**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-KSB**

**(MarkOne)**

**x       **ANNUAL REPORT UNDERSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

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

**o        TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934.**

** **

**For the transition period from             to          **

**Commission file number:  001-12531**

**ISONICSCORPORATION**

(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 telephone number:**(303) 279-7900

**Securities registered pursuant to Section 12(b) ofthe Exchange Act:** None

**Securities registered pursuant to Section 12(g) ofthe Exchange Act:**

**Common Stock, no par valueClass B Common Stock WarrantsClass C Common Stock Warrants**

**(Title of Class)**

Check whether the issueris not required to file reports pursuant to Section 13 or 15(d) ofthe Exchange Act: o

Check whether the issuer (1) filedall 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 xNo o

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

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

Registrant’s revenues forthe fiscal year ended April 30, 2006 were $23,716,000.

The aggregate market valueof the voting stock held by non-affiliates of the Registrant based on theaverage bid and asked prices of the Registrant’s Common Stock on July 21,2006 was $19,236,176.

The number of sharesoutstanding of the Registrant’s Common Stock, no par value, as of July 21,2006, was 46,358,044 shares.

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

TransitionalSmall Business Disclosure Format (check one): Yes oNo x

 

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**ITEM 1.     BUSINESS**

**Because we want toprovide you with more meaningful and useful information, this Form 10-KSBcontains certain “forward-looking statements” (as such term is defined insection 21E of the Securities Exchange Act of 1934, as amended). These statementsreflect our current expectations regarding our possible future results ofoperations, performance, and achievements. These forward-looking statements aremade pursuant to the safe harbor provisions of the Private SecuritiesLitigation Reform Act of 1995 and applicable common law and SEC rules.**

**Wherever possible,we have tried to identify these forward-looking statements by using words suchas “anticipate,” “believe,” “estimate,” “expect,” “plan,” “intend,” and similarexpressions. These statements reflect our current beliefs and are based oninformation currently available to us. Accordingly, these statements aresubject to certain risks, uncertainties, and contingencies, which could causeour actual results, performance, or achievements to differ materially fromthose expressed in, or implied by, such statements. We have described theserisks, uncertainties and contingencies under “Risk Factors” and “Management’sDiscussion and Analysis of Financial Condition or Plan of Operation.”**

**We have no obligation to update or revise any suchforward-looking statements that may be made to reflect events or circumstancesafter the date of this report.**

**General Discussion**

**Isonics Corporation**

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.

We were formed in March 1992, as a partnership,and were subsequently incorporated in California in March 1993, as A&RMaterials, Inc. In September 1996, we changed our name to IsonicsCorporation. Our web site is www.isonics.com.Our common stock is traded on the Nasdaq Capital Market under the symbol “ISON.”In June 2006, we received notification from Nasdaq that we have failed tomeet certain listing requirements (including stockholders’ equity of at least$2.5 million or market value of listed securities of at least $35 million). Wewere provided until July 26, 2006 to regain compliance or face delistingprocedures. We believe with the filing of this Form 10-KSB we havemet the stockholders’ equity requirement and, as a result, we are in compliancewith this Nasdaq Marketplace Rule.

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. We cannot give any assurance that we will be able to meetthe Nasdaq requirements to maintain our Nasdaq Capital Market listing, or thatif we do, a stable trading market will develop for our stock or our warrants.

As a result of the low market price for our commonstock, our outstanding Class B Warrants and Class C Warrants (both ofwhich expire on December 29, 2006) will no longer be exercisable pursuantto the existing registration statement (SEC file no. 333-110032). Weintend to file a post-effective amendment to that registration statement in thefuture, but we can give no assurance that any such registration statement willbe effective in time for the exercise of the Class B Warrants or the Class CWarrants prior to 

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their expiration date,assuming (without assurance) that market conditions recover so that thewarrants are economically exercisable.

The address of our principal executive offices and ourtelephone and facsimile numbers at that address are:

IsonicsCorporation5906 McIntyre StreetGolden, Colorado 80403Telephone No.: (303) 279-7900Facsimile No.: (303) 279-7300

During our 2006 fiscalyear and subsequently, we raised over $9,900,000 (net of expenses and$4,100,000 of payments on our 8% Convertible Debentures (“8% Debentures”))through the issuance of 6% Convertible Debentures (“6% Debentures”), theexercise of stock options and the exercise of common stock warrants. Inaddition, the purchaser of our 6% Debentures has an obligation to purchase anadditional $3,000,000 6% Debenture two days before the registration statementunderlying the 6% Debentures is declared effective. As a result of the recentfinancing and the commitment for the purchase of an additional $3,000,000 6%Debenture, we believe we have enough cash to finance our anticipated operationsand projected negative cash flow into our 2008 fiscal year.

*Subsidiaries*

We currently conduct someof our operations through five wholly owned-subsidiaries. The following chartprovides some information about those subsidiaries:

| **Name and Headquarters**                         | ** ** | ** **    | ** ** | **Place of Formation** | ** ** | **Ownership Percentage**                                                                                                                                                                                                                                                          | ** ** | **Business** |
|---------------------------------------------------|------------|---------------|------------|------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|
| Isonics Homeland Security and Defense Corporation |       | Delaware, USA |       | 100%                   |       | Isonics Homeland Security and Defense Corporation (“HSDC”) was formed in  October 2004 and it coordinates our efforts in the homeland security  market.                                                                                                            |
| IUT Detection Technologies, Inc.             |       | Colorado, USA |       | 100% by HSDC           |       | IUT Detection Technologies, Inc. (“IUTDT”) (of which the remaining 15%  was acquired from Institut fur Umwelttechnologien GmbH (“IUT”) in  April 2006) owns and is attempting to commercialize the detection  technology that we acquired from IUT. |
| Protection Plus Security Corporation              |       | New York, USA |       | 100% by HSDC           |       | Protection Plus Security Corporation (“PPSC”) (which was acquired on  May 16, 2005) is a provider of advanced security and investigative  services for leading businesses and institutions.                                                                        |

