




As
directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and
Exchange Commission adopted rules requiring public companies to include a report
by management on the company’s internal controls over financial reporting in
their annual reports on Form 10-K.  This report is required to contain
an assessment by management of the effectiveness of such company’s internal
controls over financial reporting.  In addition, the public accounting
firm auditing a public company’s financial statements must attest to and report
on management’s assessment of the effectiveness of the company’s internal
controls over financial reporting.  While we are expending significant
resources in developing the necessary documentation and testing procedures
required by Section 404, we currently do not comply with all of the requirements
imposed by Section 404.  If we fail to implement the required new or
improved controls, we may be unable to comply with the requirements of Section
404 in a timely manner.  This could result in an adverse reaction in
the financial markets due to a loss of confidence in the reliability of our
financial statements, which could cause the market price of our common stock to
decline and make it more difficult for us to finance our
operations.




Under
current rules, we are required to report on the effectiveness of our internal
controls for the year ended June 30, 2008.  In the fiscal year ending
June 30, 2010, our independent registered public accounting firm will be
required to report on the effectiveness of our internal controls.




Risks
Related to Competition




We
believe that our ability to compete in the explosive detection systems market is
based upon such factors as: product performance, functionality, quality and
features; quality of customer support services, documentation and training; and
the capability of the technology to appeal to broader applications beyond the
inspection of passengers, baggage, and cargo carried on
airlines.  Although we believe that our current product has all of the
capabilities to meet the United States government’s decree that all passengers,
baggage, and cargo carried on airlines must be screened thoroughly, certain of
our competitors may have advantages over our existing technology with respect to
these factors.  There can be no assurance that we will be successful
in convincing potential customers that our products will be superior to other
systems given all of the necessary performance criteria, that new systems with
comparable or greater performance, lower price and faster or equivalent
throughput will not be introduced, or that, if such products are introduced,
customers will not delay or cancel potential orders.  Further, there
can be no assurance that we will be able to bring to commercialization and
further enhance our product to better compete on the basis of cost, throughput,
accommodation of detection of passengers, baggage or other cargo carried onto
airlines, or that we will otherwise be able to compete successfully with
existing or new competitors.




Moreover,
there can be no assurance that we will be able to price our products and
services at or below the prices of competing products and technologies in order
to facilitate market acceptance.  Accordingly, our success will
depend, in part, on our ability to respond quickly to technological changes
through the development and introduction of new products and
enhancements.  Product development involves a high degree of risk, and
there can be no assurance that our new product development efforts will result
in any commercially successful products.  Our failure to compete or
respond to technological change in an effective manner would have a material
adverse effect on our business and results of operations.






-16-




We
may face pricing pressures that could prevent us from maintaining the prices of
our products.




The sales
process for our security products is typically a result of a request for
quotations or tenders which are subjected to significant and time-consuming
scrutiny prior to the determination of an award.  In addition, we face
aggressive cost-containment pressures from governmental agencies and the bidding
process commonly involves several competitors, many of whom have greater
financial and other resources that may enable them to submit bids at prices
which might be significantly less than the prices we may be able to
offer.  There can be no assurances that we will be able to maintain
current prices in the face of continuing pricing pressures.  Over
time, the average price for our products may decline as the markets for these
products become more competitive.  Any material reduction in product
prices could negatively affect our gross margin, necessitating a corresponding
increase in unit sales to maintain any given level of sales.




Risks
Related to Our Securities




We
have received notification from the American Stock Exchange (now known as the
New York Stock Exchange Alternext US) that we are not in compliance with
certain standards for the continued listing of our common stock.  Our
inability to regain compliance with the AMEX’s continued listing standards could
adversely affect our business and ability to raise capital.




In April
2008, the AMEX indicated we were not in compliance with certain conditions of
the continued listing standards.  Specifically, we were not in
compliance with Section 1003(a)(ii) of the AMEX Company Guide with stockholders’
equity of less than $4,000,000 and losses from continuing operations and net
losses in three out of its four most recent fiscal years and Section
1003(a)(iii) of the AMEX Company Guide with stockholders’ equity of less than
$6,000,000 and losses from continuing operations and net losses in its five most
recent fiscal years.




We
submitted a plan of compliance to the AMEX in May 2008, and in June 2008, the
AMEX notified us that it had accepted our plan of compliance and had granted us
an extension until October 9, 2009 to regain compliance with the continued
listing standards noted above in addition to complying with Section 1003(a)(i)
of the AMEX Company Guide requiring stockholders’ equity of not less than
$2,000,000 with losses from continuing operations and net losses in two out of
its three most recent fiscal years.  We will be subject to periodic
review by the AMEX Staff during the extension period.  Failure to make
progress consistent with the plan or regain compliance with the continued
listing standards by the end of the extension period could result in our common
stock being delisted from the AMEX.




If our
common stock is delisted from the AMEX, the liquidity of our stock could be
substantially limited and our ability to raise capital would be
impaired.




Our
stock price is volatile.




The
market price of our common stock has fluctuated significantly to
date.  In the past fiscal year, our stock price ranged from $0.65 to
$2.45.  The future market price of our common stock may also fluctuate
significantly due to:




·
            variations
      in our actual or expected quarterly operating
  results;




·
            announcements
      or introductions of new products;




·
            technological
      innovations by our competitors or development setbacks by
    us;




·
            the
      commencement or adverse outcome of
litigation;




·
            changes
      in analysts’ estimates of our performance or changes in analysts’
      forecasts regarding our industry, competitors or
  customers;




·
            announcements
      of acquisitions or acquisition transactions;
or




·
            general
      economic and market conditions.




In
addition, the stock market in recent years has experienced extreme price and
volume fluctuations that have affected the market prices of many security
product companies.  These fluctuations have often been unrelated or
disproportionate to the operating performance of companies in our industry, and
could harm the market price of our common stock.






-17-




Additional
authorized shares of our common stock and preferred stock available for issuance
may adversely affect the market.




We are
authorized to issue 50,000,000 shares of our common stock.  As of June
30, 2008, there were 12,104,008 shares of common stock issued and
outstanding.  However, the total number of shares of our common stock
issued and outstanding does not include shares reserved in anticipation of the
exercise of options and warrants.  As of June 30, 2008, we had
outstanding stock options and warrants of approximately 5,016,000 shares of our
common stock, the exercise price of which range between $0.80 per share to
$12.25 per share, and we have reserved shares of our common stock for issuance
in connection with the potential exercise thereof.  To the extent such
options, warrants or additional investment rights are exercised; the holders of
our common stock will experience further dilution.  Stockholders will
also experience dilution upon the exercise of options granted under our stock
option plans.  In addition, in the event that any future financing or
consideration for a future acquisition should be in the form of, be convertible
into or exchangeable for, equity securities investors will experience additional
dilution.




The
exercise of the outstanding derivative securities will reduce the percentage of
common stock held by our current stockholders.  Further, the terms on
which we could obtain additional capital during the life of the derivative
securities may be adversely affected, and it should be expected that the holders
of the derivative securities would exercise them at a time when we would be able
to obtain equity capital on terms more favorable than those provided for by such
derivative securities.  As a result, any issuance of additional shares
of common stock may cause our current stockholders to suffer significant
dilution which may adversely affect the market.




In
addition, we have 5,000,000 shares of authorized preferred stock, the terms of
which may be fixed by our Board, of which 242,424 shares of Series D Redeemable
Convertible Preferred Stock were issued and outstanding as of June 30,
2008.  While we have no present plans to issue any additional shares
of preferred stock, our Board of Directors has the authority, without
stockholder approval, to create and issue one or more series of such preferred
stock and to determine the voting, dividend and other rights of holders of such
preferred stock.  The issuance of any of such series of preferred
stock may have an adverse effect on the holders of common stock and could make a
takeover of our company more difficult.




Shares
eligible for future sale may adversely affect the market.




From time
to time, certain of our stockholders who acquired their shares directly from our
company in privately negotiated transactions may be eligible to sell all or some
of their shares of common stock by means of ordinary brokerage transactions in
the open market pursuant to effective registration statements under the
Securities Act of 1933 and under Rule 144, promulgated under the Securities
Act.  In general, pursuant to Rule 144, a stockholder (or stockholders
whose shares are aggregated) who has satisfied a six-month holding period may,
under certain circumstances, sell within any three-month period a number of
securities which does not exceed the greater of 1% of the then outstanding
shares of common stock or the average weekly trading volume of the class during
the four calendar weeks prior to such sale.  Rule 144 also permits,
under certain circumstances, the sale of securities, without any limitation, by
our stockholders that are non-affiliates that have satisfied a one-year holding
period.  Any substantial sale of our common stock pursuant to Rule 144
or pursuant to any resale registration statement may have material adverse
effect on the market price of our securities.




There
are limitations on director and officer liability which may limit our
stockholders’ rights to recover for breaches of fiduciary duty.




As
permitted by Massachusetts law, our Restated Articles of Organization limit the
liability of our directors for monetary damages for breach of a director's
fiduciary duties except in certain instances.  As a result of these
limitations and Massachusetts law, stockholders may have limited rights to
recover against directors for breaches of their fiduciary duties.  In
addition, our bylaws provide that we will indemnify our directors, officers,
employees and agents if such persons acted in good faith and reasoned that their
conduct was in our best interest.




The
anti-takeover provisions of our Restated Articles of Organization and
Massachusetts law may delay, defer or prevent a change of control.




Our Board
of Directors has the authority to issue up to 5,000,000 shares of preferred
stock and to determine the price, rights, preferences and privileges and
restrictions, including voting rights, of those shares without any further vote
or action by our stockholders.  The rights of the holders of common
stock will be subject to, and may be harmed by, the rights of the holders of any
shares of preferred stock that may be issued in the future.  The
issuance of preferred stock may delay, defer or prevent a change in control
because the terms of any issued preferred stock could potentially prohibit our
consummation of any acquisition, reorganization, sale of substantially all of
our assets, liquidation or other extraordinary corporate transaction, without
the approval of the holders of the outstanding shares of preferred
stock.  In addition, the issuance of preferred stock could have a
dilutive effect on our stockholders.






-18-




Our
stockholders must give substantial advance notice prior to the relevant meeting
to nominate a candidate for director or present a proposal to our stockholders
at a meeting.  These notice requirements could inhibit a takeover by
delaying stockholder action.  Massachusetts law may also discourage,
delay or prevent someone from acquiring or merging with us.




We
have never paid dividends on our common stock and we do not anticipate paying
any cash dividends in the foreseeable future.




We have
paid no cash dividends on our common stock to date and we currently intend to
retain our future earnings, if any, to fund the development and growth of our
business.  In addition, our agreements with lenders prohibit the
payment of cash dividends.  As a result, capital appreciation, if any,
of our common stock will be shareholders’ sole source of gain for the
foreseeable future.




Item
      1B.
            Unresolved
      Staff Comments




None.




Item
      2.
            Description
      of Properties




We
operate out of four separate locations.  Our corporate offices are
located in an approximately 51,000 square foot leased facility in Wakefield,
Massachusetts.  In addition to our corporate offices, this facility
houses research and development, sales and marketing, and
production.  Our current lease expires in December
2008.  Our current facilities are adequate; however, after December
2008 there are various other locations available for lease should we decide to
relocate.




We lease
approximately 6,200 square feet of research and office space in San Diego,
California, under a lease expiring on January 31, 2009, and we lease office
space in Beijing, China, on a monthly basis, to support our sales activity
in the region.




Our Core
Systems semiconductor division, which is currently being offered for sale, is
located in Sunnyvale, California.  The lease expires in December
2009.




Item 3.
            Legal
      Proceedings




In May
2007, we entered into an asset purchase agreement to sell substantially all of
the assets of our Accurel Systems subsidiary to Evans Analytical Group LLC for
approximately $12,705,000, including $1,000,000 held by an escrow agent as
security for certain representations and warranties.  On February 22,
2008, Evans filed suit in the Superior Court of the State of California, Santa
Clara County, requesting rescission of the asset purchase agreement, plus
damages, based on claims of misrepresentation and fraud.  In March
2008, Evans filed a claims notice with the escrow agent prohibiting release of
any portion of the escrow to us pending resolution of the
lawsuit.  More
recently, Evans has filed motions that, if granted by the court, could result in
attachments against substantial portions of our assets prior to any final
judgment on the merits of Evans’ claims.  If these motions are granted
by the court, we may be prevented from using our cash to operate our
business.  We are vigorously defending ourselves against Evans’
claims.  No assurance can be given, however, that we will be
successful in our defense against Evans’ claims or that Evans’ motions to attach
our assets will not be granted.  The grant of these motions, or any
substantial final judgment in favor of Evans, would have a material adverse
effect on our business, assets and results of operations, and could require us
to file for protection under bankruptcy laws.  Moreover,
we believe that our litigation with Evans has made it extremely difficult to
raise capital we need to operate our business.




We are
not a party to any other legal proceedings, other than ordinary routine
litigation incidental to our business, which we believe will not have a material
affect on our business, assets or results of operations.




Item 4.
            Submission
      of Matters to a Vote of Security
Holders




None.




-19-


PART II




Item 5.
            Market
      Information for Registrant’s Common Equity, Related Stockholder Matters
      and Issuer Purchases of Equity
Securities




Our
common stock trades on the American Stock Exchange (now known as the New York
Stock Exchange Alternext US) under the symbol “IMX.”  The following
table sets forth the high and low sales prices of the common stock for each of
the last two fiscal years, as reported on the American Stock
Exchange.


Fiscal
      Year 2008High
              
              
              Low4th
      Quarter
              
              $
              1.65
              
              
              $
              0.813rd
      Quarter
              
              
              1.97
              
              
              
              0.702nd
      Quarter
              
              
              2.45
              
              
              
              0.651st
      Quarter
              
              
              2.40
              
              
              
              1.50Fiscal
      Year 2007High
              
              
              Low4th
      Quarter
              
              $
              2.23
              
              
              $
              1.023rd
      Quarter
              
              
              2.75
              
              
              
              1.952nd
      Quarter
              
              
              3.55
              
              
              
              2.111st
      Quarter
              
              
              4.20
              
              
              
              2.00


As of
October 6, 2008, there were approximately 123 stockholders of
record.  The last sale price as reported by the NYSE Alternext
US on October 6, 2008, was $0.50.  We have never paid a cash
dividend on our common stock and do not anticipate the payment of cash dividends
in the foreseeable future.  In addition, our agreements with lenders
prohibit the payment of cash dividends.  We submitted an unqualified
2008 Corporate Governance Certification to the American Stock Exchange in
connection with our fiscal year 2008.




The table
below sets forth certain information as of June 30, 2008 with respect to equity
compensation plans under which our common stock is authorized for
issuance:




Securities Authorized for Issuance
under Equity Compensation Plans as of the


End
of Fiscal 2008 Equity Compensation Plan Information


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 issuanceEquity
      compensation plans approved by stockholders
              
              
              2,646,538
              (1)
              
              $
              3.07
              
              
              
              794,805Equity
      compensation plans not approved by stockholders
              
              
              -
              
              
              
              
              
              
              
              -2,646,538
              
              
              
              
              
              
              
              794,805


_______________


(1)
            This
      total includes shares to be issued upon exercise of outstanding options
      under the equity compensation plans that have been approved by our
      stockholders (i.e., our 2000 Incentive and Nonqualified Stock Option Plan,
      and our 2004 Stock Option Plan).




-20-




Recent
      Sales of Unregistered Securities




In
January 2008, we issued 221,729 shares of our common stock, having a value
of $200,000, to OSI Systems, Inc. pursuant to a litigation settlement
agreement.


As of
June 30, 2008, we had not issued the 2,000,000 shares of our common stock,
having a value of $2,464,000, to the shareholders of Ion Metrics in connection
with our acquisition of Ion Metrics.  On August 11, 2008, we issued
the 2,000,000 shares of common stock to the Ion Metrics
shareholders.




The
issuance of these shares was exempt from registration under the Securities Act
of 1933, as amended, pursuant to an exemption provided by Section 4(2) of the
Securities Act.






Item 6.
            Selected
      Consolidated Financial Data




Not
Applicable.


-21-


Item
      7.
            Management’s
      Discussion and Analysis or Plan of
Operation




Forward-Looking
Statements




This
Annual Report on Form 10-K contains certain statements that are
“forward-looking” within the meaning of the Private Securities Litigation Reform
Act of 1995 (the “Litigation Reform Act”).  These forward looking
statements and other information are based on our beliefs as well as assumptions
made by us using information currently available.




The words
“anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and
similar expressions, as they relate to us, are intended to identify
forward-looking statements.  Such statements reflect our current views
with respect to future events, are subject to certain risks, uncertainties and
assumptions, and are not guaranties of future performance.  Should one
or more of these risks or uncertainties materialize, or should underlying
assumptions prove incorrect, actual results may vary materially from those
described herein as anticipated, believed, estimated, expected, intended or
using other similar expressions.




In
accordance with the provisions of the Litigation Reform Act, we are making
investors aware that such forward-looking statements, because they relate to
future events, are by their very nature subject to many important factors that
could cause actual results to differ materially from those contemplated by the
forward-looking statements contained in this Annual Report on Form
10-K.  Important factors that could cause actual results to differ
from our predictions include those discussed under “Risk Factors,” this
“Management’s Discussion and Analysis” and “Business.”  Although we
have sought to identify the most significant risks to our business, we cannot
predict whether, or to what extent, any of such risks may be realized, nor can
there be any assurance that we have identified all possible issues which we
might face.  In addition, assumptions relating to budgeting,
marketing, product development and other management decisions are subjective in
many respects and thus susceptible to interpretations and periodic revisions
based on actual experience and business developments, the impact of which may
cause us to alter our marketing, capital expenditure or other budgets, which may
in turn affect our financial position and results of operations.  For
all of these reasons, the reader is cautioned not to place undue reliance on
forward-looking statements contained herein, which speak only as of the date
hereof.  We assume no responsibility to update any forward-looking
statements as a result of new information, future events, or otherwise except as
required by law.




Overview




Since our
incorporation in August 1984, we have operated as a multi-faceted company
engaged in the development of ion-based technologies and providing commercial
services and products to the semiconductor, medical device and security
industries.  Beginning in March 2007, we undertook steps to divest our
semiconductor and medical business activities in order to focus on our security
business.




Since May
1999, we have been performing research to improve explosives trace detection
(“ETD”) technology, and development of ETD products which can be used for
detection of trace amounts of explosives.  We now develop, manufacture
and sell sophisticated sensors and systems for the Security, Safety and Defense
(“SS&D”) industries.  We have developed handheld and benchtop ETD
systems, which have been marketed and sold both domestically and
internationally.  These systems are used by private companies and
government agencies to screen baggage, cargo, vehicles, people and other
objects, for the detection of trace amounts of explosives.




Critical
      Accounting Policies




Our
significant accounting policies are described in Note 2 to the consolidated
financial statements included in Item 8 of our Annual Report on Form 10-K as of
June 30, 2008.  Our discussion and analysis of our financial condition
and results of operations are based upon these financial statements, which have
been prepared in accordance with accounting principles generally accepted in the
United States.  The preparation of these financial statements requires
us to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities.  On an on-going basis, we evaluate our estimates,
including those related to bad debts, product returns, inventories, investments,
intangible assets and warranty obligations.  We base our estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources.  In the past, actual results
have not been materially different from our estimates.  However,
results may differ from these estimates under different assumptions or
conditions.




We have
identified the following as critical accounting policies, based on the
significant judgments and estimates used in determining the amounts reported in
its financial statements:






-22-




·
            Revenue
      Recognition.  We recognize revenue when there is
      persuasive evidence of an arrangement with the customer which states a
      fixed or determinable price and terms, delivery of the product has
      occurred or the service performed in accordance with the terms of the
      arrangement, and collectibility of the sale is reasonably
      assured.




Government
contract revenue under cost-sharing research and development agreements is
recognized as eligible research and development expenses are
incurred.  Our obligation with respect to these agreements is to
perform the research on a best-efforts basis. For government contracts with a
deliverable, revenue is recognized based upon the proportional performance
method.




Revenues
for which we have received payment, but has not yet recognized the revenues,
pending fulfilling our obligations under the sales agreement, are reflected on
our balance sheet as deferred revenues.




·
            Accounts Receivable and
      Allowance for Doubtful Accounts.We maintain allowances
      for estimated losses resulting from the inability of our customers to make
      required payments.  Judgments are used in determining the
      allowance for doubtful accounts and are based on a combination of
      factors.  Such factors include historical collection experience,
      credit policy and specific customer collection issues.  In
      circumstances where we are aware of a specific customer’s inability to
      meet its financial obligations to us (e.g., bankruptcy filings), we record
      a specific reserve for bad debts against amounts due to reduce the net
      recognized receivable to the amount we reasonably believe will be
      collected.  We continuously monitor collections and payments
      from our customers.  While actual bad debts have historically
      been within our expectations and the provisions established, we cannot
      guarantee that we will continue to experience the same bad debt rates that
      we have in the past.  A significant change in the liquidity or
      financial position of any of our customers could result in the
      uncollectibility of the related accounts receivable and could adversely
      impact our operating cash flows in that
period.




·
            Sales Returns and
      Allowances.  We record reductions to revenue for
      estimated customer returns and allowances.  We record estimated
      allowances against revenues in the same period the revenue is
      recorded.  These estimates are based upon historical analysis of
      our credit memo data and other known factors for pricing and disputes that
      arise in the normal course of business.  To date, allowances
      have not been material.  Actual returns may differ significantly
      from our estimates if factors such as economic conditions or competitive
      conditions differ from our
expectations.




·
            Inventories.We
      value our inventories at lower of cost or market.  Cost is
      determined by the first-in, first-out (FIFO) method, including material,
      labor and factory overhead.  In assessing the ultimate
      realization of inventories, management judgment is required to determine
      the reserve for obsolete or excess inventory.  Inventory on hand
      may exceed future demand either because the product is obsolete, or
      because the amount on hand is more than can be used to meet future
      need.  We provide for the total value of inventories that we
      determine to be obsolete or excess based on criteria such as customer
      demand and changing technologies.




·
            Warranties.  We
      provide for the estimated cost of product warranties at the time revenue
      is recognized.  We record an estimate for warranty related costs
      at the time of sale based on our actual historical return rates and repair
      costs.  While our warranty costs have historically been within
      our expectations and the provisions established, we cannot guarantee that
      we will continue to experience the same warranty return rates or repair
      costs that we have in the past.  A significant increase in
      warranty return rates or costs to repair our products could have a
      material adverse impact on our operating results for the period or periods
      in which such returns or additional costs
  materialize.




·
            Valuation of Certain
      Marketable Equity Securities.  We currently classify our
      investment securities as available-for-sale
      securities.  Pursuant to Statement of Financial Accounting
      Standards (“SFAS”) No. 115, “Accounting for Certain
      Investments in Debt and Equity Securities,” such securities are
      measured at fair market value in the financial statements with unrealized
      gains or losses recorded in accumulated other comprehensive income until
      the securities are sold or otherwise disposed of.  However, in
      accordance with SFAS No. 115, a decline in fair market value below cost
      that is other than temporary is accounted for as a realized
      loss.  During fiscal 2008, we realized losses of approximately
      $51,000 from the sale of equity
securities.




·
            Income
      Taxes.  Significant management judgment is required in
      determining our provision for income taxes, our deferred tax assets and
      liabilities and any valuation allowance recorded against deferred tax
      assets.  We have recorded a full valuation allowance against our
      net deferred tax assets of $12,288,000 as of June 30, 2008, due to
      uncertainties related to our ability to utilize these assets. The
      valuation allowance is based on our estimates of taxable income and the
      period over which our deferred tax assets will be recoverable. In the
      event that actual results differ from these estimates or we adjust these
      estimates in future periods we may need to adjust our valuation allowance
      which could materially impact our financial position and results of
      operations.


-23-




·
            Goodwill and Intangible
      Assets.SFAS No. 142, “Goodwill and Other Intangible
      Assets,” requires that goodwill and intangible assets with
      indefinite lives no longer be amortized but instead be measured for
      impairment at least annually or whenever events indicate that there may be
      an impairment.  In order to determine if an impairment exists,
      management compares the reporting unit's carrying value to the reporting
      unit’s fair value.  Determining the reporting unit’s fair value
      requires management to make estimates based on market conditions and
      operational performance.  Absent an event that indicates a
      specific impairment may exist, management has selected August 31as
      the date of performing the annual goodwill impairment
      test.  Future events could cause management to conclude that
      impairment indicators exist and that goodwill associated with our acquired
      businesses is impaired.  Any resulting impairment loss could
      have a material adverse impact on our financial condition 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.  We continually evaluate 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.  We evaluate the proper classification of
      our equity transactions under SFAS No. 150, “Accounting for Certain
      Financial Instruments with Characteristic of Both Liabilities and
      Equity.”  SFAS No. 150 requires that for instruments that
      embody an unconditional obligation requiring the issuer to redeem it by
      transferring assets at a determinable date or that contain certain
      conditional obligations, typically classified as equity, be classified as
      a liability.




