**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

----

**FORM 10-KSB/A**

**(AmendmentNo. 1)**

**(Mark One)**

**x****        ****ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934.**

**For the fiscal year ended April 30, 2006**

**o****           ****TRANSITION REPORT UNDER SECTION13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

**For the transition period from               to             **

**Commission file number:  001-12531**

**ISONICS CORPORATION**

(Name of small business issuer in its charter)

| **California**                            |   | **77-0338561**       |
|-------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of          |   | (IRS Employer        |
| incorporation or  organization)           |   | Identification  No.) |
| ** **                                |   | ** **           |
| **5906  McIntyre Street**                 |   |                 |
| **Golden,  Colorado**                     |   | **80403**            |
| (Address of  principal executive offices) |   | (Zip Code)           |

 

Issuer’s telephonenumber:**  (303)279-7900**

Securitiesregistered pursuant to Section 12(b) of the Exchange Act:  **None**

Securities registeredpursuant to Section 12(g) of the Exchange Act:

**Common Stock, no par value**

**Class B Common Stock Warrants**

**Class C Common Stock Warrants**

(Title of Class)

##### Check whetherthe issuer is not required to file reports pursuant to Section 13 or 15(d) ofthe Exchange Act:   o

Check whether the issuer(1) filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past twelve (12) months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes x  No o

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

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act):

Yes o  No x

Registrant’srevenues for the fiscal year ended April 30, 2006 were $23,716,000.

The aggregatemarket value of the voting stock held by non-affiliates of the Registrant basedon the average bid and asked prices of the Registrant’s Common Stock on July21, 2006 was $19,236,176.

The number ofshares outstanding of the Registrant’s Common Stock, no par value, as of July21, 2006, was 46,358,044 shares.

No document isincorporated by reference into Part III of this Form 10-KSB.

Transitional Small Business Disclosure Format (check one):  Yes o  No x

 

----

**EXPLANATORY NOTE**

We are filing this AmendmentNo. 1 on Form 10-KSB/A (the “Amendment”) to our Annual Report on Form 10-KSBfor the fiscal year ended April 30, 2006, as filed with the Securities andExchange Commission on July 26, 2006.  The purpose of this Amendment is solely to file an audit opinion andconsent of Hein & Associates LLP which include a conforming signature, assuch original EDGARized opinion and consent as filed did not include conformingsignatures.  The audit opinion andconsent have not changed in any other manner and prior to filing the Form10-KSB on July 26, 2006, we received a physically-signed audit opinion andconsent from Hein & Associates LLP. In addition, as required by Rule 12b-15 under the Securities ExchangeAct of 1934, as amended, new certifications by our principal executive officerand principal financial officer are also filed as exhibits.

Except as described above, noother information contained in the original filing is amended hereby, and thisForm 10-KSB/A does not reflect events occurring after July 26, 2006, the dateof the original filing, or modify or update any other disclosures in the Form10-KSB for the fiscal year ended April 30, 2006.

**PART II**

**ITEM 7.  FINANCIAL STATEMENTS**

The information required by this item begins on page F-1 of Part III ofthis Report on Form 10-KSB/A and is incorporated into this part by reference.

**PART III**

**ITEM13.  EXHIBITS AND REPORTS ON FORM 8-K.**

(a)           Exhibits Pursuant toItem 601 of Regulation S-B:
| Exhibit  Number | ** ** | **Title**                                                 |
|-----------------|------------|-----------------------------------------------------------|
|            |       |                                                      |
| 23.10*          |       | Consent of Independent Registered Public Accounting  Firm |
| 31*             |       | Certification pursuant to Rule 13a-14(a)                  |
| 32*             |       | Certification pursuant to 18 U.S.C. §1350            |

 

----

*              Filed herewith.

2

----

**SIGNATURES**

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

September 25, 2006
| ** ** | **ISONICS CORPORATION,**                                            |
|------------|---------------------------------------------------------------------|
|       | a California Corporation                                            |
|       |
|       |
| By:        |  /s/ James E. Alexander                                        |   |
|       |  James E. Alexander                                            |
|       |  President, Chief Executive Officer and  Chairman of the Board |
|            |                                                                     |  |  |

 

3

----

**ISONICSCORPORATION AND SUBSIDIARIES**

**Index to FinancialStatements**
| Report  of Independent Registered Public Accounting Firm |   |   |
|----------------------------------------------------------|--------|--------|
| Consolidated Financial Statements                        |   |   |
| Consolidated  Balance Sheets                             |   |   |
| Consolidated  Statements of Operations                   |   |   |
| Consolidated  Statements of Stockholders’ Equity    |   |   |
| Consolidated  Statements of Cash Flows                   |   |   |
| Notes to  Consolidated Financial Statements              |   |   |

F-1

----

** **

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of DirectorsIsonics CorporationGolden, Colorado

We have audited the consolidated balance sheets ofIsonics Corporation and subsidiaries (the “Company”) as of April 30, 2006and 2005, and the related consolidated statements of operations, stockholders’equity and cash flows for each of the two years in the period ended April 30,2006. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provided a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Isonics Corporation and subsidiaries as of April 30, 2006 and2005, and the results of their operations and their cash flows for each of thetwo years in the period ended April 30, 2006, in conformity with U.S.generally accepted accounting principles.

/s/ Hein & Associates LLP

Denver, ColoradoJuly 19, 2006

F-2

----

**Isonics Corporation and Subsidiaries**

**CONSOLIDATED BALANCE SHEETS**

**(In thousands, exceptshare amounts)**
| ** **                                                                                                                                                                               | ** ** | **April 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                               | ** ** | **2006**           | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                                               | ** ** | ** **         | ** ** | ** ** | ** ** |
| CURRENT ASSETS:                                                                                                                                                                          |       |               |       |   |   |
| Cash and cash equivalents                                                                                                                                                                |       | $                  | 2,117      |   | $ | 21,206 |   |
| Accounts receivable (net of allowances of $67 and  $59, respectively)                                                                                                                    |       | 3,410              |       | 935 |   |
| Inventories                                                                                                                                                                              |       | 1,077              |       | 1,550 |   |
| Prepaid expenses and other current assets                                                                                                                                                |       | 1,142              |       | 153 |   |
| Assets held for sale                                                                                                                                                                     |       | 560                |       | — |   |
| Total current assets                                                                                                                                                                     |       | 8,306              |       | 23,844 |   |
| LONG-TERM  ASSETS:                                                                                                                                                                       |       |               |       |   |   |
| Property and equipment, net                                                                                                                                                              |       | 4,854              |       | 5,589 |   |
| Goodwill                                                                                                                                                                                 |       | 3,631              |       | — |   |
| Intangible assets, net                                                                                                                                                                   |       | 491                |       | 241 |   |
| Equity in net assets of investee                                                                                                                                                         |       | 386                |       | — |   |
| Other assets                                                                                                                                                                             |       | 195                |       | 1,507 |   |
| Total long-term assets                                                                                                                                                                   |       | 9,557              |       | 7,337 |   |
| TOTAL ASSETS                                                                                                                                                                             |       | $                  | 17,863     |   | $ | 31,181 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                            | ** ** | ** **         | ** ** | ** ** | ** ** |
| CURRENT  LIABILITIES:                                                                                                                                                                    |       |               |       |   |   |
| Accounts payable                                                                                                                                                                         |       | $                  | 2,175      |   | $ | 1,079 |   |
| Accrued liabilities                                                                                                                                                                      |       | 1,606              |       | 1,033 |   |
| Current portion of obligations under capital lease                                                                                                                                       |       | 14                 |       | 44 |   |
| Current portion of notes payable                                                                                                                                                         |       | 786                |       | 672 |   |
| Current portion of convertible debentures, net of  discount                                                                                                                              |       | 10,432             |       | 3,025 |   |
| Total current liabilities                                                                                                                                                                |       | 15,013             |       | 5,853 |   |
| Obligations  under capital lease, net of current portion                                                                                                                                 |       | 34                 |       | 47 |   |
| Notes payable,  net of current portion                                                                                                                                                   |       | 173                |       | 653 |   |
| Convertible  debentures, net of discount and of current portion                                                                                                                          |       | —             |       | 15,040 |   |
| TOTAL  LIABILITIES                                                                                                                                                                       |       | 15,220             |       | 21,593 |   |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                              |       |               |       |   |   |
| Preferred Stock; shares authorized: 2006—7,650,000;  2005—7,656,666                                                                                                            |       |               |       |   |   |
| Series A Convertible Preferred Stock—no par  value; shares issued and outstanding:  2006—zero; 2005—6,666; liquidation preference: 2006—zero; 2005—$10     |       | —             |       | 5 |   |
| Series D Convertible Preferred Stock—no par  value; shares issued and outstanding:  2006—zero; 2005—800; liquidation preference: 2006—zero; 2005—$80       |       | —             |       | 90 |   |
| Series E Convertible Preferred Stock—no par  value; shares issued and outstanding:  2006—zero; 2005—33,000; liquidation preference: 2006—zero; 2005—$3,300 |       | —             |       | 3,938 |   |
| Common stock—no par value; 75,000,000 shares  authorized; shares issued and outstanding:  2006—42,071,119; 2005—27,696,800                                                |       | 57,061             |       | 28,401 |   |
| Additional paid in capital                                                                                                                                                               |       | 13,910             |       | 13,080 |   |
| Deferred compensation                                                                                                                                                                    |       | (24                | )          | (64 | ) |
| Accumulated deficit                                                                                                                                                                      |       | (68,304            | )          | (35,862 | ) |
| Total stockholders’ equity                                                                                                                                                          |       | 2,643              |       | 9,588 |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                         |       | $                  | 17,863     |   | $ | 31,181 |   |

 

See Notes to Consolidated Financial Statements.

F-3

----

**IsonicsCorporation and Subsidiaries**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except per share amounts)**
| ** **                                              | ** ** | **Year Ended  April 30,** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                              | ** ** | **2006**                            | ** ** | **2005** | ** ** |
| Revenues                                                |       | $                                   | 23,716     |   | $ | 10,105 |   |
| Cost of revenues                                        |       | 22,729                              |       | 12,841 |   |
| Gross margin                                            |       | 987                                 |       | (2,736 | ) |
| Operating expenses:                                     |       |                                |       |   |   |
| Selling, general  and administrative                    |       | 11,859                              |       | 7,473 |   |
| Impairment loss  on assets held for sale                |       | 466                                 |       | — |   |
| Impairment of  goodwill and intangible assets           |       | —                              |       | 2,682 |   |
| Research and  development                               |       | 5,293                               |       | 1,271 |   |
| Total operating  expenses                               |       | 17,618                              |       | 11,426 |   |
| Operating loss                                          |       | (16,631                             | )          | (14,162 | ) |
| Other income (expense):                                 |       |                                |       |   |   |
| Amortization of  debt issuance costs                    |       | (1,260                              | )          | (166 | ) |
| Debt conversion  expense                                |       | (7,227                              | )          | — |   |
| Interest and  other income                              |       | 301                                 |       | 117 |   |
| Interest expense                                        |       | (7,554                              | )          | (1,000 | ) |
| Equity in net  income of investee                       |       | 30                                  |       | — |   |
| Foreign exchange                                        |       | —                              |       | 34 |   |
| Total other  income (expense), net                      |       | (15,710                             | )          | (1,015 | ) |
| Loss before income tax  benefit                         |       | (32,341                             | )          | (15,177 | ) |
| Income tax benefit                                      |       | —                              |       | — |   |
| NET LOSS                                                |       | (32,341                             | )          | (15,177 | ) |
| DEEMED DIVIDEND ON  PREFERRED STOCK                     |       | —                              |       | (1,206 | ) |
| DIVIDENDS ON SERIES E  CONVERTIBLE PREFERRED STOCK      |       | (101                                | )          | (132 | ) |
| NET LOSS ATTRIBUTABLE  TO COMMON STOCKHOLDERS           |       | $                                   | (32,442    | ) | $ | (16,515 | ) |
| **Net loss per common share—basic  and diluted**   | ** ** | ** **                          | ** ** | ** ** | ** ** |
| Net loss per  share attributable to common stockholders |       | $                                   | (1.00      | ) | $ | (.74 | ) |
| Shares used in  computing per share information         |       | 32,410                              |       | 22,383 |   |

 

See Notes to Consolidated Financial Statements.

F-4

----

 