 

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| Isonics  Vancouver, Inc.        |   | Washington,  USA |   | 100% |   | Isonics  Vancouver, Inc. (“IVI”) operates our 300-millimeter silicon test  and reclaim and SOI plant in Vancouver, Washington.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|--------------------------------------|--------|------------------|--------|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Chemotrade GmbH  Dusseldorf, Germany |   | Germany          |   | 100% |   | Chemotrade GmbH (“Chemotrade”) was a value-added re-seller of stable and radioactive  isotopes. It supplied radioactive isotopes for pharmaceutical and industrial  research as well as for industrial and medical imaging, calibration sources  and for cancer therapy (brachytherapy) applications. Additionally, Chemotrade  supplied various stable isotope labeled compounds for pharmaceutical research  and drug design, as well as oxygen-18 for use in producing a  radioisotope used in positron emission tomography. Chemotrade’s market was  primarily Europe, but sales were also made to North America and Asia.  Effective December 31, 2005, we elected to close the Chemotrade office  and consolidate its operation with ours in the United States. |

 

Theforegoing does not include our minority ownership in three companies:

·       Wehave a 30% interest in IUT, an entity based in Berlin, Germany, which performsresearch and development, and manufacturing of radioisotopes.

·       Wehave a 25% interest in Interpro Zinc, LLC, a Colorado entity that engages inthe research and development for the recovery and recycling of zinc metal fromvarious sources. Interpro Zinc, LLC has suspended its operations due to a lackof funding and it is unclear as to if or when it will resume such operations.

·       We have an approximate 9% interest in ISCON VideoImaging, Inc. (“ISCON”), a company that is attempting to developpatent-pending infrared imaging-based technologies for the non-invasivedetection of objects hidden under clothing as well as technology for thedetermination of the chemical composition of such objects to identify explosivesand drugs

The purchase and ownershipof our common stock and warrants involves a high degree of risk. *See* Item 6*“Management’s Discussionand Analysis—Risk Factors”*, below. We have not authorized anyone togive you information or to make any representation other than those containedin this annual report.

**Trading Symbols**

| Common Stock          |   | “ISON”  |   |
|-----------------------|--------|-------------------|--------|
| Class B Warrants |   | “ISONL” |   |
| Class C Warrants |   | “ISONZ” |   |

 

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**Company Strategy**

We believe our strength lies in our ability to bringthe necessary resources together to identify, evaluate, develop, engineer andsuccessfully commercialize applications for homeland security, stable isotopes,radioactive isotopes, non-isotopic materials and value-added productsmanufactured from these foregoing materials.

We believe we havecreated a product development model that can serve as a basis for our currentand future expansion. To capitalize on the commercial opportunities that havebeen identified for stable isotopes, we have adopted a business strategydesigned to maximize the value of our technologies, business development, andmanagement resources, while minimizing capital costs. This strategy involves:

·       focusingon development of high value-added products, which products should give us acompetitive advantage in large or growing markets;

·       leveragingresearch and development expenditures through collaborations, governmentprograms, and corporate and academic partnerships;

·       minimizingearly capital needs by obtaining stable and radioactive isotopes throughalliances and supply agreements with existing stable and radioactive isotopesources;

·       obtainingvalue-added processing technology through sub-contract manufacturingagreements, joint ventures, and acquisitions of strategically importanttechnologies and companies; and

·       developinga time-balanced product pipeline to provide a continual supply of new businessopportunities.

To further our business strategy, in December 2002,we acquired certain trace and bulk detection technology from IUT to be used forhomeland security applications. In late 2004, we began to take steps towardmarketing and then commercializing our first homeland security product, theNeutroTestTM explosive detection prototype. While we are still working onNeutroTestTM, we are focusing the majority of our efforts on the development andmarketing of our Ion Mobility Spectroscopy (“IMS”) based products. Additionally,we are considering other products and services for our homeland securityoperations as well.

In calendar year 2002, wecommenced a new line of business—the manufacture and marketing of SOI wafers.In June 2004, we expanded our SOI wafer manufacturing operations when weacquired the business and assets of Encompass Materials Group, Ltd. (“EMG”),which was engaged in the business of manufacture and reclamation of siliconwafers. During fiscal year 2006, we have focused our efforts on higher margin300-millimeter products and services, wafer thinning and SOI products. In May 2005, we completed an importantstep in our business plan to build a multi-dimensional, high-growth homelandsecurity business capable of delivering a range of next-generation technologiesand services with the acquisition of PPSC.

**Lines of Businessand Products**

During fiscal years 2006 and 2005, our revenues weregenerated from sales of stable and radioactive isotopes, small and largediameter test and reclaim silicon wafers, and SOI wafers. Additionally, as aresult of the acquisition of PPSC in May 2005, we also generated revenuesfrom providing advanced security services for leading businesses andinstitutions in healthcare, education, retail, manufacturing and the art worldduring fiscal year 2006. We expect that sales from our semiconductor operationswill continue to increase during our 2007 fiscal year due mainly to the growthof our 300-millimeter large-diameter silicon wafer and thinning productlines. We do not however anticipate any significant increases (if at all) insmall diameter wafer manufacturing or reclamation services as we are movingcapacity away from these products and towards our other higher-margin products.PPSC has successfully obtained its Government Contract Schedule (“GSA Schedule”)for security services. As a result, PPSC is actively attempting to acquire 

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federal securitycontracts, a market they do not currently serve. We are hopeful that PPSC willbe successful in acquiring such federal security contracts but we can offer noassurances that it will be able to do so. In addition, we are hopeful that wewill begin to generate revenue from our trace and bulk detection andintelligent digital video technologies during fiscal year 2007.

As evidenced by ourhomeland security operations and the introduction of new products into oursemiconductor products and materials and life sciences segments, we areattempting to bring our recently developed product lines to market, which weexpect to add to our revenue stream in the future. The following is a morespecific discussion of our current products.