In many
of our financing transactions, warrants have been issued.  We apply
the principles of SFAS No. 123(R), “Share-Based Payment,” to
value these awards, which inherently include a number of estimates and
assumptions including stock price volatility factors.  We record
financing and certain offering costs associated with our capital raising efforts
in our statements of operations.  These include amortization of debt
issue costs such as cash, warrants and other securities issued to finders and
placement agents, and amortization of preferred stock discount created by
in-the-money conversion features on convertible debt accounted for in accordance
with Emerging Issues Task Force (“EITF”) Issue 98-5, “Accounting for Convertible
Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Ratios,” and Issue 00-27, “Application of Issue 98-5 to
Certain Convertible Instruments,” by other securities issued in
connection with preferred stock as a result of allocating the proceeds amongst
the securities in accordance with Accounting Principles Board (“APB”) Opinion
No. 14, “Accounting for
Convertible Debt and Debt Issued with Stock Purchase Warrants,” based on
their relative fair values.  We based our estimates and assumptions on
the best information available at the time of valuation, however, changes in
these estimates and assumptions could have a material effect on the valuation of
the underlying instruments.




We
determined our Series D Redeemable Convertible Preferred Stock contained certain
derivative instruments and we account for such instruments under SFAS No. 133,
“Accounting for Derivative
Instruments and Hedging Activities.”  Under SFAS No. 133, we
bifurcated these derivative instruments from the Series D Redeemable Convertible
Preferred Stock, recorded them as a liability, and included the changes in the
fair value of the instruments within other income (expense) in the accompanying
consolidated statement of operations.




·
            Stock-Based
      Compensation.   Effective July 1, 2006, we adopted
      SFAS 123(R), “Share-Based
      Payment,”which requires
      the expense recognition of the estimated fair value of all stock-based
      payments issued to employees.






-24-




The
valuation of employee stock options is an inherently subjective process, since
market values are generally not available for long-term, non-transferable
employee stock options.  Accordingly, an option pricing model is
utilized to derive an estimated fair value.  In calculating the
estimated fair value of our stock options we use the Black-Scholes pricing
model, which requires the consideration of the following six variables for
purposes of estimating fair value:




·
            the
      stock option exercise price;




·
            the
      expected term of the option;




·
            the
      grant price of our common stock, which is issuable upon exercise of the
      option;




·
            the
      expected volatility of our common
stock;




·
            the
      expected dividends on our common stock (we do not anticipate paying
      dividends in the foreseeable future);
and




·
            the
      risk free interest rate for the expected option
  term.




Stock Option Exercise Price
and Grant Date Price of our Common Stock.  Stock option
exercise price is typically the closing market price of our common stock on the
date of grant.




Expected Term. 
The
expected term of options granted is calculated using the Company’s historical
option exercise transactions as outlined SFAS 123(R) and reflects the period of
time that options granted are expected to be outstanding.




Expected
Volatility.  The expected volatility is a measure of the amount
by which our stock price is expected to fluctuate during the expected term of
options granted.  We determine the expected volatility solely based
upon the historical volatility of our common stock over a period commensurate
with the option’s expected term.  We do not believe that the future
volatility of our common stock over an option’s expected term is likely to
differ significantly from the past.




Expected
Dividends.  We have never declared or paid any cash dividends
on any of our capital stock and do not expect to do so in the foreseeable
future.  Accordingly, we use an expected dividend yield of zero to
calculate the grant-date fair value of a stock option.




Risk-Free Interest
Rate.  The risk-free interest rate is the implied yield
available on U.S. Treasury zero-coupon issues with a remaining term equal to the
option’s expected term on the grant date.




Of the
variables above, the selection of an expected term and expected stock price
volatility are the most subjective.




Upon
adoption of SFAS No. 123(R), we were also required to estimate the level of
award forfeitures expected to occur and record compensation expense only for
those awards that are ultimately expected to vest.  This requirement
applies to all awards that are not yet vested, including awards granted prior to
July 1, 2006.  We have estimated a forfeiture rate of 10%, which
assumptions we will review periodically and as changes in the composition of our
option pool dictate.




Changes
in the inputs and assumptions, as described above, can materially affect the
measure of estimated fair value of our share-based compensation.  The
Company anticipates the amount of stock-based compensation to increase in the
future as additional options are granted.  As of June 30, 2008, there
was approximately $818,000 of unrecognized compensation cost related to stock
option awards that is expected to be recognized as expense over a weighted
average period of 2.85 years.




Results
of Operations




Fiscal Year Ended June 30,
2008 vs. June 30, 2007




Revenues




Security
revenues for the year ended June 30, 2008 were $5,152,000 as compared with
$4,582,000 for the comparable prior fiscal year, an increase of $570,000 or
12.4%.  Revenue from security products for the year ended June 30,
2008 was $4,554,000 as compared with $2,159,000 for the comparable prior year
period, an increase of $2,395,000 or 111%.  Revenue from government
funded contracts for the year ended June 30, 2008 was $598,000 as compared with
$2,423,000 for the comparable prior year period, a decrease of $1,825,000 or
75%.  The increase in security revenue is primarily a result of an
increase in the number of units of our explosives detection products in fiscal
2008 as compared to fiscal 2007.  Approximately $2,647,000 of
security revenues were recognized in the fourth quarter of fiscal 2008, as
compared to $1,075,000 in the comparable prior year period, as a result of a
significant shipment of our handheld explosives detection equipment to a
customer in China.  The increase in revenues resulting from security
product sales
during both the three months and year






-25-
 
  ended
June 30, 2008 was offset by a decrease in government contract revenue during the
respective comparable prior year periods as more of our resources were focused
on internally funded research projects during fiscal 2008 as compared with
fiscal 2007 and the expiration of certain government funded contracts during
fiscal 2008.




Cost
of Revenues




Cost of
revenues for the year ended June, 2008 were $3,577,000 as compared with
$3,332,000 for the comparable prior year, an increase of $245,000 or
7.4%.   The increase in cost of revenues is primarily a result of
the increase in sales of security products, offset by a decline in government
contract revenue and the associated direct expenses.




Gross
Margin




Gross
margin for the year ended June 30, 2008 was $1,575,000 or 30.6% of security
revenues as compared with $1,250,000 or 27.3% of security revenues for the
comparable prior year.  The increase in gross margin is a result of
increased sales volume of our handheld explosives detection
equipment; design changes to our handheld explosives detectors which
improved the manufacturability; and overall cost efficiencies realized in the
production process, including efficiencies realized by our outsourced contract
manufacturer.




Research
and Development Expense




Research
and development expense for the fiscal year ended June 30, 2008 was $3,097,000
as compared with $1,662,000 for the comparable prior year, an increase of
$1,435,000 or 86.3%.  We continue to expend funds to expand our staff
to further the development of new products in the areas of explosives detection,
as well as to prepare for certain government laboratory acceptance
testing.  In addition, the increase in research and development
expenses relates to the volume and timing of customer funded programs, primarily
through government grants and contracts.  We focused additional
resources on our internally funded research and development programs during
fiscal 2008 as compared with fiscal 2007.  We charge our research and
development personnel to cost of revenues for work performed on these contracts
and grants.  Research and development expenses incurred prior to starting
government contracts are charged to operating expenses.




Selling,
General and Administrative Expenses




Selling,
general and administrative expenses for the year ended June 30, 2008 was
$6,414,000 as compared with $4,591,000 for the comparable prior fiscal year, an
increase of $1,823,000, or 39.7%.  The increase is primarily a result
of costs associated with the additions to our senior management team; increased
expenditures in our sales and marketing efforts; charges recorded in fiscal 2008
for the unpaid portion of wages and fringe benefits owed to our former chief
executive officer under the terms of his transition agreement; increased
audit and legal costs, and expenses related to consultants hired to assist
management with its investor relations and Sarbanes-Oxley
compliance.




Other
Income and Expense, Net




For the
year ended June 30, 2008, we recorded other income, net of $198,000 as compared
with $270,000, for the comparable prior year, a decrease of $72,000 or
26.7%.  During the year ended June 30, 2008 we recorded interest
income of $204,000 as compared with $121,000 for the comparable prior
year.  The increase in interest income is a result of a higher average
balance of cash available for investment in short-term investments during fiscal
2008 as compared with fiscal 2007.  During the year ended June 30,
2008 we recorded interest expense of $88,000 as compared with $654,000 for the
comparable prior year.  The decrease in interest expense is a result
of lower notes payable balances in fiscal 2008 as compared with
2007.  Included in interest expense during the year ended June 30,
2007 is $450,000 of non-cash interest related to the fair value of warrants
issued in December 2006 in conjunction with the issuance of a short-term
note.  During the year ended June 30, 2007 we had $1,500,000
outstanding in a short term note payable to Laurus Master Fund, LLP, which was
repaid in May 2007.  The reduction in interest expense was offset by
an increase in expenses to mark to market the embedded derivatives associated
with the Series D Redeemable Convertible Preferred Stock.  The income
associated with this embedded derivative during the year ended June 30, 2008 was
$133,000 as compared to income of $961,000 for the comparable prior
year.




Loss
from Continuing Operations




Loss from
continuing operations for the year ended June 30, 2008 was $7,714,000 as
compared with $4,733,000 for the comparable prior year, an increase of
$2,981,000, or 63.0%.  The increase in loss from continuing operations
is primarily the result of increased spending for (i) research and development
to enhance our technology and bring new products to market, (ii) the addition of
senior management to execute upon our strategic repositioning and focus on the
development and sale of security products, and (iii) the addition of senior
management and staff to assess market requirements for security products and
market and sell our current products.






-26-




Preferred
Distribution, Dividends and Accretion




Preferred
distribution, dividends and accretion on the Series D Redeemable Convertible
Preferred Stock for the year ended June 30, 2008 was $1,058,000 as compared with
$951,000 for the comparable prior year, an increase of $107,000 or
11.3%.




Loss
from Discontinued Operations




Net loss
from discontinued operations for the year ended June 30, 2008 was $3,021,000 as
compared with $5,955,000 for the comparable prior year, a decrease of $2,934,000
or 49.3%.  Net loss from discontinued operations for fiscal 2008 is
composed of operating losses of $3,021,000 from our semiconductor and medical
reporting units, which are being reported as held for sale.  The
semiconductor reporting unit reflects only our Core Systems
subsidiary.  Net loss from discontinued operations for fiscal 2007
includes:  (i) losses of $4,809,000 from operations of our Core
Systems subsidiary, which offers for sale continue to be solicited; (ii) income
of $482,000 from operations of our former subsidiary, Accurel Systems, which was
sold in May 2007; (iii) loss on the sale of Accurel Systems of $1,246,000; and
(iv) losses of $382,000 from operations of our medical reporting unit, of which
approximately $89,000 of assets were sold subsequent to June 30, 2008 and the
remainder continues to be offered for sale.




Income
Taxes




As of
June 30, 2008, we had federal and state net operating loss carry forwards
available to offset future taxable income of approximately $25,770,000, expiring
between 2021 and 2029, and $30,039,000, expiring between 2009 and 2024,
respectively.  As of June 30, 2008, we had federal and state
investment, alternative minimum tax and research credit carry forwards available
to offset future taxable income of approximately $489,000, expiring between 2021
and 2029, and $362,000, expiring between 2009 and 2024,
respectively.




Liquidity
and Capital Resources




As of
June 30, 2008, we had approximately $412,000 of cash and cash equivalents, a
decrease of $9,209,000 when compared with a balance of $9,621,000 as of June 30,
2007.




Our cash
and cash equivalents at June 30, 2007 were primarily the result of our sale in
May 2007 of our Accurel Systems subsidiary to Evans Analytical Group, LLC for
approximately $12,705,000, including $1,000,000 held by an escrow agent as
security for certain representations and warranties.  As described
elsewhere in this Annual Report, Evans has filed a lawsuit against us requesting
rescission of the asset purchase agreement, plus damages, based on claims of
misrepresentation and fraud and has taken steps to prohibit the escrow
agent from releasing the balance of the escrow account to pending resolution of
the lawsuit.  As a result, we have classified the amount held in
escrow, $1,000,000 at June 30, 2008, as a long term asset.  More
recently, Evans has filed motions that, if granted by the court, could result in
attachments against substantial portions of our assets prior to any final
judgment on the merits of Evans’ claims. If these motions are granted by the
court, we may be prevented from using our cash to operate our
business.  We are vigorously defending ourselves against Evans’
claims.  No assurance can be given, however, that we will be
successful in our defense against Evans’ claims or that Evans’ motions to attach
our assets will not be granted.  The grant of these motions, or any
substantial final judgment in favor of Evans would have a material
adverse effect on our business, assets and results of operations, and could
cause our business to fail.  Moreover, we believe that our litigation
with Evans has made it extremely difficult to raise capital.




During
the year ended June 30, 2008 we had net cash outflows of $4,734,000 from
operating activities of continuing operations as compared to net cash outflows
from operating activities of continuing operations of $2,859,000 for the
comparable prior year period.  The approximate $1,875,000 increase in
net cash outflows used in operating activities of continuing operations during
the year ended June 30, 2008, as compared to the comparable prior year period,
was primarily a result of cash used to fund (i) the increased loss from
continuing operations and (ii) increases in both accounts receivable and
inventories.  These increases in cash outflows were partially offset
by (i) reduction in the change in fair value of embedded derivatives, non-cash
interest expense and equity loss in unconsolidated subsidiaries and (ii)
increases in accounts payables and accrued expenses.




-27-




During
the year ended June 30, 2008 we had net cash outflows of $1,428,000 from
investing activities of continuing operations as compared to net cash inflows of
$9,727,000 from investing activities of continuing operations for the comparable
prior year period.  The approximate $11,155,000 increase in net cash
outflows used in investing activities of continuing operations during the year
ended June 30, 2008, as compared to the comparable prior year period, was
primarily a result of net cash of $9,826,000 provided in fiscal 2007 in
connection with the sale of Accurel Systems and certain medical business unit
assets, which did not recur in fiscal 2008; and the use of aggregate cash of
$993,000 during fiscal 2008 to purchase certificates of deposits, acquire Ion
Metrics, and pay certain lease liabilities.




During
the year ended June 30, 2008 we had net cash outflows of $2,255,000 from
financing activities of continuing operations as compared to net cash outflows
of $68,000 from financing activities of continuing operations for the comparable
prior year period.  The approximate $2,187,000 increase in net cash
outflows used in financing activities of continuing operations during the year
ended June 30, 2008, as compared to the comparable prior year period, was
primarily a result of (i) increased payments of principal and dividends on the
Series D Cumulative Redeemable Convertible Preferred Stock in fiscal 2008 as
compared to fiscal 2007, and (ii) increased repayments of long-term debt and
capital lease obligations in fiscal 2008.  Offsetting these cash
outflows were borrowings on our line of credit in fiscal 2008 as opposed to
repayments on our line of credit in fiscal 2007.




We currently
have a $1.5 million revolving credit facility with Bridge Bank,
N.A..  This line of credit, which expires in January 2009, provides
for advances of up to 80% of our eligible domestic accounts receivable and up to
the lesser of $500,000 or 50% of eligible foreign accounts receivable, bears
interest at the prime rate, plus 2.25% per annum, and is collateralized by all
of our assets.  As of June 30, 2008, we were in violation of our
minimum current ratio and minimum net worth financial covenants (collectively,
the “Financial Covenant Defaults”) in our loan agreements with Bridge Bank,
N.A.  On October 10, 2008, we received a notice of default with
respect of violation of depository accounts, financial reporting and failure to
complete sale of an asset (collectively, the “Subsequent Covenant
Defaults”)  We received a waiver from Bridge Bank with respect of the
Financial Covenant Default, but cannot be certain that the bank will continue to
grant waivers in the future due to the potential for financial covenant
non-compliance.  We did not receive a waiver for the Subsequent
Covenant Defaults.  If the bank does not agree to grant us such
waivers, there is a risk that the bank may call the loan or prevent us from
taking additional advances until the default is cured.  We havea credit facility with
the bank, which matures in January 2009, having an unpaid balance of
approximately $862,000 as of June 30, 2008, consisting of a $385,000 term note
and $477,000 of borrowings under the revolving line of credit that matures in
January 2009.




On
September 30, 2008, we amended the Securities Purchase Agreement dated as of
September 30, 2005, between the Company and Laurus Master Fund,
Ltd.  Under the amendment, we paid $250,000 to Laurus’s agent, which
payment was applied first to accrued and unpaid dividends on the shares of
Series D Cumulative Convertible Preferred Stock purchased by Laurus pursuant to
the Purchase Agreement (and subsequently assigned to Valens Offshore SPV I,
Ltd.), and then to the outstanding principal balance under the Securities
Purchase Agreement and certain related documents.  In exchange for
this payment, Laurus, Valens Offshore and the agent agreed to change the
Mandatory Redemption Date of the Series D Cumulative Convertible Preferred Stock
from September 29, 2008 to October 24, 2008, at which time the remaining
principal is due.  As of June 30, 2008, the outstanding balance due to
Laurus was approximately $2,269,000.  On
October 2, 2008, we remitted the $250,000 payment to Laurus, inclusive of
$22,000 of dividends and upon application of this payment, the balance due
to Laurus on October 24, 2008 is approximately $1,893,000.




We are
currently expending significant resources to develop the next generation of our
current products and to develop new products.  Although we continue to
fund as much research and development as possible through government grants and
contracts in accordance with the provisions of the respective grant awards, we
will require additional funding in order to continue the advancement of the
commercial development and manufacturing of the explosives detection
system.  We will attempt to obtain such financing by: (i) government
grants, (ii) private financing, or (iii) strategic
partnerships.  However, there can be no assurance that we will be
successful in our attempts to raise such additional financing.




We will
require substantial funds for further research and development, regulatory
approvals, and the marketing of our explosives detection
products.  Our capital requirements depend on numerous factors,
including but not limited to; the progress of our research and development
programs; the cost of filing, prosecuting, defending and enforcing any
intellectual property rights; competing technological and market developments;
changes in our development of commercialization activities and arrangements; and
the hiring of additional personnel, and acquiring capital
equipment.






-28-
 
  Our
ability to continue operations beyond October 24, 2008 will depend significantly
on our ability either to refinance our obligations to Laurus or negotiate a
further extension of our obligation to redeem the Series D Preferred
Stock.  If we are unable to refinance or extend these obligations,
Laurus may seize our assets and we may be forced to curtail or discontinue
operations entirely.
  are
discretionary and can be adjusted as can certain selling, general and
administrative expenses, based on the availability of cash.  The
financial statements do not include any adjustments relating to the
recoverability and classification of asset amounts or the amounts and
classification of liabilities that might be necessary should we be unable to
continue as a going concern.




Off-Balance
Sheet Arrangements




As of
June 30, 2008 we had an irrevocable standby letter of credit outstanding in the
approximate amount of $418,000.  The letter of credit provides
performance security equal to 10% of the contract amount for product which is
expected to be shipped in the first quarter of fiscal 2009.  The
letter of credit expires on July 31, 2010.




As of
June 30, 2008, we did not have any other off-balance sheet arrangements that
have, or are reasonably likely to have, a current or future material effect on
our consolidated financial condition, results of operations, liquidity, capital
expenditures or capital resources.




Item
      8.
            Financial
      Statements and Supplementary Data




The
following documents are filed as part of this report on Form 10-K




PageReport of UHY LLP,
      Independent Registered Public Accounting Firm
            
            F-1Consolidated Balance Sheets at June 30, 2008
      and 2007
            
            F-2Consolidated
      Statements of Operations for the years ended June 30, 2008 and
      2007
            
            F-3Consolidated
      Statements of Stockholders’ Equity for the years ended June 30, 2008 and
      2007
            
            F-4Consolidated
      Statements of Cash Flows for the years ended June 30, 2008 and
      2007
            
            F-5Notes
      to Consolidated Financial Statements
            
            F-7


Item 9.
            Changes
      In and Disagreements With Accountants on Accounting and Financial
      Disclosure




None.




Item 9A.
            Controls
      and Procedures




The
certifications of the Company’s Chief Executive Officer and Chief Financial
Officer attached as Exhibits 31.1 and 31.2 to this Annual Report on Form 10-K
include, in paragraph 4 of such certifications, information concerning the
Company’s disclosure controls and procedures, and internal control over
financial reporting.  Such certifications should be read in
conjunction with the information contained in this Item 9A for a more complete
understanding of the matters covered by such certifications.




Disclosure
      Controls and Procedures.




The
Company’s management, with the participation of the Company’s Chief Executive
Officer and Chief Financial Officer, evaluated the effectiveness of the
Company’s disclosure controls and procedures as of June 30, 2008.  The
term “disclosure controls and procedures”, as defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), means
controls and other procedures of a company that are designed to ensure that
information required to be disclosed by the company in the reports that it files
or submits under the Exchange Act is recorded, processed, summarized, and
reported, within the time periods specified in the rules and forms of the
Securities and Exchange Commission.  Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that




-29-








Management’s
Annual Report on Internal Control Over Financial Reporting




The
Company’s management is responsible for establishing and maintaining adequate
internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act).  A company’s internal control over
financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with U.S. generally
accepted accounting principles.  Internal control over financial
reporting includes those policies and procedures that (i) pertain to the
maintenance of records that, in reasonable detail, accurately and fairly reflect
the transactions and dispositions of the assets of the Company; (ii) provide
reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the Company are
being made only in accordance with authorizations of management and directors of
the Company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
Company’s assets that could have a material effect on the interim or annual
consolidated financial statements.  Because of its inherent
limitations, internal control over financial reporting may not prevent or detect
misstatements.  Also, projections of any evaluation of effectiveness
to future periods are subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.




The
Company’s management, with the participation of its Chief Executive Officer and
Chief Financial Officer, conducted an evaluation of the effectiveness of the
Company’s internal control over financial reporting as of June 30, 2008 based on
the framework in Internal
Control Integrated Frameworkissued by the Committee of Sponsoring
Organizations of the Treadway Commission.  Based on this assessment,
the Company’s management concluded that, as of June 30, 2008, the Company’s
internal control over financial reporting was effective based on those
criteria.




This
Annual Report on Form 10-K does not include an attestation report of the
Company's registered public accounting firm regarding internal control over
financial reporting.  Management's report was not subject to
attestation by the Company's registered public accounting firm pursuant to
temporary rules of the Securities and Exchange Commission that permit the
Company to provide only management's report in this annual report.




Changes
in Internal Control Over Financial Reporting




There
were no changes to the Company’s internal control over financial reporting
during the fourth quarter ended June 30, 2008 that has materially affected, or
are reasonably likely to materially affect, the Company’s internal control over
financial reporting.




Item 9B.
            Other
      Information




None.




-30-


PART III





Item 10.
            Directors,
      Executive Officers and Corporate
Governance




The
information required by this Item 10 will be incorporated by reference from our
definitive proxy statement or will be filed as an amendment to our Form 10-K
within 120 days of our fiscal year end.




Item 11.
            Executive
      Compensation




The
information required by this Item 11 will be incorporated by reference from our
definitive proxy statement or will be filed as an amendment to our Form 10-K
within 120 days of our fiscal year end.




Item 12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters




The
information required by this Item 12 will be incorporated by reference from our
definitive proxy statement or will be filed as an amendment to our Form 10-K
within 120 days of our fiscal year end.




Item
      13.
            Certain
      Relationships and Related Transactions, and Director
      Independence




The
information required by this Item 13 will be incorporated by reference from our
definitive proxy statement or will be filed as an amendment to our Form 10-K
within 120 days of our fiscal year end.




Item
      14.
            Principal
      Accounting Fees and Services




The information required by this
Item 14 will be incorporated by reference from our definitive proxy statement or
will be filed as an amendment to our Form 10-K within 120 days of our fiscal
year end.









-31-


PART
IV




Item 15.
            Exhibits,
      Financial Statement Schedules




The
      following are filed as part of this Form
10-K:




(1)
            Financial
      Statements: For a list of financial statements which are filed as part of
      this Annual Report on Form 10-K, See Page
28.