**Isonics Corporation andSubsidiaries**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**(In thousands, except share amounts)**
| ** **                                                                                                         | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional  Paid in** | ** ** | **Deferred** | ** ** | **Accumulated** | ** ** | ** **       | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|------------------------------|------------|--------------|------------|-----------------|------------|------------------|------------|
| ** **                                                                                                         | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**                   | ** ** | **Amount**   | ** ** | **Capital**     | ** ** | **Compensation** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| Balances as of  April 30, 2004                                                                                |       | 1,005,616                |       | $                     | 5,613      |                         | 15,344,913 |         | $          | 14,817          |       | $                | 6,732      |   | $ | (104 | ) | $ | (19,347 | ) | $ | 7,711 |   |
| Exercise  of common stock warrants                                                                                 |       | —                   |       | —                |       | 5,366,201                    |       | 6,708        |       | —          |       | —           |       | — |   | 6,708 |   |
| Cashless  exercise of common stock warrants                                                                        |       | —                   |       | —                |       | 363,719                      |       | 45           |       | (45             | )          | —           |       | — |   | — |   |
| Common  stock issued in legal settlement                                                                           |       | —                   |       | —                |       | 4,257                        |       | 20           |       |            |       | —           |       | — |   | 20 |   |
| Exercise  of common stock options                                                                                  |       | —                   |       | —                |       | 93,000                       |       | 111          |       | —          |       | —           |       | — |   | 111 |   |
| Fair  value of common stock issued for the acquisition of the assets of  Encompass Materials Group, Ltd. |       | —                   |       | —                |       | 731,930                      |       | 1,171        |       | —          |       | —           |       | — |   | 1,171 |   |
| Issuance  of Series E Convertible Preferred Stock and related common  stock warrants                     |       | 33,000                   |       | 2,732                 |       | —                       |       | —       |       | 337             |       | —           |       | — |   | 3,069 |   |
| Deemed  dividend on preferred stock                                                                                |       | —                   |       | 1,206                 |       | —                       |       | —       |       | —          |       | —           |       | (1,206 | ) | — |   |
| Preferred  stock dividends                                                                                         |       | —                   |       | —                |       | —                       |       | —       |       | —          |       | —           |       | (132 | ) | (132 | ) |
| Conversion  of convertible preferred stock into common stock:                                                 |       |                     |       |                  |       |                         |       |         |       |            |       |             |       |   |   |   |   |
| Series A                                                                                                      |       | (957,000                 | )          | (740                  | )          | 1,914,000                    |       | 740          |       | —          |       | —           |       | — |   | — |   |
| Series C                                                                                                      |       | (9,000                   | )          | (1,141                | )          | 947,368                      |       | 1,141        |       | —          |       | —           |       | — |   | — |   |
| Series D                                                                                                      |       | (32,150                  | )          | (3,637                | )          | 2,922,726                    |       | 3,637        |       | —          |       | —           |       | — |   | — |   |
| Fair  value of common stock warrants issued to members of HSDC advisory board  for services                   |       | —                   |       | —                |       | —                       |       | —       |       | 669             |       | —           |       | — |   | 669 |   |
| Discount  on convertible debentures due to issuance of detachable warrants and  beneficial conversion feature |       | —                   |       | —                |       | —                       |       | —       |       | 5,245           |       | —           |       | — |   | 5,245 |   |
| Fair  value of common stock warrants issued to convertible debenture placement  agent                         |       | —                   |       | —                |       | —                       |       | —       |       | 142             |       | —           |       | — |   | 142 |   |
| Common  stock issued under Employee Stock Purchase Program                                                    |       | —                   |       | —                |       | 8,686                        |       | 11           |       | —          |       | —           |       | — |   | 11 |   |
| Amortization  of deferred compensation                                                                             |       | —                   |       | —                |       | —                       |       | —       |       | —          |       | 40               |       | — |   | 40 |   |
| Net  loss                                                                                                          |       | —                   |       | —                |       | —                       |       | —       |       | —          |       | —           |       | (15,177 | ) | (15,177 | ) |
| Balances as of  April 30, 2005                                                                                |       | 40,466                   |       | 4,033                 |       | 27,696,800                   |       | 28,401       |       | 13,080          |       | (64              | )          | (35,862 | ) | 9,588 |   |
| Exercise  of common stock warrants                                                                                 |       | —                   |       | —                |       | 1,012,511                    |       | 1,367        |       | —          |       | —           |       | — |   | 1,367 |   |
| Cashless  exercise of common stock warrants                                                                        |       | —                   |       | —                |       | 10,000                       |       | 13           |       | (13             | )          | —           |       | — |   | — |   |
| Fair  value of common stock warrants issued in legal settlements                                              |       | —                   |       | —                |       | —                       |       | —       |       | 110             |       | —           |       | — |   | 110 |   |
| Exercise  of common stock options                                                                                  |       | —                   |       | —                |       | 419,115                      |       | 356          |       | —          |       | —           |       | — |   | 356 |   |
| Fair  value of common stock issued for the acquisition of Protection Plus  Security Corporation               |       | —                   |       | —                |       | 706,527                      |       | 1,228        |       | —          |       | —           |       | — |   | 1,228 |   |
| Fair  value of extension of warrant expiration dates                                                               |       | —                   |       | —                |       | —                       |       | —       |       | 510             |       | —           |       | — |   | 510 |   |
| Common  stock issued in payment of interest due on convertible debentures                                     |       | —                   |       | —                |       | 451,604                      |       | 949          |       | —          |       | —           |       | — |   | 949 |   |
| Common  stock issued in payment of principal due on convertible debentures                                    |       | —                   |       | —                |       | 2,712,663                    |       | 4,313        |       | —          |       | —           |       | — |   | 4,313 |   |
| Conversion  of convertible debentures into common stock                                                            |       | —                   |       | —                |       | 6,206,897                    |       | 16,227       |       | —          |       | —           |       | — |   | 16,227 |   |
| Preferred  stock dividends                                                                                         |       | —                   |       | —                |       | —                       |       | —       |       | —          |       | —           |       | (101 | ) | (101 | ) |
| Conversion  of convertible preferred stock into common stock:                                                 |       |                     |       |                  |       |                         |       |         |       |            |       |             |       |   |   |   |   |
| Series D                                                                                                      |       | (800                     | )          | (90                   | )          | 72,727                       |       | 90           |       | —          |       | —           |       | — |   | — |   |
| Series E                                                                                                      |       | (33,000                  | )          | (3,938                | )          | 2,661,290                    |       | 3,938        |       | —          |       | —           |       | — |   | — |   |
| Redemption  of Series A Convertible Preferred Stock                                                      |       | (6,666                   | )          | (5                    | )          | —                       |       | —       |       | (5              | )          | —           |       | — |   | (10 | ) |
| Fair  value of common stock warrants issued for services                                                           |       | —                   |       | —                |       | —                       |       | —       |       | 228             |       | —           |       | — |   | 228 |   |
| Fair  value of common stock issued for services                                                                    |       | —                   |       | —                |       | 100,000                      |       | 140          |       | —          |       | —           |       | — |   | 140 |   |
| Common  stock issued under Employee Stock Purchase Program                                                    |       | —                   |       | —                |       | 20,985                       |       | 39           |       | —          |       | —           |       | — |   | 39 |   |
| Amortization  of deferred compensation                                                                             |       | —                   |       | —                |       | —                       |       | —       |       | —          |       | 40               |       | — |   | 40 |   |
| Net  loss                                                                                                          |       | —                   |       | —                |       | —                       |       | —       |       | —          |       | —           |       | (32,341 | ) | (32,341 | ) |
| Balances as of April 30, 2006                                                                                 |       | —                   |       | $                     | —     |                         | 42,071,119 |         | $          | 57,061          |       | $                | 13,910     |   | $ | (24 | ) | $ | (68,304 | ) | $ | 2,643 |   |

 

See Notes to Consolidated Financial Statements.

F-5

----

 

**Isonics Corporation andSubsidiaries**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In thousands)**
| ** **                                                                                                                     | ** ** | **Year Ended  April 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                     | ** ** | **2006**                            | ** ** | **2005** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                                                         |       |                                |       |   |   |
| Net loss                                                                                                                       |       | $                                   | (32,341    | ) | $ | (15,177 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:                                                   |       |                                |       |   |   |
| Depreciation and  amortization of intangible assets                                                                            |       | 1,677                               |       | 1,193 |   |
| Amortization of  debt discount and debt issuance costs                                                                         |       | 6,939                               |       | 732 |   |
| Debt conversion  expense                                                                                                       |       | 7,227                               |       | — |   |
| Interest paid in  shares of common stock                                                                                       |       | 949                                 |       | — |   |
| Impairment of  goodwill and intangible assets                                                                                  |       | —                              |       | 2,682 |   |
| Impairment of  property and equipment (including assets held for sale)                                                         |       | 498                                 |       | — |   |
| Accounting  charge for extension of warrant expiration dates                                                                   |       | 510                                 |       | — |   |
| Fair value of  common stock and warrants issued for services, amortization of deferred  compensation and legal settlement |       | 355                                 |       | 729 |   |
| Equity in net  income of investee                                                                                              |       | (30                                 | )          | — |   |
| Changes in  operating assets and liabilities:                                                                                  |       |                                |       |   |   |
| Accounts  receivable                                                                                                           |       | (1,087                              | )          | 225 |   |
| Inventories                                                                                                                    |       | 473                                 |       | (284 | ) |
| Prepaid expenses  and other current assets                                                                                     |       | (858                                | )          | 4 |   |
| Accounts payable                                                                                                               |       | 688                                 |       | 201 |   |
| Accrued  liabilities                                                                                                           |       | (410                                | )          | 332 |   |
| Net cash used in  operating activities                                                                                         |       | (15,410                             | )          | (9,363 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                                         |       |                                |       |   |   |
| Purchases of  property and equipment                                                                                           |       | (1,700                              | )          | (3,741 | ) |
| Equity  investment in a business                                                                                               |       | (336                                | )          | — |   |
| Acquisition of  assets of a business, net of cash acquired                                                                     |       | (2,468                              | )          | (49 | ) |
| Net cash used in  investing activities                                                                                         |       | (4,504                              | )          | (3,790 | ) |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                                                                         |       |                                |       |   |   |
| Principal  payments under capital lease obligations                                                                            |       | (44                                 | )          | (64 | ) |
| Principal  payments on borrowings                                                                                              |       | (791                                | )          | (375 | ) |
| Proceeds from  the issuance of preferred stock and related warrants                                                            |       | —                              |       | 3,069 |   |
| Proceeds from  the issuance of convertible debentures and related warrants                                                     |       | —                              |       | 21,340 |   |
| Proceeds from  issuance of common stock                                                                                        |       | 1,761                               |       | 6,830 |   |
| Preferred stock  dividends                                                                                                     |       | (101                                | )          | (132 | ) |
| Net cash  provided by financing activities                                                                                     |       | 825                                 |       | 30,668 |   |
| NET (DECREASE)  INCREASE IN CASH AND CASH EQUIVALENTS                                                                          |       | (19,089                             | )          | 17,515 |   |
| Cash and cash  equivalents at beginning of year                                                                                |       | 21,206                              |       | 3,691 |   |
| Cash and cash equivalents at end of year                                                                                       |       | $                                   | 2,117      |   | $ | 21,206 |   |

 

See Notes to Consolidated Financial Statements.

F-6

----

**Isonics Corporation and Subsidiaries**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1—ORGANIZATION AND SIGNIFICANT ACCOUNTINGPOLICIES**

**Organization**

We are an advanced materials and technology companyfocused on the development and provision of homeland security products andservices, the manufacture and reclamation of silicon wafers and the manufactureof silicon-on-insulator (“SOI”) wafers to the semiconductor industry and thesupply of isotopes for life sciences and health-care applications. The consolidatedfinancial statements (the “financial statements”) include our accounts andthose of our wholly-owned subsidiaries, including: Protection Plus SecurityCorporation (“PPSC”), Isonics Homeland Security and Defense Corporation (“HSDC”),Isonics Vancouver, Inc. (“IVI”), Chemotrade GmbH (“Chemotrade”) and IUTDetection Technologies, Inc. (“IUTDT”).

We incurred significant losses from operations for thefiscal years presented and, as of April 30, 2006, have a working capitaldeficit of $6,707,000. Additionally, barring a restructuring of our company, itis likely that we will also incur operating losses in fiscal year 2007 as wecontinue to fund research and development of new and existing products andcover operating costs. Should losses be greater than anticipated, we mayencounter liquidity problems which could require us to curtail developmentprojects, seek joint venture partners, sell assets and/or obtain additionalfinancing with terms that may not be as favorable as might otherwise beavailable. However, subsequent to year end (see Note 17) we raised additionalfinancing, through long-term debt with a single investor, in the amount of$13,000,000. That investor has committed an additional $3,000,000 pending thesuccessful registration with the Securities and Exchange Commission of thesecurities underlying the convertible debentures issued. We believe that basedon our financial position at April 30, 2006, the subsequent financing(including the additional $3 million commitment by the investor) and our projectionsof future operations, we will be able to continue operations into fiscal year2008.

**Principles ofConsolidation**

These financial statements have been prepared inconformity with accounting principles generally accepted in the United Statesof America. Intercompany accounts and transactions have beeneliminated in consolidation.

**Use of Estimatesin the Financial Statements**

In preparing financial statements in conformity withaccounting principles generally accepted in the United States of America, weare required to make estimates and assumptions that affect the amounts reportedin the financial statements and accompanying notes, including those related toimpairment of goodwill and intangible assets, impairment of equity investmentsand assets held for sale, recoverability of inventory and accounts receivable,the recording of various accruals, the useful lives of long-lived assets,income tax and potential losses from contingencies. These estimates are basedupon management’s best findings, after considering past and current events andassumptions about future events. Actual results could differ from thoseestimates.

**Cash Equivalents**

Cash equivalents include investments purchased with anoriginal maturity of less than ninety days.

F-7

----

**Concentration of CreditRisk**

The majority of our cash is maintained with one majorbank headquartered in the United States and our cash equivalents are primarilyheld with one major financial institution. Cash balances with the bank exceedthe amount of insurance provided on such deposits. Cash balances held inforeign bank accounts, $531,000 and $608,000 at April 30, 2006 and 2005,respectively, are subject to local banking laws and may bear higher or lowerrisk than cash deposited in the United States. We periodically evaluate thecredit standing of the financial institutions and we have not sustained anycredit losses from instruments held at these financial institutions.

Financial instruments that potentially subject us toconcentrations of credit risk consist principally of trade receivables, forwhich our accounting policies are discussed in *AccountsReceivable*.

**AccountsReceivable**

The majority of our accounts receivable are due fromcustomers of our security services segment and our semiconductor products andservices segment. Credit is extended based on evaluation of a customer’sfinancial condition and, generally, collateral is not required. Accountsreceivable are generally due within 30 days and are stated at amounts due fromcustomers net of an allowance for doubtful accounts. Accounts outstandinglonger than the contractual payment terms are considered past due. We determineour allowance by considering a number of factors, including length of timetrade accounts receivable are past due, our previous loss history, our customer’scurrent ability to pay their obligation to us and the condition of the generaleconomy and the industry as a whole. We write-off accounts receivable when theybecome uncollectible, and payments subsequently received on such receivablesare credited to the allowance for doubtful accounts. Interest accrues beginningon the day after the due date of the receivable. Interest accruals arediscontinued on accounts past due 90 days or more, and all interest previouslyaccrued but not collected is reversed against current interest income. Interestincome is subsequently recognized on these accounts only to the extent cash isreceived, or when the future collection of interest and the receivable balanceis considered probable by management.

**Inventories**

Inventories are stated at the lower of cost (first-in,first-out) or market. We perform periodic assessments to determine theexistence of obsolete, slow moving and non-salable inventories, and recordprovisions to reduce such inventories to net realizable value when necessary.

**Property andEquipment**

Property and equipment are stated at cost.Depreciation is computed using the straight-line method over the estimateduseful lives of the assets.  Theestimated useful lives for office furniture and equipment range from three toseven years, for production equipment range from three to seven years and forvehicles are three years.  Leaseholdimprovements are depreciated over the shorter of their estimated useful livesor the lease term.

**Goodwill and OtherIntangible Assets**

Goodwill is recorded when the purchase price paid foran acquisition exceeds the estimated fair value of the net identified tangibleand intangible assets acquired. Goodwill is not amortized, but instead istested for impairment at the reporting unit level annually during our fiscalthird quarter or more frequently

F-8

----

if the presence ofcertain circumstances indicates that impairment may have occurred. Theimpairment review process compares the fair value of the reporting unit inwhich goodwill resides to its carrying value. If the carrying amount of areporting unit exceeds its fair value, then the amount of the impairment lossmust be measured. The impairment loss would be calculated by comparing theimplied fair value of reporting unit goodwill to its carrying amount. Incalculating the implied fair value of reporting unit goodwill, the fair valueof the reporting unit is allocated to all of the other assets and liabilitiesof that unit based on their fair values. The excess of the fair value of areporting unit over the amount assigned to its other assets and liabilities isthe implied fair value of goodwill. An impairment loss would be recognized whenthe carrying amount of goodwill exceeds its implied fair value (see Note 3).

Acquired identified intangible assets (other thangoodwill) are amortized on a straight-line basis over the periods of benefit,ranging from three to ten years. We evaluate the recoverability of identifiableintangible assets whenever events or changes in circumstances indicate that anintangible asset’s carrying amount may not be recoverable. We measure thecarrying amount of the asset against the estimated undiscounted future cashflows associated with it. Should the sum of the expected future net cash flowsbe less than the carrying value of the asset being evaluated, an impairmentloss would be recognized. The impairment loss would be calculated as the amountby which the carrying value of the asset exceeds its fair value (see Note 3).

**Equity MethodInvestments**

Investee companies that are not consolidated, but overwhich we exercise significant influence, are accounted for under the equitymethod of accounting. Whether or not we exercise significant influence withrespect to an investee depends on an evaluation of several factors including,among others, representation on the investee company’s board of directors andownership level, which is generally a 20% to 50% interest in the votingsecurities of the investee company. Under the equity method of accounting, ourshare of the earnings or losses of the investee company is recognized and isreflected in the consolidated statements of operation in the caption “Equity innet income of investee.”  The carryingvalue of the investment is reflected in the condensed consolidated balancesheet in the caption “Equity in net assets of investee.”  We evaluate the recoverability of equitymethod investments whenever events or changes in circumstance indicate that itscarrying amount may not be recoverable. A loss in value which is deemed otherthan temporary would result in recognition of an impairment loss.

**Debt IssuanceCosts**

Debt issuance costs are capitalized, included in otherassets and amortized over the term of the related debt issuance using theeffective interest method. If the underlying debt instrument related to thedebt issuance costs is a convertible debenture, upon conversion of suchinstrument by its holder the related unamortized debt issuance cost would berecognized as an expense immediately upon conversion.

**Long-Lived Assets**

Our policy is to record long-lived assets at cost,amortizing these costs over the expected useful lives of the related assets. Inaccordance with Statement of Financial Accounting Standards (“SFAS”)No. 144 *Accounting for the Impairmentor Disposal of Long-Lived Assets*, these assets are reviewed on aperiodic basis for impairment whenever events or changes in circumstancesindicate that the carrying amounts of the assets may not be realizable.Furthermore, assets held and used in operations are evaluated for continuingvalue and proper useful lives by comparison to expected undiscounted futurecash flows. If

F-9

----

impairment has occurred,it is calculated based on the difference between the asset’s carrying value andthe underlying discounted future cash flows it is expected to generate.

**Income Taxes**

We account for income taxes using an asset andliability approach for financial accounting and reporting purposes. A valuationallowance is provided when, based on the weight of available evidence, it ismore likely than not that some portion or all of the deferred tax assets willnot be realized.