***HomelandSecurity***

In October 2004, we formed a new subsidiary, HSDCto focus and consolidate our efforts in the homeland security sector and toprovide better visibility to our activities in this area. These efforts includeentry into the security services market, acquisition and development of certaintrace and bulk detection technology that can be used to detect various types ofexplosives and/or chemical agents, the launch of a partnership to provideintelligent digital video solutions and the entry into an agreement with anestablished partner to develop innovative infrared imaging technology. HSDC’sownership includes our 100% interests in IUTDT and PPSC along with our 30%minority interest in IUT. We previously held an 85% interest in IUTDT untilApril 2006 at which time we acquired the remaining 15% ownership from IUT(along with contractual clarification of ownership of certain trace and bulkdetection technology) in exchange for a royalty in an amount equal to 2% of thenet selling price of existing developed products (based upon the trace and bulkdetection technology previously acquired from IUT in December 2002) thatare sold, leased or otherwise put into use by HSDC or any of its affiliatedentities anywhere in the world. We previously held an 8% interest in IUT untilDecember 1, 2005 at which time we increased our ownership to 30%. Thefollowing is a detail of each of our product lines within our homeland securitysegment:

**Security****Services****—**In May 2005, we acquired PPSC, a providerof a wide range of security-related services. Since the effective date of theacquisition, PPSC has delivered significant revenue totaling $12,814,000 andgross margin of approximately 24%. Although the segment generated an operatingloss for the year ended April 30, 2006, of $(24,000), this amount isinclusive of amortization of acquisition-related customer intangibles in theamount of $138,000 and also includes incremental investment in personnelspecifically focused on selling to the government sector of the Unites States.Further, we believe that the acquisition of PPSC provides us with a deep sourceof knowledge and contacts within the homeland security space and that it iscapable of providing key insight for the development of our next-generationproducts along with successful marketing and sales processes.

During our fiscal year ended April 30, 2006, PPSCsecured over approximately $5,000,000 in cumulative new contracts for sevenprivate sector customers for security services to be performed throughout theUnited States. The contract terms range from one to three years in length. Weexpect these new contracts to generate incremental revenue for fiscal year 2007of approximately $2,000,000. Among the new clients are Forbes, Inc. andthe National Basketball Association. We had previously announced that weobtained North General Hospital as a customer as well but this relationship wassubsequently terminated by PPSC.

Further, although currently PPSC does not have anygovernment service contracts, in July 2005 PPSC was awarded a GSA Scheduleunder which PPSC can and has begun to pursue government service contracts.While we believe that we will be successful in acquiring government servicecontracts in fiscal year 2007, we can offer no assurance that we will be ableto do so.

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**Detection****Technology Our**—effortsare currently focused on two detection technologies, as follows:

*IonMobility Spectroscopy—IMS*is a “sniffer” technologyoriginally developed by IUT. During the last six months of fiscal year 2006, weramped up our marketing and sales efforts of EnviroSecureTM, a new system thatcan monitor and identify chemical weapons and toxic substances in the air in avariety of venues including airports, mass transit facilities, sports venuesand public and private sector office buildings. Our system is designed tocontinuously monitor the air and immediately detect and identify harmfulsubstances at the parts per billion (ppb) level, providing warning of apossible attack in a matter of minutes. Earlier generations of this producthave been in continuous use at the German parliament building since 1999,effectively monitoring the air for toxic substances and chemical weapons. Thisturnkey solution includes system design, engineering, hardware, software,installation, training and maintenance. It is anticipated that theEnviroSecureTM system could be installed in any facility and become fullyoperational within three to nine months, though the time frame will varydepending on the size and complexity of each installation. While we have not yetmade any sales of this product, the product is available for sale, and wecontinue to focus our efforts on marketing and customer engagement.

Through our ongoing funding of research anddevelopment efforts at IUT, we continue to explore other commercialapplications for our IMS technology. We are currently in the process of takingour IMS technology and miniaturizing and re-designing it for low-cost,high-volume manufacturing in the United States.

In November 2005 we signed a developmentagreement with DualDraw LLC (“Dual Draw”), a manufacturer of air qualityequipment. Under that agreement, we have developed and are testing a prototypethat combines our IMS based technology with DualDraw’s mailroom inspectionworkstations, a downdraft workstation that keeps toxic substances away from thebreathing zone of mailroom workers who are sorting or opening mail and capturessuch substances with a HEPA filtration system. The incorporation of our IMScapability would provide an alarm if toxic or explosive substances are detected.We completed a prototype of the product and exhibited that prototype at varioustrade shoes including the 2006 National Postal Forum and ISC West Expo 2006.

We are also seeking to package our IMS technology in ahand-held “sniffer” designed for military and first responder use.

Although we have not yet made any sales of productsincorporating the smaller version of the IMS technology, we have receivedfavorable feedback from potential customers. We have, therefore, placed aninitial order of 100 units with our contract manufacturer for use in themailroom workstation and with the hand-held sniffers. We expect the firstdelivery of units from our manufacturer will be available for commercial salein August 2006 (after the completion of certain testing) and while we areconfident that we will begin to generate revenue from these IMS based productsduring fiscal year 2007, we can offer no assurances that we will be able to doso.

*Neutronbased detection*—We have developed a hand-heldexplosive detection device named NeutroTestTM. We had earlier projected that weexpected to have a NeutroTestTM product available for international sales inlate second calendar quarter and for United States sales in the third calendarquarter of 2005, respectively. As expected, we completed the sale of two,first-generation units to a German entity in June 2005, although we havenot completed any subsequent sales in Europe or the United States. Feedback onthe performance of these two units has been positive and has also includedproduct enhancement recommendations. We have taken the feedback from ourinitial international sales of the first-generation NeutroTestTM and haveimplemented them into our second-generation units, one of which is nowavailable in the United States for customer demonstrations and several areavailable in Germany. Our marketing plan for the second-generation NeutroTestTMproduct includes targeting potential United States based customers to which wewill demonstrate the value of NeutroTestTM. To facilitate this plan, we 

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have reached an agreementwith a third party to establish a fully licensed customer demonstration andtraining facility in the United States.