(2)
            Exhibits




Exhibit
      No.
            Ref.
      No.
            Description3.1
            1
            Articles
      of Amendment to the Articles of Organization of the Company, dated June 9,
      1999.3.2
            1
            Restated
      Articles of Organization of the Company, dated June 9.
    1999.3.3
            5
            Certificate
      of Vote of Directors establishing Series A 7% Cumulative Convertible
      Preferred Stock, dated October 7, 2002.3.4
            6
            Certificate
      of Vote of Directors establishing Series B 5% Cumulative Convertible
      Preferred Stock, dated August 26, 2003.3.5
            7
            Certificate
      of Vote of Directors establishing Series C 5% Cumulative Convertible
      Preferred Stock, dated November 25, 2003.3.6
            17
            Certificate
      of Vote of Directors establishing Series D Convertible Preferred Stock,
      dated September 30, 2005.3.7
            18
            Form
      of Amendment to Series D Cumulative Convertible Preferred Stock and
      Securities Purchase Agreement dated May 31, 2006.3.8
            4
            Amended
      and Restated By-Laws of the Company.4.1
            2
            Specimen
      certificate for the Common Stock of the Company.10.1
            1
            1992
      Stock Option Plan.10.2
            1
            Form
      of Stock Option Agreement under the 1992 Stock Option
  Plan.10.3
            1
            1998
      Incentive and Nonqualified Stock Option Plan.10.4
            2
            Form
      of Incentive Stock Option under the 1998 Incentive and Nonqualified Stock
      Option Plan.10.5
            2
            Form
      of Nonqualified Stock Option under the 1998 Incentive and Nonqualified
      Stock Option Plan.10.6
            2
            Form
      of Nonqualified Stock Option for Non-Employee Directors under the 1998
      Incentive and Nonqualified Stock Option Plan.10.7
            5
            Common
      Stock Purchase Warrant for 55,000 shares issued to Laurus Master Fund,
      Ltd. Dated October 7, 2002.10.8
            6
            Common
      Stock Purchase Warrant for 70,000 shares issued to Laurus Master Fund,
      Ltd. Dated August 28, 2003.10.9
            7
            Securities
      Purchase Agreement between Implant Sciences Corporation and Laurus Master
      Fund, Ltd, Dated November 25, 2003.10.10
            7
            Security
      Agreement between Implant Sciences Corporation and Laurus Master Fund,
      Ltd. Dated November 25, 2003.10.11
            7
            Common
      Stock Purchase Warrant for 100,000 shares issued to Laurus Master Fund,
      Ltd. Dated November 25, 2003.10.12
            8
            Exchange
      and Venture agreement between Implant Sciences Corporation, CardioTech
      International, and CorNova, Inc. dated March 5, 2004.10.13
            9
            Form
      of Securities Purchase Agreement between Implant Sciences and certain
      investors.10.14
            9
            Form
      of Warrant dated June, 17, 2004.10.15
            9
            Form
      of Additional Investors Rights Agreement dated June 17, 2004 between
      Implant Sciences and certain investors.10.16
            9
            Form
      of Registration Rights Agreement dated June 17, 2004 between Implant
      Sciences and certain investors.10.17
            10
            Employment
      Agreement with Anthony J. Armini, dated June 30, 2004.10.18
            11
            Agreement
      and Plan of Merger and Reorganization, dated October 13, 2004, by and
      among the Company, C Acquisition Corp., Core Systems Incorporated and
      Donald W. Lindsey.10.19
            12
            Securities
      Purchase Agreements, dated March 4, 2005, by and between the Company and
      the Purchasers thereunder, with attached schedules.10.20
            12
            Form
      of Common Stock Purchase Warrant, dated March 4, 2005, by the Company in
      favor of Pacific Wave Partners
Limited.






-32-




10.21
            12
            Form
      of Common Stock Purchase Warrant, dated March 4, 2005, by the Company in
      favor of the Purchasers.10.22
            12
            Form
      of Additional Investment Right, dated March 4, 2005, by and between the
      Company in favor of the purchasers.10.23
            12
            Registration
      Rights Agreement, dated March 4, 2005, by and between the Company and the
      parties thereto.10.24
            13
            Stock
      Purchase Agreement dated March 9, 2005 by and among the Company, Accurel
      Systems International Corporation and its
      Stockholders.10.25
            13
            Form
      of the Secured Promissory Note dated March 9, 2005 made out by the Company
      in favor of the Stockholders.10.26
            13
            Note
      and Security Agreement dated March 9, 2005, by and among the Company, the
      Stockholders and the Escrow Agent thereunder.10.27
            13
            Holdback
      and Escrow Agreement dated March 9, 2005, by and among the Company, the
      Stockholders and the Escrow Agent thereunder.10.28
            14*
            Development,
      Distribution and Manufacturing Agreement dated March 23, 2005 by and
      between the Company and Rapiscan Systems, Inc.10.29
            15
            Form
      of Business Financing Agreement dated June 1, 2005 between the Company and
      Bridge Bank, N.A.10.30
            15
            Form
      of Intellectual Property Security Agreement dated June 1, 2005 between
      Implant Sciences Corporation and Bridge Bank, N.A.10.31
            15
            Form
      of Intellectual Property Security Agreement dated June 1, 2005 between C
      Acquisition Corp. and Bridge Bank, N.A.10.32
            16
            Form
      of Securities Purchase Agreement, dated as of July 6, 2005, by and between
      the Company and Laurus Master Fund, Ltd.10.33
            16
            Form
      of Secured Term Note, dated as of July 6, 2005, by the Company in favor of
      Laurus Master Fund, Ltd.10.34
            16
            Form
      of Subsidiary Guaranty, dated as of July 6, 2005, by the Company in favor
      of Laurus Master Fund, Ltd.10.35
            16
            Form
      of Common Stock Purchase Warrant, by the Company in favor of Laurus Master
      Fund, Ltd.10.36
            16
            Form
      of Funds Escrow Agreement.10.37
            16
            Form
      of Master Security Agreement.10.38
            17
            Securities
      Purchase Agreement by and between the Company and Laurus Master Fund,
      dated September 30, 2005.10.39
            17
            Registration
      Rights Agreement by and between the Company and Laurus Master Fund, dated
      September 30, 2005.10.40
            17
            Subsidiary
      Guaranty dated September 30, 2005.10.41
            17
            Form
      of Common Stock Purchase Warrant dated September 30,
  2005.10.42
            17
            Form
      of Funds Escrow Agreement by and among the Company, Laurus Master Fund and
      Loeb & Loeb LLP.10.43
            17
            Form
      of Master Security Agreement by and among the Company, C-Acquisition
      Corporation, Accurel Systems and Laurus Master Fund, dated September 30,
      2005.10.44
            17
            Form
      of Stock Pledge Agreement by and between the Company and Laurus Master
      Fund dated September 30, 2005.10.45
            18
            Form
      of Common Stock Purchase Warrant, by the Company in favor of Laurus Master
      Fund, Ltd, dated May 31, 2006.10.46
            18
            Form
      of Amendment to Securities Purchase Agreement by and between the Company
      and Laurus Master Fund dated May 31, 2006.10.47
            19
            2000
      Incentive and Non-Qualified Stock Option Plan10.48
            20
            2005
      Incentive Stock Option Plan10.49
            21
            2004
      Employee Stock Purchase Plan10.50
            22
            Form
      of Business Financing Agreement with Bridge Bank dated January 3, 2007 and
      Form of Short term note with Laurus Master Fund, Ltd, dated December 29,
      2006.10.51
            23
            Transition
      Agreement between the Company and Anthony J. Armini dated September 27,
      200710.52
            24
            Employment
      Agreement dated September 27, 2007, by and between Phillip C. Thomas the
      Company.






-33-




10.53
            25
            Agreement
      between the Company, OSI Systems, Inc. and Rapiscan Systems, Inc. dated
      January 4, 2008.10.54
            26
            Employment
      Agreement dated February 29, 2008 by and between Diane J. Ryan and the
      Company.10.55
            27
            Agreement
      and Plan of Merger and Reorganization by and among Implant Sciences
      Corporation, IMX Acquisition Corp., Ion Metrics, Inc., All Shareholders of
      Ion Metrics, Inc. and David J. Ferran, as Shareholder Representative dated
      April 10, 2008.10.56
            28
            Asset
      Purchase Agreement between Implant Sciences Corporation and International
      Brachytherapy, s.a. dated June 27, 2008.10.57
            29
            Employment
      Agreement dated July 31, 2008 by and between Glenn D. Bolduc and the
      Company.10.58
            30
            Omnibus
      Amendment, dated as of September 30, 2008, amount Implant Sciences
      Corporation and LV Administrative Services, Inc. as administrative and
      collateral agent for each of Laurus Master Fund, Ltd. and Valens Offshore
      SPV I, Ltd., to (i) that certain Securities Purchase Agreement, dated as
      of September 29, 2005, by and between the Company and Laurus Master Fund,
      Ltd. and (ii) certain the other related agreements referred to in the
      Purchase Agreement.21.1
            
            Subsidiaries
      of the Company.23.1
            
            Consent
      of UHY LLP.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 Pursuant to 18 U.S.C. 1350, as adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.32.2
            
            Certification
      of the 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 on Form 8-K on December 18, 2007, 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 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 on Form 8-K on June 13, 2005 and is incorporated herein by
      reference.16
            Previously
      filed on Form 8-K on July 14, 2005 and is incorporated herein by
      reference.17
            Previously
      filed on Form 8-K on October 5, 2005 and is incorporated herein by
      reference.18
            Previously
      filed on Form 8-K on June 6, 2006 and is incorporated herein by
      reference.19
            Previously
      filed on Form S-8 on December 12, 2003 and is incorporated herein by
      reference.20
            Previously
      filed on Form S-8 on October 27, 2006 and is incorporated herein by
      reference.21
            Previously
      filed on Form S-8 on July 26, 2007 and is incorporated herein by
      reference.22
            Previously
      filed on Form 8-K on January 5, 2007 and is incorporated herein by
      reference.






-34-




23
            Previously
      filed on Form 8-K on October 3, 2007 and is incorporated herein by
      reference.24
            Previously
      filed on Form 8-K on December 14, 2007 and is incorporated herein by
      reference.25
            Previously
      filed on Form 8-K on January 10, 2008 and is incorporated herein by
      reference.26
            Previously
      filed on Form 8-K on March 18, 2008 and is incorporated herein by
      reference.27
            Previously
      filed on Form 8-K on April 16, 2008 and is incorporated herein by
      reference.28
            Previously
      filed on Form 8-K on July 9, 2008 and is incorporated herein by
      reference.29
            Previously
      filed on Form 8-K on August 4, 2008 and is incorporated herein by
      reference.30
            Previously
      filed on Form 8-K on October 6, 2008 and is incorporated herein by
      reference.*
            Filed
      pursuant to a request for confidential
  treatment.







-35-


Report of
Independent Registered Public Accounting Firm









The Board
of Directors and Stockholders of Implant Sciences Corporation:




We have
audited the accompanying consolidated balance sheets of Implant Sciences
Corporation and subsidiaries (the "Company") as of June 30, 2008 and 2007, and
the related consolidated statements of operations, stockholders’ equity, and
cash flows for the two years then ended.  These financial
statements are the responsibility of the Company’s management.  Our
responsibility is to express an opinion on these financial statements based on
our audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
Company is not required to have, not were we engaged to perform, an audit of its
internal controls over financial reporting.  Our audit included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over  financial reporting.  Accordingly, we
express no such opinion.  An audit also includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial
statement presentation.  We believe that our audits provide a
reasonable basis for our opinion.




In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Implant Sciences
Corporation and subsidiaries at June 30, 2008 and 2007 and the results of
their operations and their cash flows for each of the years then ended, in
conformity with generally accepted accounting principles in the United
States .




The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern.  As discussed in Note 1
to the consolidated financial statements, the Company has suffered recurring
losses from operations which raises substantial doubt about its ability to
continue as a going concern.  Management's plans in regard to these
matters are also described in Note 1.  The consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.







/s/
      UHY LLP


Boston,
Massachusetts


October
14, 2008








F-1
  Implant
      Sciences CorporationConsolidated
      Balance SheetsJune
      30,2008
              
              
              2007ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              412,000
              
              
              $
              9,621,000Restricted
      cash
              
              
              514,000
              
              
              
              25,000Accounts
      receivable-trade, net of allowance of $9,000 and
      $20,000,  respectively
              
              
              667,000
              
              
              
              346,000Accounts
      receivable, unbilled
              
              
              152,000
              
              
              
              162,000Inventories
              
              
              725,000
              
              
              
              683,000Investments
      - available for sale securities
              
              
              -
              
              
              
              133,000Prepaid
      expenses and other current assets
              
              
              369,000
              
              
              
              712,000Current
      assets held for sale
              
              
              1,883,000
              
              
              
              2,071,000Total
      current assets
              
              
              4,722,000
              
              
              
              13,753,000Property
      and equipment, net
              
              
              443,000
              
              
              
              530,000Amortizable
      intangible assets, net
              
              
              54,000
              
              
              
              -Other
      non-current assets
              
              
              1,096,000
              
              
              
              711,000Goodwill
              
              
              3,136,000
              
              
              
              -Non-current
      assets held for sale
              
              
              2,645,000
              
              
              
              4,606,000Total
      assets
              
              $
              12,096,000
              
              
              $
              19,600,000LIABILITIES
      AND STOCKHOLDERS' (DEFICIT) EQUITYCurrent
      liabilities:Current
      maturities of long-term debt and obligations under capital
      lease
              
              $
              417,000
              
              
              $
              705,000Line
      of credit
              
              
              477,000
              
              
              
              -Notes
      payable
              
              
              181,000
              
              
              
              -Payable
      to Med-Tec
              
              
              80,000
              
              
              
              143,000Payable
      to Ion Metrics shareholders
              
              
              2,514,000
              
              
              
              -Accrued
      expenses
              
              
              2,062,000
              
              
              
              1,763,000Accounts
      payable
              
              
              2,439,000
              
              
              
              570,000Current
      portion of long-term lease liability
              
              
              317,000
              
              
              
              301,000Deferred
      revenue
              
              
              66,000
              
              
              
              71,000Current
      liabilities held for sale
              
              
              1,079,000
              
              
              
              1,111,000Total
      current liabilities
              
              
              9,632,000
              
              
              
              4,664,000Long-term
      liabilities:Long-term
      debt and obligations under capital lease, net of current
      maturities
              
              
              113,000
              
              
              
              629,000Long-term
      lease liability
              
              
              446,000
              
              
              
              735,000Derivatives
      related to preferred stock features
              
              
              -
              
              
              
              133,000Long-term
      liabilities held for sale
              
              
              1,000
              
              
              
              4,000Total
      long-term liabilities
              
              
              560,000
              
              
              
              1,501,000Total
      liabilities
              
              
              10,192,000
              
              
              
              6,165,000Commitments
      and contingencies (Note 9)Series
      D Cumulative Redeemable Convertible Preferred Stock, $10 stated
      value;500,000
      shares authorized, 242,424 and 393,939 shares outstanding,
      respectively(liquidation
      value $2,424,000 and $3,939,000, respectively)
              
              
              2,269,000
              
              
              
              2,989,000Stockholders'
      (deficit) equity:Common
      stock; $0.10 par value; 50,000,000 shares authorized; 12,114,553
      and
                12,104,008
      and 11,835,661 and 11,825,116 shares issued and outstanding,
      respectively
              
              
              1,211,000
              
              
              
              1,183,000Additional
      paid-in capital
              
              
              58,317,000
              
              
              
              57,358,000Accumulated
      deficit
              
              
              (59,720,000
              )
              
              
              (47,927,000
              )Deferred
      compensation
              
              
              (2,000
              )
              
              
              (30,000
              )Accumulated
      other comprehensive loss
              
              
              (98,000
              )
              
              
              (65,000
              )Treasury
      stock, 10,545 common shares, respectively, at cost
              
              
              (73,000
              )
              
              
              (73,000
              )Total
      stockholders' (deficit) equity
              
              
              (365,000
              )
              
              
              10,446,000Total
      liabilities and stockholders' (deficit) equity
              
              $
              12,096,000
              
              
              $
              19,600,000The
      accompanying notes are an integral part of these financial
      statements.
  F-2
    Implant
      Sciences CorporationConsolidated
      Statements of OperationsFor
      The Years Ended June 30,2008
              
              
              2007Security
      revenues
              
              $
              5,152,000
              
              
              $
              4,582,000Cost
      of revenues
              
              
              3,577,000
              
              
              
              3,332,000Gross
      margin
              
              
              1,575,000
              
              
              
              1,250,000Operating
      expenses:Research
      and development
              
              
              3,097,000
              
              
              
              1,662,000Selling,
      general and administrative
              
              
              6,414,000
              
              
              
              4,591,0009,511,000
              
              
              
              6,253,000Loss
      from operations
              
              
              (7,936,000
              )
              
              
              (5,003,000
              )Other
      income (expense), net:Interest
      income
              
              
              204,000
              
              
              
              121,000Interest
      expense
              
              
              (88,000
              )
              
              
              (654,000
              )Change
      in fair value of embedded derivatives related to
                preferred
      stock features
              
              
              133,000
              
              
              
              961,000Loss
      on sale of investments
              
              
              (51,000
              )
              
              
              -Equity
      losses in unconsolidated subsidiaries
              
              
              -
              
              
              
              (158,000
              )Total
      other income, net
              
              
              198,000
              
              
              
              270,000Loss
      from continuing operations before income tax benefit
              
              
              (7,738,000
              )
              
              
              (4,733,000
              )Income
      tax benefit
              
              
              24,000
              
              
              
              -Loss
      from continuing operations
              
              
              (7,714,000
              )
              
              
              (4,733,000
              )Preferred
      distribution, dividends and accretion
              
              
              (1,058,000
              )
              
              
              (951,000
              )Loss
      from continuing operations applicable to common
    shareholders
              
              
              (8,772,000
              )
              
              
              (5,684,000
              )Loss
      from discontinued operations
              
              
              (3,021,000
              )
              
              
              (4,709,000
              )Loss
      on sale of discontinued operations, net of tax of $197,000
              
              
              -
              
              
              
              (1,246,000
              )Loss
      from discontinued operations
              
              
              (3,021,000
              )
              
              
              (5,955,000
              )Net
      loss applicable to common shareholders
              
              $
              (11,793,000
              )
              
              $
              (11,639,000
              )Net
      loss
              
              $
              (10,735,000
              )
              
              $
              (10,688,000
              )Loss
      per share from continuing operations, basic and diluted
              
              $
              (0.65
              )
              
              $
              (0.40
              )Loss
      per share from continuing operations applicable to common
                shareholders,
      basic and diluted
              
              $
              (0.73
              )
              
              $
              (0.48
              )Loss
      per share from discontinued operations, basic and diluted
              
              $
              (0.25
              )
              
              $
              (0.50
              )Net
      loss per share applicable to common shareholders, basic and
      diluted
              
              $
              (0.99
              )
              
              $
              (0.99
              )Net
      loss per share
              
              $
              (0.90
              )
              
              $
              (0.91
              )Weighted
      average shares used in computing net loss per common
                share,
      basic and diluted
              
              
              11,935,515
              
              
              
              11,794,599







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






F-3


Implant
      Sciences CorporationConsolidated
      Statements of Stockholders' Equity (Deficit)For
      the Years Ended June 30, 2007 and 2008Common
      Stock
              
              
              
              
              
              
              
              
              
              
              
              Treasury
      StockNumber
      of Shares
              
              
              Amount
              
              
              Additional
                Paid-in
                Capital
              
              
              Accumulated
                Deficit
              
              
              Deferred
                Compensation
              
              
              Accumulated
                Other
                Comprehensive
                Income
      (Loss)
              
              
              Number
                of
                Shares
              
              
              Amount
              
              
              Total
                Stockholders'
                Equity
      (Deficit)
              
              
              Comprehensive
                (Loss)Balance
      at June 30, 2006
              
              
              11,733,804
              
              
              $
              1,173,000
              
              
              $
              55,282,000
              
              
              $
              (36,288,000
              )
              
              $
              (17,000
              )
              
              $
              14,000
              
              
              
              26,994
              
              
              $
              (236,000
              )
              
              $
              19,928,000
              
              
              $
              -Issuance
      of common stock in connection
                with
      employee stock purchase plan
              
              
              67,492
              
              
              
              7,000
              
              
              
              149,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              156,000Issuance
      of common stock in connection
                with
      exercise of stock options
              
              
              34,365
              
              
              
              3,000
              
              
              
              47,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              50,000Fair
      value of warrants issued to consultants
              
              
              
              
              
              
              
              
              
              
              136,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              136,000Fair
      value of warrants issued in connection
                with
      sale of Accurel
              
              
              
              
              
              
              
              
              
              
              389,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              389,000Fair
      value of warrants issued in connection
                with
      Laurus Master Fund short-term note
              
              
              
              
              
              
              
              
              
              
              450,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              450,000Fair
      value of warrants issued in connection
                with
      Bridge Bank loans
              
              
              
              
              
              
              
              
              
              
              28,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              28,000Amortization
      of deferred compensation
              
              
              
              
              
              
              
              
              
              
              18,000
              
              
              
              
              
              
              
              (13,000
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5,000Share-based
      compensation
              
              
              
              
              
              
              
              
              
              
              1,022,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,022,000Series
      D accretion and dividends
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (951,000
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (951,000
              )Effect
      of CorNova's IMX stock transactions
              
              
              
              
              
              
              
              
              
              
              (163,000
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (16,449
              )
              
              
              163,000Unrealized
      gain on available for sale securities
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (79,000
              )
              
              
              
              
              
              
              
              
              
              
              (79,000
              )
              
              
              (79,000
              )Net
      loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (10,688,000
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (10,688,000
              )
              
              
              (10,688,000
              )Balance
      at June 30, 2007
              
              
              11,835,661
              
              
              
              1,183,000
              
              
              
              57,358,000
              
              
              
              (47,927,000
              )
              
              
              (30,000
              )
              
              
              (65,000
              )
              
              
              10,545
              
              
              
              (73,000
              )
              
              
              10,446,000
              
              
              
              (10,767,000
              )Issuance
      of common stock in connection
                with
      employee stock purchase plan
              
              
              57,163
              
              
              
              6,000
              
              
              
              47,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              53,000Issuance
      of common stock in connection
                with
      settlement of Rapiscan litigation
              
              
              221,729
              
              
              
              22,000
              
              
              
              178,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              200,000Fair
      value of warrants issued to consultants
              
              
              
              
              
              
              
              
              
              
              15,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              15,000Fair
      value of warrants issued in connection
                with
      Bridge Bank loans
              
              
              
              
              
              
              
              
              
              
              29,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              29,000Amortization
      of deferred compensation
              
              
              
              
              
              
              
              
              
              
              (7,000
              )
              
              
              
              
              
              
              28,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              21,000Share-based
      compensation
              
              
              
              
              
              
              
              
              
              
              697,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              697,000Series
      D accretion and dividends
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,058,000
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,058,000
              )Unrealized
      loss on available for sale securities
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (33,000
              )
              
              
              
              
              
              
              
              
              
              
              (33,000
              )
              
              
              (33,000
              )Net
      loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (10,735,000
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (10,735,000
              )
              
              
              (10,735,000
              )Balance
      at June 30, 2008
              
              
              12,114,553
              
              
              $
              1,211,000
              
              
              $
              58,317,000
              
              
              $
              (59,720,000
              )
              
              $
              (2,000
              )
              
              $
              (98,000
              )
              
              
              10,545
              
              
              $
              (73,000
              )
              
              $
              (365,000
              )
              
              $
              (10,768,000
              )The
      accompanying notes are an integral part of these financial
      statements.