**RevenueRecognition**

We recognize revenue when the following criteria aremet: 1) persuasive evidence of an arrangement exists; 2) delivery has occurredor services have been rendered; 3) the sales price is fixed or determinable;and 4) collectibility is probable. Revenue from product sales is recognizedupon shipment if all other revenue recognition criteria have been met.Customers are not granted return rights for reasons other than warranty claimsand product returns have not been material in any period. Revenue for siliconwafer reclamation services is recognized when all services have been renderedand the reclaimed wafer is shipped back to the customer, if all other revenuerecognition criteria have been met. Revenue for security services is recognizedupon delivery of the services, if all other revenue recognition criteria havebeen met.

**Warranty**

We accrue for our product warranty costs at the timeof shipment. Product warranty costs are estimated based upon our historicalexperience and specific identification of the products’ requirements. Warrantycosts have not been material in any period.

**Shipping Costs**

Our shipping and handling costs for product sales areincluded in cost of sales for all periods presented.

**Research andDevelopment Expenditures**

Costs related to the research, design, and developmentof products are charged to research and development expenses as incurred.

**Fair Values ofFinancial Instruments**

The fair value of cash and cash equivalents, tradereceivables, trade payables and capital lease obligations approximates carryingvalue due to the short maturity of such instruments.

**Translation ofForeign Currencies**

We conduct substantially all of our transactions inU.S. dollars, except for certain transactions of Chemotrade that are conductedin Euros. The financial statements of Chemotrade are prepared in Euros andremeasured into U.S. dollars for purposes of consolidation, with the U.S.dollar as the functional currency. Gains and losses from remeasurement andtransaction gains and losses are included in the statement of operations.

F-10

----

**Accounting for Stock-Based Compensation**

We account for stock-based compensation to employeesand directors using the intrinsic value method in accordance with AccountingPrinciples Board Opinion No. 25, *Accounting for StockIssued to Employees*andrelated interpretations, as permitted by SFAS No. 123 *Accounting for Stock-Based Compensation*, as amended by SFAS No. 148 *Accounting for Stock-based Compensation—Transition and Disclosure*. Compensation expense for stockoptions is measured as the excess, if any, of the quoted market price of ourstock at the date of grant over the amount an employee must pay to acquire thestock. No stock-based employee compensation costs relating to options isreflected within our net loss as all options granted had an exercise priceequal to or greater than the market value of the underlying common stock on thedate of grant (though we have recognized expense for warrants granted toexternal parties for services as disclosed in Note 12). We record compensationexpense for restricted stock awards based on the quoted market price of ourstock at the date of the grant and the vesting period.

The followingtable illustrates the effect on net loss and net loss per share if we hadapplied the fair value recognition provisions of SFAS No. 123 tostock-based compensation (in thousands, except per share data):
|                                                                                                                                           | ** ** | **Year Ended  April 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                | ** ** | **2006**                            | ** ** | **2005** | ** ** |
| Net loss  attributable to common stockholders, as reported                                                                                |       | $                                   | (32,442    | ) | $ | (16,515 | ) |
| Add: stock-based  compensation costs included in reported net loss, net of tax effects                                               |       | 245                                 |       | 709 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (1,362                              | )          | (1,759 | ) |
| Adjusted net loss  attributable to common stockholders                                                                                    |       | $                                   | (33,559    | ) | $ | (17,565 | ) |

 
|                                                                           | ** ** | **Year Ended  April 30,** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                            | ** ** | **2005** | ** ** |
| Basic and  diluted net loss per share attributable to common stockholders |       |                                |       |   |   |
| As reported                                                               |       | $                                   | (1.00      | ) | $ | (.74 | ) |
| Adjusted                                                                  |       | $                                   | (1.04      | ) | $ | (.78 | ) |

 

**Net Loss Per Share**

Basic net loss per share is computed using theweighted average number of common shares outstanding during the period.Contingently issuable shares are included in the computation of basic netincome (loss) per share when the related conditions are satisfied. Diluted netincome (loss) per share is computed using the weighted average number of commonshares and potentially dilutive securities outstanding during the period.Potentially dilutive securities consist of contingently issuable shares, theincremental common shares issuable upon conversion of preferred stock orconvertible debt (using the “if converted” method) and shares issuable upon theexercise of stock options and warrants (using the “treasury stock” method).Potentially dilutive securities are excluded from the computation if theireffect is anti-dilutive.

F-11

----

As of April 30,2006, (a) a total of 2,933,932 outstanding stock options, (b) a totalof 5,005,010 outstanding common stock warrants and (c) the unissued sharesunderlying our outstanding convertible debentures were excluded from thediluted net loss per share calculations, as their inclusion would be anti-dilutive.As of April 30, 2005, (a) a total of 2,846,647 outstanding stockoptions, (b) a total of 5,404,510 common stock warrants, (c) 6,666,800 and 33,000 outstanding shares of Series A, D and E ConvertiblePreferred Stock, respectively, and (d) the unissued shares underlying ouroutstanding convertible debentures were excluded from the diluted net loss pershare calculations, as their inclusion would be anti-dilutive.

**Recently IssuedAccounting Standards**

In December 2004, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 123 (revised 2004) *Share-Based Payments*(“SFAS 123(R)”). Thisstatement requires that we record all share-based payment expense in ourfinancial statements based on a fair value methodology.  On April 14, 2005, the Securities andExchange Commission (“SEC”) announced amended compliance dates forSFAS 123(R). The SEC previously required companies to adopt this standardno later than July 1, 2005, but the new rules now require us to adoptFAS 123(R) starting with our first quarter of our fiscal year beginningMay 1, 2006. Additionally, in March 2005, the SEC issued StaffAccounting Bulletin No. 107 (SAB No. 107), which summarizes the staff’sviews regarding share-based payment arrangements for public companies. We areevaluating the impact of the new standards and, although we have not completedour analysis, we anticipate that the expense would not exceed the amountsdisclosed in *Accounting for Stock-BasedCompensation*had we been expensing under the new rule.

In September 2005, the FASB ratified theconsensus reached by the Emerging Issues Task Force (“EITF”) on EITF IssueNo. 05-08 *Income Tax Consequencesof Issuing Convertible Debt with a Beneficial Conversion Feature*(“EITF05-08”). The EITF consensus noted that for the purpose of applyingSFAS No. 109, Accounting for Income Taxes, (1) the issuance ofconvertible debt with a beneficial conversion feature results in a basisdifference, (2) the basis difference is a temporary difference and(3) the recognition of deferred taxes for the temporary difference of theconvertible debt with a beneficial conversion feature should be recorded as anadjustment to additional paid-in capital. The EITF also reached a consensusthat the guidance in EITF 05-08 should be applied to financial statementsbeginning in the first interim or annual reporting period beginning afterDecember 15, 2005. The guidance should be applied by retrospectiveapplication pursuant to SFAS No. 154, Accounting Changes and ErrorCorrections, to all instruments with a beneficial conversion feature accountedfor under EITF Issue No. 00-27, *Application of IssueNo. 98-5 to Certain Convertible Instruments*. The adoptionof EITF 05-08 has not had a material impact on our consolidated financialstatements.

In September 2005, the FASB ratified theconsensus reached by the EITF on EITF Issue No. 05-07 *Accounting for Modifications to Conversion OptionsEmbedded in Debt Instruments and Related Issues* (“EITF 05-07”).The EITF consensus requires that, when a modification of a convertible debtinstrument results in a change in the fair value of an embedded conversionoption, the change in fair value of the embedded conversion option be includedin the analysis of whether there has been a substantial change in the terms ofthe convertible debt instrument for purposes of determining whether the debthas been extinguished. The consensus also requires subsequent recognition ofinterest expense for any change in the fair value of the embedded conversionoption resulting from a modification of a convertible debt instrument. EITF 05-07is effective beginning in the first interim or annual reporting periodbeginning

F-12

----

after December 15,2005. We do not expect the adoption of EITF 05-07 to have an impact onour results of operations or financial condition.

In September 2005, the FASB staff reported thatthe EITF postponed further deliberations on Issue No. 05-04 *The Effect of a Liquidated Damages Clause on aFreestanding Financial Instrument Subject to Issue No. 00-19*(“EITF 05-04”) pending the FASB reaching a conclusion as to whether aregistration rights agreement meets the definition of a derivative instrument.The legal agreements related to our 8% Convertible Debentures include afreestanding registration rights agreement. Once the FASB ratifies thethen-completed consensus of the EITF on EITF 05-04, we will assess theimpact on our consolidated financial statements of adopting the standard and,if an impact exists, follow the transition guidance for implementation.

In February 2006, the FASB issuedSFAS No. 155, *Accounting for CertainHybrid Financial Instruments* (“SFAS 155”), which amendsSFAS No. 133, *Accounting for DerivativeInstruments and Hedging Activities* and SFAS No. 140, *Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities*. SFAS 155 simplifies theaccounting for certain derivatives embedded in other financial instruments byallowing them to be accounted for as a whole if the holder elects to accountfor the whole instrument on a fair value basis. The statement also clarifiesand amends certain other provisions of SFAS No. 133 andSFAS No. 140. SFAS 155 is effective for all financialinstruments acquired, issued, or subject to a remeasurement event occurring infiscal years beginning after September 15, 2006. We do not expect theadoption of SFAS 155 to have an impact on our results of operations orfinancial condition.

In March 2006, the FASB issuedSFAS No. 156, *Accounting forServicing of Financial Assets—an amendment to FASB Statement No. 140*(“SFAS 156”). SFAS 156 requires that all separately recognized servicingrights be initially measured at fair value, if practicable. In addition, thisstatement permits an entity to choose between two measurement methods(amortization method or fair value measurement method) for each class ofseparately recognized servicing assets and liabilities. This new accountingstandard is effective January 1, 2007. We do not expect the adoption ofSFAS 156 to have an impact on our results of operations or financialcondition.

In June 2006, the FASB ratified the consensusreached by the EITF on EITF Issue No. 05-01, *Accounting for the Conversion of an Instrument ThatBecomes Convertible Upon the Issuer’s Exercise of a Call Option*(“EITF05-01”). The EITF consensus applies to the issuance of equity securitiesto settle a debt instrument that was not otherwise currently convertible butbecame convertible upon the issuer’s exercise of call option when the issuanceof equity securities is pursuant to the instrument’s original conversion terms.The adoption of EITF 05-01 is not expected to have an impact on ourresults of operations or financial condition.

In July 2006, the FASB issued InterpretationNo. 48, *Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109 (“FIN 48”).*Thisinterpretation clarifies the application of SFAS 109 by defining a criterionthan an individual tax position must meet for any part of the benefit of thatposition to be recognized in an enterprise’s financial statements and alsoprovides guidance on measurement, derecognition, classification, interest andpenalties, accounting in interim periods and disclosure. FIN 48 is effectivefor our fiscal year commencing May 1, 2007. At this time, we have not completedour review and assessment of the impact of adoption of FIN 48.

F-13

----

**NOTE 2—FINANCIAL STATEMENT COMPONENTS**

Inventoriesconsist of the following (in thousands):
|                         | ** ** | **April 30,** | ** ** |
|-------------------------|------------|--------------------|------------|
| ** **              | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Finished goods          |       | $                  | 604        |   | $ | 565 |   |
| Work in process         |       | 40                 |       | 701 |   |
| Materials and  supplies |       | 433                |       | 284 |   |
|                    |       | $                  | 1,077      |   | $ | 1,550 |   |

 

Property and equipment consists of the following (inthousands):
|                                            | ** ** | **April 30,** | ** ** |
|--------------------------------------------|------------|--------------------|------------|
| ** **                                 | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Office furniture  and equipment            |       | $                  | 322        |   | $ | 264 |   |
| Production  equipment                      |       | 5,941              |       | 5,579 |   |
| Vehicles                                   |       | 175                |       | — |   |
| Construction in  process                   |       | 608                |       | 814 |   |
| Leasehold  improvements                    |       | 653                |       | 396 |   |
|                                       |       | 7,699              |       | 7,053 |   |
| Accumulated  depreciation and amortization |       | (2,845             | )          | (1,464 | ) |
|                                       |       | $                  | 4,854      |   | $ | 5,589 |   |

 

Depreciation expense for the years endedApril 30, 2006 and 2005, was $1,496,000 and $1,106,000, respectively. Suchamounts include amortization on equipment under capital lease of $23,000 and$50,000 for the years ended April 30, 2006 and 2005, respectively.

Supplementaldisclosure of non-cash investing and financing activities (in thousands):
|                                                                                                                            | ** ** | **Year Ended  April 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                 | ** ** | **2006**                            | ** ** | **2005** | ** ** |
| Deemed dividends  associated with beneficial conversion feature on issued Preferred Stock                                  |       | $                                   | —     |   | $ | 1,206 |   |
| Capital lease  obligations for property and equipment                                                                      |       | $                                   | —     |   | $ | 70 |   |
| Capitalized debt  issuance costs associated with issuance of convertible debenture and common  stock warrants for services |       | $                                   | —     |   | $ | 887 |   |
| Stock issued in  connection with an acquisition                                                                            |       | $                                   | 1,228      |   | $ | 1,171 |   |
| Note payable  issued in connection with an acquisition                                                                     |       | $                                   | —     |   | $ | 1,700 |   |
| Payment of  principal due on convertible debentures in common stock                                                        |       | $                                   | 4,313      |   | $ | — |   |
| Note payable issued for  equipment                                                                                         |       | $                                   | 49         |   | $ | — |   |

 

In the year ended April 30, 2006, we also issued10,000 shares of common stock in a cashless exercise of a common stock warrant,issued 2,734,017 shares of common stock upon conversion of convertiblepreferred stock and issued 6,206,897 shares of common stock upon conversion ofconvertible debentures. In the year ended April 30, 2005, we also issued 363,719shares of common stock in cashless exercises of

F-14

----

common stock warrants andissued 5,784,094 shares of common stock upon conversion of convertiblepreferred stock.

Supplementaldisclosures of cash flow information (in thousands):
|                                   | ** ** | **Year Ended  April 30,** | ** ** |
|-----------------------------------|------------|-------------------------------------|------------|
| ** **                        | ** ** | **2006**                            | ** ** | **2005** | ** ** |
| Cash paid during  the period for: |       |                                |       |   |   |
| Interest                          |       | $                                   | 850        |   | $ | 276 |   |
| Income taxes                      |       | $                                   | —     |   | $ | — |   |

 

**NOTE 3—GOODWILLAND OTHER INTANGIBLE ASSETS**

**Goodwill**

Changes in thecarrying amount of goodwill, by reportable segment, are as follows (inthousands):
|                                    | ** ** | **Homeland  security  products** | ** ** | **Security  services** | ** ** | **Semiconductor  products  and  services** | ** ** | **Life  sciences** | ** ** | **Total** | ** ** |
|------------------------------------|------------|----------------------------------|------------|------------------------|------------|--------------------------------------------|------------|--------------------|------------|-----------|------------|
| Balance as of  April 30, 2004 |       | $                                | —     |                   | $          | —                                     |       | $                  | —     |      | $          | 1,807 |   | $ | 1,807 |   |
| Goodwill acquired during the year  |       | —                           |       | —                 |       | 447                                        |       | —             |       | 447       |       |
| Impairments                        |       | —                           |       | —                 |       | (447                                       | )          | (1,807             | )          | (2,254    | )          |
| Balance as of  April 30, 2005 |       | —                           |       | —                 |       | —                                     |       | —             |       | —    |       |
| Goodwill acquired during the year  |       | —                           |       | 3,631                  |       | —                                     |       | —             |       | 3,631     |       |
| Impairments                        |       | —                           |       | —                 |       | —                                     |       | —             |       | —    |       |
| Balance as of  April 30, 2006 |       | $                                | —     |                   | $          | 3,631                                      |       | $                  | —     |      | $          | — |   | $ | 3,631 |   |

 

The goodwill acquired during the year endedApril 30, 2006, relates to our acquisition of PPSC in May 2005 (seeNote 4).