One issue that has impeded the sales process is theregulatory and licensing requirements regarding the neutron-generation source,generally a radioisotope, whereby both our company and the customer must meetcertain criteria in order to possess and use the radioisotope for its intendedpurpose. Though we believe the regulatory and licensing requirements can be metby both, these requirements will likely limit the customer base for ourNeutroTestTM product to government and military entities and, possibly, largeorganizations with the resources to meet the licensing requirements. In orderto meet the needs of this customer group, the second generation of NeutroTestTMis being repackaged into a one piece, more rugged form factor that can bemanufactured in the United States. We can make no assurances that we will beable to successfully mitigate the requirements to the extent required forbroad-based market acceptance of the NeutroTestTM product. The development ofsecond-generation functionality, implementation of the domestic marketing planand addressing the existing aforementioned regulatory requirements were thefocus of activities in fiscal year 2006, and we expect to continue theseefforts during the first and second quarters of fiscal year 2007.

Although we have continued research and developmentfunding of both the IMS and neutron-based detection technologies, we expectthat future funding decisions will place a higher emphasis on IMS-based applications.We have not made any sales of our NeutroTestTMproduct after the initial sales made in June 2005.

**Intelligent****Digital VideoSolutions****—In**February 2006, we entered into an agreement with Intelligent SecuritySystems, Inc. (“ISS”), a developer of innovative video securitytechnology, to offer a range of intelligent video security solutions for thehomeland security market. These solutions integrate proprietary technology toprovide advanced security applications in addition to standard digital video monitoring,including facial recognition, iris recognition, object tracking, body tracking,behavior recognition and license plate recognition. ISS-based videosurveillance solutions have been previously successfully deployed globally inthe homeland security market. Our initial efforts have been focused onmarketing and customer engagement. We have not yet made any sales of thisproduct line.

**Infrared****ImagingTechnology****—On**December 5, 2005, we approved a development plan that resulted in usbecoming obligated under a Development & Licensing Agreement (“theAgreement”) entered into with Lucent Technologies, Inc. (“Lucent”) in September 2005.Under this Agreement, the two companies are attempting to develop anext-generation infrared imaging and night vision surveillance technology basedon research by Lucent’s Bell Labs micro electro-mechanical systems (“MEMS”) andnanotechnology fabrication facility. Infrared technology, which convertsinfrared radiation in the non-visible spectrum, such as body heat, into avisible image, is commonly found in both commercial and military/homelandsecurity applications including night vision goggles and cameras, rifle scopes,and threat detection devices used to identify concealed weapons or explosives. TheMEMS approach to infrared imaging, if successful, may lead to products, whichare at least equal in performance with a lower power consumption and price thanproducts currently available in the marketplace today. Additionally, aMEMS-based product may also provide for cost efficiencies in the manufacturingprocess. The development plan contemplates a proof-of-concept within 12 months,followed by steps towards commercialization, though we can provide noassurances that a commercially attractive product will ultimately be available.

The Agreement provides for us to receive an exclusiveright, except for certain rights reserved by Lucent, to make, use and selllicensed products arising from technology developed under the Agreement. Inexchange for this license, we will fund Lucent’s development efforts for theproject through the periodic payment over a two and one-half year period of adevelopment fee totaling $12,000,000. We paid $2,000,000 under this agreementduring the year ended April 30, 2006 and paid an additional $1,000,000 in June 2006.The remaining balance will be paid in $1,000,000 increments approximately everythree months 

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thereafter commencing in August 2006.We do not currently have sufficient funding to meet our entire paymentobligation to Lucent. If we fail to make payments when due, Lucent may cancelthe agreement or cease working on the project and then assess us a “start-up”fee if funding was to resume. We cannot offer any assurance that we will beable to make all of the required payments to Lucent, or that the technologywill be developed to a point where we want to continue to make such paymentswhen due.

We have the right to terminate the development projectfor any reason (including if the development work is not proceeding up to ourexpectations) from time-to-time, so long as termination is prior to the firstcommercial sale of a licensed product. Additionally, upon the commencement ofcommercial sales, if ever, we would be obligated to pay royalties based onrevenue, potentially a sales referral fee based on revenue and also an annualexclusivity payment to maintain our exclusive rights to the developedtechnology.

On May 12, 2006, weentered into an agreement with ISCON, (a company that is attempting to developpatent-pending infrared imaging-based technologies for the non-invasivedetection of objects hidden under clothing as well as technology for thedetermination of the chemical composition of such objects to identifyexplosives and drugs) that provides us the option to purchase shares of ISCONcommon stock based upon the successful completion of developmental andcommercial milestones. If ISCON succeeds in meeting all five milestones and ifwe choose to exercise our option to purchase shares for each completedmilestone, we would then 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 for an ownership interest of approximately 9%.

***SemiconductorProducts and Services***

Our semiconductor operations, based in Vancouver,Washington, showed continued operational and financial improvement for the yearended April 30, 2006, though still generating an operating loss andnegative cash flow. In an effort to reduce historical negative financialresults, in April 2005 we began the process to realign our business tosignificantly reduce our reliance on low margin small diameter products andfocus mainly on higher margin 300-millimeter products and services, waferthinning and SOI products. The large-diameter wafer segment has become one ofthe fastest growing segments of the silicon wafer market and the revenues andgross margins associated with the services are greater than those associatedwith the small diameter market. As a result of our strategic realignment,revenue from 300-millimeter services comprised approximately 36% of segmentrevenue for the year ended April 30, 2006 ($2,053,000 in revenue), ascompared to $0 for the year ended April 30, 2005. There has also been afocus on operational efficiency and effectiveness, which has resulted inincreased productivity and processing yields. Further, we have continued togain new customers and are also in the process of attempting to qualify ourproduct at others. We have completed the first phase of qualification for thesupply of 300-millimeter wafers to two leading global semiconductor industryparticipants. If the second phase of either or both qualifications issuccessfully completed, we expect to begin recognizing additional revenue fromthese customers in quarters subsequent to successful qualification. However, wecan offer no assurances that we will ultimately successfully qualify for eitheror both of the aforementioned customers, as well as any others.