F-4


Implant
      Sciences CorporationConsolidated
      Statements of Cash FlowsFor
      The Years Ended June 30,2008
              
              
              2007Cash
      flows from operating activities:Net
      loss
              
              $
              (10,735,000
              )
              
              $
              (10,688,000
              )Less:  Net
      loss from discontinued operations
              
              
              (3,021,000
              )
              
              
              (5,955,000
              )Loss
      from continuing operations
              
              
              (7,714,000
              )
              
              
              (4,733,000
              )Adjustments
      to reconcile net loss from continuing operations to net cash
      flows:Depreciation
      and amortization
              
              
              284,000
              
              
              
              166,000Bad
      debt expense (recoveries)
              
              
              (11,000
              )
              
              
              10,000Share-based
      compensation expense
              
              
              582,000
              
              
              
              574,000Change
      in fair value of embedded derivatives
              
              
              (133,000
              )
              
              
              (961,000
              )Non-cash
      interest expense
              
              
              29,000
              
              
              
              450,000Equity
      loss in unconsolidated subsidiaries
              
              
              -
              
              
              
              158,000Fair
      value of warrants issued to non-employees
              
              
              36,000
              
              
              
              136,000Warrant
      accretion on Bridge Bank loans
              
              
              15,000
              
              
              
              6,000Loss
      on sale of investments
              
              
              51,000
              
              
              
              -Loss
      on lease
              
              
              -
              
              
              
              487,000Changes
      in assets and liabilities, net of effect of acquisition:Accounts
      receivable
              
              
              (290,000
              )
              
              
              (149,000
              )Inventories
              
              
              (42,000
              )
              
              
              262,000Prepaid
      expenses and other current assets
              
              
              354,000
              
              
              
              273,000Accounts
      payable
              
              
              1,628,000
              
              
              
              (278,000
              )Accrued
      expenses
              
              
              482,000
              
              
              
              990,000Deferred
      revenue
              
              
              (5,000
              )
              
              
              (250,000
              )Net
      cash used in operating activities of continuing operations
              
              
              (4,734,000
              )
              
              
              (2,859,000
              )Net
      cash  (used in) provided by operating activities of discontinued
      operations
              
              
              (587,000
              )
              
              
              1,441,000Net
      cash used in operating activities
              
              
              (5,321,000
              )
              
              
              (1,418,000
              )Cash
      flows from investing activities:Purchases
      of property and equipment
              
              
              (99,000
              )
              
              
              (8,000
              )Investments
      in certificates of deposit
              
              
              (489,000
              )
              
              
              (25,000
              )Investment
      in available for sale securities
              
              
              -
              
              
              
              1,000Proceeds
      from sale of Accurel, net of transaction costs and escrow
              
              
              -
              
              
              
              9,521,000Proceeds
      from sale of medical business unit assets, net of transaction
      costs
              
              
              -
              
              
              
              305,000Proceeds
      from the sale of investments
              
              
              49,000
              
              
              
              -Acquisition
      of Ion Metrics, net of cash received
              
              
              (231,000
              )
              
              
              -Payments
      on lease liability
              
              
              (273,000
              )
              
              
              (48,000
              )Increase
      in other non-current assets
              
              
              (385,000
              )
              
              
              (19,000
              )Net
      cash (used in) provided by investing activities of continuing
      operations
              
              
              (1,428,000
              )
              
              
              9,727,000Net
      cash used in investing activities of discontinued
    operations
              
              
              (202,000
              )
              
              
              (754,000
              )Net
      cash used in investing activities
              
              
              (1,630,000
              )
              
              
              8,973,000Cash
      flows from financing activities:Proceeds
      from common stock issued in connection with exercise of stock options
      and
                employee
      stock purchase plan
              
              
              53,000
              
              
              
              206,000Dividends
      on Series D Cumulative Redeemable Convertible Preferred
    Stock
              
              
              (263,000
              )
              
              
              (379,000
              )Payments
      on Series D Cumulative Redeemable Convertible Preferred
    Stock
              
              
              (1,515,000
              )
              
              
              (151,000
              )Proceeds
      from Laurus term note
              
              
              -
              
              
              
              1,500,000Repayment
      of Laurus term note
              
              
              -
              
              
              
              (1,500,000
              )Proceeds
      from Bridge Bank term note
              
              
              -
              
              
              
              1,600,000Principal
      repayments of long-term debt and capital lease obligations
              
              
              (1,007,000
              )
              
              
              (344,000
              )Net
      borrowings (repayments) on line of credit
              
              
              477,000
              
              
              
              (1,000,000
              )Net
      cash used in financing activities of continuing operations
              
              
              (2,255,000
              )
              
              
              (68,000
              )Net
      cash used in discontinued operations
              
              
              (3,000
              )
              
              
              (70,000
              )Net
      cash used in financing activities
              
              
              (2,258,000
              )
              
              
              (138,000
              )Net
      change in cash and cash equivalents
              
              
              (9,209,000
              )
              
              
              7,417,000Cash
      and cash equivalents at beginning of period
              
              
              9,621,000
              
              
              
              2,204,000Cash
      and cash equivalents at end of period
              
              $
              412,000
              
              
              $
              9,621,000


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


F-5


Implant
      Sciences CorporationConsolidated
      Statements of Cash FlowsFor
      The Years Ended June 30,2008
              
              
              2007Supplemental
      Disclosure of Cash Flow Information:Interest
      paid
              
              $
              94,000
              
              
              $
              234,000Non-cash
      Investing and Financing Activity:Capital
      equipment acquired under capital lease
              
              $
              2,000
              
              
              $
              7,000Accretion
      of Series D Cumulative Redeemable Convertible Preferred Stock
      dividends,
                derivatives
      and warrants
              
              $
              795,000
              
              
              $
              572,000Conversion
      of line of credit into term note
              
              $
              -
              
              
              $
              1,672,000Warrants
      issued to Laurus
              
              $
              -
              
              
              $
              450,000Warrants
      issued to Bridge Bank
              
              $
              29,000
              
              
              $
              28,000Common
      stock issued in settlement of Rapiscan litigation
              
              $
              200,000
              
              
              $
              -On
      April 10, 2008 the Company acquired Ion Metrics, Inc.Fair
      value of assets and liabilities assumed:Accounts
      receivable
              
              $
              7,000Other
      receivables
              
              
              3,000Prepaid
      expenses
              
              
              11,000Property
      and equipment
              
              
              83,000Accounts
      payable
              
              
              (241,000
              )Accrued
      interest
              
              
              (20,000
              )Accrued
      payroll
              
              
              (4,000
              )Accrued
      liabilities other
              
              
              (10,000
              )Notes
      payable
              
              
              (181,000
              )Current
      maturities of obligations under capitalized lease
              
              
              (11,000
              )Long-term
      obligations under capital lease, net of current maturities
              
              
              (97,000
              )Net
      assets
              
              
              (460,000
              )Goodwill
              
              
              3,136,000Customer
      relationships
              
              
              69,000Purchase
      price
              
              
              2,745,000Cash
      paid, net of cash acquired
              
              
              (231,000
              )Payable
      to Ion Metrics shareholders
              
              $
              2,514,000















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





F-6
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




1.
            Description
      of Business




Implant
Sciences Corporation (the “Company”) provides systems and sensors for the
homeland security market and related industries.  The Company has both
developed and acquired technologies using ion mobility spectrometry to develop a
product line for use in trace explosives detection.  The Company
currently markets and sells its existing trace explosives detector products
while continuing to make significant investments in developing the next
generation of these products.




The
Company’s fiscal year ends on June 30.  References herein to fiscal
2008 and fiscal 2007 refer to the year ended June 30, 2008 and 2007,
respectively.




Acquisition
of Ion Metrics




On April
10, 2008 (the “Closing Date”), the Company entered into a definitive agreement
(the “Merger Agreement”) to acquire all of the capital stock of Ion Metrics,
Inc, a California corporation (“Ion Metrics”).  The transaction was
structured as a reorganization of Ion Metrics with and into a newly formed,
wholly-owned subsidiary of the Company (the “Transaction”).  The total
purchase price, including $564,000 of assumed liabilities, was approximately
$3,309,000.  As part of the Transaction, the Company issued to the
former stockholders of Ion Metrics (the “Ion Metrics Stockholders”)
consideration consisting of 2,000,000 shares of the Company’s common stock, par
value $0.10 per share (“Common Stock”).  Ion Metrics is in the
business of producing low cost mass sensor systems for the detection and
analysis of chemical compounds such as explosives, chemical warfare agents,
narcotics, and toxic industrial chemicals for the homeland defense, forensic,
environmental, and safety/security markets.  The integration of the
Ion Metrics technologies into the Company’s Quantum Sniffer product line is
expected to provide opportunities to introduce smaller, lower cost, and higher
performance security solutions.  Please refer to Note 17 for further
information relative to the acquisition of Ion Metrics.




Sale
of Accurel




On May 1,
2007, the Company entered into an Asset Purchase Agreement (the “Agreement”) to
sell substantially all of the assets (the “Transaction”) of its subsidiary,
Accurel Systems International Corporation (“Accurel), a California corporation,
to Evans Analytical Group LLC (“Evans”), a Delaware limited liability
company.  Evans acquired all of the fixed assets and accounts
receivable of Accurel.  The total purchase price of the Transaction
was approximately $12,705,000. In addition, the Company issued warrants to
purchase 350,000 shares of the Company’s common stock to Legend Merchant Group,
the investment banker involved with the Transaction, at a price of $2.00 per
share and agreed to pay them a fee based upon a percentage of the gross
aggregate consideration received by the Company. An additional 25,000 warrants
were issued to other consultants involved with the Agreement, at a price of
$2.00 per share.




In
connection with the Transaction, we entered into an escrow agreement (the
“Escrow Agreement”) with Evans, Accurel, and Zions First National
Bank.  Pursuant to the Escrow Agreement, Evans deposited $1,000,000
(the “Escrow Amount”) of the total purchase price for the assets into an escrow
account.  Any valid claims for indemnification made by Evans pursuant
to the Agreement shall be drawn from this sum.  The Escrow Agreement
provided, subject to any claims of indemnifications, for a release of $500,000
on approximately each of March 31, 2008 and March 31, 2009.




Also in
connection with the Transaction, we entered into a Non-competition and
Nondisclosure Agreement (the “NCD”) with Evans whereby we agreed not to engage
in any business that directly competes with the business of
Accurel.  In addition, the NCD prohibits us from disclosing any
confidential information concerning the business of Accurel.  The NCD
will remain in effect for five years from the date of its
execution.




On
February 22, 2008, Evans filed suit against the Company requesting rescission of
the Transaction and damages based on claims of misrepresentation and
fraud.  On March 28, 2008, Evans filed a formal Claims Notice with the
escrow agent prohibiting release of any portion of the escrow to the Company as
a result of the suit filed on February 22, 2008.  The Company has
retained legal counsel in defense of these claims.




Sale
of Core




In February 2008, theCompany announced its plan to sell Core Systems (“Core” or “Core
Systems”), its wholly-owned semiconductor subsidiary and engaged Noblemen
Holdings, LLC to facilitate this plan.  Because this sale is more
likely than not to occur within the next 12 months, the Semiconductor Reporting
Unit is reported as discontinued operations in the accompanying financial
statements.




F-7
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




Sale
of Medical Reporting Unit




In June
2007, the Company sold certain of the assets related to its brachytherapy
products and divested the prostate seed and medical software
businesses.  In March 2008, the Company informed its medical coatings
customers of its intention to discontinue coating operations by the end of the
2008 calendar year.  Management is currently working on several plans
to sell the remaining medical coating assets and has signed non-binding term
sheets with two different companies.  Because these series of
transactions are more likely than not to occur within the next 12 months, the
Medical Reporting Unit is reported as discontinued operations in the
accompanying financial statements.




CorNova




The
Company has partnered with CorNova, Inc. (“CorNova”), a privately-held,
development stage company focused on the development of a next-generation
drug-eluting stent.  The Company owns common stock in CorNova
representing a 15% ownership interest in CorNova, (See Note 21).




Risks
and Uncertainties




While the
Company strives to bring new products to market, it is subject to a number of
risks similar 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 to
develop and market commercially usable products and obtain regulatory approval
for its products under development; and (d) its ability to obtain substantial
additional financing necessary to adequately fund the development,
commercialization and marketing of its products.  For the year ended
June 30, 2008, the Company reported a net loss applicable to common shareholders
of $11,793,000, a loss from continuing operations of $7,714,000 and used
$5,321,000 in cash from operations.  As of June 30, 2008, the Company had
an accumulated deficit of approximately $59,720,000 and a working capital
deficit of $4,910,000.  Management continually evaluates plans to
reduce its operating expenses and increase its cash flow from operations.
 Failure of the Company to achieve its projections may require the Company
to seek additional financing or discontinue operations.




On August 29, 2008, the Company
executed an agreement with San Jose, CA-based Bridge Bank, N.A. which reduced
the Company’s revolving credit facility from $5.0 million to $1.5 million (see
Note 14).We currently have a $1.5 million revolving
credit facility with Bridge Bank, N.A..  This line of credit, which
expires in January 2009, provides for advances of up to 80% of our eligible
domestic accounts receivable and up to the lesser of $500,000 or 50% of eligible
foreign accounts receivable, bears interest at the prime rate, plus 2.25% per
annum, and is collateralized by all of our assets.  As of June 30,
2008, we were in violation of our minimum current ratio and minimum net worth
financial covenants (collectively, the “Financial Covenant Defaults”) in our
loan agreements with Bridge Bank, N.A.  On October 10, 2008, we
received a notice of default with respect of violation of depository accounts,
financial reporting and failure to complete sale of an asset (collectively, the
“Subsequent Covenant Defaults”)  We received a waiver from Bridge Bank
with respect of the Financial Covenant Default, but cannot be certain that the
bank will continue to grant waivers in the future due to the potential for
financial covenant non-compliance.  We did not receive a waiver for
the Subsequent Covenant Defaults.  If the bank does not agree to grant
us such waivers, there is a risk that the bank may call the loan or prevent us
from taking additional advances until the default is cured.  We have a
credit facility with the bank, which matures in January 2009, having an unpaid
balance of approximately $862,000 as of June 30, 2008, consisting of a $385,000
term note and $477,000 of borrowings under the revolving line of credit that
matures in January 2009.




Management
believes there are plans in place to sustain operations for the near
future.  These plans depend on current sales and cash flow
projections, the cash available from the Company's line of credit, a substantial
increase in sales of the Company’s handheld trace explosives detector product,
the sale of Core and other assets, and the ability of the Company to raise
additional capital.  To further sustain the Company, improve its cash
position, and enable it to grow while reducing debt, management will
need to seek additional capital through private financing sources during
the next twelve months.  However, there can be no assurance that
management will be successful in executing these plans.  Management
will continue to closely monitor and attempt to control costs at the Company and
actively seek needed capital through sales of its products, equity infusions,
government grants and awards, strategic alliances, and through its lending
institutions.




The
Company's consolidated financial statements have been presented on the basis
that it is a going concern, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business.  The Company
has suffered recurring losses from operations.






F-8
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




The
Company’s Series D Preferred Stock contains mandatory redemptions on a monthly
basis.  These mandatory redemptions are redeemable in cash or shares of the
Company’s common stock, at the Company’s option, so long as the price of the
Company’s stock does not fall below 110% of the fixed conversion
price.  The Company received a waiver of the monthly amortization
payments for the period December 2006 through August 2007, to the mandatory
redemption date.  The redemption payments resumed in September 2007. 
In September, 2008, the Company amended the Securities Purchase Agreement,
extending the Mandatory Redemption Date to October 24, 2008, at which time
we willbe required to redeem the remaining shares of Series D Redeemable
Convertible Preferred Stock.Management
does not believe that we will meet the conditions necessary for us to redeem the
Series D Preferred Stock by issuing shares of our common stock and that we will
be required to redeem such preferred stock for cash.  Our obligations
to Laurus are secured by a security interest in substantially all of our
assets.  As of June 30, 2008, the outstanding balance due to Laurus
was approximately $2,269,000.  We made a payment of $250,000 to
Laurus, inclusive of $22,000 of dividend, on October 2, 2008, and upon
application of this payment, the balance expected to be paid to Laurus on
October 24, 2008 is approximately $1,893,000.  If we are unable to
redeem the Series D Preferred Stock as required, refinance our obligations to
Laurus, or negotiate a further extension of the obligation to redeem the Series
D Preferred Stock, Laurus may seize our assets and we may be forced to curtail
or discontinue operations entirely.


There can
be no assurances that forecasted results will be achieved or that the Company’s
stock price will attain the fixed conversion price which would allow the
Company to redeem the outstanding shares of Series D Preferred Stock and accrued
dividends with shares of its common stock.  These conditions raise
substantial doubt about the Company's ability to continue as a going
concern.  The financial statements do not include any adjustments relating
to the recoverability and classification of asset amounts or the amounts and
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern.




As a
result of the decision of the Board of Directors to sell the remaining
semiconductor assets associated with Core Systems, in conjunction with the sale
of the assets of Accurel in May 2007, the Semiconductor Reporting Unit is being
reported as discontinued operations in the accompanying financial
statements.  In June 2007, the Company sold certain of the assets
related to its brachytherapy products and divested the prostate seed and medical
software businesses.  In March 2008, the Company informed its medical
coatings customers of its intention to discontinue coating operations by the end
of the 2008 calendar year.  Management is currently working on several
plans to sell the remaining medical coating assets.  Because these
series of transactions are more likely than not to occur within the next 12
months, the Medical Reporting Unit is reported as discontinued operations in the
accompanying financial statements.




Security
product sales tend to have a long sale cycle, and are often subject to export
controls.  In an effort to identify new opportunities and stimulate
sales, the Company has expanded its sales staff and implemented a new sales tool
to assist in this effort.  However, there can be no assurance that
these efforts will increase revenue.  In addition, the Company
expanded its research and development staff to support internal research and
development programs including new product development.




The
Company has a history of being active in submitting proposals for government
sponsored grants and contracts and successful in being awarded grants and
contracts from government agencies. Management will continue to pursue these
grants and contracts to support its research and development efforts primarily
in the areas of trace explosives detection.




2.
            Summary
      of Significant Accounting Policies




Principles
of Consolidation




The
accompanying consolidated financial statements include the accounts of the
Company reflecting its operations in Massachusetts and California.




As a
result of the May 1, 2007 sale of Accurel, the operating results are presented
in the accompanying consolidated statements of operations as discontinued
operations for the year ended June 30, 2007.




As a
result of the Company’s decision to dispose of Core, the assets and liabilities
of Core are presented in the accompanying consolidated balance sheet as assets
and liabilities held for sale as of June 30, 2008 and 2007 and the operating
results of Core are presented in the accompanying consolidated statements of
operations as discontinued operations for the year ended June 30, 2008 and
2007.




As a
result of the Company’s decision to dispose of the medical business unit, the
assets and liabilities of the medical business unit are presented in the
accompanying consolidated balance sheet as assets and liabilities held for sale
as of June 30, 2008 and 2007 and the operating results of the medical business
unit are presented in the accompanying consolidated statements of operations as
discontinued operations for the year ended June 30, 2008 and 2007.





F-9
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




Additionally,
the following notes to the consolidated financial statements include disclosures
related to the Company’s continuing operations unless specifically identified as
disclosures related to discontinued operations.
  Accounting
Principles
  The
consolidated financial statements and accompanying notes are prepared in
accordance with U.S. generally accepted accounting principles.
  Basis
of Consolidation
  The
consolidated financial statements include the accounts of the Company, and its
wholly-owned subsidiaries.  The consolidated financial statements for
all periods presented have been restated to reflect discontinued operations of
Accurel, Core and the medical business unit.




Use
of Accounting Estimates




The
preparation of these financial statements in conformity with accounting
principles generally accepted in the United States of America, requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods.  Some of the more significant
estimates include allowance for doubtful accounts, allowance for sales returns,
inventory valuation, warranty reserves, accounting for embedded derivatives, and
impairment of goodwill, intangibles and long-lived
assets.  Management's estimates are based on the facts and
circumstances available at the time estimates are made, past historical
experience, risk of loss, general economic conditions and trends and
management's assessments of the probable future outcome of these
matters.  Consequently, actual results could differ from such
estimates.




Reclassifications




Certain
reclassifications were made to the fiscal year 2007 financial statements to
conform to the fiscal year 2008 presentation.




Cash
and Cash Equivalents




The
Company considers any securities with original maturities of 90 days or less at
the time of investment to be cash equivalents.




Investments




The
Company accounts for investments 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 in order
to be held for indefinite periods of time and not intended at the time of
purchase to be held until maturity are classified as available-for-sale
securities.  At June 30, 2007, these securities consisted of common
stock in CardioTech International, Inc. (“CardioTech”), a related party which
was recorded at fair market value with any unrealized gains and losses reported
as a separate component of equity in other accumulated comprehensive income
(loss).  During the fourth quarter of fiscal 2008, the Company
received net proceeds of $49,000 from the sale of all of its common stock
of CardioTech, and realized a $51,000 loss on the sale.




Comprehensive
Loss




The
Company has accumulated other comprehensive losses resulting from the
recognition of the unrealized loss of the Company’s share of CardioTech stock
owned by CorNova, Inc. (“CorNova”), which is recorded as a separate component of
equity in other accumulated comprehensive loss.




Fair
Value of Financial Instruments




The
estimated fair values of the Company’s financial instruments, which at June 30,
2008 and 2007 include cash equivalents, investments in available for sale
securities, accounts receivable, accounts payable and long-term debt,
approximates their carrying values due to their short-term nature or market
variable rates of interest.






F-10
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




Inventories
  Inventories
consist of raw materials, work-in-process and finished goods. Work-in-process
and finished goods includes labor and overhead, and are stated at the lower of
cost (first in, first out) or market.
  Property
and Equipment
  Property
and equipment are stated at cost and depreciated using the straight-line method
over the estimated useful lives of the assets, ranging from three to seven
years.  Equipment purchased under capital leases and leasehold
improvements are amortized based upon the lesser of the term of the lease or the
useful life of the asset and such expense is included in depreciation
expense.  Expenditures for repairs and maintenance are charged to
expense as incurred.
  Warranty
Costs
  The
Company accrues warranty costs in the period the related revenue is recognized
and adjusts the reserve balance as needed to address potential future
liabilities.




Income
Taxes




The
liability method is used to account for income taxes. Deferred tax assets and
liabilities are determined based on differences between the financial reporting
and income tax bases of assets and liabilities as well as net operating loss and
tax credit carry forwards and are measured using the enacted tax rates and laws
that will be in effect when the differences reverse. Deferred tax assets may be
reduced by a valuation allowance to reflect the uncertainty associated with
their ultimate realization.




Patent
Costs




As of
June 30, 2008, there were six active patents issued.  The Company
expenses patent costs as incurred.




Goodwill,
Intangible Assets and Impairment of Long-Lived Assets




The
Company evaluates its long-lived assets, which include property and equipment
and finite-lived intangible assets for impairment as events and circumstances
indicate that the carrying amount may not be recoverable and at a minimum at
each balance sheet date in accordance with SFAS No. 144, “Accounting for the
Impairment or Disposal of Long-Lived Assets.”   The Company
evaluates the realizability of its long-lived assets based on profitability and
undiscounted cash flow expectations for the related asset or
subsidiary.  Property and equipment and amortizable intangibles are
subject to SFAS No. 144, “Accounting for the Impairment or
Disposal of Long-Lived Assets.”  Non-amortizable intangibles,
such as goodwill, are subject to SFAS No. 142, “Goodwill and Other Intangible
Assets.”




In
assessing the recoverability of goodwill, the Company must make assumptions in
determining the fair value of the asset by estimating future cash flows and
considering other factors, including any significant changes in the manner or
use of the assets or negative industry reports or economic
conditions.  If those estimates or their related assumptions change in
the future, the Company may be required to record additional impairment
charges.




SFAS No.
142, “Goodwill and Other Intangible Assets,” requires that goodwill and
intangible assets with indefinite lives no longer be amortized, but instead be
measured for impairment at least annually or whenever events indicate that there
may be an impairment.  In order to determine if an impairment exists,
management continually compares the reporting unit’s carrying value to the
reporting unit’s fair value.  The Company  recognizes
an  impairment  of a  long-lived  asset
if the carrying  value  of
the  long-lived  asset  is  not  recoverable  from  its  estimated  future  cash  flows.  We
measure an impairment loss as the difference between the carrying amount of the
asset and its estimated fair value.  At June 30, 2008 and June 30,
2007, the Company had goodwill of $3,136,000 and $2,062,000, which was allocated
to the security products and the semiconductor wafer processing
segments, respectively.  Goodwill related to the semiconductor product
segment is included in Non-current Assets Held for Sale at June 30,
2007.  Determining the segment’s fair value requires that management
make estimates based on market conditions and operational
performance.  Absent an event that indicates a specific impairment
exist, management has selected August 31st as the
date of performing the annual goodwill impairment test.




During
the second quarter of fiscal 2008 the Company determined that the long-lived
assets of its Semiconductor segment, including goodwill and intangibles, were
impaired as carrying value of the long-lived assets of the reporting unit
exceeded their estimated fair value.  The Company recorded an
impairment  charge of $867,000 to reduce the
carrying  amount of goodwill, $595,000 to reduce the carrying value of
long-lived assets used in the semiconductor segment and $25,000 to reduce the
carrying amount of intangible assets used in our semiconductor segment, which
carrying value we deemed to be not recoverable from its undiscounted future
cash  flows.  The impairment charge is included in results
of discontinued operations.








F-11
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




As a
result of the Company’s review of goodwill during the second and third quarters
of the year ended June 30, 2008 and the resulting impairment which was
determined and absent a subsequent event that indicates that a specific
impairment exists, the Company determined the fair value of goodwill and
intangible assets exceeded the carrying amount and, therefore, no additional
goodwill impairment existed as of June 30, 2008.  The Company will be
required to continue to perform a goodwill impairment test on an annual basis
and the next test is scheduled during the quarter ending September 30,
2009.
  Concentration
of Credit Risk and Major Customers
  Financial
instruments that potentially subject the Company to concentration of credit risk
consist of trade receivables.




The
Company grants credit to its customers, primarily large corporations in the
medical device and semiconductor industries and the U.S. and other foreign
governments.  The Company performs periodic evaluations of customer’s
payment history and generally does not require
collateral.  Receivables are generally due within thirty
days.  Credit losses have historically been minimal, which is
consistent with management’s expectations.  Allowances are provided
for estimated amounts of accounts receivable which may not be
collected.  The Company has no significant off-balance sheet risk such
as foreign-exchange contracts, option contracts or other foreign hedging
arrangements.  The Company places its cash with financial institutions
which it believes are of high credit quality.