Goodwill related to the life sciences reportablesegment resulted from the acquisition of Chemotrade in 1998 and was tested forimpairment annually in our fiscal fourth quarter. Due to significant marketpricing pressures on certain products (including oxygen-18) in the lifesciences segment and to changes to other strategic initiatives, the cash flowforecast for the life sciences reportable segment was revised downward fromprior forecasts to a lower positive cash flow level. In April 2005, wedetermined that the $1,807,000 of goodwill associated with this businesssegment had been impaired and the entire goodwill amount was written off toimpairment of goodwill and intangible assets. The fair value of the reportingunit was estimated using the expected present value of future cash flows.

Goodwill related to the semiconductor products andservices reportable segment resulted from the acquisition of the silicon wafermanufacturing and reclamation assets of Encompass Materials Group, Ltd. (“EMG,”see Note 4) in June 2004. Due to significant operating losses of thesegment subsequent to the acquisition, we determined that there had been asignificant adverse change to that acquired business. We determined that the$447,000 of goodwill associated with this business segment had been impairedand as a result, the entire amount of goodwill was written off to impairment ofgoodwill and intangible assets during the year ended April 30, 2005. Thefair value of the reporting unit was estimated using the expected present valueof future cash flows.

F-15

----

**Other Intangible Assets**

Informationregarding our intangible assets (other than goodwill) is as follows (inthousands):
|                                                         | ** ** | **April 30,** | ** ** |
|---------------------------------------------------------|------------|--------------------|------------|
| ** **                                              | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Gross carrying  amount:                                 |       |               |       |   |   |
| Trace and bulk detection technology                     |       | $                  | 273        |   | $ | 273 |   |
| Customer lists—Semiconductor products and services |       | 50                 |       | 50 |   |
| Customer base—Security services                    |       | 431                |       | — |   |
|                                                    |       | 754                |       | 323 |   |
| Accumulated  amortization:                              |       |               |       |   |   |
| Trace and bulk detection technology                     |       | (93                | )          | (67 | ) |
| Customer lists—Semiconductor products and services |       | (32                | )          | (15 | ) |
| Customer base—Security services                    |       | (138               | )          | — |   |
|                                                    |       | (263               | )          | (82 | ) |
|                                                    |       | $                  | 491        |   | $ | 241 |   |

 

The customer base intangible asset acquired during theyear ended June 30, 2006, relates to our acquisition of PPSC inMay 2005 (see Note 4).

On September 14, 2001 we entered into aperpetual, exclusive technology license agreement with SiliconEvolution, Inc. (“SEI”) whereby we issued 500,000 shares of common stock(valued at $590,000) for the right to indefinitely use intellectual propertyassets owned or leased by SEI. In our fiscal year 2005 and in connection withour ongoing business review of our semiconductor operations, we determined thatover the years SOI technology had been substantially modified to adapt to ourcurrent manufacturing plant and that the current processes are substantiallyremoved from those acquired from SEI. As a result, an impairment loss for thethen unamortized balance of $428,000 was recognized in the impairment ofgoodwill and intangible assets caption during the year ended April 30,2005. The estimated fair value was determined using the expected present valueof future cash flows. The impaired intangible asset relates to thesemiconductor products and services reportable segment.

Amortizationexpense for the years ended April 30, 2006 and 2005, was $181,000 and$87,000, respectively. Estimated amortization expense for the intangible assetson our April 30, 2006 balance sheet for the fiscal years endedApril 30, is as follows (in thousands):
| 2007   |   | $   | 188    |   |
|--------|--------|-----|--------|--------|
| 2008   |   | 172 |   |
| 2009   |   | 34  |   |
| 2010   |   | 27  |   |
| 2011   |   | 27  |   |
|   |   | $   | 448    |   |

 

F-16

----

**NOTE 4—SIGNIFICANTACQUISITIONS AND COMBINATIONS**

**Acquisition ofBusiness and Assets of Encompass Materials Group, Ltd.**

On June 11, 2004, we acquired the business andassets of EMG, which was engaged in the business of manufacture and reclamationof silicon wafers. The results of the operations associated with the acquiredassets have been included in the consolidated financial statements since thatdate. The aggregate purchase price was $2,920,000, which consisted of a$1,700,000 promissory note, 731,930 shares of our restricted common stock(valued at $1,171,000 based upon the fair market value of the common stock onJune 11, 2004) and $49,000 of legal and accounting fees.

**Acquisition ofProtection Plus Security Corporation**

On May 16, 2005, we signed and completed anagreement to acquire PPSC, a New York City based corporation that providesadvanced security services. The results of PPSC’s operations have been includedin the consolidated financial statements since that date.   We acquiredPPSC to enhance our product offerings in the homeland security market.

We acquired all of the outstanding equity securitiesof PPSC for a total price of $3,842,000. Of the purchase price, we paid$2,500,000 in cash and issued 506,527 shares of our restricted stock to the sellers.The number of shares issued was based on $1,125,000 (per the stock purchaseagreement) divided by the average closing bid price on the Nasdaq Small CapMarket on each of the ten consecutive trading days ending four business daysprior to the closing ($2.22 per share). The issued shares were then valuedunder purchase accounting using a measurement date of May 16, 2005, theday the acquisition was contractually agreed to and also consummated. Theclosing bid price for our common stock on the Nasdaq Small Cap Market on themeasurement date was $2.55 per share, yielding a valuation of the shares issuedfor the acquisition of $1,292,000. We paid the purchase price to the two ownersof PPSC, each of whom represented to us that he was an accredited investor andwas acquiring the shares for investment purposes only and without a view towardfurther distribution. In addition, we paid $98,000 in legal and accountingfees. These payments, net of a small amount due from the seller, increased theeffective purchase price that was allocated to the acquired tangible andintangible assets.

The stock was price protected for the benefit of theformer owners of PPSC. The price protection provision would have provided acash benefit to them if the as-defined market price of our common stock wasless than $2.22 per share at the time they could first sell the shares (asdefined, either due to their inclusion in an effective registration statementor pursuant to SEC Rule 144). On March 30, 2006, we entered into anagreement with the former owners of PPSC to settle this price protectionprovision. In exchange for 200,000 shares of common stock and forgiveness ofour receivable from them in the amount of $64,000, the price protection clausewas settled in full. The price protection clause and its ultimate settlementare deemed to be contingent consideration where the contingency is based on ourcommon stock price. No adjustment to the cost of acquiring PPSC has beenrecorded. We recorded the fair value of the additional consideration issued($282,000 for the shares of common stock based on a closing market price of$1.41 for our common stock on the date of the settlement and $64,000 for theforgiveness of the receivable from the former owners), however, the amountpreviously recorded for our common stock issued at the date of acquisition wassimultaneously reduced. The net impact of the settlement was a reduction of$64,000 in the recorded amount of the cumulative common stock shares associatedwith the transaction, from the original amount of $1,292,000 to the finalamount of $1,228,000.

F-17

----

The following table summarizes (in thousands) thefinal fair values of the assets acquired and liabilities assumed at the date ofacquisition.
| Current assets                        |   | $      | 1,473  |   |
|---------------------------------------|--------|--------|--------|--------|
| Property and  equipment               |   | 11     |   |
| Intangible  assets—customer base |   | 431    |   |
| Goodwill                              |   | 3,631  |   |
| Total assets acquired                 |   | 5,546  |   |
| Current  liabilities                  |   | (1,445 | )      |
| Long-term  liabilities                |   | (259   | )      |
| Net assets  acquired                  |   | $      | 3,842  |   |

 

The $3,631,000 of goodwill was assigned to the securityservices segment and is not expected to be deductible for tax purposes. The$431,000 of intangible assets relates to the acquired customer base and isbeing amortized ratably over its estimated life of three years. As ofApril 30, 2006, the unamortized balance of the intangible asset is$293,000. There was no in-process research and development acquired in thistransaction.

The followingtable summarizes our results of operations (in thousands) for the years endedApril 30, 2006 and 2005, as if the acquisition of PPSC had occurred onMay 1, 2005 and 2004, respectively. There have been no adjustments made tothe historical results of PPSC.
|                                                                                               | ** ** | **Year Ended** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|---------------------|------------|
| ** **                                                                                    | ** ** | **April 30,**  | ** ** |
| ** **                                                                                    | ** ** | **2006**            | ** ** | **2005** | ** ** |
| Pro forma revenues                                                                            |       | $                   | 24,230     |   | $ | 23,249 |   |
| Pro forma net loss  attributable to common stockholders                                       |       | $                   | (32,426    | ) | $ | (16,402 | ) |
| Pro forma net loss per  share attributable to common stockholders—basic and diluted |       | $                   | (1.00      | ) | $ | (.71 | ) |

 

The pro forma information is presented forinformational purposes only and is not necessarily indicative of the results ofoperations that actually would have been achieved had the acquisition beenconsummated as of that time, nor is it intended to be a projection of futureresults.

**NOTE 5—EQUITYMETHOD INVESTMENT**

On December 1, 2005, we increased our equityownership interest in Institut fur Umwelttechnologien GmbH (“IUT”), an entitylocated in Germany, from approximately 8% to 30% in exchange for cashconsideration of approximately $336,000 (EUR 284,400). The Share Transfer Agreementalso contemplates a potential further capital increase for IUT in thecumulative amount of approximately $230,000, of which approximately $70,000would be required to be contributed by us in order to retain our 30% ownershipinterest. If the IUT shareholders approve the potential capital increase, wewould have the right to fulfill our obligation by contribution of our commonstock in lieu of cash. The other IUT shareholders would have the right tofulfill their respective obligations by contribution of their respectiveoutstanding shareholder loans in lieu of cash. As of April 30, 2006, noadditional capital contributions have occurred.

F-18

----

We are now able to exert significant influence, butnot control, over the operations of IUT and, accordingly, we are applying theequity method of accounting for the investment. Prior to the December 2005equity purchase, the investment was accounted for under the cost method.  An adjustment to prior period financialstatements to restate our then-held investment from the cost method to theequity method would not be material. As of April 30, 2006, the differencebetween the carrying value of the IUT investment and the amount of underlyingequity in the net assets of IUT is approximately $74,000. We will monitor ourinvestment in IUT and recognize, if ever existing, a loss in value which isdeemed to be other than temporary.

In June 2004, we entered into a research anddevelopment agreement with IUT, which contemplated the funding of certainprojects of up to $4,000,000 over several years. The work was being funded insteps and was based upon the completion of various milestones, as defined. Wehad no obligation to fund any work under the agreement unless we had approvedsuch effort. We recognized research and development expense related to the IUTfunding of $1,463,000 and $650,000 for the years ended April 30, 2006 and2005, respectively. In April 2006, this agreement was canceled and weentered into a new research and development agreement with IUT whereby weagreed to use the services of IUT for certain development work on aproject-by-project basis.

In April 2006, we also entered into a one-yearsales, marketing and licensing agreement with IUT whereby we granted themnon-exclusive rights to be our sales representative in Europe and the MiddleEast (the “Sales Territory”). We have also granted them the right, undercertain circumstances, to brand products sold in the Sales Territory as aproduct of Isonics Corporation or a product of IUT. If IUT selects to sellproducts under an IUT brand, we will make commercially reasonable efforts toprovide them such products. We have also allowed for IUT to manufacture certainproducts for sale by them. IUT must meet quality control of such products to alevel which is reasonably acceptable to us. Failure of IUT to maintain thequality control of the products may lead to a revocation of our license tomanufacture the products.

In April 2006, in exchange for the 15% of IUTDTformerly owned by IUT and of contractually clarifying our ownership of certaintrace and bulk detection technology, we granted IUT a royalty of 2% of the netselling price of product produced through technology developed under theresearch and development agreement. We now own 100% of IUTDT, an entity whichholds intellectual property but which has no operations.

Additionally, IUT has, in the past, produced carbon-14precursors for us that we resold in the market place. Total purchases from IUTfor this product during the years ended April 30, 2006 and 2005 were $279,000and $353,000, respectively. However, as of April 30, 2006, no furthercarbon-14 purchases are expected to be made from IUT.

**NOTE 6—DEVELOPMENTAND LICENSING AGREEMENT**

On December 5, 2005, we approved a developmentplan that resulted in us becoming obligated under a Development &Licensing Agreement (the “Agreement”) entered into with LucentTechnologies, Inc. (“Lucent”) in September 2005. Under thisAgreement, the two companies will endeavor to develop a next-generationinfrared imaging and night vision surveillance technology at Lucent’s microelectro-mechanical systems and nanotechnology fabrication facility. TheAgreement provides for us to receive an exclusive right, except for certainrights reserved by Lucent, to make, use and sell licensed products arising fromtechnology developed under the Agreement. In exchange for this license, we willfund Lucent’s development efforts for the project through the periodic paymentover a two and one-half year period of a

F-19

----

development fee totaling$12,000,000. We paid $2,000,000 under this agreement during the year endedApril 30, 2006 and have charged $2,500,000 to research and developmentexpense during the corresponding period. The balance will be paid in $1,000,000increments approximately every three months thereafter (including a payment of$1,000,000 made on June 2, 2006). These development payments will continueto be expensed to research and development expense as the expenses areincurred. We have the right to terminate the development project for any reasonfrom time-to-time, so long as termination is prior to the first commercial saleof a licensed product. When, if ever, commercial sales of developed productscommence, a royalty payment based on revenue will be due Lucent (subject to aminimum semi-annual cumulative royalty payment amount). Additionally, if Lucentexpends substantial sales effort to accomplish a sale, we will also pay them asales referral fee based on revenue. Lastly, in order to retain the exclusivityof our license for the developed technology, we have agreed to pay an annualexclusivity payment commencing the October 1 following the firstcommercial sale or the end of the development project.

**NOTE 7—ASSETS HELDFOR SALE**

During the first quarter of fiscal year 2006,management committed to a plan to sell specific production equipment in oursemiconductor products and services segment. Based on ongoing analysis of thesemiconductor operations, these assets were deemed to be obsolete, unnecessaryto support a more focused product portfolio or incompatible with the futuredirection of the segment’s operations. We have listed these assets for sale andare actively attempting to sell them. Immediately prior to the decision to sellthe assets, the equipment had a cumulative net book value of approximately$1,026,000. In the first and fourth quarters of fiscal year 2006, certainassets have been written down to their fair value, less selling costs, yieldinga cumulative impairment loss on assets held for sale in the amount of $466,000.The assets held for sale are now classified in current assets at the lower oftheir book value or fair value, less selling costs, in the cumulative amount of$560,000. During the year ended April 30, 2006, none of the assets heldfor sale were sold.

**NOTE 8—CAPITALLEASES**

We lease certain production equipment under agreementsthat are classified as capital leases. The cost of equipment under capitalleases is included in the consolidated balance sheets as property and equipmentand was $70,000 and $244,000 at April 30, 2006, and April 30, 2005,respectively. Accumulated amortization of the leased equipment atApril 30, 2006, and April 30, 2005, was approximately $43,000 and$91,000, respectively. Amortization of assets under capital leases is includedin depreciation expense.

F-20

----

The following represents the future minimum leasepayments remaining under capital leases as of April 30, 2006 (inthousands):
| Year ending April 30,                      | ** ** | ** ** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|
| 2007                                                      |       | $          | 19         |   |
| 2008                                                      |       | 19         |       |
| 2009                                                      |       | 19         |       |
| Total minimum  lease payments                             |       | 57         |       |
| Less: amount  representing interest                       |       | 9          |       |
| Present value of  minimum lease payments                  |       | 48         |       |
| Less: current  portion of obligation under capital leases |       | 14         |       |
| Long term obligation  under capital leases                |       | $          | 34         |   |

 

**NOTE 9—BORROWINGS**

**Commercial Debt,Line of Credit and Letter of Credit**

We currently have three active lending facilities withfinancial institutions. Upon acquisition of PPSC in May 2005, thereremained $376,000 on a bank term loan PPSC held with HSBC Bank USA, which ispayable monthly through April 2008 and bears an interest rate of 6.90%. Asof April 30, 2006, the outstanding balance on the loan is $259,000, ofwhich $125,000 is a current liability. The note is not secured by collateraland bears no significant financial covenants. A line of credit bearing aninterest rate of 10.1% is available to Chemotrade in the amount of 100,000Euros (approximately $128,000). There were no borrowings under the line ofcredit during the years ended April 30, 2006 and 2005, respectively. Aletter of credit for $50,000 formerly held by Chemotrade and relating toimports and exports expired on April 30, 2006. In March 2006, weentered into a note payable in the amount of $49,000 to fund the purchase of afixed asset. The note bears an interest rate of 9.66% and is payable monthlythrough February 2011.