As a result, while thesegment generated an operating loss of $(5,151,000) for the year ended April 30, 2006,this operating loss is approximately 21% less than the operating loss of$(6,484,000) experienced for the year ended April 30, 2005. Additionally,the operating loss was reduced each sequential quarter during fiscal year 2006,with the fourth quarter being $(777,000), and it has continued to improve inthe first quarter of the year ending April 30, 2007. We continue tomonitor the situation closely and, while we believe that our realignment of thebusiness has enhanced our chances to reach profitability in the future and thatwe will continue to see improving financial results in the segment, the overallprocess will take time and there are no assurances that profitability will bereached.

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***LifeSciences***

Our life sciences division has historically beenprimarily a distribution business. We acquire isotopes from severalmanufacturers who are located primarily in republics that were part of theformer Soviet Union. We buy these isotopes from the manufacturers and resellthem in the form of common chemical compounds. For example, oxygen-18 is soldas water, and zinc-68 is sold as zinc oxide. We sell these isotopes for use inbasic scientific research, medical diagnostics/therapy and industrialapplications. An isotope is one of two or more species (or nuclides) of thesame chemical element that differ from one another only in the number ofneutrons in the atom’s nucleus. The different number of neutrons can createsignificantly different nuclear properties. The most well known of theseproperties is radioactivity. Radioactive isotopes (or radioisotopes) can befound in nature. Most of our radioisotopes, however, are man-made. Stableisotopes, as distinguished from radioisotopes, are not radioactive. We continueto evaluate possible applications for stable isotopes, radioisotopes andnon-isotopic materials.

At the present time, our life sciences division isbeing adversely affected by increased domestic and international competition. Theoxygen-18 market continues to be dynamic and volatile. Established suppliershave increased capacity and reputable suppliers have entered the market with acomparable high quality product. The market is currently in a surplus state andwe expect it to be so for several years to come. Prices have declined over 60%from highs of approximately three years ago. Our average selling price foroxygen-18 during fiscal year 2006 decreased approximately 31% from thatreceived during fiscal year 2005. Additionally, this average selling price islikely in excess of the spot rate in the market due to the advanced pricingagreements we have with certain customers. As such, additional price erosionmay be expected. In an attempt to offset the degradation of the oxygen-18market, we have successfully lowered our acquisition price of oxygen-18 and weare expanding into other areas, such as actinium-225 and indium-111 (throughour June 2005 joint production and marketing agreement with CentralRadiopharmaceutical Services, Inc. (“CRS”)). While we don’t expect theseisotopes to contribute significantly to our revenues until the third quarter ofour fiscal year ending April 30, 2007, this expansion is indicative of ourbusiness goal to broaden revenue beyond the concentration found in a few, coreproducts (mainly oxygen-18).

Our internationalradioisotope business has also experienced rising supplier prices in a marketthat is highly price-sensitive. In an effort to reduce costs, we closed ourEuropean trading office (Chemotrade) during the second half of fiscal year 2006.During fiscal year 2006, our ability to pass on these increasing supply pricesto our customers proved to be problematic as our customers have access toradioisotope supplies from other entities. In response, we concluded thatcontinuing the sales operations of our European trading office was not aneconomically viable option and we terminated sales activity with the existingcustomer base. Revenue from our international isotope trading business was$1,563,000 for the year ended April 30, 2006, as compared to $2,700,000for the year ended April 30, 2005. We do not anticipate material, if any,revenue from this business during fiscal year 2007. For our life sciences business in theaggregate, as with all our reportable segments, we continually monitor businessconditions and marketplace changes and evaluate all investment, divestiture andother strategic options.

**Distribution Method**

We operate life sciencessales offices in Columbia, Maryland and Golden, Colorado. Effective December 31,2005, we closed our life sciences office in Dusseldorf, Germany. We currentlymanufacture and reclaim various types of silicon wafers at our facilities inVancouver, Washington. PPSC provides advanced security services from our NewYork office. We operate our homeland security products division in Columbia,Maryland. We identify customers through industry sales journals, websiteidentification and trade shows. In addition, many customers come to us byreferral from existing customers. There are a limited number of suppliers inthe isotope industry and, therefore, most customers are aware of the productsand services we offer. Customers directly place the orders and we either shipdirectly to the 

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customerthrough our sales offices or the product is shipped directly from the supplier.We package and ship from our own manufacturing facilities using commercialcourier services such as Federal Express and DHL.

**SignificantCustomers**

As of April 30, 2006, three****customersaccounted for approximately 30%****of total net accounts receivable. Three customers accountedfor approximately 29% of total net accounts receivable at April 30, 2005. Two****customers(Foot Locker Retail, Inc. and Qimonda Richmond LLC, formerly InfineonTechnologies Richmond) accounted for approximately 17% and 10% of revenues, respectively, for the year ended April 30,2006. Two customers (Eastern Isotopes, Inc. and PerkinElmer, Inc.)accounted for approximately 19% and 10%of revenues, respectively, for the year ended April 30, 2005.

Significant reductions insales to any of our large customers have had, and may in the future have, amaterial adverse effect on us by reducing our revenues and our gross margins. Presentor future customers could terminate their purchasing patterns with us orsignificantly change, reduce, or delay the amount of isotopes or other productsordered from us.

**Research andDevelopment**

Consistent with our product development strategy, weare seeking to identify and evaluate new products for our homeland security andsemiconductor operations as well as new stable and radioactive isotope productsand potential markets for economic and technical feasibility. During fiscalyears 2006 and 2005, research and development expenses were $5,293,000 and$1,271,000, respectively. The 2006 increase was due primarily to the $2,000,000payments made to Lucent Technologies, and the recognition of $1,463,000 ofresearch and development expense related to IUT during fiscal year 2006 (ascompared to $650,000 made during the prior year) for the continuing developmentof our IMS-based and NeutroTestTM products.