During
the year ended June 30, 2008, the Company had revenues from two customers
representing 55% and 15% of the Company’s total revenues for the year ended June
30, 2008.  During the year ended June 30, 2007, the Company had
revenues from two customer representing 52% and 15% of total
revenues.




At June
30, 2008 two customers accounted for approximately $670,000 of accounts
receivable, or 81% of accounts receivable outstanding as of that
date.  At June 30, 2007 two customers accounted for approximately
$458,000 of accounts receivable, or 90% of accounts receivable outstanding as of
that date.




Stock-Based
Compensation




In
December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
123R, Share-Based Payment—An
Amendment of FASB Statements No. 123 and 95 (“SFAS No. 123R”), which
requires all companies to measure compensation cost for all share-based
payments, including employee stock options, at fair value. Generally, the
approach in SFAS No. 123R is similar to the approach described in SFAS No. 123,
Accounting for Stock-Based
Compensation (“SFAS No.123”).  However, SFAS No. 123R requires
all share-based payments to employees, including grants of employee stock
options, to be recognized in the financial statements based on their fair value
over the requisite service period.  Pro forma disclosure is no longer
an alternative.  In March 2005, the SEC issued Staff Accounting
Bulletin (“SAB”) No. 107 (“SAB No. 107”), which expressed the views of the SEC
regarding the interaction between SFAS No. 123R and certain rules and
regulations of the SEC. SAB No. 107 provides guidance related to the valuation
of share-based payment arrangements for public companies, including assumptions
such as expected volatility and expected term.




Prior to
July 1, 2006, the Company applied the pro forma disclosure requirements under
SFAS No. 123 and accounted for its stock-based employee compensation plans using
the intrinsic value method under the recognition and measurement provisions of
APB No. 25, Accounting for
Stock Issued to Employees and related interpretations.




Effective
July 1, 2006, the Company adopted the fair value recognition provisions of SFAS
No. 123R, using the modified prospective transition method.  Under
this transition method, compensation cost recognized in the statement of
operations for the fiscal year ended June 30, 2007 includes: (a) compensation
cost for all share-based payments granted prior to, but not yet vested as of
July 1, 2006, based on the grant-date fair value estimated in accordance with
the original provisions of SFAS No. 123; and (b) compensation cost for all
share-based payments granted, modified or settled subsequent to July 1, 2006,
based on the grant date fair value estimated in accordance with the provisions
of SFAS 123R.  In accordance with the modified prospective transition
method, results for prior periods have not been restated.








F-12
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




For the
fiscal years ended June 30, 2008 and 2007, the Company recorded stock-based
compensation expense for options that vested of approximately $582,000 and
$574,000, respectively, which would not have been recorded prior to the adoption
of SFAS No. 123R.  As of June 30, 2008, the Company has approximately
$818,000 of unrecognized compensation cost related to stock options that is
expected to be recognized as expense over a weighted average period of 2.85
years.




The
valuation of employee stock options is an inherently subjective process, since
market values are generally not available for long-term, non-transferable
employee stock options.  Accordingly, an option pricing model is
utilized to derive an estimated fair value.  The Black-Scholes option
valuation model was developed for use in estimating the fair value of traded
options, which have no vesting restrictions and are fully
transferable.  In calculating the estimated fair value of our stock
options the Company uses the Black-Scholes pricing model, which requires the
consideration of the following six variables for purposes of estimating fair
value:
  ·
              the
      stock option exercise price;
  ·
              the
      expected term of the option;
  ·
              the
      grant price of the Company’s common stock, which is issuable upon exercise
      of the option;
  ·
              the
      expected volatility of the Company’s common
  stock;




·
            the
      expected dividends on the Company’s common stock (the Company does not
      anticipate paying dividends in the foreseeable future);
  and




·
            the
      risk free interest rate for the expected option
  term.




Because
the Company’s employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management’s
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.




The fair
value of each option granted during fiscal years 2008 and 2007 is estimated on
the date of grant using the Black-Scholes option pricing model with the
following assumptions:




Stock
      Option Plans
              
              Stock
      Purchase PlanYears
      Ended June 30,
              
              Years
      Ended June 30,2008
              
              2007
              
              2008
              
              2007Dividend
      yield
              0.0%
              
              0.0%
              
              0.0%
              
              0.0%Range
      of volatility
              55%
      - 103%
              
              76%
      - 79%
              
              87%
      - 97%
              
              78%Range
      of risk-free interest rate
              1.80%
      - 4.34%
              
              4.58%
      - 5.07%
              
              3.34%
      - 4.95%
              
              5.07%
      - 5.17%Range
      of life of options
              2 -
      8.5 years
              
              3.5
      - 6 years
              
              0.5
      years
              
              0.5
      yearsForfeiture
      rate
              10.0%
              
              10.0%
              
              0.0%
              
              0.0%




Stock Option Exercise Price
and Grant Date Price of Common Stock.  The closing market price
of the Company’s common stock on the date of grant.




Expected
Term.  The expected term of options granted is calculated using
the Company's historical option exercise transactions as outlined in SFAS 123(R)
and reflects the period of time that options granted are expected to be
outstanding.




Expected
Volatility.  The expected volatility is a measure of the amount
by which the Company’s stock price is expected to fluctuate during the expected
term of options granted.  The Company determines the expected
volatility solely based upon the historical volatility of its common stock over
a period commensurate with the option’s expected term.  The Company
does not believe that the future volatility of its common stock over an option’s
expected term is likely to differ significantly from the past.




Expected
Dividends.  The Company has never declared or paid any cash
dividends on any of its capital stock and does not expect to do so in the
foreseeable future.  Accordingly, the Company uses an expected
dividend yield of zero to calculate the grant-date fair value of a stock
option.








F-13
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




Risk-Free Interest
Rate.  The risk-free interest rate is the implied yield
available on U.S. Treasury zero-coupon issues with a remaining term equal to the
option’s expected term on the grant date.
  Upon
adoption of SFAS 123R, the Company was also required to estimate the level of
award forfeitures expected to occur and record compensation expense only for
those awards that are ultimately expected to vest.  This requirement
applies to all awards that are not yet vested.  Due to the limited
number of unvested options outstanding, the majority of which are held by
executives and members of the Company’s Board of Directors, the Company has
estimated a 10% forfeiture rate.  The Company will revisit this
assumption periodically and as changes in the composition of our option pool
dictate.
  Changes
in the inputs and assumptions as described above can materially affect the
measure of estimated fair value of share-based compensation.  The
Company anticipates the amount of stock-based compensation will increase in the
future as additional options are granted.
  Revenue
Recognition
  The
Company recognizes revenue when there is persuasive evidence of an arrangement
with the customer which states a fixed or determinable price and terms, delivery
of the product has occurred or the service has been performed in accordance with
the terms of the sale, and collectibility of the related receivable is
reasonably assured. The Company provides for estimated returns at the time of
shipment based on historical data. Shipping costs charged to the customer are
include in revenues and are not significant.




Contract
revenue under cost-sharing research and development agreements is recognized as
eligible research and development expenses are incurred. The Company’s
obligation with respect to these agreements is to perform the research on a
best-efforts basis.




Deferred
revenues are recorded when the Company receives payments for product or services
for which it has not yet completed its obligation to deliver product or has not
completed services required by contractual agreements.




Accounts
Receivable




Contract
revenue under cost sharing research and development agreements is recognized as
eligible expenses are incurred. Invoicing of research and development contracts
occurs in accordance with the terms of the contract. Revenue recognized but
unbilled is recorded as unbilled accounts receivable.  At June 30,
2008 and 2007, unbilled accounts receivable represented approximately 19% and
32% of total accounts receivable.  Generally, there are no
prerequisites necessary to invoice.




Research
and Development Costs




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




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






June
      30,2008
              
              
              2007Company
      funded
              
              $
              3,097,000
              
              
              $
              1,662,000Customer
      funded
              
              
              368,000
              
              
              
              1,853,000Total
      research and development
              
              $
              3,465,000
              
              
              $
              3,515,000


Advertising
Costs




Advertising
costs are expensed when incurred within selling, general and administrative
expense.  Advertising costs were immaterial for the years ended June
30, 2008 and 2007.




Shipping
and Handling




The
Company accounts for its shipping and handling cost within its cost of
revenues.






F-14
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  Basic
and Diluted Earnings Per Share
  The
Company follows SFAS No. 128, “Earnings Per Share,” where
basic earnings per share is computed by dividing net income (loss) by the
weighted average number of common shares outstanding during the
period.  Diluted earnings per share are based upon the weighted
average number of common shares outstanding during the period plus additional
weighted average common equivalent shares outstanding during the
period.  Common equivalent shares
result from the assumed exercise of outstanding stock options and warrants, the
proceeds of which are then assumed to have been used to repurchase outstanding
commonstock using the treasury stock method.  In addition, the
numerator is adjusted for any changes in income or loss that would result from
the assumed conversion of potential shares.


The
Company had the following potential dilutive securities outstanding on June 30,
2008: i) options and warrants to purchase 2,646,538 and 2,369,627 shares,
respectively, of the Company’s common stock at weighted average exercise prices
of $3.07 and $5.01 per share, respectively and (ii) Series D Preferred Stock
convertible into an aggregate of 584,096 shares of the Company’s common
stock.  Such potential dilutive securities were not included in the
calculation of diluted loss per share in 2008 because the inclusion thereof
would be antidilutive.




The
Company had the following potential dilutive securities outstanding on June 30,
2007: i) options and warrants to purchase 1,790,738 and 2,593,267 shares,
respectively, of the Company’s common stock at weighted average exercise prices
of $4.66 and $5.59 per share, respectively and (ii) Series D Preferred Stock
convertible into an aggregate of 949,157 shares of the Company’s common
stock.  Such potential dilutive securities were not included in the
calculation of diluted loss per share in 2007 because the inclusion thereof
would be antidilutive.




Recent
Accounting Pronouncements




In
September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurements.”  SFAS No. 157 defines fair value, establishes a
framework for measuring the fair value of assets and liabilities, and expands
disclosure requirements regarding the fair value measurement.  SFAS
No. 157 does not expand the use of fair value measurements.  This
statement, as issued, is effective for financial statements issued for fiscal
years beginning after November 15, 2007, and interim periods within those fiscal
years.  FASB Staff Position FAS No. 157-2 was issued in February 2008
and deferred the effective date of SFAS No. 157 for nonfinancial assets and
liabilities to fiscal years beginning after November 2008. As such, the
Company expects to adopt SFAS No. 157 as of July 1, 2008 for financial assets
and liabilities only and does not expect it to have a material effect on the
Company’s financial statements.  In addition, the Company does
not believe that the adoption of SFAS No. 157 to non-financial assets and
liabilities will have a material effect on the Company's financial
statements.




In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities,” which provides companies with an
option to report selected financial assets and liabilities at fair
value.  The objective of SFAS No. 159 is to reduce both complexity in
accounting for financial instruments and the volatility in earnings caused by
measuring related assets and liabilities differently.  SFAS No. 159
establishes presentation and disclosure requirements designed to facilitate
comparisons between companies that choose different measurement attributes for
similar types of assets and liabilities and to more easily understand the effect
of the company’s choice to use fair value on its earnings.  SFAS No.
159 also requires entities to display the fair value of the selected assets and
liabilities on the face of the balance sheet.  SFAS No. 159 does not
eliminate disclosure requirements of other accounting standards, including fair
value measurement disclosures in SFAS No. 157.  This Statement is
effective as of the beginning of an entity’s first fiscal year beginning after
November 15, 2007.  The Company expects to adopt SFAS No. 159 on July
1, 2008, and does not expect it to have a material affect on the Company’s financial
position and results of operations.




In
December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in
Consolidated Financial Statements.”  SFAS No. 160 clarifies
that a non-controlling or minority interest in a subsidiary is considered an
ownership interest and accordingly, requires all entities to report such
interests in subsidiaries as equity in the consolidated financial
statements.  SFAS No. 160 is effective for fiscal years beginning
after December 15, 2008. The Company expects to adopt SFAS No. 160 on July 1,
2009, and does not expect it to have a material affect on the Company’s financial
position and results of operations.




In
December 2007, the FASB issued SFAS No. 141(R), “Business
Combinations.”  SFAS No. 141(R) replaces SFAS No. 141, “Business Combinations” and
establishes principles and requirements for how an acquirer recognizes and
measures in its financial statements the identifiable assets acquired, the
liabilities assumed, any non-controlling interests in the acquiree and the
goodwill acquired.  Some of the key changes under




F-15
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




3.
            Restricted
  Cash




As of
June 30, 2008 and 2007, the Company had restricted cash of $514,000 and $25,000,
respectively.  As of June 30, 2008, restricted cash consisted of
$439,000 held in a money market account which collateralized the Company’s
performance under an irrevocable letter of credit issued on June 25, 2008, in
the amount of $418,000.  The letter of credit provides performance
security equal to 10% of the contract amount for security product which is
expected to be shipped in the first quarter of fiscal 2009.  At June
30, 2008 and 2007, restricted funds also included $75,000 and $25,000,
respectively, deposited in certificates of deposit, which collateralize two (2)
credit cards issued by the Company’s primary lender.




4.
            Inventories




Inventories
consist of the following:




June
      30,2008
              
              
              2007Raw
      materials
              
              $
              400,000
              
              
              $
              391,000Work
      in progress
              
              
              23,000
              
              
              
              30,000Finished
      goods
              
              
              302,000
              
              
              
              262,000Total
      inventories
              
              $
              725,000
              
              
              $
              683,000


5.
            Property and
    Equipment




Property
and equipment consist of the following:


June
      30,2008
              
              
              2007Machinery
      and equipment
              
              $
              517,000
              
              
              $
              514,000Computers
      and software
              
              
              871,000
              
              
              
              742,000Furniture
      and fixtures
              
              
              164,000
              
              
              
              164,000Leasehold
      improvements
              
              
              369,000
              
              
              
              369,000Equipment
      under capital lease
              
              
              93,000
              
              
              
              43,0002,014,000
              
              
              
              1,832,000Less:  accumulated
      depreciation and amortization
              
              
              1,571,000
              
              
              
              1,302,000Total
      property and equipment
              
              $
              443,000
              
              
              $
              530,000


Depreciation
expense for the fiscal years ended June 30, 2008 and 2007 was approximately
$269,000 and $166,000, respectively.








F-16
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  6.
                Goodwill,
      Other Intangibles and Long-Lived
Assets
  At June
30, 2008 and 2007, the Company had goodwill of $3,136,000 and $0,
respectively.  SFAS No. 142, “Goodwill and Other Intangible
Assets,” requires that goodwill and intangible assets with indefinite
lives no longer be amortized but instead be measured for impairment at 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 on market conditions
and operational performance.  The Company may employ the work of
independent appraisers in making its determination.  The Company makes
its annual assessment as of August 31st  of
each year to determine if its goodwill is impaired or whenever events indicate
that there may be an impairment.
  Intangible
assets with finite lives are valued according to the future cash flows they are
estimated to produce.  These assigned values are amortized over the
period of time those cash flows are estimated to be
produced.  Management continually evaluates whether events or
circumstances have occurred that indicate that the estimated remaining useful
life or the carrying value of these assets has been
impaired.




SFAS No.
144, “Accounting for the Impairment or
Disposal of Long-Lived Assets,” requires that long lived assets and/or
asset groups shall be tested for recoverability whenever events or changes in
circumstances indicate that its carrying amount may not be recoverable due to
certain events or changes in circumstances.  When management measured
the semiconductor processing reporting unit, it concluded that an impairment
existed at June 30, 2007 and recorded an adjustment of
$3,829,000.  This impairment charge was allocated to the fixed assets,
intangible assets and goodwill in the approximate amounts of $1,723,000, $77,000
and $2,029,000, respectively.  The impairment charge is included in
the loss from discontinued operations for the year ended June 30,
2007.  During fiscal 2008, the Company completed an appraisal of
goodwill and long-lived assets of its Semiconductor Segment and determined that
an impairment existed and recorded an adjustment of $1,487,000.  The
impairment charge was allocated to fixed assets, intangible assets and goodwill
in the amounts of $595,000, $25,000 and $867,000, respectively, and is included
in the loss from discontinued operations for the year ended June 30,
2008.




Changes
in the carrying value of goodwill for the years ended June 30, 2008 and 2007 by
reportable segment are as follows:


Security
                Products
              
              
              Semiconductor
                ServicesBalance
      as of July 1, 2006
              
              $
              -
              
              
              $
              4,091,000Impairment
              
              
              -
              
              
              
              (2,029,000
              )Balance
      as of June 30, 2007
              
              
              -
              
              
              
              2,062,000Ion
      Metrics acquisition
              
              
              3,136,000
              
              
              
              -Impairment
              
              
              -
              
              
              
              (867,000
              )Balance
      as of June 30, 2008
              
              $
              3,136,000
              
              
              $
              1,195,000


The
Semiconductor Services goodwill is included in our balance sheet in current
assets held for sale as of June 30, 2008 and 2007.




The
following table summarizes the Company’s intangible assets as of June 30, 2008
and 2007:





Gross
      Carrying Amount
              
              
              
              
              
              Accumulated
      Amortization
              
              
              Net
      Carrying
                AmountJune
      30,
                2007
              
              Additions/
                reductions
              
              June
      30,
                2008
              
              June
      30,
                2007
              
              Additions/
                reductions
              
              June
      30,
                2008
              
              June
      30,
                2008Customer
      Relationship
              
              $
              -
              
              
              $
              69,000
              
              
              $
              69,000
              
              
              $
              -
              
              
              $
              15,000
              
              
              $
              15,000
              
              
              $
              54,000


Estimated
amortization expense of intangible assets with finite lives for the years ended
June 30, 2008 is $15,000.







F-17
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
following table summarizes the Company’s intangible assets of its discontinued
operations which are included in Non-current Assets Held for Sale as of June 30,
2008 and 2007:
 Gross
      Carrying Amount
                  
                  
                  Accumulated
      Amortization
                  
                  
                  Net
                    Carrying
                    AmountJune
      30,
                    2007
                  
                  
                  Additions/
                    reductions
                  
                  
                  June
      30,
                    2008
                  
                  
                  June
      30,
                    2007
                  
                  
                  Additions/
                    reductions
                  
                  
                  June
      30,
                    2008
                  
                  
                  June
      30,
                    2008Customer
      Relationship
                  
                  $
                  161,000
                  
                  
                  $
                  (16,000
                  )
                  
                  $
                  145,000
                  
                  
                  $
                  113,000
                  
                  
                  $
                  13,000
                  
                  
                  $
                  126,000
                  
                  
                  $
                  19,000Technology
                  
                  
                  97,000
                  
                  
                  
                  (9,000
                  )
                  
                  
                  88,000
                  
                  
                  
                  68,000
                  
                  
                  
                  8,000
                  
                  
                  
                  76,000
                  
                  
                  
                  12,000Total
                  
                  $
                  258,000
                  
                  
                  $
                  (25,000
                  )
                  
                  $
                  233,000
                  
                  
                  $
                  181,000
                  
                  
                  $
                  21,000
                  
                  
                  $
                  202,000
                  
                  
                  $
                  31,000


7.
            Accrued
      Expenses




Accrued
expenses consist of the following:






June
      30,2008
              
              
              2007Accrued
      compensation and benefits
              
              $
              807,000
              
              
              $
              252,000Accrued
      taxes
              
              
              289,000
              
              
              $
              478,000Accrued
      legal and accounting
              
              
              259,000
              
              
              
              192,000Accrued
      interest
              
              
              46,000
              
              
              
              105,000Accrued
      warranty costs
              
              
              104,000
              
              
              
              47,000Rapiscan
      settlement accrual
              
              
              -
              
              
              
              200,000Other
      accrued liabilities
              
              
              557,000
              
              
              
              489,000$
              2,062,000
              
              
              $
              1,763,000




8.
            Income
      Taxes




The Company adopted the provisions of Financial
Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in
Income Taxes,” an interpretation of SFAS No. 109, “Accounting for Income
Taxes,” on April 1, 2007.  FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in an enterprise’s financial statements
in accordance with SFAS No. 109 and prescribes a recognition threshold and
measurement process for financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. FIN 48 also provides
guidance on de-recognition, classification, interest and penalties, accounting
in interim periods, disclosure and transition. At the adoption date and as of
June 30, 2008, the Company had no material unrecognized tax benefits and no
adjustments to liabilities or operations were required.




The
Company may from time to time be assessed interest or penalties by major tax
jurisdictions.  The Company recognizes interest and penalties related
to uncertain tax positions in income tax expense.  No interest and
penalties have been recognized by the Company to date.




Tax
years 2005 through 2008 are subject to examination by the federal and
state taxing authorities.  There are no income tax examinations
currently in process.






F-18
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  Reconciliation
between the Company’s effective tax rate and the United States statutory rate is
as follows:
 
 For
      The Years Ended June 30,2008
                  
                  2007Expected
      federal tax rate
                  
                  -34.0%
                  
                  -34.0%State
      income taxes, net of federal tax benefit
                  
                  -5.3%
                  
                  -1.0%Non-deductible
      expenses
                  
                  2.9%
                  
                  14.8%Credits
      and other, net
                  
                  -0.6%
                  
                  -0.3%Change
      in valuation allowance
                  
                  37.1%
                  
                  20.5%Effective
      tax rate
                  
                  0.0%
                  
                  0.0%
 Deferred
tax assets and liabilities are determined based on the differences between the
financial statement carrying amounts and the tax basis of the assets and
liabilities using the enacted tax rate in effect in the years in which the
differences are expected to reverse.  A valuation allowance has been
recorded against the deferred tax asset as it is more likely than not, based
upon the analysis by the Company of all available evidence, that the tax benefit
of the deferred tax asset will not be realized.




Significant
components of the Company’s deferred tax assets and deferred tax liabilities as
of June 30, 2008 and 2007 consisted of the following:





June
      30,2008
              
              
              2007Deferred
      Tax Assets:Net
      operating loss and tax credit carryforwards
              
              $
              9,681,000
              
              
              $
              8,090,000Accrued
      expenses deductible when paid
              
              
              801,000
              
              
              
              453,000Stock-based
      compensation
              
              
              214,000
              
              
              
              57,000Financial
      statement over tax amortization
              
              
              45,000
              
              
              
              28,000Net
      deferred tax assets - discontinued operations
              
              
              1,780,000
              
              
              
              734,000Deferred
      tax assets
              
              
              12,521,000
              
              
              
              9,362,000Deferred
      Tax Liabilities:Tax
      over financial statement depreciation
              
              
              178,000
              
              
              
              1,037,000Investments
      in affiliates
              
              
              (2,000
              )
              
              
              11,000Net
      deferred tax liabilities - discontinued operations
              
              
              57,000
              
              
              
              44,000Deferred
      tax liabilities
              
              
              233,000
              
              
              
              1,092,00012,288,000
              
              
              
              8,270,000Valuation
      allowance
              
              
              (12,288,000
              )
              
              
              (8,270,000
              )Net
      deferred tax asset
              
              $
              -
              
              
              $
              -




A
valuation allowance has been established for the Company’s tax assets as their
use is dependent on the generation of sufficient future taxable income, which
cannot be predicted at this time.  Included in the valuation allowance
is approximately $1,439,000 related to certain operating loss carryforwards
resulting from the exercise of employee stock options, the tax benefit of which,
when recognized, will be accounted for as a credit to additional paid-in capital
rather than a reduction in income tax.




As of
June 30, 2008, the Company has the following unused net operating loss and tax
credit carry forwards available to offset future federal and state taxable
income, both of which expire at various times as noted below:




Net
      Operating Losses
              
              
              Investment,
                AMT
      &
                Research
      Credits
              
              Expiration
      DatesFederal
              
              $
              25,770,000
              
              
              $
              489,000
              
              2021
      to 2029State
              
              $
              30,039,000
              
              
              $
              362,000
              
              2009
      to 2024






F-19
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
Company’s net operating loss carry forwards are subject to review and possible
adjustment by the Internal Revenue Service and are subject to certain
limitations in the event of cumulative changes in the ownership interest of
significant stockholders over a three-year period in excess of 50%.
  9.
                Commitments and
      Contingencies
  Capital
and Operating Leases
  The
Company leases manufacturing, research and office space in Wakefield, MA, the
lease of which expires on December 31, 2008.  Under the terms of the
lease, the Company is responsible for its proportionate share of real estate
taxes and operating expenses relating to this facility.  The Company
leases two facilities in Sunnyvale, CA.  The leases expire in December
2009 and September 2010, respectively.  The Company has an option to
extend each lease for five additional years.  Effective with the sale
of the assets of Accurel Systems on May 1, 2007, the Company executed a sublease
agreement for one of its California facilities.  As a result of the
Ion Metrics acquisition, the company assumed the obligation of a lease for
research and office space in San Diego, CA, which lease expires on January 31,
2009.  In addition, in March 2008, the Company entered into a six
month lease for office space in Beijing, China, to support the sales activities
in the region.  Total rent expense, including assessments for
maintenance and real estate taxes for the fiscal years ended June 30, 2008 and
June 30, 2007, for both continuing and discontinued operations was $1,372,000
and $1,356,000, respectively.