**Note Issued inConnection with EMG Acquisition**

In connection with the acquisition of  the business and assets of EMG inJune 2004, we issued a $1,700,000 promissory note that is collateralizedby the assets acquired by us and certain other assets owned by us relating toour pre-existing semiconductor operations. The note was originally payable over33months, through March 2007, with an interest rate of 6% and has acurrent outstanding balance as of April 30, 2006, of $653,000. The note ispayable by our subsidiary, IVI. In accordance with the terms of the acquisitionof the business and assets of EMG, we have guaranteed all payments of such loanshould IVI be in default at any point over the life of the loan.

**8% ConvertibleDebentures**

*Initial Accounting*

On February 24, 2005, we completed a privateplacement pursuant to which we issued to accredited investors 8% convertibledebentures (the “8% Debentures”) in the aggregate principal amount of$22,000,000 and common stock warrants (collectively, the “Warrants”) grantingthe right to purchase a total of 1,540,000 common shares. The Debentures areconvertible by the holders into shares of our common stock at any time and at aconversion price of $5.00 per share (the “Conversion Price”). This ConversionPrice will be adjusted upon the occurrence of any stock dividends, stocksplits, pro rata

F-21

----

distributions, orfundamental transactions as described in the 8% Debenture agreement. TheWarrants are exercisable for a period of three years and at an exercise priceof $6.25 per share. Under specified conditions, including the lack of aneffective registration statement for the underlying shares, and after a periodof one year from issuance, the Warrants may be exercised by means of a cashlessexercise. This provision permits the warrant holder to cancel a portion of thewarrants at the then current share price to receive the balance of the warrantsin common stock without payment to us. Further, the Warrants contain a ratchetprovision triggered by a subsequent equity sale. Under this provision, thewarrant exercise price would be reduced to the effective price per share (oreffective exercise price per share) of the subsequent equity sale.  Concurrently, the number of warrants would beadjusted such that the aggregate exercise price would be equal to the aggregateexercise price prior to adjustment. See Note 17—Subsequent Events for furtherdiscussion of the warrant ratchet provision.

Interest on the 8% Debentures was payable quarterly atthe end of each calendar quarter until March 1, 2006, at which time allaccrued and unpaid interest became payable the first day of each calendar monththereafter. We commenced monthly principal payments on March 1, 2006,whereby we pay 1¤12of the original principal balance on the first day of each calendar month onall 8% Debentures outstanding at the time of each payment. The 8% Debentureswill mature on February 28, 2007. We may not prepay the principal amountof the 8% Debentures without the consent of the holders (see Note 17—SubsequentEvents for information on prepayments which have occurred subsequent toApril 30, 2006).

Both the principal and interest are payable, at ouroption, in common stock or cash, subject to various requirements. If we chooseto make a scheduled principal payment by issuing common stock, and allrequirements to do so are met, the conversion price will be the lesser of thethen Conversion Price or 88% of the average of the ten final bid prices endingon the trading day immediately prior to the monthly redemption date.  If we choose to make a scheduled interestpayment by issuing common stock, and all requirements to do so are met, theconversion price will be the lesser of the then Conversion Price or the lesserof  (i) 90% of the average of thetwenty final bid prices ending on the trading day immediately prior to theapplicable interest payment date or (ii) 90% of the average of the twentyfinal bid prices ending on the trading day immediately prior to the date theapplicable interest payment shares are issued and delivered if after theinterest payment date.

The 8% Debentures are now redeemable at our option, inwhole or in part, if the closing prices for any twenty days in a thirtyconsecutive trading day period (such period commencing after February 25,2006) exceeds 150% of the then Conversion Price.

The 8% Debentures and the Warrants have certainlimitations on our ability to issue shares to the holders of the 8% Debenturesand Warrants (the “Holders”). Under the terms of the 8% Debentures and theWarrants, we are prohibited from issuing shares of our common stock to theholders of the 8% Debentures (upon conversion, in payment of interest, or inredemption or payment of the 8% Debentures) and the Warrants (upon exercise)if:  (a) the issuance would resultin any Holder owning more than 4.99% of our outstanding common stock (althoughthe holders can waive this provision upon more than 60 days’ notice to us)or  (b) the issuance would result inmore than 5,514,601 shares having been issued pursuant to the Debentures andthe Warrants (19.999% of the total number of shares outstanding onFebruary 24, 2005) unless our shareholders have approved the transactionas required by the Nasdaq rules. As our shareholders approved the transaction onOctober 25, 2005, the 19.999% contractual limitation as to the number ofshares that can be issued is no longer be applicable, although the 4.99%limitation will continue

F-22

----

to be applicable until(if ever) waived by a the respective Holder. Waiver by one Holder does noteliminate the provision as to all Holders.

As a result of a freestanding registration rightsagreement, we had an obligation to register the shares underlying the 8%Debentures and Warrants (the registration statement became effective on July 26,2005) and have a continuing obligation to keep the registration statementcontinuously effective. Failure to meet this obligation, as defined, willresult in our incurring liquidated damages in the amount of 1.0% of theprincipal amount of the purchase price per month for any shares derived fromthe Debentures or Warrants and then held by each of the holders of the 8%Debentures at the time liquidated damages are payable.

Additionally, other events, as defined in the 8%Debenture agreement, may also allow the 8% Debenture holders to declare us indefault. Remedies for an event of default include the option to acceleratepayment of the full principal amount of the 8% Debentures, together withinterest and other amounts due, to the date of acceleration. The principalamount of the 8% Debentures shall be equal to 130% of the then-principal amountof the 8% Debentures plus all interest and other amounts due or a conversioncalculation, whichever is higher.

We evaluated the embedded conversion feature in the 8%Debentures and concluded that the feature does not require classification as aderivative instrument because the feature would be classified in equity if itwere a freestanding instrument and, therefore, meets the scope exception foundin SFAS 133 *Accounting for DerivativeInstruments and Hedging Activities* (“SFAS 133”). Included in thisevaluation is the conclusion that the Debentures meet the definition of “conventionalconvertible debt instrument” and, therefore, the embedded conversion feature isnot subject to the more onerous provisions of EITF 00-19. Further, weevaluated the detachable Warrants and concluded that the warrants also meet thescope exception found in SFAS 133 and, therefore, are appropriately classifiedin equity. Lastly, we evaluated the freestanding registration rights agreement(discussed above) and concluded that it meets the definition of a derivativeinstrument under SFAS 133. The fair value of this derivative liability isimmaterial based on a probability-weighted, discounted cashflow evaluation ofits terms.

We allocated the proceeds received between the 8%Debentures and the Warrants based on the relative fair value of eachinstrument. The $3,525,000 allocated to the Warrants was recorded as additionalpaid-in capital and as a corresponding reduction to the carrying value of the8% Debentures. In addition, in accordance with EITF 00-27 “Application ofIssue No. 98-5 to Certain Convertible Instruments” we calculated theintrinsic value of the conversion option by using the effective conversionprice based on the proceeds allocated to the 8% Debentures. As a result, wedetermined that the value of the beneficial conversion feature (based upon a$5.00 conversion price) contained in the 8% Debentures to be $1,720,000. Thisamount was recorded as additional paid-in capital and as a correspondingreduction to the carrying value of the 8% Debentures. The cumulative discounton the 8% Debentures as originally booked is being amortized to interestexpense over the term of the 8% Debentures using the effective interest methodat an effective interest rate of 19%. During the year ended April 30,2006, $4,270,000 of this discount was amortized to interest expense.

In connection with completing the financingarrangement, we paid a placement agent (i) a 6.5% fee consisting of$660,000 and a $770,000 convertible debenture and (ii) a Common StockPurchase Warrant granting the right to purchase 53,900 shares of common stock(valued at $142,000 using the Black-Scholes pricing model). The convertibledebenture and related debt issuance cost was measured at the fair value of theconvertible debenture, $745,000. The total debt issuance costs of $1,547,000were capitalized and are

F-23

----

being amortized toamortization of debt issuance costs over the life of the convertible debentureusing the effective interest method. During year ended April 30, 2006,$1,260,000 of the capitalized debt issuance costs was amortized to expense. AtApril 30, 2006, the unamortized debt issuance cost is $121,000. The termsof both the convertible debenture and the warrant are the same as those for theaccredited investors, as described above. The discount on the convertibledebenture is being amortized to interest expense over the term of theconvertible debenture using the effective interest method.

*Payment of Principal and Interest inShares of Common Stock*

In our third fiscal quarter of our year endedApril 30, 2006, we determined that it had become probable that we wouldrepay the principal portion of the 8% Debentures in common stock instead ofcash. As such, we commenced accreting the aggregate 8% Debentures balance inour consolidated balance sheet to the fixed monetary amount of the obligationwhen settled in common stock. If paid in common stock, the fixed monetary amountof principal repayment would have been $25,875,000, as compared to $22,770,000if paid in cash, the difference being due to the aforementioned fixed discountapplied to the price of our common stock in the calculation of the number ofcommon shares due for each principal payment, as defined.  As a result, for the year endedApril 30, 2006, we recorded additional interest expense of $1,392,000,representing the increased accretion resulting from the probable repayment ofthe 8% Debentures principal in common stock.

Having met all requirements to allow us to do so, weelected to make the quarterly interest payment due on September 30, 2005,in shares of our common stock. Accordingly, we issued 200,600 shares of commonstock in settlement of our interest obligation for the quarter endedSeptember 30, 2005. A charge in the amount of $506,000 was recorded asinterest expense related to the share issuance, an amount that represents thefixed monetary amount of the interest obligation when settled in stock (asopposed to a fixed monetary amount of $455,000 if the interest payment had beenmade in cash).

Having met all requirements to allow us to do so, weelected to make the monthly principal and interest payments due for our 8% Debentures on March 1, 2006and April 1, 2006, in shares of our common stock. Accordingly, we issued atotal of 1,347,361 and 1,606,270 shares of common stock, respectively, insettlement of (1) our repayment of 1¤12 of theoriginal principal balance (an amount of $2,156,000 for each payment whichrepresents the fixed monetary amount of the payment when made in stock, ascompared to a fixed monetary amount of $1,897,000 if the payment had been madein cash) and (2) our interest obligation for the two months endingFebruary 2006 and the one month of March 2006, respectively. In ourstatement of operations for the year ended April 30, 2006, charges in theamount of $337,000 and $89,000, respectively, were recorded as interest expenserelated to the share issuance, an amount that represents the fixed monetaryamount of the interest obligation when settled in stock (as compared to a fixedmonetary amounts of $304,000 and $79,000, respectively, if the interestpayments had been made in cash).

See Note 17—Subsequent Events for additionalinformation about payments on our Debentures made in shares of our commonstock.

*Induced Conversion*

On March 9, 2006, holders of our 8% Debentures converted outstandingprincipal in the amount of $9,000,000 into 6,206,897 shares of our commonstock. We gave the holders of all 8% Debenturesthe temporary right to convert a portion or their entire principal amount intoshares of our common stock at a

F-24

----

temporary conversionprice of $1.45 per share (a reduction from the prior conversion price of $5.00per share). At the close of business on March 8, 2006, the closing pricefor our common stock was $1.64 per share. Additionally, we issued 10,036 sharesof our common stock in payment of interest then due on the converted principalamount. We have accounted for this transaction by applying the inducedconversion principles set out in SFAS No. 84 *InducedConversions of Convertible Debt—An Amendment of APB Opinion No. 26*(“SFAS84”). This standard sets out the method of accounting for conversions ofconvertible debt to equity securities when the debtor induces conversion of thedebt by offering additional securities or other consideration to convertibledebt holders. In accordance with SFAS 84, we calculated the expense equal tothe fair value of all securities transferred in the transaction in excess ofthe fair value of securities issuable pursuant to the original conversionterms. As a result, for the year ended April 30, 2006, we recognized debtconversion expense in the amount of $7,227,000.

The followingrepresents the scheduled maturities of long-term debt, excluding capitalleases, for amounts on our balance sheet as of April 30, 2006 (inthousands):
| Year ending April 30, | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|
| 2007                                 |       | $          | 11,218     |   |
| 2008                                 |       | 143        |       |
| 2009                                 |       | 10         |       |
| 2010                                 |       | 10         |       |
| 2011                                 |       | 10         |       |
| Long-term obligations                |       | $          | 11,391     |   |

 

**NOTE10—COMMITMENTS AND CONTINGENCIES**

As of April 30, 2006 we had commitmentsoutstanding for capital expenditures of $1,470,000.

**Operating leasecommitments**

In February 2006, we renewed a month-to-monthlease (at a rate of $3,077 per month) with the Colorado School of MinesResearch Institute to continue leasing office and storage space at our currentlocation.

We rent additionaloffice and production facilities under operating leases expiring throughSeptember 2013. Rent expense for operating leases was $468,000 and$308,000 for the years ended April 30, 2006 and 2005, respectively. Futureminimum annual operating lease commitments are as follows (in thousands):
| Year ending April 30, | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|
| 2007                                 |       | $          | 323        |   |
| 2008                                 |       | 280        |       |
| 2009                                 |       | 175        |       |
| 2010                                 |       | 180        |       |
| 2011                                 |       | 193        |       |
|                                 |       | $          | 1,151      |   |

 

F-25

----

**Purchasecommitment**

In December 2003 we extended our production,marketing and sales agreement with our supplier of oxygen—18 throughJuly 2010.  The agreement originallyrequired the purchase of certain quantities at prices to be determined as apercentage of the then prevailing market price. In June 2006, werenegotiated the pricing terms with our supplier to a fixed price negotiatedannually in advance. Additionally, we have moved from the long-term purchaseobligations in the plan to successive one-year purchase commitments setannually in advance. Under the terms of the agreement and communications withour supplier since entering the agreement, we estimate that our purchaseobligation (based on estimates of future market prices) is approximately$5,100,000 through the end of the agreement. During fiscal years 2006 and 2005,we made purchases under this agreement of $2,638,000 and $3,380,000,respectively.

**Othercontingencies**

In October 2004, we received an inquiry from theNasdaq Listing Investigation Unit (the “Nasdaq inquiry”), which includedquestions regarding our press releases, our public relations advisors andcertain other disclosures that we have made publicly. In December 2004, wereceived an informal request for information from the SEC which asked questionssimilar to those posed in the Nasdaq inquiry, but which also asked about thetermination of Grant Thornton LLP as our independent auditor. We have providedinformation, which we believe to be responsive to all of the questions posed inthe Nasdaq inquiry and to the SEC. We have not received further requests forinformation from either entity since January 2005. We have no knowledge,however, whether either investigation will result in any action against us,which action may materially and adversely impact us, and our ability to carryon our business.

In June 2006, we received notification fromNasdaq that we have failed to meet certain listing requirements (includingstockholders’ equity of at least $2.5 million or market value of listedsecurities of at least $35 million). We were provided until July 26, 2006to regain compliance or face delisting procedures. Compliance can be obtainedby, among other things, having stockholders’ equity in excess of $2.5 millionin a company’s most current filing with the SEC. Within these consolidatedfinancial statements, our stockholders equity as of April 30, 2006, is$2,643,000, which we believe will be sufficient to satisfy the issues raised byNasdaq in June 2006. On July 10, 2006, we received a second letterfrom Nasdaq that advised us that the minimum bid price of our common stock hadclosed at less than $1.00 per share over the previous 30 consecutive businessdays, and, as a result, did not comply with Marketplace Rule 4310(c)(4).Therefore, in accordance with Marketplace Rule 4310(c)(8)(D), we wereprovided 180 calendar days, or until January 8, 2007, to regain compliancewith the Rule (which consists of the bid price of our common stock closingat $1.00 per share or more or a minimum of 10 consecutive business days). If wefail to obtain compliance, as long as we meet the Nasdaq Capital Market initiallisting criteria as set forth in Marketplace Rule 4310(c), except for thebid price requirement, we will be granted an additional 180 calendar days toobtain compliance.