During fiscal year 2007, we expect to continue tofocus our research and development efforts on existing and new products for ourhomeland security and semiconductor operations, and the production of highchemical-purity silicon-28 silane gases and epitaxial wafers. Theseefforts continue the research and development we performed in fiscal years 2006and 2005. Trace and bulk detection technology and product development continuesto focus on very low-level detection of various types of explosives utilizingIMS and other low concentration analytics techniques. Additionally, through thePacific Northwest National Lab, in partnership with the Highly PureBiopreperation Lab in St Petersburg, Russia we (at a minimal cost) are researchingthe effectiveness of a bioremediation system for advancement of cleanliness inour hospitals. This program is sponsored by the United States Department ofEnergy as a threat reduction and proliferation effort. We have, as partners tothe program, specific rights to the systems developed from these efforts.Recently, the program has been expanded to test for efficacy against the H5N1virus more commonly known as Avian Flu. Although promising, we do not havesufficient results from testing to advance a prognosis as to the systemsoverall capability at this time.

While we continue to moveforward with our development program and to pursue the establishment of a lowcost supply of silicon-28, we did not receive significant revenues in our2006 or 2005 fiscal years, and we are not aware of any plans by any company forthe introduction of products based on silicon-28 wafers. Therefore we donot anticipate significant proceeds from silicon-28 product sales duringfiscal year 2007, although we could respond to customer demand in a relativelyshort time frame. Our goal ultimately is toproduce bulk silicon-28 wafers at an acceptable cost, which will producethe maximum benefits to the end user.

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**Patents andProprietary Rights**

We rely primarily on a combination of patents andpatent applications, trade secrets, confidentiality procedures and contractualprovisions to protect our technology. Despite our efforts to protect ourrights, unauthorized parties may attempt to copy aspects of our products or toobtain and use information that we regard as proprietary. Policing unauthorizeduse of our technology and products is difficult. In addition, the laws of manycountries do not protect our rights in information, materials and intellectualproperty that we regard as proprietary to as great an extent as do the laws ofthe United States. There can be no assurance that our means of protecting ourrights in proprietary information, materials and technology will be adequate orthat our competitors will not independently develop similar information,technology or intellectual property. See “Risk Factors.”

We currently have five United States patents in ourown name (US 6,653,658 dated November 2003, US 6,838,020 dated January 2005,US 6,897,459 dated March 2005, 6,926,876 dated March 2005 and6,926,876 dated August 2005) and have filed several other patentapplications regarding silicon-28 and other isotopically purifiedmaterials. Ongoing work in the area of isotope separation by chemical means(which is currently being performed by outside entities) may also lead topatentable inventions.

In 1999, we entered into an exclusive licensingagreement with Yale University that entitles us to exclusive intellectual propertyrights to patents covering semiconductor devices derived from isotopicallyengineered materials. The license requires payment by us of a royalty based ona percentage of our, or our sublicensees’, net sales of products derived fromtechnology covered by the Yale patents (US 5,144,409, dated September 1,1992, and US 5,442,191, dated August 15, 1995). Each of these patentsexpires seventeen years after issuance.

Several disclosuresrelated to the trace detection technology underlying NeutroTestTM have beenwritten and two patent applications have been filed. We can offer no assurancesthat any patents will be awarded related to these developments.

**Competition**

Many of our potentialcompetitors are larger and have significantly greater financial, technical,marketing and other resources than we. Some of our competitors may formpartnerships or alliances with large pharmaceutical or electronics companies,with the resulting entity possessing greater market strength than we have. Weface competition relative to many of our products, including:

***HomelandSecurity***

A large number ofcompanies are involved in the homeland security industry, an industry thatreceived a significant impetus from the events of September 11, 2001. Manyof these companies (such as General Electric, OSI Systems, Inc., SmithsHeimann, Inc. and L-3 Communications Holdings, Inc.) aresignificantly larger than are we and generally have greater financial resourcesat their disposal. We believe that the technology that we have acquired fromIUT will result in better detection products that will be attractive to themarketplace. Given the size and importance of the homeland security market, weanticipate that even greater competition will emerge. Additionally, within theservices segment of homeland security, there will continue to be significantadditions to security services required. There will be continued pressurewithin this business segment by larger service providers such as Smith Heimann, Inc.,however there are niche segments that provide PPSC opportunities that otherwisecould be underrepresented. We are hopeful that the award of our GSA Schedulewill significantly enhance PPSC’s opportunity for growth.

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***SemiconductorMaterials***

*Siliconwafers—manufacturing and reclamation.**  *There are a number of competitors in the virgin testwafer and wafer reclamation business. We compete for business primarily inNorth America, but have begun soliciting business from the European Union. Largercompetitors, such as Pure Wafer Ltd., Rasa Industries Ltd. and Exsil Inc.,provide a wide range of products and services comparable to us and compete on aglobal basis. There are numerous smaller competitors that provide a morefocused product or service offering and compete on a local or regional basis. Customersselect a supplier based on a combination of factors including price, deliverytime, and quality.

*SOIWafers.**  *Thereare a number of competitors in the thick-film SOI wafer business, several ofwhom are larger than we and have significant financial resources as compared toIsonics. SUMCO, Okmetic and SEH-Japan are our most significant competitors****for thick-film SOI wafers.

*Silicon-28.**  *Although we have not yet identified significantcompetitors, numerous companies in the United States and throughout the worldare currently manufacturing semiconductor materials and are working to improvethe thermal conductivity and other beneficial characteristics of semiconductormaterials. Many of these companies may be larger than are we and generally havesignificantly greater financial resources at their disposal. In addition, manytypes of technologies can address the issue of thermal management (i.e., bettercooling technology, new designs, etc.). It remains to be seen whichtechnologies, if any, will prove to be the most cost effective and gain marketacceptance.