In
conjunction with the acquisition of Accurel, in March 2005, the Company recorded
a lease liability of $829,000.  This liability reflected management’s
estimate of the excess of payments required under the Accurel facility lease, at
the date of acquisition, versus the fair market value of lease payments that
would have been required, had the lease been negotiated under current market
conditions.  Subsequently, as a result of the sale of Accurel, the
Company has recorded an additional liability of $487,000 representing that
portion of the lease in excess of the sublease arrangement with
Evans.  The balance of the lease liability on June 30, 2008 is
$763,000 of which $317,000 is current.




In April
2007, in conjunction with the Company’s plans to conduct research, development
and minor manufacturing work in New Mexico, the Company executed an operating
lease which was initially to expire on May 1, 2010.  The lease allowed
for early termination, which the Company elected in February 2008.  As
a result of the early termination, the Company is responsible for reimbursing
the landlord for certain leasehold improvements over a 24 month
period.  As of June 30, 2008, the balance due is approximately $35,000
and is included in Accrued Expenses.




Future
minimum rental payments required under capital and operating leases for both
continuing and discontinued operations, with non-cancelable terms in excess of
one year at June 30, 2008, together with the present value of net minimum lease
payments, are as follows:




Year
      ending June 30:
              
              Capital
      Lease
                Payments
              
              
              Operating
      Lease
                Payments
      (1)
              
              
              Sublease
                Payments
      (1)2009
              
              $
              54,000
              
              
              $
              1,273,000
              
              
              $
              277,0002010
              
              
              46,000
              
              
              
              578,000
              
              
              
              260,0002011
              
              
              34,000
              
              
              
              85,000
              
              
              
              65,0002012
              
              
              31,000
              
              
              
              -
              
              
              
              -2013
      and thereafter
              
              
              63,000
              
              
              
              -
              
              
              
              -228,000
              
              
              $
              1,936,000
              
              
              $
              602,000Less:
      amounts representing interest
              
              
              (83,000
              )Present
      value of future minimum lease payments
              
              
              145,000Less:
      current portion
              
              
              (32,000
              )Capital
      lease obligation, net of current portion
              
              $
              113,000(1)
      Adjusted for sublease payments on theformer
      Accurel facility.





F-20
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  License
Agreements
  The
Company is obligated under two license agreements, assumed in connection with
the acquisition of Ion Metrics, whereby the Company has been granted rights to
use certain intellectual property for safety, security and drug applications,
which the Company intends to incorporate into future security product
offerings.  Future minimum royalty payments due under the license
agreements are as follows:
 Year
      ending June 30:2009
                  
                  $
                  50,0002010
                  
                  
                  116,0002011
                  
                  
                  203,0002012
                  
                  
                  331,0002013
      and thereafter
                  
                  
                  1,780,000$
                  2,480,000


10.
            Financial
      Information by Segment




SFAS No.
131, “Disclosures about Segments of an Enterprise and Related Financial
Information” (“SFAS No..131”),  defines operating segments as
components of an enterprise about which separate financial information is
available that is regularly evaluated by the chief operating decision maker or
decision making group, in determining how to allocate resources and in accessing
performance.  The Company’s chief operating decision making group is
composed of the chief executive officer and members of senior
management.  Based on qualitative and quantitative criteria
established by SFAS No. 131, the Company has determined that it operates within
one reportable segment, which is the Security Products Segment.




During
the fiscal year ended June 30, 2008, foreign sales represented 78% of total
revenue with one customer from China representing 55% of the Company’s annual
revenue.  For the fiscal year ended June 30, 2007, foreign sales
represented 39% of total revenue with one customer from China representing 15%
of the Company’s annual revenue.




11.
            Research
      and Development Arrangements




The
Company is the recipient of several grants under the U.S. Government’s Small
Business Innovative Research (SBIR) Program.  The contracts with the
Department of Defense and the Department of Homeland Security are both
firm-fixed price and cost-plus type programs with contract terms varying from
six to twenty-four months.  Revenues under such arrangements amounted
to approximately $598,000 and $2,423,000 for the years ended June 30, 2008 and
June 30, 2007, respectively.  Revenues recognized under these
contracts are included in the security products segments.  Unbilled
accounts receivable relating to such arrangements was approximately $120,000 and
$162,000 at June 30, 2008 and June 30, 2007, respectively.




12.
            Related
      Party Transactions




SFAS No.
57, “Related Party
Disclosures,” specifies the nature of information that is required to be
disclosed in financial statements regarding related party
transactions.  The former chairman of Ion Metrics, Inc., (“Ion
Metrics”) which entity was acquired by the Company on April 10, 2008, serves as
a Managing Director of a merger and acquisition and management advisory company,
which has been engaged by the Company to market the Company’s wholly-owned
subsidiary, Core Systems.  In connection with the acquisition of Ion
Metrics, the Company entered into a Board Observer Rights Agreement, effective
as of April 10, 2008, providing for, among other things, the right of one
representative of the Ion Metrics Shareholders to attend the Company’s board of
directors’ meetings as an observer, which role has been represented by the
former chairman of Ion Metrics.  On October 13, 2008, the Ion Metrics
Shareholders agreed to terminate the Board Observers Rights Agreement. 
Further, the Company has entered into a Fixed Asset Lease Agreement with Ferran
Scientific, Inc., a firm owned by the father of the former Ion Metrics
chairman.




F-21
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  13.
                Long-Term Debt and Credit
      Arrangements
  Med-Tec
Payment Obligation
  On July
31, 2003, the Company entered into an Asset Purchase Agreement (the “Agreement”)
with Med-Tec Iowa, Inc (“Med-Tec”) its former exclusive distributor of prostate
seeds, to purchase Med-Tec’s customer lists and further to release each other
from further obligations under the January 26, 2000 Distribution Agreement (the
“Distribution Agreement”).  The purchase price of $1,250,000 which was
payable in varying amounts over twenty-eight months, with the final payment
payable on December 1, 2005, was recorded at the present value of the future
payment stream, using a rate of 10.24%, which equaled
$1,007,000.  This amount was recorded as an intangible asset and is
being amortized over its estimated useful life of 29 months.  The
outstanding and past due principal balance as of June 30, 2008 and 2007 was
approximately $80,000, and $143,000 respectively.
  Revolving
Credit Facility and Term Note
  On June
1, 2005, the Company executed a revolving credit facility for $1,500,000 with
Silicon Valley based Bridge Bank, N.A. (the “Bank”).  The revolving
credit facility provides for advances of up to eighty percent (80%) of the
Company’s eligible accounts receivable, bears interest at the prime rate plus
one-half percent (1/2%) which is subject to a one-half percent (1/2%) increase
should minimum cash balances not be maintained.  The revolving credit
facility is collateralized by certain assets of the Company and is subject to
certain covenants.




On
January 3, 2007, the Company executed an Amended and Restated Loan and Security
Agreement (the “Loan Agreement”) which amended and restated the terms of a
Business Financing Agreement originally dated as of June 1, 2005 with the Bank
increasing the revolving credit facility from $1,500,000 to
$5,000,000.  This revolving credit facility (the “line of credit”) has
a two year term, provides for advances of up to eighty percent (80%) of the
Company’s eligible accounts receivable and up to the lesser of $1,000,000 or
forty percent (40%) of eligible inventory, bears interest at the prime rate,
plus one-half percent (1/2%) per annum, and is collateralized by all assets of
the Company.  In addition, the expiration date of the facility was
extended to December 21, 2008.




On April
27, 2007, in conjunction with the sale of the assets of Accurel, the Company
entered into a Loan and Security Modification Agreement whereby the Bank
consented to the sale of the Accurel assets and removed Accurel as a borrower
under the Loan Agreement.




On May
16, 2007, the Company entered into a Loan and Security Modification Agreement
whereby the Bank added Accurel and its remaining assets as a borrower under the
Loan Agreement.




In
conjunction with this financing, the Company drew from funds available on the
line of credit and paid in full an outstanding term loan balance of
approximately $623,000 at Comerica Bank.  In addition, pursuant to the
terms of the Loan Agreement, the Company converted $1,600,000 of the outstanding
line of credit balance into a 30 month term note bearing an interest rate at the
prime rate plus one percent (1%) per annum payable in thirty (30) equal monthly
installments of principal, plus all accrued interest beginning on February 10,
2007.




Pursuant
to the Loan Agreement, the Company issued to the Bank a seven-year warrant to
purchase up to 18,939 shares of the Company’s common stock at a price equal to
$2.64 per share.  The warrants were valued using the Black Scholes
model and the following assumptions: volatility of 78%, an expected life 7
years, and a risk free interest rate of 4.54%.  Pursuant to ABP No 14
“Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants”,
the note and warrants have been recorded at their relative fair
value.  The Company will accrete the value of the warrants, $28,000,
to the term note over the life of the note.   As of June 30,
2008, approximately $21,000 has been amortized.




On June
27, 2008, the Company entered into an Amendment to Amended and Restated Loan and
Security Agreement with the Bank, which amended and restated the terms of the
revolving credit facility and whereby the Bank waived certain Existing Events of
Default and certain Anticipated Events of Default arising from the Company’s
failure and anticipated failure to comply with the required minimum current
ratio and minimum tangible net worth financial covenants and the failure to
comply with planned revenue and annual forecast for the quarter ended March 31,
2008 and June 30, 2008, respectively.  The Company was in violation of the
required minimum current ratio and minimum tangible net worth covenants
associated with this facility at June 30, 2008, which noncompliance was also
waived by the bank.  On
October 10, 2008, we received a notice of default with respect of violation of
depository accounts, financial reporting and failure to complete sale of an
asset  We did not receive a waiver for the these
defaults.






F-22
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  As
amended, the revolving credit facility provides for advances of up to eighty
percent (80%) of the Company’s eligible accounts receivable and up to the lesser
of $500,000 or forty percent (40%) of eligible inventory, bears interest at the
prime rate, plus one and one-half percent (1.5%) per annum on advances and at
the prime rate, plus two percent (2.0%) on borrowings under term loans and is
collateralized by all assets of the Company.
  Further,
the bank consented to the following transaction, contemplated by the Company: i)
The sale of certain assets of the Company’s medical business, ii) The sale of
certain assets of the Company’s brachytherapy business, and iii) the sale of the
Company’s semiconductor business, subject to minimum proceeds of
$3,000,000.
  Pursuant
to the amended Loan Agreement, the company was required to pay a $10,000 default
fee and reimburse the bank for legal expenses of approximately $2,000 incurred
in connection with the amendment.  Further, the Company issued a
seven-year warrant to purchase up to 43,860 shares of the Company’s common stock
at a price equal to $1.14 per share.  The warrants were valued using
the Black Scholes model and the following assumptions: volatility of 85%, an
expected life 7 years, and a risk free interest rate of
3.46%.  Pursuant to ABP No 14 “Accounting for Convertible Debt and
Debt Issued with Stock Purchase Warrants”, the note and warrants have been
recorded at their relative fair value.  The Company recorded the value
of the warrants, $29,000, as interest expense in the year ended June 30,
2008.
  The
Company entered into a Loan and Security Modification Agreement with the Bank on
August 29, 2008, which agreement amended and restated the terms of the revolving
credit facility.  As amended, the credit facility was reduced to
$1,500,000, from $5,000,000 and provides for advances of up to eighty percent
(80%) of the Company’s eligible domestic accounts receivable and the lesser of
$500,000 or fifty percent (50%) of the Company’s eligible foreign accounts
receivable, bears interest at the prime rate, plus two and one-quarter
percent  (2-1/4%) per annum, and is collateralized by all assets of
the Company.


As of
June 30, 2008 and 2007, the Company’s obligation for borrowed funds under the
revolving credit facility amounted to $477,000 and $0,
respectively.  As of June 30, 2008 and 2007, the term note had a
balance of $385,000 and $1,299,000, respectively.




Laurus
Short-Term Note




On
December 29, 2006, the Company executed a $1.5 million secured term note (the
“Note”) payable to Laurus.   The Company received $1,500,000 in
gross proceeds, less a management fee of $60,000 and related transaction costs
of approximately $500.  The term note is collateralized by
substantially all of the Company’s assets and two of its subsidiaries, has a
9-month term and bears interest at a rate equal to prime plus 1% per annum. The
Note contains certain restrictive and financial covenants. Upon the occurrence
of certain events of default specified in the Note, amounts owed under the Note
may be declared immediately due and payable. In connection with the financing,
the Company issued Laurus a warrant to purchase up to 458,000 shares of the
Company’s common stock at a price equal to $2.50 per share.  The
warrants were valued using the Black Scholes model and the following
assumptions: volatility of 78%, an expected life of 5 years, and a risk free
interest rate of 4.53%. Net cash proceeds from this financing were $1,439,500
and were used for general working capital.




Pursuant
to ABP No 14 “Accounting for Convertible Debt and Debt Issued with Stock
Purchase Warrants”, the note and warrants have been recorded at their relative
fair value.  The Company accreted the value of the warrants, to
interest expense, $450,000, to the term note over the life of the
note.  As of June 30, 2007, the warrants have been fully accreted to
interest expense and the loan has been paid in full.




14.
            Redeemable
      Convertible Preferred Stock




On July
6, 2005, the Company executed a $3,000.000 secured term note payable to Laurus
Master Fund, Ltd. (“Laurus”).  The Company received $2,833,000,
comprising $3,000,000 in gross proceeds, less a management fee of $135,000 and
related transaction costs of approximately $32,000.  The term note
which was collateralized by substantially all of the Company’s assets, had a
four month term and bore interest at a rate equal to the prime rate plus one
percent (1%). In connection with the financing, on September 30, 2005, the
Company issued Laurus a warrant to purchase up to 250,000 shares of the
Company’s common stock at a price equal to $3.75 per share. The warrants were
valued using the Black Scholes model and the following assumptions: volatility
of 67%, expected life of 5 years and a risk free interest rate of 3.77%. Net
proceeds from the financing were used for increasing the capacity of the Quantum
SnifferTM production line, increasing unit inventories and the repayment of
certain indebtedness due and owed by the Company to the former shareholders of
Accurel in connection with the acquisition of this wholly-owned
subsidiary.








F-23
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  On
September 30, 2005, the Company issued 500,000 shares of Series D Redeemable
Convertible Preferred Stock (“Series D”) having a stated value of $10 per share,
pursuant to a Securities Purchase Agreement with Laurus.  The Company
received net cash proceeds of $1,883,000, consisting of $5,000,000 in gross
proceeds, less the repayment of $3,000,000 of principal related to the July 6,
2005 note and further reduced by a management and placement agent fee of
approximately $90,000, and related transaction costs of approximately
$27,000.  The Series D has a dividend equal to the prime rate plus one
percent (1%) (6.00% at June 30, 2008) and provides for redemption over a
thirty-six month period pursuant to an amortization schedule. In conjunction
with the Series D, the Company also issued to Laurus a warrant to purchase up to
50,000 shares of the Company’s common stock at a price equal to $10.20 per
share. The Company applied the Black Scholes model to determine the fair value
of the warrants, which included the use of the following assumptions: volatility
of 80%, an expected life 5 years, and a risk free interest rate of
4.12%.
  On May
31, 2006, the Company amended the Series D and the Certificate of Vote of
Directors Establishing a Class or Series of Stock. The terms of the amendment
permit the Company to defer approximately $455,000 of cash payments,
representing the January 2006, February 2006 and March 2006 amortization
payments, and to defer the October 2006 amortization payment, should such
payment be required in cash, to the mandatory redemption date of September 30,
2008. In consideration, the Company agreed to the conversion of the April 2006,
May 2006, June 2006, July 2006, August 2006 and September 2006 amortization
payments into 261,233 shares of common stock of the Company at a conversion
price of $3.48 per share, representing a reduction in principal of approximately
$909,000, and to reduce the Fixed Conversion Price of the remaining Series D
stock from $6.80 per share to $4.15 per share. In addition, Laurus was granted a
warrant to purchase 150,000 shares of the Company’s common stock at an exercise
price of $4.26 per share. The warrants were valued at $375,000 using the Black
Scholes model and the following assumptions: volatility of 79%, an expected life
5 years, and a risk free interest rate of 4.89%.




On
December 28, 2006, Laurus consented to permit the Company to defer the December
2006, January 2007, February 2007, March 2007, April 2007, May 2007, June 2007,
July 2007, and August 2007 redemptions to the end of the term. The monthly
redemption of approximately $152,000 plus accrued dividends resumes on September
1, 2007.  Subject to certain conditions, it is at the Company’s option
to pay this amount in cash or in common stock at a fixed conversion price of
$4.15 per common share. This fixed conversion price is subject to reset should
the Company declare a stock dividend or split, combine the outstanding common
stock into a smaller number of shares, or issue, by reclassification of its
common stock, any shares or other securities of the Company. The fixed
conversion price shall be adjusted proportionately so that the holder of the
Series D shall be entitled to receive the kind and number of shares or other
securities of the Company which such Laurus would have owned or have been
entitled to receive after the happening of any of the events described above,
had such shares of Series D Preferred Stock been converted immediately prior to
the happening of such event.




On
September 30, 2008, the Company amended the Securities Purchase Agreement, dated
as of September 30, 2005, by and between the Company and Laurus Master Fund,
Ltd. (“Laurus”).  As amended, the Series D Redeemable Convertible
Preferred Stock (“Series D”) will have a Mandatory Redemption Date of October
24, 2008, at which time the Company is required to redeem the shares of Series D
Preferred Stock, including unpaid dividends.  In consideration for
extending the Mandatory Redemption Date, the Company agreed to pay an amount
equal to no less than $250,000, which payment shall be applied first to accrued
and unpaid dividends on the Series D Preferred Stock and then to any outstanding
principal balance.




The
following table reflects the redemption of the Series D Preferred Stock, before
the effect of the accrued dividends:





Year
      Ending June 30:
              
              Preferred
      Stock Redemption2009
              
              $
              2,424,000$
              2,424,000


The
following conditions must be met in order for the Company to be permitted to pay
in common stock: (i) the shares must be issued pursuant to an effective
registration statement, (ii) the average closing market price of the common
stock for the five trading days immediately preceding a payment date must exceed
the fixed conversion price by 110% and no one day’s closing price may be less
than the fixed conversion price, and (iii) the conversion dollar value may not
exceed the aggregate of the prior 22 trading days’ dollar volume. The dividend
rate is subject to a 2% decrease for every 25% the average trading price for the
five trading days prior to a repayment date exceeds the fixed conversion price,
to a minimum of 0%. In addition, upon notifying the holder, the Company has the
option of redeeming any outstanding shares of Series D with cash by paying 130%
of the stated value plus accrued interest.








F-24
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  As a
condition of closing, the Company and each of its Subsidiaries granted a
security interest in their respective assets as well as providing Laurus a right
of first refusal on future financing arrangements during the term of the
Agreement. In the event Laurus declines to exercise its right of first refusal,
it agreed to enter into such documentation as shall be reasonably requested by
the Company in order to subordinate its rights under the Series D to the
subsequent financier. The registration rights associated with the Agreement
state that the Company will use its best efforts to have the registration
statement effective within 120 days from closing. In addition, the Company is
required to maintain an effective registration statement, and ensure that shares
are not suspended from trading. Upon notice from Laurus, should the Company be
declared in default of these items and have not cured the default within the
prescribed period, the Company may be assessed liquidated damages equal to
1/30th of 0.1%
of the outstanding preferred balance, payable in cash, for each day the event
has occurred and remains outstanding. However, pursuant to the Agreement,
“liquidated damages do not apply should the Securities and Exchange Commission
(“SEC”) have an issue with respect to the Holder or with respect to the
structure of the transaction.”
  In
accordance with the provisions of Emerging Issues Task Force (“EITF”) Issue
00-19, “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock,” the Company concluded that the Series D contained a conversion
feature which should be valued at fair value and be recorded as a liability on
the balance sheet. This conversion feature is not considered to be a
“conventional preferred” instrument because the Agreement includes certain
conditions under which the conversion price may be reset. This condition would
suggest that the number of shares to be issued upon conversion is not fixed,
which is a requirement of a “conventional preferred” instrument. This conversion
feature was also determined to be a liability since it may be required to be
repaid in cash, cannot be paid in unregistered shares and has certain penalties.
These conditions define the conversion feature as an embedded derivative which
must be separated from the host and reported at fair value pursuant to SFAS 133,
“Accounting for Derivative Instruments and
Hedging Activities” (“SFAS No. 133”).




The
Series D also contains certain other embedded derivatives which, pursuant to
SFAS No. 133, must be bifurcated from the host contract and reported at its fair
market value. The first feature includes a dividend rate that is subject to
adjustment based on the market price of the Company’s common stock. The second
feature, related to potential default provisions, could potentially increase the
dividend and redemption price, similar to a default or penalty clause in a
debt-like instrument. Although the Company has valued all embedded derivatives
of the host contract as one derivative instrument, the Company believes the
value of the adjustable dividend rate and the potential default provisions
features are immaterial. Management considered a number of factors, including
independent appraisals when making this determination. The Company will continue
to measure all derivatives at each reporting period as future changes in value
may become material.




The
conversion feature aggregated to $1,397,000 on September 30, 2005 based on the
Black- Scholes valuation model and the following assumptions: volatility 80%,
expected life 1.5 years, and a risk free interest rate of 3.96%.  The
conversion feature is marked to market at each reporting period with changes
flowing through the statement of operations.  As of June 30, 2008 and
2007, the fair value of this conversion feature approximated $0 and $133,000,
respectively.  The expected life of the conversion feature at June 30,
2008, was estimated to be 0.13 years.  The value of the embedded
derivates related to the adjustable dividend rate and the potential default
provisions were determined to be immaterial at June 30, 2008.




The
Company valued the Series D at issuance at its residual value of $2,700,000
based on the fair values of the financial instruments issued in connection with
this preferred stock financing, including the warrants, the embedded derivative
instruments and offering costs.  The amounts recorded in the financial
statements represent the amounts attributed to the sale of the Series D
preferred stock, the amount allocated to warrants of $672,000, the value
attributed to the embedded derivatives of $1,397,000 and $271,000 of issuance
costs (including $154,000 of unamortized costs of the July 6, 2005 term
note).  The Company is accreting these discounts on the carrying value
of the preferred stock to its redemption value at September 29, 2008, or the
actual conversion date, whichever is earlier.  The accretion of these
amounts is being recorded as a preferred dividend in the period of
accretion.  For the years ended June 30, 2008 and 2007, $795,000 and
$1,351,000, respectively, was amortized.  As of June 30, 2008 and
2007, the outstanding balance on the Series D was $2,424,000 and $3,939,000,
respectively.




The
amendment of the Series D, as described above, was accounted for as an
extinguishment of debt in accordance with EITF 96-19 “Debtor's Accounting for a
Modification or Exchange of Debt Instruments.”  The Company determined
a substantial difference in the net present value of the






F-25
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  15.
                Stockholders’
      Equity
  Common
Stock Options and Warrants
  In
December 2006, in conjunction with a short term note, the Company issued
warrants to purchase 458,000 shares of common stock at an exercise price of
$2.50 per share. The warrants are exercisable between December 29, 2006 and
December 29, 2011. The Company recorded the relative fair value of these
warrants of approximately $450,000 as interest expense in the accompanying
statement of operations during the year ended June 30, 2007.
  In
January 2007, in conjunction with a term note, the Company issued warrants to
purchase 18,939 shares of common stock at an exercise price of $2.64 per share.
The warrants are exercisable between January 2, 2007 and January 2, 2014. The
Company recorded the relative fair value of these warrants of approximately
$28,000 and is accreting their value to the term note over the life of the note
as an interest expense in the accompanying statement of operations during the
year ended June 30, 2007.


In May
2007, in conjunction with the sale of the assets of Accurel, the Company issued
warrants to various advisors to purchase 375,000 shares of common stock at an
exercise price of $2.00 per share. The warrants are exercisable between May 1,
2007 and May 1, 2012. The Company recorded the fair value of these warrants of
approximately $389,000 as part of the loss on sale of assets in the accompanying
statement of operations during the year ended June 30, 2007.




During
the year ended June 30, 2007, the Company issued fully vested warrants to
various advisors in exchange for services, to purchase a total of 80,000 shares
of common stock at exercise prices ranging from $2.32 to $2.82. The Company
recorded the fair value of these warrants of approximately $136,000 as stock
based compensation expense.  In addition, approximately $5,000 of
additional compensation expense was recorded relating to certain warrants and
non-qualified stock options issued in prior years being expensed over their
vesting period.