F-26

----

**NOTE 11—INCOMETAXES**

Deferred taxassets (liabilities) are comprised of the following (in thousands):
|                                                     | ** ** | **April 30,** | ** ** |
|-----------------------------------------------------|------------|--------------------|------------|
| ** **                                          | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Deferred tax assets                                 |       |               |       |   |   |
| Accruals and  expenses deductible in future periods |       | $                  | 4,094      |   | $ | 1,773 |   |
| Net operating  loss and credit carryforwards        |       | 16,629             |       | 9,570 |   |
| Total deferred tax  assets                          |       | 20,723             |       | 11,343 |   |
| Valuation  allowance                                |       | (20,723            | )          | (11,343 | ) |
|                                                |       | —             |       | — |   |
| Deferred tax  liabilities                           |       |               |       |   |   |
| Amortization and  depreciation                      |       | —             |       | — |   |
|                                                |       | $                  | —     |   | $ | — |   |

 

Income tax expense(benefit) consists of the following (in thousands):
|            | ** ** | **April 30,** | ** ** |
|------------|------------|--------------------|------------|
| ** ** | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Current    |       |               |       |   |   |
| Federal    |       | $                  | —     |   | $ | — |   |
| State      |       | —             |       | — |   |
| Foreign    |       | —             |       | — |   |
|       |       | —             |       | — |   |
| Deferred   |       |               |       |   |   |
| Federal    |       | —             |       | — |   |
| State      |       | —             |       | — |   |
| Foreign    |       | —             |       | — |   |
|       |       | —             |       | — |   |
|       |       | $                  | —     |   | $ | — |   |

 

A reconciliationof our effective tax rate to the federal statutory tax rate of 34% follows (inthousands):
|                                                            | ** ** | **April 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                 | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Expected benefit at  federal statutory rate                |       | $                  | (10,996    | ) | $ | (5,160 | ) |
| State taxes net of federal  benefit                        |       | (1,003             | )          | (470 | ) |
| Foreign income taxed at  different rates                   |       | 23                 |       | 233 |   |
| Warrant exercise tax  deductions in excess of book expense |       | (29                | )          | (1,277 | ) |
| Debt conversion expense                                    |       | 2,457              |       | — |   |
| Other items                                                |       | 168                |       | 189 |   |
| Change in valuation  allowance                             |       | 9,380              |       | 6,485 |   |
|                                                       |       | $                  | —     |   | $ | — |   |

 

F-27

----

The federal net operating loss (“NOL”) carryforward ofapproximately $42,367,000 as of April 30, 2006 expires on various datesthrough 2026. Internal Revenue Code Section 382 places a limitation on theamount of taxable income which can be offset by NOL carryforwards after achange in control (generally greater than 50% change in ownership) of a losscorporation. Generally, after a change in control, a loss corporation cannotdeduct NOL carryforwards in excess of the Section 382 limitation. Due tothese “change in ownership” provisions, utilization of NOL carryforwards may besubject to an annual limitation regarding their utilization against taxableincome in future periods. We have not performed a Section 382 analysis.However, if performed, Section 382 may be found to limit potential futureutilization of our NOL carryforwards.

Chemotrade has a net operating loss carryforward ofapproximately $3,645,000. Under current German tax law, the carryforward islimited to 1 million Euros of net income in a given year without restriction.Any remaining loss can be offset against up to 60% of the net income exceedingthe limit.

We have established a full valuation allowance againstthe deferred tax assets because, based on the weight of available evidenceincluding our continued operating losses, it is more likely than not that allof the deferred tax assets will not be realized.

**NOTE 12—EQUITYINSTRUMENTS ISSUED FOR SERVICES OR SETTLEMENT OF LITIGATION**

In March 2006, we entered into a financial advisoryservices agreement with Harborview Capital Management LLC, whereby we issued100,000 shares of restricted common stock (valued at $140,000 based on themarket price of our common stock on the date of grant). The common stock wasrecorded as prepaid consulting expense, to be amortized ratably over theexpected service period of approximately ten months. As of April 30, 2006,$28,000 has been expensed to selling, general and administrative expenses.

In September 2005,we entered into a financial advisory services agreement with Clayton DunningCapital Partners, Inc., whereby we issued a common stock warrant (valuedat $152,000 using the Black-Scholes pricing model) to purchase 100,000shares of common stock at $2.81 per share. The common stock warrant vestedimmediately, expires on September 8, 2007, and was recorded as prepaidconsulting expense, to be amortized ratably over the expected service period ofone year. As of April 30, 2006, $101,000 has been expensed to selling,general and administrative expenses. In May 2006, we granted ClaytonDunning Capital Partners, Inc. a warrant to purchase an additional 50,000shares of common stock at $1.05 per share.

In September 2005, we entered into a consultingagreement with an individual to provide management services in oursemiconductor products and services segment, whereby we issued a common stockwarrant (valued at $75,000 using the Black-Scholes pricing model) to purchase50,000 shares of common stock at $2.84 per share. The common stock warrantvested immediately, expires on August 16, 2007, and was recorded asprepaid consulting expense, to be amortized ratably over the expected serviceperiod of eight months. As of April 30, 2006, the entire $75,000 has beenexpensed to selling, general and administrative expenses.

On October 7, 2004, we established HSDC, a whollyowned Delaware corporation to consolidate our efforts in the homeland securitymarket. In connection with the establishment of HSDC, we created an advisoryboard which provides guidance and advice to HSDC in matters of technology,business and applications as we develop technologies and products for thehomeland security marketplace. In November 2004 we issued 300,000 commonstock warrants (valued at $669,000 using the Black-Scholes pricing model) tothree newly hired advisory board members. The common stock warrants vested

F-28

----

immediately, areexercisable at $4.00 per share, expire on November 1, 2007 and wereexpensed to selling, general and administrative expenses during the year endedApril 30, 2005. In May 2005 (see the discussion of PPSC in Note 4) weacquired an entity owned in part by one of our advisory board members.

On October 22, 2003, we entered into anon-exclusive investment banking agreement with vFinance, Inc. (“vFinance”)whereby we issued a common stock warrant (valued at $369,600 using theBlack-Scholes pricing model) to purchase 560,000 shares of our restrictedcommon stock at $1.25 per share. The common stock warrant (which was exercisedin its entirety during the year ended April 30, 2005) vested immediately,would have expired on April 30, 2006, and was considered full payment forservices to be provided through June 30, 2004. The common stock warrantwas expensed to selling, general and administrative expenses ratably over theeight-month period beginning November 1, 2003. We recognized expense of$92,000 during the year ended April 30, 2005.

On March 25, 2005, Prime International Equities,LLC (“the Plaintiff”) filed a complaint against us in the United StatesDistrict Court for the District of Colorado (Civil Case No. 05-F-562(BNB). On October 31, 2006, a settlement agreement was signed in which noliability or wrongdoing was admitted. In return for dismissal of the complaint,we paid the Plaintiff $50,000 and issued a common stock warrant (valued$109,000 using the Black-Scholes pricing model) to purchase 120,000 shares ofcommon stock at $2.40 per share. The common stock warrant vested immediately,expires on December 29, 2006, and was recorded as a selling, general andadministrative expense in the three months ended October 31, 2005.Further, the common stock warrant included a registration rights clause wherebywe agreed to use our best efforts to include the common stock underlying thewarrant in a registration statement by not later than May 31, 2006. Weincluded the shares underlying the warrant in a registration statement whichwas declared effective in April 2006.

**NOTE13—STOCKHOLDERS’ EQUITY**

**Preferred StockAuthorized**

Originally 10,000,000 shares of preferred stock wereauthorized for issuance, while at April 30, 2006, there were 7,650,000shares remaining which may be issued. As of April 30, 2006, there are no outstanding shares of anyseries of our preferred stock, but there remain 2,500,000 shares designated asSeries B Preferred Stock, 22,000 shares designated as Series CPreferred Stock, 32,950 shares designated as Series D Preferred Stock and33,000 shares designated as Series E Preferred Stock. The designation ofrights, preferences, privileges and restrictions of the Series C PreferredStock, Series D Preferred Stock, and Series E Preferred Stock will becancelled by filing an amendment to our articles of incorporation with theCalifornia Secretary of State and thereby the shares will be returned toundesignated “blank check” preferred stock. Our authorized preferred stockbalance as of April 30, 2005, has been amended from 7,622,516 previouslyreported to 7,656,666 in order to recognize the impact of California state law(our state of incorporation) on our authorized preferred stock balance.

**Series EConvertible Preferred Stock**

On October 4, 2004 we completed a financingarrangement whereby we issued 33,000 shares of our Series E ConvertiblePreferred Stock (“Series E Stock”) and 614,000 common stock warrants to AssetManagers International, Ltd. (“AMI”) for $3,300,000. In addition, we paid AMI$251,000 in due diligence fees and related expenses. Each common stock warrantis exercisable for one share of common stock through October 4, 2007.One-half (307,000) of the common stock warrants had an exercise price of

F-29

----

$1.24 per sharewhile the remaining half (307,000) of the common stock warrants had an exerciseprice of $1.35 per share. As of April 30, 2006, common stock warrantsexercisable for a total of 153,500 shares of common stock remain outstanding.On July 27, 2005, 23,000 shares of Series E Stock were converted into1,854,838 shares of common stock. On October 19, 2005, the remaining10,000 shares of Series E Stock were converted into 806,452 shares ofcommon stock. As a result, as of April 30, 2006, there were zero shares ofSeries E Stock outstanding.

We had an obligation to register the shares underlyingthe Series E Stock and the common stock warrants, including the obligationto file a registration statement by November 7, 2004 and to obtaineffectiveness of the registration statement within 70 days after the filing ofthe registration statement. We incurred a penalty under this obligation in theamount of $2,200 per day until such time that the registration was filed anddeclared effective. Accordingly, an expense in the amount of $368,000 wasrecognized in the year ended April 30, 2005.

We allocated the proceeds received between theSeries E Stock and related warrants based on the relative fair value ofeach instrument. In addition, in accordance with EITF 00-27 “Applicationof Issue No. 98-5 to Certain Convertible Instruments” we calculatedthe intrinsic value of the conversion option by using the effective conversionprice based on the proceeds allocated to the convertible instrument. As aresult, we determined that the value of the beneficial conversion feature(based upon a $1.24 conversion price) contained in our Series E Stock tobe $1,206,000, which has been reported as a deemed dividend on preferred stockfor the year ended April 30, 2005.

**Series DConvertible Preferred Stock**

On April 5, 2004 we completed a financingarrangement whereby we issued 32,950 shares of our Series D ConvertiblePreferred Stock (“Series D Stock”) and 600,000 common stock warrants toaccredited investors who are affiliated with Mercator Advisory Group, LLC (“MAG”)for $3,295,000. In addition, we paid MAG $230,000 in due diligence fees andrelated expenses and issued them a common stock warrant to acquire 2,400,000shares of our common stock. The common stock warrants, which were exercisablefor one share of common stock for between $1.10 and $1.30 per share, wereexercised in their entirety during the year ended April 30, 2005. Duringthe year ended April 30, 2005, 32,150 shares of Series D Stock wereconverted into 2,922,726 shares of common stock. On May 19, 2005, theremaining 800 shares of Series D Stock were converted into 72,727 sharesof common stock. As a result, as of April 30, 2006, there were zero sharesof Series D Stock outstanding.

**Series CConvertible Preferred Stock**

On January 27, 2004 we completed a financingarrangement whereby we issued 22,000 shares of our Series C ConvertiblePreferred Stock (“Series C Stock”) and 200,000 common stock warrants toaccredited investors who are affiliated with MAG for $2,200,000. In addition,we paid MAG $200,000 in due diligence fees and related expenses and issued thema common stock warrant to acquire 227,701 shares of our common stock. Eachcommon stock warrant (which were exercised in their entirety as of May 23,2005) issued in this transaction is exercisable for one share of common stockat $1.25 per share and would have expired on January 27, 2007. During theyear ended April 30, 2005, the remaining 9,000 shares of Series C Stockwere converted (at $.95 per share) into 947,368 shares of common stock. As aresult of these conversions, there were no shares of Series C Stockoutstanding as of April 30, 2005.

F-30

----

 

**Series AConvertible Preferred Stock**

The Series A Stock originally consisted of1,830,000 shares issued with a liquidation preference of $1.50 per share.During the year ended April 30, 2005, 957,000 shares of Series AConvertible Preferred Stock (“Series A Stock”) were converted into1,914,000 shares of common stock. As of April 30, 2005, there were 6,666shares of Series A Stock outstanding convertible into 13,332 shares ofcommon stock based upon the current conversion ratio. On August 9, 2005,we redeemed the remaining 6,666 outstanding shares of the Series A Stock.As a result, the holder no longer is able to convert the shares and the rightsand preferences associated with the Series A Stock have been terminated.The holder is entitled to receive $1.50 for each share of the Series AStock, an amount of approximately $10,000.

**Stock Option andPurchase Plans**

*2005 Stock Option Plan*

The 2005 Stock Option Plan authorized the grant to ourkey employees, officers, consultants or advisors of incentive and nonqualifiedstock options to purchase shares of our authorized but unissued common stock.The maximum number of shares of our common stock available for issuance underthis plan is 3.5 million shares. As of April 30, 2006, there are 680,000options outstanding and the maximum number of shares available for futuregrants under this plan is 2,820,000 shares. The exercise period shall notexceed ten years from the date of grant or three months following the date oftermination of employment, whichever occurs earlier. The option price shall notbe less than the fair market value of the common stock on the date of grant.

*1996 Stock Option Plan*

The 1996 Stock Option Plan authorized the grant ofincentive and nonqualified stock options to our key employees, directors orconsultants. The options generally expire ten years from the date of grant. InSeptember 1997, the Board of Directors terminated the 1996 Stock OptionPlan. As of April 30, 2006, there remain 151,429 options outstanding andzero shares are available for grant under the 1996 Stock Option Plan.

*Directors’ Stock Option Plan*

The 1998 Directors’ Plan provides that each personserving as a member of the Board, who is not an employee of Isonics, receiveoptions to purchase 20,000 shares of common stock when such person accepts hisposition as a director and to receive an additional option to purchase 10,000shares when such person is re-elected as a director provided such person is notan employee of Isonics at the time of election (such amount was increased to20,000 shares upon reelection as a director effective May 1, 2006). Theexercise price for the options is the quoted market price on the date of grantand the options are exercisable for five years from such date. The optionsgranted under the directors’ plan vest immediately. In the event a directorresigns or is not re-elected to the Board, failure to exercise the optionswithin three months results in the options’ termination. As of April 30,2006, options to purchase a total of 190,000 shares were outstanding under thedirectors’ plan.

*Executive and Incentive Stock OptionPlans*

In November 1996 (and modified subsequently), theBoard of Directors adopted the Executives’ Incentive and Incentive Stock OptionPlans authorizing the granting of up to 1,000,000 and 500,000

F-31

----

incentive andnonqualified stock options, respectively, to our key employees, directors orconsultants. Effective November 13, 2001, our shareholders approved anincrease in the authorized shares for the Executive and Incentive Stock OptionPlans to 2,000,000 and 1,000,000, respectively. Incentive stock options aregranted at a price not less than fair market value, and nonqualified stockoptions are granted at a price not less than 85% of the fair market value.Options are exercisable when vested, typically over four to five years andexpire five to ten years after the date of grant. In April 2005, the Boardof Directors terminated the Executives’ Incentive and Incentive Stock OptionPlans. As of April 30, 2006, options to purchase a total of 1,912,503shares remain outstanding and zero shares are available for grant under theExecutive’s Incentive and Incentive Stock Option Plans.