***Isotopesfor Life Sciences***

While the situation will change if the CRS alliancebegins producing radioisotopes, we have not actually produced stable orradioactive isotopes for use in the life sciences applications mentioned here. Instead,we distribute products made for us by a variety of producers in Russia, Europeand North America. In many cases, we have long-term, exclusive supplyrelationships in place with producers. In others, we have the advantage ofrelationships that have developed over more than 25 years.

Competitors for stable isotopes fall into two categories—otherproducers and other distributors. Our primary competition from other producerscomes from the other manufacturers of oxygen-18 including Rotem, CIL andMarshall Industries. To counter this, we have an exclusive supply agreement(which expires July 2010) in place with our producer. As for competitionwith other distributors, our primary competition comes from Trace Sciences, aprivately-held company in Canada with long-standing supply relationships withseveral stable isotope producers.

Competitors forradioactive isotopes fall into three categories: bulk radiochemical producers;value-added labeled compound producers; and other distributors. Our primarycompetition for bulk production comes from MDS Nordion in Canada. Most otherbulk producers are government-owned or university-operated. They typically sellthrough distributors like Isonics. We have either an exclusive supply agreementor long-standing supply relationships with many of these organizations. In thesegment of value-added producers, we have the June 2005 agreement with CRS.As for competition with other distributors, the primary competitor, Tenex, isalso our supply partner from time to time.

***Summaryof Competition***

Many of the areas in whichwe either compete or intend to compete are rapidly evolving. Competition maydevelop a patentable product or process that may prevent us from competing inour intended markets. While we expect to compete primarily on the basis ofproduct performance, proprietary position and price, in many cases the firstcompany to introduce a product to the market will obtain at least a temporarycompetitive advantage over subsequent market entrants.

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**Manufacturing andSupply**

While we initially manufactured our bulk and tracedetection technology products using the existing IUT facilities andsubcontractors, we have recently entered into contracts for the manufacturingof such product with independent, non-affiliated contractors in the UnitedStates. We are also exploring additional manufacturing options in Europe thatare expected to increase our capacity, if necessary. In each case, thecontracts are or will be with unaffiliated entities on terms that we negotiate.

We obtain stable isotopes from a variety of isotopesources, primarily located in Russia. Other facilities elsewhere in the world,including the Oak Ridge National Laboratory in Oak Ridge, Tennessee, andprivate and pseudo-governmental facilities in Great Britain, Germany, theNetherlands and the Republic of South Africa, have the potential to producestable isotopes.

To date, we have only been able to obtain limitedquantities of silicon-28 for use in manufacturing epitaxial wafers. Webelieve however that if we obtain the necessary customers, we will be able toobtain adequate supplies of silicon-28.

We manufacture and reclaim silicon wafers at ourfacilities in Vancouver, Washington. The majority of the research anddevelopment work associated with our NeutroTestTM and IMS products is performedat IUT (who outsources the manufacturing work to various European entities)while the remaining work is performed by non-affiliated entities in the UnitedStates.

Except for the agreements with CRS, our homeland securityproducts manufacturers and our suppliers of oxygen-18 and actinium-225in Russia, we do not have any written agreements with our suppliers andprocessors. Although we attempt to reduce our dependence on our suppliers,disruption or termination of any of the sources could occur, and suchdisruptions or terminations could have at least a temporary, materially adverseeffect on our business, financial condition, and results of operations. Moreover,a prolonged inability to obtain alternative sources for processing could have amaterially adverse affect on our relations with our customers.

Generally we find the rawmaterials necessary for our operations to be readily available, either from thegeneral market place for raw materials that are commonly available or throughour suppliers, although the increased demand in the silicon market hasdecreased the availability (and increased the price) of raw materials forvirgin test wafers.

**GovernmentRegulation**

Regulation by government authorities in the United Statesand other countries is a significant consideration in the research,development, production, distribution and marketing of our homeland securityand life sciences products. In order to clinically test, manufacture,distribute, market and sell products, we must follow safety and other standardsestablished by applicable regulatory authorities. We may be subject to variouslaws, regulations and requirements relating to such matters as the import andexport of our products, ensuring safe working conditions, laboratory andmanufacturing practices, and the use, storage and disposal of hazardous orpotentially hazardous substances used in connection with our research,development and manufacturing activities. The regulations potentially materialto our business are summarized below.

*HomelandSecurity Products.**  *Ourresearch has indicated that review or approval of our NeutroTestTM explosivedetection device by one or more government agency will be required since ituses radioactive Californium-252 as a source of neutrons. A Sealed SourceDevice Registration must be completed with a state or the Nuclear RegulatoryCommission (“NRC”). In order to complete the registration, final designspecifications and schematics are required, as well as safety testing. Inaddition, customers who wish to purchase and use NeutrotestTM must also obtain alicense from the local State Regulatory Agency (or NRC, depending on thelocation). Such licenses can take up to 180 days to be issued. These Regulatory

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requirements greatly slowthe sales process and limit the customer base to organizations with sufficientresources to undertake the licensing process.

*LifeSciences Products.**  *We arenot currently subject to any FDA regulation because we do not currentlymanufacture any Diagnostic Breath Tests, drug products or other medical devices.Our customers may in many cases be subject to FDA regulation. However, if wetest, manufacture, market, distribute, export or sell diagnostic products ormedical devices in the future, we will also likely be subject to extensiveregulation nationally and internationally.

The import, export, handling, transportation, sale,storage and other activities undertaken in connection with our non-medicalproducts are subject to, or are potentially subject to, significant federal,state, local and foreign government controls pertaining to hazardous chemicals,import and export controls and other matters. These regulations are complex,pervasive, and constantly evolving. Our ability to effect and maintaincompliance with these controls is important to our commercial success. We arenot currently engaged in any activities that may require us to incursignificant expenses related to environmental compliance.

We rely predominantly on European and U.S. freightcarriers to handle and deliver all our shipments, and utilize domesticovernight courier services for shipments to our customers. These carriers mustcomply with Department of Transportation and State regulations pertaining tohazardous chemicals and hazardous waste disposal. These shipments are stored inan area of the facility designated for such materials. We believe we are incompliance, in all material respects, with applicable federal and stateenvironmental regulatory requirements.