In June
2008, in conjunction with a modification to a loan agreement, the Company issued
warrants to purchase 43,860 shares of common stock at an exercise price of $1.14
per share. The warrants are exercisable between June 27, 2007 and June 27, 2014.
The Company recorded the relative fair value of these warrants of approximately
$29,000 as interest expense in the accompanying statement of operations during
the year ended June 30, 2008.




The
Company estimated the fair value of the warrants issued during fiscal 2008 and
2007 using the Black-Scholes option-pricing model.  The Company
estimated the fair value of the warrants using the following input
assumptions:





Years
      Ended June 30,2008
              
              2007Dividend
      yield
              0.0%
              
              0.0%Weighted-average
      volatility
              85.3%
              
              77.0%Weighted-average risk-free
      interest rate
              3.50%
              
              4.6%Weighted-average
      life of options
              7
      years
              
              4 years




F-26
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
following table presents the weighted average exercise price of warrants
outstanding at June 30, 2008:
  Warrants
      Outstanding and ExercisableRange
      of Exercise Prices
                  
                  
                  Number
      of Shares
                  
                  
                  Weighted
      Average
                    Exercise
      Price
                  
                  
                  Weighted
      Average
                    Intrinsic
      Value
                    per
      Share$
      1.14
      - $2.82
                  
                  
                  
                  975,799
                  
                  
                  $
                  2.26
                  
                  
                  $
                  (1.34
                  )$3.40
      - $6.88
                  
                  
                  
                  622,402
                  
                  
                  
                  4.13
                  
                  
                  
                  (5.11
                  )$8.25
      - $12.45
                  
                  
                  
                  771,426
                  
                  
                  
                  9.21
                  
                  
                  
                  (8.64
                  )2,369,627
                  
                  
                  
                  5.01
                  
                  
                  
                  (4.71
                  )
 The
following table presents the warrant activity for the years ended June 30, 2008
and 2007:
  2008
                  
                  
                  2007Shares
                  
                  
                  Weighted
      Average
                    Exercise
      Price
                  
                  
                  Shares
                  
                  
                  Weighted
      Average
                    Exercise
      PriceWarrants
      outstanding as of July 1
                  
                  
                  2,593,267
                  
                  
                  $
                  5.59
                  
                  
                  
                  1,756,003
                  
                  
                  $
                  7.64Issued
                  
                  
                  43,860
                  
                  
                  
                  1.14
                  
                  
                  
                  931,939
                  
                  
                  
                  3.31Exercised
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Expired
                  
                  
                  (267,500
                  )
                  
                  
                  9.90
                  
                  
                  
                  (94,675
                  )
                  
                  
                  12.00Warrants
      outstanding as of June 30
                  
                  
                  2,369,627
                  
                  
                  $
                  5.01
                  
                  
                  
                  2,593,267
                  
                  
                  $
                  5.60Warrants
      exercisable as of June 30
                  
                  
                  2,369,627
                  
                  
                  $
                  5.01
                  
                  
                  
                  2,485,677
                  
                  
                  $
                  5.59Weighted-average
      fair value of warrants
                    granted
      during the year
                  
                  
                  $
                  0.65
                  
                  
                  
                  
                  
                  
                  $
                  1.27


Employee
Stock Purchase Plan




In
September 1998, the Company adopted the 1998 Employee Stock Purchase Plan (the
“Plan”). The Plan provides a method whereby employees of the Company will have
an opportunity to acquire an ownership interest in the Company through the
purchase of shares of common stock of the Company through payroll deductions.
After 12 months of employment, an employee is eligible to participate and can
defer up to 10% of their wages into this Plan, with a maximum of $25,000 in any
calendar year. The purchase price of the common stock is calculated at the lower
of 85% of the closing price of the stock on the first day of the plan period or
the last day of the plan period. The periods are January 1 to June 30 and July 1
to December 31. Fractional shares are not issued. Participants may withdraw at
any time by giving written notice to the Company and will be credited the
amounts of deferrals in their account. The maximum number of shares eligible to
be issued under the Plan is 141,000. As of June 30, 2008, a total of 10,669
shares are available for issuance under the Plan.




In
December 2006, the Company adopted the 2006 Employee Stock Purchase Plan (the
“2006 Plan”). The 2006 Plan provides a method whereby employees of the Company
will have an opportunity to acquire an ownership interest in the Company through
the purchase of shares of common stock of the Company through payroll
deductions. After 12 months of employment, an employee is eligible to
participate and can defer up to 10% of their wages into this Plan, with a
maximum of $25,000 in any calendar year. The purchase price of the common stock
is calculated at the lower of 85% of the closing price of the stock on the first
day of the plan period or the last day of the plan period. The periods are
January 1 to June 30 and July 1 to December 31. Fractional shares are not
issued. Participants may withdraw at any time by giving written notice to the
Company and will be credited the amounts of deferrals in their account. The
maximum number of shares eligible to be issued under the 2006 Plan is 500,000.
As of June 30, 2008, a total of 411,690 shares are available for issuance under
the 2006 Plan.




Treasury
Stock and Other Transactions




In June
2004, the Board authorized the Company to repurchase up to 300,000 shares of the
Company’s common stock, from time to time in the open market, privately
negotiated transactions, block transactions or at time and prices deemed
appropriate by management.  As of June 30, 2008 and 2007, 10,545
shares were held in treasury at cost.  As of June 30, 2008 and 2007,
the maximum number of shares authorized to be repurchased were
289,455.






F-27
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  16.
                Stock
      Based Compensation
  In September 1998, the Company
adopted the 1998 Stock Option Plan (the “1998 Plan”). The 1998 Plan provides for
the grant of incentive stock options and nonqualified stock options to employees
and affiliates. The exercise price of the options equals 100% or 110% of the
fair market value on the date of the grant. The exercise price of the options
equal 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 Company stock.
Options expire between five and ten years from the date of the option grant and
have various vesting periods. Options may be exercised by the Holder delivering
to the Company cash in an amount equal to such aggregate exercise price, or with
the consent of the Committee, shares of Company Common Stock having a fair
market value equal to such aggregate exercise price, a personal recourse note
issued to the Company in a principal amount equal to such aggregate exercise
price or other acceptable consideration including a cashless exercise/resale
procedure or any combination of the foregoing. The Committee may in its
discretion provide upon the grant of any option that the Company shall have an
option to repurchase, upon terms and conditions determined by the Committee, all
or any number of shares purchased upon exercise of such option. A total of
280,000 options were reserved for issuance under the 1998 Plan. Upon adoption of
the 1998 Plan, the 1992 Stock Option Plan was terminated.
  In
December 2000, the Company adopted the 2000 Incentive and Non Qualified Stock
Option Plan (the “2000 Plan”). The 2000 Plan provides for the grant of incentive
stock options and nonqualified stock options to employees and affiliates. The
exercise price of the options equal 100% of the fair market value on the date of
the grant or 110% of the fair market value for greater than 5% beneficial owners
of the Company stock. Options expire between five and ten years from the date of
the option grant and have various vesting periods. Options may be exercised by
the Holder delivering to the Company cash in an amount equal to such aggregate
exercise price, or with the consent of the Committee, shares of Company Common
Stock having a fair market value equal to such aggregate exercise price, a
personal recourse note issued to the Company in a principal amount equal to such
aggregate exercise price or other acceptable consideration including a cashless
exercise/resale procedure or any combination of the foregoing. The Committee may
in its discretion provide upon the grant of any option that the Company shall
have an option to repurchase, upon terms and conditions determined by the
Committee, all or any number of shares purchased upon exercise of such option. A
total of 600,000 options were originally reserved for issuance under the 2000
Plan. In December 2003, the stockholders of the Company approved an increase in
the 2000 Incentive and Non-Qualified Stock Option Plan from 600,000 shares to
1,000,000 shares. In December 2004, the stockholders of the Company approved an
increase in the 2000 Incentive and Non-Qualified Stock Option Plan from
1,000,000 shares to 1,500,000 shares.




In
December 2004, the Company adopted the 2004 Stock Option Plan (the “2004 Plan”).
The 2004 Plan provides for the grant of incentive stock options and nonqualified
stock options to employees and affiliates. A total of 500,000 options were
originally reserved for issuance under the 2000 Plan. The exercise price of the
options equa1 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 Company
stock. Options expire between five and ten years from the date of the option
grant and have various vesting periods. At the December 2005 annual meeting the
shareholders voted to increase the shares available for issuance under the 2004
Plan by 500,000 to 1,000,000 shares. Options may be exercised by the Holder
delivering to the Company cash in an amount equal to such aggregate exercise
price, or with the consent of the Committee, shares of Company Common Stock
having a fair market value equal to such aggregate exercise price, a personal
recourse note issued to the Company in a principal amount equal to such
aggregate exercise price or other acceptable consideration including a cashless
exercise/resale procedure or any combination of the foregoing. In December 2005,
the stockholders of the Company approved an increase in the 2004 Incentive and
Non-Qualified Stock Option Plan from 500,000 shares to 1,000,000
shares.  In December 2007, the stockholders of the Company approved an
increase in the 2004 Incentive and Non-Qualified Stock Option Plan from
1,000,000 shares to 2,000,000 shares.




As of
June 30, 2008, a total of 137,003, 120,302, and 537,500 shares are available for
issuance under the 1998, 2000 and 2004 Plans, respectively.






F-28
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
following table presents the activity of the 1998, 2000 and 2004 Stock Option
Plans for the year ended June 30, 2008:
  Options
      Outstanding
                  
                  
                  Weighted
                    Average
                    Exercise
      Price per Share
                  
                  
                  Weighted
                    Average
                    Remaining
      Contractual
                    Term
      in Years
                  
                  
                  Aggregate
      Intrinsic ValueOptions
      outstanding as of July 1, 2007
                  
                  
                  1,790,738
                  
                  
                  $
                  4.66Granted
                  
                  
                  1,353,000
                  
                  
                  
                  1.29Exercised
                  
                  
                  -
                  
                  
                  
                  -Cancelled
                  
                  
                  (497,200
                  )
                  
                  
                  3.96Options
      outstanding as of June 30, 2008
                  
                  
                  2,646,538
                  
                  
                  $
                  3.07
                  
                  
                  
                  5.60
                  
                  
                  $
                  (5,677,000
                  )Options
      exercisable as of June 30, 2008
                  
                  
                  1,317,248
                  
                  
                  $
                  4.59
                  
                  
                  
                  5.70
                  
                  
                  $
                  (4,830,000
                  )Options
      vested or expected to vest as
                    of
      June 30, 2008
                  
                  
                  2,513,609
                  
                  
                  $
                  3.15
                  
                  
                  
                  5.60
                  
                  
                  $
                  (5,592,000
                  )
 The
following table sets forth information regarding outstanding options at June 30,
2008:
  Options
      Outstanding
                  
                  
                  Options
      ExercisableRange
      of Exercise Prices
                  
                  
                  Number
      of Shares
                  
                  
                  Weighted
                    Average
                    Remaining
      Contractual
                    Life
      in Years
                  
                  
                  Weighted
                    Average
                    Exercise
      Price
                  
                  
                  Number
      of Shares
                  
                  
                  Weighted
                    Average
                    Exercise
      Price$0.80
      - $2.89
                  
                  
                  
                  1,632,988
                  
                  
                  
                  5.8
                  
                  
                  $
                  1.50
                  
                  
                  
                  
                  357,488
                  
                  
                  $
                  1.71$3.07
      - $4.50
                  
                  
                  
                  598,550
                  
                  
                  
                  5.2
                  
                  
                  
                  3.92
                  
                  
                  
                  
                  557,960
                  
                  
                  
                  3.94$6.30
      - $7.56
                  
                  
                  
                  240,000
                  
                  
                  
                  4.3
                  
                  
                  
                  6.68
                  
                  
                  
                  
                  226,800
                  
                  
                  
                  6.69$9.15
      - $10.90
                  
                  
                  
                  175,000
                  
                  
                  
                  6.2
                  
                  
                  
                  9.80
                  
                  
                  
                  
                  175,000
                  
                  
                  
                  9.802,646,538
                  
                  
                  
                  5.6
                  
                  
                  
                  3.07
                  
                  
                  
                  
                  1,317,248
                  
                  
                  
                  4.59




As of
June 30, 2008 there was $818,000 of total unrecognized compensation expense
related to unvested share based compensation arrangements under the various
share-based compensation plans.  This expense is expected to be
recognized as follows:





Years
      Ending June 30:2009
              
              $
              471,0002010
              
              
              262,0002011
              
              
              85,000$
              818,000


As of
June 30, 2008, the unrecognized compensation expense related to stock option
awards is expected to be recognized as expense over a weighted-average period of
2.85 years.




The
aggregate intrinsic value in the table above represents the total pre-tax
intrinsic value (the difference between the closing price of the common stock on
June 30, 2008 of $0.92 and the exercise price of each in-the-money option) that
would have been received by the option holders had all option holders exercised
their options on June 30, 2008.  Total intrinsic value of stock
options exercised under the Plan for the years ended June 30, 2008 and 2007 was
$0 and $28,000, respectively.  The total fair value of stock options
that vested during the years ended June 30, 2008 and 2007 were $1,214,000 and
$1,281,000, respectively.






F-29
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  17.
                Acquisition
  On
April 10, 2008 (the “Closing Date”), the Company entered into a definitive
agreement (the “Merger Agreement”) to acquire all of the capital stock of Ion
Metrics, Inc, a California corporation (“Ion Metrics”).  The
transaction is being structured as a reorganization of Ion Metrics with and into
a newly formed, wholly-owned subsidiary of the Company (the
“Transaction”).  The operating results of Ion Metrics have been
included in the Company’s statement of operations commencing on April 10,
2008.
  The
aggregate purchase price of Ion Metrics, excluding assumed liabilities, was
$2,745,000.  As part of the Transaction, the Company will issue to the
former stockholders of Ion Metrics (the “IMI Stockholders”) consideration
consisting of 2,000,000 shares of the Company’s common stock, par value $0.10
per share (“Common Stock”).  The fair value of the Company's common
stock was determined based on the average market price of the Company's common
stock over a period of time before April 10, 2008, the date fair value is to be
determined, pursuant to Emerging Issues Task Force ("EITF") Issue No. 99-12,
“Determination of the Measurement Date for the
Market Price of Acquirer Securities Issued in a Purchase Business
Combination.”  As of June 30, 2008, the Company had not issued
the 2,000,000 shares of the Company’s common stock, which obligation amounting
to $2,464,000 is included in the Payable Due to Ion Metrics, Inc
Shareholders.  In August 2008, the Company issued the 2,000,000 shares
of common stock to the IMI Stockholders.  The Company entered into an
agreement with Ferran Scientific (the “FS Agreement”) whereby the Company
assumed certain Ion Metrics obligations and rights.  In consideration
for the assignment of these obligations and rights, the Company agreed to a
$50,000 fee payable to the Ion Metrics shareholders for these
assignments.  The FS Agreement also included modifications to these
assumed obligations including the deferral of payment obligations for a period
up to 12 months from the Closing Date.
  The IMI
Stockholders have agreed not to sell any of their shares of Common Stock for a
period of eighteen (18) months from the Closing Date (the “Lock-up Period”);
provided however for the period from six (6) to eighteen (18) months from the
Closing Date, each holder may sell, in any three (3) month period, the greater
of (a) one percent (1%) of the outstanding shares of the same class being sold
or (b) if the class is listed on a stock exchange or quoted on the American
Stock Exchange, the greater of (i) one percent (1%) of the outstanding shares of
such class or (ii) the average reported weekly trading volume during the four
weeks preceding the sale.
  In
connection with the Transaction, the Company entered into an escrow agreement
(the “Escrow Agreement”) with Ion Metrics and ComputerShare Trust
Company.  The Company will deposit 400,000 shares of common stock,
representing 20% of the purchase price, into an escrow account.  Any
valid claims for indemnification made by the Company pursuant to section 9.3 of
the Merger Agreement shall be paid from these shares.  The Escrow
Agreement provides, subject to any claims of indemnifications, for a release of
the shares on April 10, 2009.
  The
Transaction also included board observer rights which permit a designee of the
IMI Stockholders to attend Company board meetings.  This right expires
upon the termination of the Lock-Up Period.


The
following table summarizes the purchase price:





Cash
              
              $
              91,000Direct
      costs
              
              
              140,000Payable
      to Ion Metrics Shareholders
              
              
              2,514,000$
              2,745,000






F-30
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
following table summarizes the purchase price allocation to the fair value of
the assets acquired and liabilities assumed at the date of
acquisition:
  Accounts
      receivable
                  
                  $
                  7,000Other
      receivables
                  
                  
                  3,000Prepaid
      expenses
                  
                  
                  11,000Property,
      plant and equipment
                  
                  
                  83,000Goodwill
                  
                  
                  3,136,000Customer
      relationships
                  
                  
                  69,000Accounts
      payable
                  
                  
                  (241,000
                  )Accrued
      interest
                  
                  
                  (20,000
                  )Accrued
      payroll
                  
                  
                  (4,000
                  )Accrued
      liabilities other
                  
                  
                  (10,000
                  )Notes
      payable
                  
                  
                  (181,000
                  )Current
      maturities of obligations under capitalized lease
                  
                  
                  (11,000
                  )Long-term
      obligations under capital lease, net of current maturities
                  
                  
                  (97,000
                  )$
                  2,745,000
 The
allocation of purchase price is the responsibility of management.  The
Company considered a number of factors, including professional appraisals, for
the valuation of equipment acquired, in making its purchase price allocation
determination.  The acquisition of Ion Metrics resulted in goodwill of
$3,136,000 and the identification of $69,000 of intangible assets with finite
lives.  The intangible assets are being amortized over a period of
twelve months, the estimated useful lives of the assets, from the date of
acquisition, April 10, 2008.  Amortization expense for the year ended
June 30, 2008 to the intangible assets was $15,000.
  The
acquisition of Ion Metrics is accounted for as a purchase under SFAS No. 141,
“Business Combinations.”  Accordingly, the operating results of Ion
Metrics are included in the accompanying consolidated financial statements since
the acquisition date as part of the Company's Security segment.
  18.
                Discontinued
      Operations
  Accurel
Systems International, Inc.
  On May
1,2007,
the Company completed the sale of the assets of its Accurel subsidiary to Evans
(“Asset Sale”).  The Asset Sale was completed in accordance with the
terms and conditions of the Purchase Agreement.  As consideration for
the Asset Sale, the Company received cash proceeds of approximately $12,705,000
of which $1,000,000 was placed in escrow. At June 30, 2007, the Company
determined that the proceeds, less the related transaction costs of
approximately $1,794,000 in cash fees and expenses, taxes of $197,000, and
$390,000 in a non-cash charge for three year warrants issued, were less than the
book value of the net assets transferred of $11,570,000 and therefore a loss on
the sale of Accurel of $1,246,000 was recorded in the fourth quarter of fiscal
2007 as a component of the loss from discontinued operations.
  In
accordance with SFAS No.144, “Accounting for the Impairment or
Disposal of Long-Lived Assets”, the accompanying consolidated balance
sheets and statements of operations present the results of Accurel as
discontinued operations.  The Company’s Board of Directors approved a
plan to sell Accurel in March 2007.  The Company executed the Accurel
Purchase Agreement and completed the sale on May 1, 2007.  The Company
has (i) eliminated Accurel’s financial results from its ongoing operations, (ii)
determined that Accurel, which operated as a separate subsidiary, was a separate
component of its aggregated business as, historically, management reviewed
separately the Accurel financial results and cash flows apart from its ongoing
continuing operations, and (iii) determined that it will have no further
continuing involvement in the operations of Accurel or cash flows from Accurel
after the sale.









F-31
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  Condensed
results of operations relating to Accurel for the years ended June 30, 2008 and
2007 are as follows:
 Years
      Ended June 30,2008
                  
                  
                  2007Revenues
                  
                  $
                  -
                  
                  
                  $
                  7,561,000Gross
      margin
                  
                  
                  -
                  
                  
                  
                  2,238,000Operating
      income
                  
                  
                  -
                  
                  
                  
                  625,000Loss
      on sale of Accurel
                  
                  
                  -
                  
                  
                  
                  (1,246,000
                  )Loss
      from discontinued operations
                  
                  
                  -
                  
                  
                  
                  (764,000
                  )
 Core
Systems, Inc.
  In
accordance with SFAS No.144, “Accounting for the Impairment or
Disposal of Long-Lived Assets”, the accompanying consolidated balance
sheets and statements of operations present the results of Core as discontinued
operations.  As noted above, the Company’s Board of Directors approved
a plan to sell Core in February 2008.  The Company has (i) eliminated
Core’s financial results from its ongoing operations, (ii) determined that Core,
which operated as a separate subsidiary, was a separate component of its
aggregated business as, historically, management reviewed separately the Core
financial results and cash flows apart from its ongoing continuing operations,
and (iii) determined that it will have no further continuing involvement in the
operations of Core or cash flows from Core after the
sale.  Accordingly, the assets and liabilities of Core are classified
as held for sale as of June 30, 2008 and 2007.
  Condensed
results of operations relating to Core for the years ended June 30, 2008 and
2007 are as follows:
  Years
      Ended June 30,2008
                  
                  
                  2007Revenues
                  
                  $
                  6,332,000
                  
                  
                  $
                  6,874,000Gross
      margin
                  
                  
                  561,000
                  
                  
                  
                  468,000Operating
      loss
                  
                  
                  (2,180,000
                  )
                  
                  
                  (4,808,000
                  )Loss
      from discontinued operations
                  
                  
                  (2,181,000
                  )
                  
                  
                  (4,809,000
                  )






F-32
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
assets and liabilities of Core as of June 30, 2008 and 2007 are as
follows:
 June
      30,2008
                  
                  
                  2007Assets
      of Discontinued OperationsCurrent
      assets of discontinued operations:Accounts
      receivable-trade, net
                  
                  $
                  1,178,000
                  
                  
                  $
                  1,005,000Inventories
                  
                  
                  251,000
                  
                  
                  
                  228,000Prepaid
      expenses and other current assets
                  
                  
                  -
                  
                  
                  
                  44,000Total
      current assets of discontinued operations
                  
                  
                  1,429,000
                  
                  
                  
                  1,277,000Non-current
      assets of discontinued operations:Property
      and equipment, net
                  
                  
                  833,000
                  
                  
                  
                  1,709,000Goodwill
                  
                  
                  1,195,000
                  
                  
                  
                  2,062,000Other
      assets
                  
                  
                  25,000
                  
                  
                  
                  75,000Intangible
      assets, net
                  
                  
                  32,000
                  
                  
                  
                  77,000Total
      non-current assets of discontinued operations
                  
                  
                  2,085,000
                  
                  
                  
                  3,923,000Total
      assets of discontinued operations
                  
                  $
                  3,514,000
                  
                  
                  $
                  5,200,000Liabilities
      of Discontinued OperationsCurrent
      liabilities of discontinued operations:Current
      portion of long term debt and capital leases
                  
                  $
                  5,000
                  
                  
                  $
                  3,000Accounts
      payable
                  
                  
                  517,000
                  
                  
                  
                  381,000Accrued
      expenses
                  
                  
                  316,000
                  
                  
                  
                  402,000Deferred
      revenue
                  
                  
                  10,000
                  
                  
                  
                  10,000Total
      current liabilities of discontinued operations
                  
                  
                  848,000
                  
                  
                  
                  796,000Non-current
      liabilities of discontinued operations:Long-term
      debt and obligations under capital lease, net of current
      maturities
                  
                  
                  1,000
                  
                  
                  
                  4,000Total
      liabilities of discontinued operations
                  
                  $
                  849,000
                  
                  
                  $
                  800,000
 Medical
Business Unit
  In
accordance with SFAS No.144, “Accounting for the Impairment or
Disposal of Long-Lived Assets”, the accompanying consolidated balance
sheets and statements of operations present the results of the Medical Business
Unit as discontinued operations.
  Condensed
results of operations relating to the Medical Business Unit for the years ended
June 30, 2008 and 2007 are as follows:
  Years
      Ended June 30,2008
                  
                  
                  2007Revenues
                  
                  $
                  681,000
                  
                  
                  $
                  3,977,000Gross
      margin
                  
                  
                  (709,000
                  )
                  
                  
                  260,000Operating
      loss
                  
                  
                  (849,000
                  )
                  
                  
                  (381,000
                  )Loss
      from discontinued operations
                  
                  
                  (840,000
                  )
                  
                  
                  (382,000
                  )








F-33
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
assets and liabilities of the Medical Business Unit as of June 30, 2008 and 2007
are as follows:
  June
      30,2008
                  
                  
                  2007Assets
      of Discontinued OperationsCurrent
      assets of discontinued operations:Accounts
      receivable-trade, net
                  
                  $
                  149,000
                  
                  
                  $
                  540,000Inventories
                  
                  
                  305,000
                  
                  
                  
                  254,000Total
      current assets of discontinued operations
                  
                  
                  454,000
                  
                  
                  
                  794,000Non-current
      assets of discontinued operations:Property
      and equipment, net
                  
                  
                  560,000
                  
                  
                  
                  683,000Total
      non-current assets of discontinued operations
                  
                  
                  560,000
                  
                  
                  
                  683,000Total
      assets of discontinued operations
                  
                  $
                  1,014,000
                  
                  
                  $
                  1,477,000Liabilities
      of Discontinued OperationsCurrent
      liabilities of discontinued operations:Accounts
      payable
                  
                  $
                  100,000
                  
                  
                  $
                  182,000Accrued
      expenses
                  
                  
                  131,000
                  
                  
                  
                  133,000Total
      liabilities of discontinued operations
                  
                  $
                  231,000
                  
                  
                  $
                  315,000
 19.
                Valuation and Qualifying
      Accounts
  Balance
      at beginning of period
                  
                  
                  Charged
      to
                    (recoveries
      of) costs and expenses
                  
                  
                  Write-off
                  
                  
                  Balance
      at end of periodYear
      ended June 30, 2008:Deducted
      from asset accounts:Allowance
      for doubtful accounts
                  
                  $
                  20,000
                  
                  
                  $
                  (11,000
                  )
                  
                  $
                  -
                  
                  
                  $
                  9,000Excess
      and obsolescence reserve
                  
                  
                  290,000
                  
                  
                  
                  (9,000
                  )
                  
                  
                  -
                  
                  
                  
                  281,000Total
                  
                  $
                  310,000
                  
                  
                  $
                  (20,000
                  )
                  
                  $
                  -
                  
                  
                  $
                  290,000Deducted
      from liability accounts:Warranty
      reserve
                  
                  $
                  47,000
                  
                  
                  $
                  58,000
                  
                  
                  $
                  (1,000
                  )
                  
                  $
                  104,000Total
                  
                  $
                  47,000
                  
                  
                  $
                  58,000
                  
                  
                  $
                  (1,000
                  )
                  
                  $
                  104,000Year
      ended June 30, 2007:Deducted
      from assets accounts:Allowance
      for doubtful accounts
                  
                  $
                  10,000
                  
                  
                  $
                  10,000
                  
                  
                  $
                  -
                  
                  
                  $
                  20,000Excess
      and obsolescence reserve
                  
                  
                  155,000
                  
                  
                  
                  135,000
                  
                  
                  
                  -
                  
                  
                  
                  290,000Total
                  
                  $
                  165,000
                  
                  
                  $
                  145,000
                  
                  
                  $
                  -
                  
                  
                  $
                  310,000Deducted
      from liability accounts:Warranty
      reserve
                  
                  $
                  54,000
                  
                  
                  $
                  103,000
                  
                  
                  $
                  (110,000
                  )
                  
                  $
                  47,000Total
                  
                  $
                  54,000
                  
                  
                  $
                  103,000
                  
                  
                  $
                  (110,000
                  )
                  
                  $
                  47,000
  20.
                Benefit Plans and Employment
      Agreements of Executive
Officers
  The
Company has a defined contribution plan, the Implant Sciences Corporation 401(k)
Profit Sharing Plan, established under Section 401(k) of the Internal Revenue
Code.   All full-time employees who are twenty-one years of age
are eligible to participate on the beginning of the first month after 90 days of
employment.  The Company’s contributions are
discretionary.   The Company made no matching contributions
during either fiscal 2008 or 2007.