*Employee Stock Purchase Plan*

The employee stock purchase plan has reserved 200,000shares of our common stock for sale to all permanent employees who have metminimum employment criteria. Employees who do not own 5% or more of theoutstanding shares are eligible to participate through payroll deductions. Atthe end of each offering period, shares are purchased by the participants at85% of the lower of the fair market value of our common stock at the beginningor the end of the offering period. As of April 30, 2006, 78,209 shareshave been issued under the plan. As of May 1, 2006, the Employee StockPurchase Plan was terminated.

*SFAS No. 123 Disclosures*

We have adopted the disclosure-only provisions of SFASNo. 123, *Accounting for Stock-BasedCompensation*. See Note 1 for the related pro forma disclosures, inaccordance with SFAS No. 148, *Accountingfor Stock-Based**Compensation—Transitionand Disclosure*. The following assumptions were applied for the SFASNo. 123 disclosure-only provision information included in Note 1.

For purposes ofthe pro forma disclosures, the fair value of each option grant is estimated onthe date of grant using the Black-Scholes option pricing model with the followingweighted average assumptions for the years ended April 30, 2006 and 2005,respectively; no expected dividends, volatility of 100%; risk-free interestrate of 4.0%; and expected lives of three to five years. A summary of thestatus of our stock option plans as of April 30, 2006 and 2005, andchanges during the years ended on these dates is presented below.
|                                   | ** ** | ** **         | ** ** | **Weighted** | ** ** |
|-----------------------------------|------------|--------------------|------------|--------------|------------|
| ** **                        | ** ** | ** **         | ** ** | **Average**  | ** ** |
| ** **                        | ** ** | **Number of** | ** ** | **Exercise** | ** ** |
| ** **                        | ** ** | **Shares**         | ** ** | **Price**    | ** ** |
| Outstanding,  April 30, 2004 |       | 1,745,647          |       | $            | 1.39       |   |
| Granted                           |       | 1,410,000          |       | 2.70         |       |
| Exercised                         |       | (93,000            | )          | 1.19         |       |
| Canceled                          |       | (216,000           | )          | 2.86         |       |
| Outstanding,  April 30, 2005 |       | 2,846,647          |       | 1.93         |       |
| Granted                           |       | 525,000            |       | 2.13         |       |
| Exercised                         |       | (419,115           | )          | 0.84         |       |
| Canceled                          |       | (18,600            | )          | 2.19         |       |
| Outstanding, April 30, 2006  |       | 2,933,932          |       | $            | 2.12       |   |

 

F-32

----

 

The weighted average fair value of options grantedduring the years ended April 30, 2006 and 2005 was $1.57 and $2.04,respectively. The fair value of the options granted was determined using theBlack-Scholes model with the following weighted-average assumptions for fiscal2006: expected life of 4.7 years, interest rate of 4%, volatility of 100% andno dividend yield.

The followinginformation applies to options outstanding at April 30, 2006:
|                         | ** ** | ** **      | ** ** | ** **                | ** ** | **Weighted**               | ** ** | ** **      | ** ** | ** **                | ** ** |
|-------------------------|------------|-----------------|------------|---------------------------|------------|----------------------------|------------|-----------------|------------|---------------------------|------------|
| ** **              | ** ** | ** **      | ** ** | ** **                | ** ** | **Average Remaining** | ** ** | ** **      | ** ** | ** **                | ** ** |
| **Range of**       | ** ** | **Number**      | ** ** | **Weighted Average** | ** ** | **Contractual**            | ** ** | **Number**      | ** ** | **Weighted Average** | ** ** |
| **Exercise Price** | ** ** | **Outstanding** | ** ** | **Exercise Price**   | ** ** | **Life (Years)**      | ** ** | **Exercisable** | ** ** | **Exercise price**   | ** ** |
| $.90 - $1.52            |       | 1,452,503       |       | $                         | 1.24       |                       | 5.1        |            | 1,109,753  |                      | $          | 1.16 |   |
| $1.69 - $3.50           |       | 1,006,429       |       | $                         | 2.21       |                       | 6.4        |            | 685,179    |                      | $          | 2.28 |   |
| $4.64                   |       | 475,000         |       | $                         | 4.64       |                       | 8.8        |            | 197,500    |                      | $          | 4.64 |   |
|                    |       | 2,933,932       |       | $                         | 2.12       |                       | 6.2        |            | 1,992,432  |                      | $          | 1.89 |   |

 

**Warrants**

We have issued warrants in connection with debtofferings, private placements of both common and convertible preferred stock,our IPO, services, legal settlements and as consideration for concessions fromlenders and vendors. A summary of the activity in our warrants follows:
|                                                                                    | ** ** | ** **         | ** ** | **Weighted** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------|------------|--------------|------------|
| ** **                                                                         | ** ** | ** **         | ** ** | **Average**  | ** ** |
| ** **                                                                         | ** ** | **Number of** | ** ** | **Exercise** | ** ** |
| ** **                                                                         | ** ** | **Shares**         | ** ** | **Price**    | ** ** |
| Outstanding,  April 30, 2004                                                  |       | 8,825,311          |       | $            | 1.35       |   |
| Warrants issued  for services                                                      |       | 300,000            |       | 4.00         |       |
| Warrants issued  in connection with financings                                     |       | 2,207,900          |       | 4.87         |       |
| Exercised                                                                          |       | (5,858,701         | )          | 1.25         |       |
| Expired                                                                            |       | (70,000            | )          | 3.00         |       |
| Outstanding,  April 30, 2005                                                  |       | 5,404,510          |       | 3.03         |       |
| Warrants issued  for services                                                      |       | 151,000            |       | 2.82         |       |
| Warrants issued  for legal settlement                                              |       | 120,000            |       | 2.40         |       |
| Class C  warrants issued in connection with exercise of Class B warrants |       | 362,011            |       | 2.50         |       |
| Exercised                                                                          |       | (1,032,511         | )          | 1.34         |       |
| Expired                                                                            |       | —             |       | —       |       |
| Outstanding, April 30, 2006                                                   |       | 5,005,010          |       | $            | 3.32       |   |

F-33

----

 

The outstandingwarrants as of April 30, 2006, are summarized as follows:
|                       | ** ** | ** **      | ** ** | **Weighted** | ** ** | ** **     | ** ** |
|-----------------------|------------|-----------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | ** **      | ** ** | **Average**  | ** ** | ** **     | ** ** |
| ** **            | ** ** | **Number**      | ** ** | **Exercise** | ** ** | **Expiration** | ** ** |
| ** **            | ** ** | **Outstanding** | ** ** | **Price**    | ** ** | **Date**       | ** ** |
| Class B Warrants |       | 1,418,099       |       | $            | 1.50       |           | 12-29-2006 | (1) |
| Class C Warrants |       | 564,511         |       | $            | 2.50       |           | 12-29-2006 | (1) |
| Other Warrants        |       | 3,022,400       |       | $            | 4.32       |           |       | (2) |
|                  |       | 5,005,010       |       | $            | 3.32       |           |       |   |

 

----

(1)             Theexpiration date of the Class B Warrants and Class C Warrants wasextended from December 31, 2005, to December 29, 2006, inJune 2005.

(2)             Theother warrants expire at various dates ranging from June 2006 throughFebruary 2008.

**Extension ofWarrant Expiration Dates**

On June 17, 2005, we extended the expiration dateof the Class B Warrants and the Class C Warrants fromDecember 31, 2005, to December 29, 2006, via an amendment to theWarrant Agreement. There were no other changes made to the terms and conditionsof the Warrant Agreement. The holders of these warrants had been unable toexchange the warrants for registered shares of our common stock sinceOctober 2004, at which time the underlying registration statement was nolonger current. We attempted to file a post-effective amendment to therespective registration statement, but we were unable to do so because ourformer auditor, Grant Thornton LLP, was unwilling to consent to the inclusionof its report on our April 30, 2004 and 2003, financial statements in thepost-effective amendment. In the first quarter of our fiscal year 2006, werecorded a non-cash charge in the statement of operations in the amount ofapproximately $300,000, such charge representing the excess of the fair valueof the amended warrant over the fair value of the original warrant immediatelyprior to amendment.

On December 29, 2005, we extended the expirationdate of certain warrants to purchase 232,500 shares of common stock at anexercise price of $1.25. The warrants were initially issued in a financingtransaction and the holder of the warrants had, for a period of time asdescribed in the Class B and C Warrant disclosure above, an inability toexercise the warrants for registered shares of our common stock. The expirationdate of the warrants was extended from December 31, 2005, toDecember 29, 2006. There were no other changes made to the terms andconditions of the warrant agreements. During the year ended April 30,2006, we recorded a non-cash operating expense in the statement of operationsin the amount of approximately $213,000, such charge representing the excess ofthe fair value of the amended warrant over the fair value of the originalwarrant immediately prior to amendment.

**NOTE 14—EMPLOYEEBENEFIT PLAN**

We contribute to a multi-employer retirement savingsplan qualified under section 401(k) of the Internal Revenue Code. The planis a defined contribution plan, covering substantially all of our non-PPSCemployees. Our contributions to the plan aggregated approximately $104,000 and$82,000 for the years ended April 30, 2006 and 2005, respectively.

F-34

----

**NOTE 15—BUSINESSSEGMENT, GEOGRAPHIC, CUSTOMER AND PRODUCT INFORMATION**

**Segmentinformation**

We currently have four reportable segments: homelandsecurity products, security services, semiconductor products and services andlife sciences. Our homeland security products segment is currently marketingand developing certain trace and bulk detection technologies. Our securityservices segment provides advanced security and investigative services and issubstantially comprised of the operations of PPSC which was acquired inMay 2005. Our semiconductor products and services segment (formerly calledthe “semiconductor materials and products” segment) manufactures and reclaimssilicon wafers, sells SOI wafers and is involved in several research anddevelopment projects including silicon-28. Our life sciences segmentsells stable and radioisotopes in elemental and simple compound forms for usein life sciences applications. Our segments are strategic business units, eachof which consists of similar products or services. They are managed separatelybecause each segment requires different technology and marketing strategy andbecause each segment sells to different customers. Reconciling items consistprimarily of corporate assets or expenses that have not been allocated to aspecific reportable segment. Prior period amounts have been reclassified toconform to current period presentation.

Information by segment is set forth below (inthousands):

|                                          | ** ** | **As of and for the Year Ended** | ** ** |
|------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                               | ** ** | **April 30,**                                             | ** ** |
| ** **                               | ** ** | **2006**                                                       | ** ** | **2005** | ** ** |
| Segment revenues from  external sources: |       |                                                           |       |   |   |
| Homeland  security products              |       | $                                                              | 35         |   | $ | — |   |
| Security  services                       |       | 12,814                                                         |       | — |   |
| Semiconductor  products and services     |       | 5,731                                                          |       | 2,692 |   |
| Life sciences                            |       | 5,136                                                          |       | 7,413 |   |
| Total                                    |       | $                                                              | 23,716     |   | $ | 10,105 |   |
| Segment operating  (loss) income         |       |                                                           |       |   |   |
| Homeland  security products              |       | $                                                              | (3,489     | ) | $ | (1,728 | ) |
| Security  services                       |       | (24                                                            | )          | — |   |
| Semiconductor  products and services     |       | (5,151                                                         | )          | (6,484 | ) |
| Life sciences                            |       | (968                                                           | )          | (2,206 | ) |
| Reconciling  amounts(1)                  |       | (6,999                                                         | )          | (3,744 | ) |
| Total                                    |       | $                                                              | (16,631    | ) | $ | (14,162 | ) |
| Total assets:                            |       |                                                           |       |   |   |
| Homeland  security products              |       | $                                                              | 800        |   | $ | 206 |   |
| Security  services                       |       | 5,992                                                          |       | — |   |
| Semiconductor  products and services     |       | 7,027                                                          |       | 6,356 |   |
| Life sciences                            |       | 1,713                                                          |       | 2,432 |   |
| Reconciling  amounts(2)                  |       | 2,331                                                          |       | 22,187 |   |
| Total                                    |       | $                                                              | 17,863     |   | $ | 31,181 |   |

 

----

(1)             Reconcilingamounts for the operating loss information includes corporate expensesconsisting primarily of payments to Lucent under our development agreement (seeNote 6), corporate salaries and benefits, professional and consulting fees,investor relations costs, insurance and directors’ compensation.

F-35

----

(2)             Reconcilingamounts for the total asset information includes corporate assets consistingprimarily of cash and cash equivalents invested centrally, unamortized debtissuance costs and miscellaneous prepaid items.

**Geographicinformation**

A summary of our operations by geographic area ispresented below (in thousands):

|                                      | ** ** | **As of and for the Year Ended** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                           | ** ** | **April 30,**                                             | ** ** |
| ** **                           | ** ** | **2006**                                                       | ** ** | **2005** | ** ** |
| Net revenues from  external sources: |       |                                                           |       |   |   |
| United States                        |       | $                                                              | 22,153     |   | $ | 7,405 |   |
| Germany                              |       | 1,563                                                          |       | 2,700 |   |
| Total                                |       | $                                                              | 23,716     |   | $ | 10,105 |   |
| Long-lived assets:                   |       |                                                           |       |   |   |
| United States                        |       | $                                                              | 4,853      |   | $ | 5,586 |   |
| Germany                              |       | 1                                                              |       | 3 |   |
| Total                                |       | $                                                              | 4,854      |   | $ | 5,589 |   |
| Net assets:                          |       |                                                           |       |   |   |
| United States                        |       | $                                                              | 2,077      |   | $ | 8,861 |   |
| Germany                              |       | 566                                                            |       | 727 |   |
| Total                                |       | $                                                              | 2,643      |   | $ | 9,588 |   |

 

The geographic summary of net revenue from externalsources is based on the Isonics sales location generating the respective sales.The shipment locations corresponding to the respective customers may be outsidethat geographic area. The geographic summary of long-lived and total assets isbased on physical location. During the year ended April 30, 2006, weelected to close the Chemotrade office due to increasing supplier pricescausing the loss of substantially all of our radioisotope customers.

**CustomerInformation**

Two customers (Foot Locker Retail, Inc.andQimonda Richmond LLC, formerly Infineon Technologies Richmond) accounted forapproximately 17% and 10% of revenues, respectively, for the year endedApril 30, 2006. Two customers (Eastern Isotopes, Inc. and  PerkinElmer, Inc.) accounted forapproximately 19% and 10% of revenues, respectively, for the year endedApril 30, 2005. As of April 30, 2006, three customers accounted forapproximately 30% of total net accounts receivable. As of April 30, 2005,three customers accounted for approximately 29% of total net accountsreceivable. A decision by a significant customer to substantially decrease ordelay purchases from us or an inability to collect significant amounts owed tous could have a material adverse effect on our consolidated financial conditionand results of operations.

**ProductInformation**

One product (oxygen-18) accounted forapproximately 14% and 43% of revenue for the years ended April 30, 2006and 2005, respectively. A change in customer demand or market pricing of thisproduct could have a material adverse effect on our consolidated financialcondition and results of operations.

F-36

----

**NOTE 16—RELATEDPARTY TRANSACTIONS**

On January 1, 2002, we entered into a one-yearconsulting agreement with HS-Consult GmbH (“HSC”) primarily to assistChemotrade in buying and selling isotope products. HSC primarily consists ofthe former managing director of Chemotrade and an additional former keyemployee of Chemotrade. The initial consulting agreement expired onDecember 31, 2002 and required a monthly payment of 5,500 Euros(approximately $7,000) for the services to be provided. The consultingagreement was renewed for terms of one year on January 1, 2005 and 2004and required monthly payments of 5,500 Euros. The consulting agreement was notrenewed for calendar year 2006.

PPSC continues to lease premises partially owned by aformer owner who is a current employee of PPSC. The lease term was originally for the four-year period endedMay 15, 2009. Annual rent payments were originally $48,000 in each of thefour years of the lease term. In March 2006, we amended the lease from afixed term to a month-to-month term and increased the monthly base rent to$4,500 per month. Additionally, we reimburse the landlord 80% of the costsincurred by the landlord for taxes, maintenance of common areas and fire andhazard insurance as well as the entire amount of the premium incurred forrental loss insurance.

**NOTE 17—SUBSEQUENTEVENTS**

**Investment inISCON Video Imaging, Inc.**

ISCON Video Imaging, Inc. (“ISCON”) is a companythat is attempting to develop patent-pending infrared imaging-basedtechnologies for the non-invasive detection of objects hidden under clothing aswell as technology for the determination of the chemical composition of suchobjects to identify explosives and drugs. On May 12, 2006, we signed astock purchase agreement with ISCON that provides us the option, but not theobligation, to purchase authorized but unissued shares of Series B commonstock from ISCON at five intervals based on successful completion ofdevelopmental and commercial milestones. If ISCON succeeds in meeting all fivemilestones and if we choose to exercise our option to purchase shares for eachcompleted milestone, we would own 51% of ISCON for a cumulative investment of$1,750,000. On June 9, 2006, we made our first investment in the amount of$100,000. As a result, we currently own approximately 9% of ISCON.

**8% ConvertibleDebentures**

On May 18, 2006, we made an offer to the holdersof our outstanding 8% Debentures to pay in cash the principal balance remainingimmediately subsequent to making the monthly payment scheduled June 1,2006, plus a 5% premium and accrued interest, both items to also be paid incash. On May 19, 2006, approximately $5.0 million out of thethen-outstanding $8.2 million 8% Debentures accepted our offer. The offer wasmade and accepted contingent upon the cash payment being made to the acceptingholders on or before June 1, 2006, from the proceeds of a financing thatwere then working to complete and which is discussed below. In accepting ouroffer, the holders agreed to limit the anti-dilution provision on theirwarrants originally issued with their debentures such that the warrants wouldfully ratchet based upon the financing completed on May 31, 2006, and thenthe ratchet would be converted to a price-only ratchet whereby the exerciseprice would still be reduced to theeffective price per share (or effective exercise price per share) of thesubsequent equity sale but where the number of shares purchasable under thewarrant would be fixed. The holders also agreed to waive certainprovisions of the Securities Purchase Agreement entered into concurrently withthe 8% Debentures which relate to entering into a future 

F-37

----

financing with variableconversion terms (such contractual terms we do not believe to be in force). Inaccordance with this offer and subsequently to closing the financing onMay 31, 2006, we paid approximately $4.1 million from the proceeds of thefinancing to the holders accepting our offer. This payment resulted in areduction in the principal balance of the 8% Debentures of $3,880,000.

As a result of entering the financing transactiondiscussed below, which includes a fixed conversion price of $1.25, the warrantsassociated with the 8% Debentures were amended per the warrant such that thewarrant exercise price was reduced from $6.25 per share of common stock to$1.25 per share of common stock. Simultaneously, the number of shares purchasableunder the warrants increased from 1,593,900 to 7,969,500. Due to our offer madeon May 18, 2006, to the holders of the 8% Debentures and the acceptance ofthe offers by certain holders, of the currently outstanding warrants associatedwith the 8% Debentures, warrants to purchase 4,557,000 shares of common stockhave a price ratchet only whereby no change to the number of shares purchasablewill occur and warrants to purchase 3,412,500 shares of commons stock continueto retain the original ratchet provisions.

Having met all requirements to allow us to do so, weelected to make the monthly principal and interest payments due for our 8%Debentures on May 1, 2006, and June 1, 2006, in shares of our commonstock. Accordingly, we issued a total of 1,616,433 and 1,997,265 shares ofcommon stock, respectively, in settlement of (1) principal amounts owed onthe 8% Debentures in the amounts of $1,822,500 and $1,647,500, respectively and(2) interest obligations for the months of April 2006 and May 2006in the nominal amounts of $66,500 and $21,250, respectively. As discussed inNote 9—Borrowings, as the payments were made in stock in lieu of cash, thefixed monetary amounts of the principal and interest payments will have alarger impact on the consolidated financial statements as compared to thenominal amounts disclosed. Thisdifference is due to application of the fixed discount applied to the price ofour common stock in the calculation of the number of common shares due for eachprincipal payment and interest payment when made in shares of our common stock,as defined. We elected to make our monthly principal and interest payment dueon July 1, 2006 in cash. This payment included a reduction to outstandingprincipal of $562,000 and interest in the amount of  $17,500. Subsequent to this payment, theoutstanding principal balance on the 8% Debentures was $2,062,500.

In June 2006, one of the two remaining holders ofour 8% Debentures, with remaining principal outstanding in the amount of$312,500, asserted that the issuance of the 6% Convertible Debentures (seediscussion below) constituted a default (due to a potential variable conversionprovision contained within the 6% Convertible Debenture agreement) under the 8%Debentures. We have contested that allegation on several bases and will defendagainst any further allegation of default as necessary.  As outline in Note 9—Borrowings, remedies for an event of default include theoption to accelerate payment of the full principal amount of the debentures,together with interest and other amounts due, to the date of acceleration. Theprincipal amount of the debentures shall be equal to 130% of the then-principalamount of the debentures plus all interest and other amounts due or aconversion calculation, whichever is higher. The holder hadapproximately $937,000 (and the other remaining holder had $2,250,000) due onits debenture at the time we entered into the 6% Convertible Debentures.

F-38

----

**6% ConvertibleDebentures**

On May 31, 2006, we completed a private placementpursuant to which we issued to one accredited investor, Cornell Capital, L.P. (“Cornell”)a 6% secured convertible debenture with a principal amount of $10,000,000,which is the first of three 6% secured convertible debentures (cumulatively,the “6% Debentures”), for which the aggregate principal amount will be$16,000,000. On June 5, 2006 (two trading days prior to filing of aregistration statement contemplated in the transaction documents correlatedwith the 6% Debentures), we issued the second of the three 6% Debentures. This6% Debenture has a principal amount of $3,000,000. The final 6% Debenture witha principal amount of $3,000,000 is scheduled to be issued and funding receivedtwo trading days prior to a registration statement being declared effective bythe Securities and Exchange Commission. The 6% Debentures are convertible intoshares of our common stock at the lesser of $1.25 (the “Fixed Conversion Price”)or 80% of the average of the two lowest daily volume weighted average prices ofour stock during the five trading days immediately preceding the conversiondate (the “Market Conversion Price”). The 6% Debentures mature on May 31,2009 (the “Maturity Date”). In addition to the 6% Debentures, we issued threewarrants (the “6% Debenture Warrants”) to purchase a total of 8,000,000 sharesof our common stock at exercise prices of $1.25 per share (2,000,000 warrants),$1.75 per share (3,000,000 warrants) and $2.00 per share (3,000,000 warrants).Each of the warrants can be exercised for a period of three years.

The then-effective conversion price will be adjustedupon the occurrence of any stock dividends, stock splits, pro ratadistributions, or fundamental transactions as described in the 6% Debentureagreement. Additionally, the Fixed Conversion Price will be reduced if we issueshares of stock or other instruments that are exchangeable into or convertibleinto common stock at an effective price less than the Fixed Conversion Price.The Fixed Conversion Price will be adjusted to mirror the conversion, exchangeor purchase price at issue. Our issuance and exercise of options which arecompensatory and pursuant to our stock option or stock purchase plans will notcause an adjustment under this provision.

Interest accrues on the outstanding principal balanceat the annual rate of 6%. Interest is payable on the Maturity Date in cash orshares of our common stock, at our option. If we choose to pay accrued interestin shares of our common stock, the number of shares to be issued will becalculated as the amount of interest due divided by 88% of the volume weightedaverage price of our common stock for the five trading days preceding theMaturity Date.

The investor and an unaffiliated party provided usservices in connection with completing the transaction. To compensate thesepeople for those services, we issued them 660,000 shares of our common stock(the “Buyers Shares”). We also have paid Cornell or its affiliates fees in theamount of $735,000 and will pay from proceeds of the unissued $3 million 6%Debenture an additional $165,000 when issued.

We have agreed to seek shareholder approval of thistransaction by no later than October 31, 2006, (exclusive of any sharesacquired in this transaction or related transactions), including the ability toissue a maximum of 64 million shares upon conversion of the 6% Debentures andto approve an increase in authorized shares of common stock to at least 175million shares.

The 6% Debentures,the 6% Debenture Warrants and the Buyers Shares have certain limitations on ourability to issue shares to the holders of the instruments and impose certainlimitations on Cornell’s ability to sell shares.

·       We are prohibited fromissuing shares of our common stock to the holders of the 6% Debentures (uponconversion or payment of interest) and the 6% Debenture Warrants (uponexercise) if the 

F-39

----

issuance wouldresult in Cornell beneficially owning more than 4.99% of our outstanding commonstock (although Cornell can waive this provision upon more than 65 days’notice to us).

·       Until (and if) the shareholdersapprove the transaction as required by Nasdaq rules, the number of sharesissuable upon conversion of the 6% Debentures shall not be greater than6,075,785, which along with the Buyers Shares and the 2,000,000 warrant sharesexercisable at $1.25 represent less than 19.99% of the total number of sharesoutstanding on May 31, 2006.

·       Cornell is prohibited fromselling shares related to the 6% Debentures until the later of the relatedregistration statement achieving effectiveness or September 28, 2006 (120days subsequent to the issuance of the first 6% Debenture).

·       Between September 29,2006, and January 26, 2007, if converting using the Market ConversionPrice, Cornell is limited to converting no more than $200,000 of the principalor accrued interest on the 6% Debentures into shares of our common stock in anyseven calendar day period.  Subsequent toJanuary 26, 2007, if converting using the Market Conversion Price, Cornellis limited to converting no more than $400,000 of the principal or accruedinterest on the 6% Debentures into shares of our common stock in any sevencalendar day period.

·       The maximum number ofshares that may be issued upon conversion of the principal amount of the 6%Debentures is contractually limited to 64 million shares.

If there is an effective underlying registrationstatement and if the volume weighted average price of our common stock is equalto or greater than $2.50 for twenty consecutive trading days, we may forceCornell to convert the outstanding principal and any accrued interest, subjectto the share issuance limitations discussed above.

We have the right, after providing ten trading daysadvance written notice, to redeem a portion or all amounts outstanding underthe 6% Debentures prior to the Maturity Date provided the closing bid price ofour common stock is less than $2.50 at the time the redemption notice isprovided. If we exercise this redemption right, a redemption premium in theamount of 20% of the principal amount being redeemed will be due. During theten day notification period, Cornell may elect to convert any portion or all ofthe outstanding 6% Debenture amount.

For a period of one year subsequent to entering intothe 6% Debenture agreements on May 31, 2006, we have granted Cornell theright to participate in any allowed capital raise up to 50% of the raise. Afterthat one year period expires and until such time no portion of the principaland interest due on the 6% Debentures is outstanding, we have granted Cornellthe right to participate in any allowed capital raise up to 25% of the raise.

As a result of a freestanding registration rightsagreement, we have an obligation to register the shares underlying the 6%Debentures, Buyers Shares and 6% Debenture Warrants. We were required to filean initial registration statement to register 8,735,785 shares of common stockunderling no later than August 7, 2006 (a registration statement was filed onJune 7, 2006) and to have the initial registration statement declared effectiveby September 28, 2006. If we fail to meet our effectiveness deadline, we willincur liquidated damages of one percent of the outstanding balance of the 6%Debentures for each thirty-day period subsequent to the date of the deadlinemissed until such time as the registration statement is declared effective.Within thirty days of obtaining shareholder approval to issue in excess of19.99% of the outstanding shares of ours as of May 31, 2006, we must file anamended registration statement to register 

F-40

----

the full number of sharesrequired under the 6% Debenture transaction documents (representing the BuyersShares, shares underlying the 6% Debenture Warrants and shares upon theconversion of the 6% Debentures based on a defined formula but in an amount notto exceed 64 million shares). Additionally, once effectiveness of both theinitial and the amended registration statement is achieved and until such timethat all eligible shares have been sold under the registration statements, ifsales are not able to be made under the registration statement (due to failureto keep the registration statement effective or failure to register sufficientshares or otherwise), Cornell will have recourse to the aforementioned 1% perthirty day liquidated damages penalty. We are contractually not obligated to payliquidated damages for more than a total of 365 calendar days. Failure tocomply with our registration obligations may, subsequent to any grace periodsand opportunities to cure, be deemed an event of default.

Additionally, other events, as defined in the 6%Debenture agreement, may also allow the 6% Debenture holders to declare us indefault. Remedies for an event of default, include the option to acceleratepayment of the full principal amount of the Debentures, together with interestand other amounts due, to the date of acceleration and Cornell will have theright to request such payment in cash or in shares of our common stock.

So long as principal amounts are outstanding under the6% Debentures, we have agreed to not sell capital stock or grant securityinterests which meet certain defined characteristics without the prior consentof Cornell. However, certain transactions defined as Excluded Securities areexempted from this prior consent provision. Excluded Securities include(1) securities issued in connection with a strategic partnership or jointventure, (2) securities issued as consideration for a merger orconsolidation or the acquisition of a business, product, license or other assetof another person or entity, (3) options (priced not less than at themarket) provided to employees within the first thirty days of employment,(4) securities issued pursuant to an approved stock plan, (5) up to 1million shares (priced not less than market) which may be issued as long as noregistration rights are included and as long as not pursuant to a Form S-8and (6) any other issuances to holders of other pre-existing securities ifsuch issuances are provided for in the terms of such instrument.

The 6% Debenture Warrants are exercisable for cashonly, unless after January 15, 2007, there is no effective underlyingregistration statement, at which point a cashless exercise can be elected bythe holder. Thethen-effective warrant exercise price will be adjusted upon the occurrence ofany stock dividends, stock splits, pro rata distributions, or fundamentaltransactions as described in the 6% Debenture Warrant agreements. Additionally,the exercise price and number of shares upon issuance of common stockare subject to adjustment in cases where we issue shares of common stock (otherthan Excluded Securities or issuances in connection with other components ofthe 6% Debenture documents) for consideration per share less than thethen-existing warrant exercise price. If an adjustment is triggered, thewarrant exercise price for the warrant for 2,000,000 shares at an exerciseprice of $1.25 per share and the warrant for 3,000,000 shares at an exerciseprice of $1.75 per share will be adjusted to a price determined by multiplyingsuch exercise price by a fraction of which (a) the numerator shall be thenumber of shares of common stock outstanding immediately before such issuanceplus the number of shares of common stock that the aggregate considerationreceived by us for such issuance would purchase at the warrant exercise pricethen in effect and (b) the denominator shall be the number of shares ofcommon stock outstanding immediately prior to such issuance plus the number ofnew shares to be issued in the triggering event. Concurrently, the number of shares issuableupon exercise of the warrant will be adjusted such that the aggregate exerciseprice would be equal to the aggregate exercise price prior to adjustment. Thewarrant for 3,000,000 shares exercisable at $2.00 per share has a differentadjustment calculation whereby a subsequent 

F-41

----

triggering equity issuance would lead to a reductionin the warrant exercise price per share equal to the price per share (ofeffective exercise price per share) of the subsequent equity issuance. Therewould be no change to the number shares issuable under the warrant.

The 6% Debentures are secured by individual securityagreements with IVI, HSDC and PPSC.

We are currently computing the cumulative accountingimpact of the issuance of the 6% Debentures, including the allocation of debtproceeds between the financial instruments issued, the potential existence ofderivative liabilities and the potential existence of a beneficial conversionfeature. While our accounting evaluation is not complete, because ofcertain contractual provisions in the 6% Debentures and accompanyingtransaction documents together with certain provisions of United StatesGenerally Accepted Accounting Principles, we will likely be required to recordsignificant non-cash interest charges over the life of the 6% Debentures (inaddition to interest expense relating to the 6% interest rate borne by the 6%Debentures which will be paid in cash or shares of our common stock, at ouroption). Additionally, we will likely be required to initially record theaccompanying warrants and the embedded conversion feature of the 6% Debenturesas derivative liabilities, which will be required to be marked to market on aquarterly basis.

F-42

----