F-34
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  On
September 27, 2007, the Company entered into a Transition Agreement with Dr.
Anthony J. Armini, the Company’s former President and Chief Executive Officer,
with a term of 24 months.  Under this Transition Agreement Dr. Armini
resigned from his positions and assumed the position of Scientific
Advisor.  Dr. Armini remained the Chairman of the Board of Directors
until the December 2007 annual meeting of shareholders, at which time he left
the Board.  During the transition period, the Company will compensate
Dr. Armini at the annual rate of $250,000.  At June 30, 2008, the
Company recorded a $339,000 charge in selling, general and administrative
expenses representing the unpaid portion of wages, taxes and health and life
insurance benefits owed to Dr. Armini under the terms of the Transition
Agreement.  In addition, Dr. Armini may participate in the Company’s
medical and dental insurance programs.  The Company may terminate this
Transition Agreement only for cause and Dr. Armini may terminate the Transition
Agreement for any reason, with each party giving the other written
notice.  In conjunction with this agreement, Dr. Armini has been
issued a stock option for 200,000 shares of common stock at an exercise price of
$2.09 per share, of which 25,000 shares vested immediately, and the remaining
175,000 shares vest at a rate of 25,000 per quarter over the term of the
Transition Agreement.  These options were valued using the Black
Scholes method and the following assumptions:  volatility 55%, risk
free interest rate of 4.01% and expected life of 1.75 years.
  On
December 12, 2007, the Company entered into an employment agreement with Mr.
Phillip Thomas, the Company’s President and Chief Executive Officer, having an
initial term of three years, an annual base salary of $275,000, an annual
incentive bonus program and a car allowance.  In conjunction with this
agreement, Mr. Thomas has been issued an option for 280,000 shares of common
stock at an exercise price of $1.15 per share, of which 93,333 vested
immediately, and the remaining 186,667 vest over 24 months.  These
options were valued using the Black Scholes method and the following
assumptions:  volatility 82%, risk free interest rate of 3.67% and
expected life of six years.  In addition, Mr. Thomas may participate
in the Company’s employee fringe benefit plans or programs generally available
to employees of comparable status and position. The Company may terminate his
employment for any material breach of his employment agreement at any
time.   In the event the Company terminates Mr. Thomas’
employment without cause, the Company will pay him 12 months salary on a regular
payroll basis.  Under his employment agreement, Mr. Thomas is subject
to restrictive covenants, including confidentiality provisions and a one year
non-compete and non-solicitation provision.
  On March
18, 2008, the Company entered into an employment agreement with Ms. Diane Ryan,
the Company’s then Chief Financial Officer, having an initial term of three
years, an annual base salary of $155,000, and an annual incentive bonus
program.  In conjunction with this agreement, Ms. Ryan has been issued
an option for 50,000 shares of common stock at an exercise price of $1.10 per
share, of which 16,667 vested immediately, and the remaining 33,333 vest over 24
months.  These options were valued using the Black Scholes method and
the following assumptions:  volatility 80%, risk free interest rate of
3.21% and expected term of 8.5 years.  In addition, Ms. Ryan may
participate in the Company’s employee fringe benefit plans or programs generally
available to employees of comparable status and position.  The Company
may terminate her employment for any material breach of her employment agreement
at any time.  In the event the Company terminates Ms. Ryan’s
employment without cause, the Company will pay her 12 months salary on a regular
payroll basis.  Under her employment agreement, Ms. Ryan is subject to
restrictive covenants, including confidentiality provisions and a one year
non-compete and non-solicitation provision.
  On July
31, 2008, the Company entered into an employment agreement with Mr. Glenn
Bolduc, the Company’s Chief Financial Officer, having an initial term of three
years, an annual base salary of $200,000, an annual cash incentive bonus program
and long-term incentives in the form of incentive stock options to purchase
shares of the Company’s common stock.  Mr. Bolduc joined the Company
on July 7, 2008.  In conjunction with this agreement, Mr. Bolduc has
been issued an option for 140,000 shares of common stock at an exercise price of
$0.91 per share, which vests annually in equal installments of 46,666,
commencing on the first anniversary date.  These options were valued
using the Black Scholes method and the following
assumptions:  volatility 90.2%, risk free interest rate of 3.30% and
expected term of 6.0 years.  In addition, Mr. Bolduc may participate
in the Company’s employee fringe benefit plans or programs generally available
to employees of comparable status and position.  The Company may
terminate his employment for any material breach of his employment agreement at
any time.  In the event the Company terminates Mr. Bolduc’s employment
without cause, the Company will pay him 12 months salary on a regular payroll
basis.  Under his employment agreement, Mr. Bolduc is subject to
restrictive covenants, including confidentiality provisions and a one year
non-compete and non-solicitation provision.






F-35
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  21.
                Investment in CorNova,
      Inc.
  As of
June 30, 2008 and 2007, the Company had a 15% and 16% ownership interest,
respectively, in the common stock of CorNova.  During the fiscal year
ended June 30, 2007, the Company recorded equity in the net loss of CorNova of
$158,000, and equity in comprehensive income of CorNova of $16,000 (related to
unrealized holding gains on securities classified as available-for-sale). 
As a result of the cumulative net losses incurred, the Company's investment in
CorNova was $0 as of June 30, 2008.
  The
Company has historically accounted for its investment in this unconsolidated
subsidiary under the equity method, due in part, to the significant influence
the Company had over CorNova resulting from Dr. Anthony J. Armini serving on
CorNova’s Board of Directors.  Dr. Armini served as the President and
Chief Executive Officer of the Company, resigning both positions on September
27, 2007.  As a result of Dr. Armini’s resignation from CorNova’s
board in September 2007, the equity method is no longer appropriate and the cost
method was used.  Therefore, no additional losses were recorded from
the Company’s equity ownership in CorNova in fiscal 2008.  The Company
has no additional obligation to contribute assets or additional common stock or
to assume any liabilities or to fund any losses that CorNova may
incur.
  22.
                Legal
      Proceedings
  From time
to time, we are subject to various claims, legal proceedings and investigations
covering a wide range of matters that arise in the ordinary course of our
business activities. Each of these matters is subject to various
uncertainties.
  Evans
Analytical Group LLC
  On May 1,
2007, the Company entered into an Asset Purchase Agreement (the “Evans
Agreement”) to sell substantially all of the assets (the “Transaction”) of its
subsidiary, Accurel Systems International Corporation (“Accurel), a California
corporation, to Evans Analytical Group LLC (“Evans”), a Delaware limited
liability company.  Evans acquired all of the fixed assets and
accounts receivable of Accurel.  The total purchase price of the
Transaction was approximately $12,705,000.
  In
connection with the Transaction, we entered into an escrow agreement (the
“Escrow Agreement”) with Evans, Accurel, and Zions First National
Bank.  Pursuant to the Escrow Agreement, Evans deposited $1,000,000
(the “Escrow Amount”) of the total purchase price for the assets into an escrow
account.  Any valid claims for indemnification made by Evans pursuant
to the Agreement shall be drawn from this sum.  The Escrow Agreement
provided, subject to any claims of indemnifications, for a release of $500,000
on approximately each of March 31, 2008 and March 31, 2009.
  Also in
connection with the Transaction, we entered into a Non-competition and
Nondisclosure Agreement (the “NCD”) with Evans whereby we agreed not to engage
in any business that directly competes with the business of
Accurel.  In addition, the NCD prohibits us from disclosing any
confidential information concerning the business of Accurel.  The NCD
will remain in effect for five years from the date of its
execution.
  On
February 22, 2008, Evans filed suit requesting rescission of the Evans
Agreement, plus damages, based on claims of misrepresentation and
fraud.  On March 28, 2008, Evans filed a formal Claims Notice with the
escrow agent prohibiting release of any portion of the escrow to the Company as
a result of the suit filed on February 22, 2008.  As a result that
Company has classified the $1,000,000 Escrow Amount as a long term
asset.  The Company has retained legal counsel in defense of these
claims.
  Rapiscan
Systems, Inc.
  On March
23, 2005, we entered into a Development, Distribution and Manufacturing
Agreement (the “Rapiscan Agreement”) with Rapiscan Systems, Inc. (“Rapiscan”),
wherein we gave Rapiscan the exclusive worldwide rights to market our Quantum
SnifferTM
portable and benchtop trace detection devices under their private
label.  We also agreed to give Rapiscan the exclusive worldwide rights
to distribute certain other new security products which we may develop in the
future with their funding, as well as rights, in some circumstances, to
manufacture certain components of the private-labeled Quantum SnifferTM
portable and benchtop trace detection devices.
  On March
23, 2006, Rapiscan filed a complaint against the Company and its contract
assembler, Columbia Tech, in the United States District Court for the Central
District of California, regarding the Rapiscan Agreement.  Rapiscan’s
complaint against the Company alleged claims of breach of contract and breach of
warranty and requested specific performance, declaratory relief and injunctive
relief.  Rapiscan’s complaint against Columbia Tech alleged tortuous
interference with contractual relations and requested injunctive relief and
declaratory relief.  On April 12, 2006, Rapiscan dismissed all claims
against Columbia Tech.





F-36
 
  On
January 4, 2008, the Company executed a Settlement Agreement (the “Settlement
Agreement”) with OSI and Rapiscan to resolve the Pending Litigation and to enter
into additional agreements.  In addition to the immediate dismissal of
the Pending Litigation, other terms of the Settlement Agreement include, (i) the
rescission of the Rapiscan Agreement, (ii) the payment by the Company of
$200,000, such payment to be made in the form of 221,729 shares of the Company’s
common stock,  (iii) the granting of non-exclusive distribution rights
to Rapiscan, (iv) the payment by the Company of up to $1,000,000 in Technology
Transfer Fees, payable over time at a rate of 2% of the gross sales price
received by the Company when and if a passenger portal is sold, and (v) the
opportunity for OSI to supply certain components to the Company.
  We may,
from time to time, be involved in other actual or potential proceedings that we
consider to be in the normal course of our business.  We do not
believe that any of these proceedings will have a material adverse effect on our
business.
  23.
                Subsequent
      Events
  On June
27, 2008, the Company and International Brachytherapy, s.a. (“IBt”), entered
into an Asset Purchase Agreement (the “Agreement”).  The Agreement
provided for the purchase by IBt of the assets used in the Company’s Xenation
Business, including without limitation, certain Xenation machines and related
assets, including raw materials, supplies, and repair parts, together with
United States Patent Number 6,060,036 (the “Patent”) and all related
intellectual property, technology and know-how.  IBt granted back to
the Company a perpetual, worldwide, royalty-free, exclusive license to use
and/or assign certain claims in the Patent relating to Ytterbium
technology.  IBt is excluded from using the Ytterbium
technology.  In addition, IBt received a perpetual, worldwide,
royalty-free, exclusive license to use and/or assign certain claims in the
United States Patent Number 6,183,409 relating to Xenon
technology.  The Company is excluded from using the Xenon
technology.  The total purchase price for the assets was $750,000 and
was received by the Company on July 1,2008.  The transaction was
completed on July 1, 2008 and will be reflected in the results of operations for
the quarter ending on September 30, 2008.
  The
Company entered into an employment agreement with Mr. Glenn Bolduc, the
Company’s Chief Financial Officer, on July 31, 2008, having an initial term of
three years.  Please refer to Note 20 for additional information
regarding Mr. Bolduc’s employment agreement.
  As of
June 30, 2008, the Company had not issued the 2,000,000 shares of the Company’s
common stock, which obligation amounting to $2,464,000 is included in the
Payable Due to Ion Metrics, Inc Shareholders.  On August
11, 2008, the Company issued the 2,000,000 shares of common stock to the
IMI Stockholders.
  On August
29, 2008, the Company executed an agreement with San Jose, CA-based Bridge Bank,
N.A. which reduced the Company’s revolving credit facility from $5.0 million to
$1.5 million.  Please refer to Note 9 for further information
regarding this amendment to the Bridge Bank credit facility.
  On
September 30, 2008, the Company amended the Securities Purchase Agreement, dated
as of September 30, 2005, by and between the Company and Laurus Master Fund,
Ltd. (“Laurus”).  Please refer to Note 14 for further information
relative to the amended securities agreement with Laurus.
  O n October
10, 2008, we received a notice of default with respect of violation of
depository accounts, financial reporting and failure to complete sale of an
asset  We did not receive a waiver for the these
defaults.
  O n October
13, 2008, the Ion Metrics Shareholders agreed to terminate the Board Observers
Rights Agreement.




F-37


SIGNATURES




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




Dated:
      October 14, 2008
            Implant
      Sciences CorporationBy:
            /s/
      Phillip C. ThomasPhillip
      C. Thomas
              Chief
      Executive Officer and President







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




Dated:
      October 14, 2008
            
            /s/
      Phillip C. ThomasPhillip
      C. Thomas
              Chief
      Executive Officer and President
              (Principal
      Executive Officer)Dated:
      October 14, 2008
            
            /s/
      Joseph LevangieJoseph
      Levangie
              DirectorDated:
      October 14, 2008
            
            /s/
      Michael TurmelleMichael
      Turmelle
              DirectorDated:
      October 14, 2008
            
            /s/
      David EisenhaureDavid
      Eisenhaure
              DirectorDated:
      October 14, 2008
            
            /s/
      Michael SzycherMichael
      Szycher
              DirectorDated:
      October 14, 2008
            
            /s/
      Glenn D. BolducGlenn
      D. Bolduc
              Vice
      President and Chief Financial Officer
              (Principal
      Financial Officer and Principal Accounting Officer)










EXHIBIT
21




SUBSIDIARIES OF IMPANT SCIENCES
CORPORATION




State or
Other Jurisdiction of:




Name
            
            
            Incorporation
      or OrganizationC-Acquisition Corp. d/b/a Core Systems
            DelawareAccurel Systems International Corporation
            CaliforniaIMX Acquisition Corporation
            Delaware




















Exhibit
23




CONSENT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM













We
hereby consent to the incorporation by reference in the Registration Statements
on Forms S-3 (No.’s 333-109677, 333-111434, 333-117366, 333-124058, 333-127167,
333-129911) and Forms S-8 (No.’s 333-42816, 333-111117, 333-138292, 333-144892)
of our report dated October 14, 2008, relating to the consolidated financial
statements which appears in the Annual Report to Shareholders, which is included
in this Annual Report on Form 10-K of Implant Sciences Corporation for the year
ended June 30, 2008.







/s/ UHY
LLP


Boston,
Massachusetts


October
14, 2008







Exhibit
31.1




CERTIFICATION




I,
Phillip C. Thomas, hereby certify that:




1.       I
have reviewed this Annual Report on Form 10-K of Implant Sciences Corporation
(the “Company”);




2.       Based
on my knowledge, this report does not contain any untrue statement of a material
fact or omit to state a material fact necessary to make the statements made, in
light of the circumstances under which such statements were made, not misleading
with respect to the period covered by this report;




3.       Based
on my knowledge, the financial statements, and other financial information
included in this report, fairly present in all material respects the financial
condition, results of operations and cash flows of the Company as of, and for,
the periods presented in this report;




4.       The
Company’s other certifying officer and I are responsible for establishing and
maintaining disclosure controls and procedures (as defined in Exchange Act Rules
13a-15(e) and 15d-15(e)) and internal control over financial reporting (as
defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Company and
have:




a.       Designed
such disclosure controls and procedures, or caused such disclosure controls and
procedures to be designed under our supervision, to ensure that material
information relating to the Company, including its consolidated subsidiaries, is
made known to us by others within those entities, particularly during the period
in which this report is being prepared;




b.       Designed
such internal control over financial reporting, or caused such internal control
over financial reporting to be designed under our supervision, to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles;




c.       Evaluated
the effectiveness of the Company’s disclosure controls and procedures and
presented in this report our conclusions about the effectiveness of the
disclosure controls and procedures, as of the end of the period covered by this
report based on such evaluation; and




d.       Disclosed
in this report any change in the Company’s internal control over financial
reporting that occurred during the Company’s fourth fiscal quarter that has
materially affected, or is reasonably likely to materially affect, the Company’s
internal control over financial reporting; and




5.       The
Company’s other certifying officers and I have disclosed, based on our most
recent evaluation of internal control over financial reporting, to the Company’s
auditors and the audit committee of the Company’s board of directors (or persons
performing the equivalent functions):




a.       All
significant deficiencies and material weaknesses in the design or operation of
internal controls over financial reporting which are reasonably likely to
adversely affect the Company’s ability to record, process, summarize and report
financial information; and




b.       Any
fraud, whether or not material, that involves management or other employees who
have a significant role in the Company’s internal control over financial
reporting.




Date:
October 14, 2008




/s/
      Phillip C. ThomasPhillip
      C. ThomasChairman,
      Chief Executive Officer(Principal
      Executive Officer)





Exhibit
31.2




CERTIFICATION




I, Glenn
D. Bolduc, hereby certify that:




1.       I
have reviewed this Annual Report on Form 10-K of Implant Sciences Corporation
(the “Company”);




2.       Based
on my knowledge, this report does not contain any untrue statement of a material
fact or omit to state a material fact necessary to make the statements made, in
light of the circumstances under which such statements were made, not misleading
with respect to the period covered by this report;




3.       Based
on my knowledge, the financial statements, and other financial information
included in this report, fairly present in all material respects the financial
condition, results of operations and cash flows of the Company as of, and for,
the periods presented in this report;




4.       The
Company’s other certifying officer and I are responsible for establishing and
maintaining disclosure controls and procedures (as defined in Exchange Act Rules
13a-15(e) and 15d-15(e)) and internal control over financial reporting (as
defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Company and
have:




a.       Designed
such disclosure controls and procedures, or caused such disclosure controls and
procedures to be designed under our supervision, to ensure that material
information relating to the Company, including its consolidated subsidiaries, is
made known to us by others within those entities, particularly during the period
in which this report is being prepared;




b.       Designed
such internal control over financial reporting, or caused such internal control
over financial reporting to be designed under our supervision, to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles;




c.       Evaluated
the effectiveness of the Company’s disclosure controls and procedures and
presented in this report our conclusions about the effectiveness of the
disclosure controls and procedures, as of the end of the period covered by this
report based on such evaluation; and




d.       Disclosed
in this report any change in the Company’s internal control over financial
reporting  that occurred during the Company’s fourth fiscal quarter
that has materially affected, or is reasonably likely to materially affect, the
Company’s internal control over financial reporting; and




5.       The
Company’s other certifying officers and I have disclosed, based on our most
recent evaluation of internal control over financial reporting, to the Company’s
auditors and the audit committee of the Company’s board of directors (or persons
performing the equivalent functions):




a.       All
significant deficiencies and material weaknesses in the design or operation of
internal controls over financial reporting which are reasonably likely to
adversely affect the small business issuer’s ability to record, process,
summarize and report financial information; and




b.      Any
fraud, whether or not material, that involves management or other employees who
have a significant role in the small business issuer’s internal control over
financial reporting.




Date:
      October 14, 2008/s/
      Glenn D. BolducGlenn
      D. BolducVice
      President and Chief Financial Officer










Exhibit
32.1




CERTIFICATION PURSUANT TO 18
U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY
ACT OF 2002




In
connection with the Annual Report of Implant Sciences Corporation., a
Massachusetts corporation (the “Company”), on Form 10-K for the fiscal year
ended June 30, 2008, as filed with the Securities and Exchange Commission on the
date hereof (the “Report”), I, Phillip C. Thomas, Chief Executive Officer and
President of the Company, hereby certify, pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the
best of my knowledge:




(1)                The
Report fully complies with the requirements of Section 13(a) or 15(d) of the
Securities Exchange Act of 1934; and




(2)                The
information contained in the Report fairly presents, in all material respects,
the financial condition and results of operations of the Company.




/s/
      Phillip C. ThomasPhillip
      C. ThomasChief
      Executive Officer and PresidentDate:
      October 14, 2008







This
certification accompanies each report of the Company on Form 10-Q and Form 10-K
pursuant to §906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the
extent required by the Sarbanes-Oxley Act of 2002, be deemed filed by the
Company for purposes of §18 of the Securities Exchange Act of 1934, as
amended.




A signed
original of this written statement required by §906 has been provided to the
Company and will be retained by the Company and furnished to the Securities and
Exchange Commission or its staff upon request.

















Exhibit
32.2




CERTIFICATION PURSUANT TO 18
U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY
ACT OF 2002




In
connection with the Annual Report of Implant Sciences Corporation, a
Massachusetts corporation (the “Company”), on Form 10-K for the fiscal year
ended June 30, 2008, as filed with the Securities and Exchange Commission on the
date hereof (the “Report”), I, Glenn D. Bolduc, the chief financial officer of
the Company, hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the best of
my knowledge:




(1)                The
Report fully complies with the requirements of Section 13(a) or 15(d) of the
Securities Exchange Act of 1934; and




(2)                The
information contained in the Report fairly presents, in all material respects,
the financial condition and results of operations of the Company.




/s/
      Glenn D. BolducGlenn
      D. BolducVice
      President and Chief Financial OfficerDate:
      October 14, 2008







This
certification accompanies each report of the Company on Form 10-Q and Form 10-K
pursuant to §906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the
extent required by the Sarbanes-Oxley Act of 2002, be deemed filed by the
Company for purposes of §18 of the Securities Exchange Act of 1934, as
amended.




A signed
original of this written statement required by §906 has been provided to the
Company and will be retained by the Company and furnished to the Securities and
Exchange Commission or its staff upon request.