Our facilities and employees must also comply withenvironmental, safety and other regulations concerning our operations. Failureto ensure compliance with such federal, state, or local laws and regulationscould have a material adverse effect on us. To date, the cost of compliancewith environmental and other regulations has been nominal.

In addition, themanufacture, distribution and export of some of our current or potentialproducts and technology may be subject to governmental controls pertaining tomaterials and technology that have potential military, nuclear power or nuclearweapons purposes. These controls include export license requirements or otherrestrictions. We may be unable to obtain or maintain such licenses. Further,the failure to obtain or maintain such licenses, or comply with otherrestrictions that might be placed on such manufacturing and exports, may have amaterial adverse effect on us and our operations.

**Product Liabilityand Insurance**

Our business exposes us tosubstantial product, environmental, occupational and other liability risks. Theserisks are inherent in product research and development, manufacturing,marketing, distribution, and in the use of our products and operations. Wehave, and will attempt to renew product liability insurance (which currentlyexpires April 30, 2007) inorder to protect ourselves from such potential exposures, however there can beno guarantee that upon expiration of our current coverage that adequateinsurance coverage will be available, or, if available, the cost will beacceptable. Furthermore, a product liability or other claim could materiallyand adversely affect our business or financial condition. The terms of ourcustomer agreements provide that liability is limited to our standard warrantyto replace non-conforming product, and liability for consequential damagescaused by the improper use of our products is limited by contractual terms.Nevertheless, one or more third parties could file suit against us based onproduct liability, breach of warranty or other claims. The foregoing contractclauses might effectively limit our liability in any such actions. Additionally,we are applying for Homeland Security product coverage under the United StatesSafety Act. If this application is accepted, we, our manufactures and ourclients would be covered for liability of that product in the event thespecified product were in place during a occurrence defined as a terrorismattack.

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**Employees**

As of June 30,2006, we had 561 full-time employees. We have:

6 employees (including oursenior vice president who is president of HSDC) in our homeland securityoperations;

489 employees at PPSC;

57 employees in oursilicon and SOI wafer manufacturing and reclamation operation;

2 employees in our lifesciences operation; and

7 employees in ourcorporate offices.

An employee’sresponsibilities may also encompass areas other than his or her primary area ofresponsibility. We consider our relations with our employees to be good. Noneof our employees are covered by a collective bargaining agreement.

**ITEM 2.     PROPERTIES**

In February 2006, we renewed our 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 have two facility leases in Vancouver, Washington.The first lease requires a minimum payment of $9,700 per month and terminatesAugust 31, 2007 while the second lease requires a minimum payment of $6,150 permonth and terminates January 31, 2008.

We lease 1,750 square feet for an administrative salesoffice in Columbia, Maryland that requires a minimum payment of $3,059 permonth and terminates September 30, 2007. Chemotrade held a lease foroffice space in Düsseldorf, Germany that expired June 30, 2006.

PPSC leases office spacefrom a related party in New York, New York on a monthly basis at a rate of$4,500 per month. Additionally, PPSC entered into a new lease, effective May 1,2006, which requires a minimum payment of $13,750 per month and terminates September 30,2013. PPSC plans to terminate its original lease and move into the new facilityafter the tenant improvements are completed (estimated to be the summer of2006).

**ITEM 3.     LEGAL PROCEEDINGS**

None

**ITEM 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

We did not hold a meeting of our shareholders duringthe fourth quarter of the year ended April 30, 2006.

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**PART II**

**ITEM 5.**                MARKETFOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

**(a)****          MarketInformation.**

Ourcommon stock is quoted on the Nasdaq Capital Market. As of July 21, 2006,we had outstanding 46,358,044 shares of our common stock, 564,511 Class CWarrants and 1,418,099 registered Class B Warrants. The Class BWarrants and the Class C Warrants are also quoted on the Nasdaq CapitalMarket. Currently the trading symbols for our outstanding securities are asfollows:

| Common stock           |   | “ISON”  |   |
|------------------------|--------|-------------------|--------|
| Class B  Warrants |   | “ISONL” |   |
| Class C Warrants  |   | “ISONZ” |   |

 

As described above, we have received two notices fromNasdaq, either of which may result in our being delisted from the NasdaqCapital Market.

Thefollowing table sets forth the closing bid prices for the common stock(quotations reflect inter-dealer prices, without retail mark-up, mark-down orcommission and may not represent actual transactions) for the two most recentfiscal years as reported by the Nasdaq Capital Market.

| ** **          | ** ** | **Quarter Ended**                 | ** ** |
|---------------------|------------|----------------------------------------|------------|
| ** **          | ** ** | **July 31, 2006**            | ** ** |
| ** **          | ** ** | **(through July 21,  2006)** | ** ** |
| Common Stock (ISON) |       |                                   |       |   |   |
| High                |       |                                   | $          | 1.25 |   |   |
| Low                 |       |                                   | $          | .45 |   |   |

 

| ** **          | ** ** | **Quarter Ended**      | ** ** |
|---------------------|------------|-----------------------------|------------|
| ** **          | ** ** | **July 31, 2005** | ** ** | **October 31, 2005** | ** ** | **January 31, 2006** | ** ** | **April 30, 2006** | ** ** |
| Common Stock (ISON) |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| High                |       |                        | $          | 3.54 |   |   |   | $ | 3.37 |   |   |   | $ | 2.30 |   |   |   | $ | 2.10 |   |   |
| Low                 |       |                        | $          | 1.72 |   |   |   | $ | 1.99 |   |   |   | $ | 1.79 |   |   |   | $ | 1.26 |   |   |

 

| ** **          | ** ** | **Quarter Ended**      | ** ** |
|---------------------|------------|-----------------------------|------------|
| ** **          | ** ** | **July 31, 2004** | ** ** | **October 31, 2004** | ** ** | **January 31, 2005** | ** ** | **April 30, 2005** | ** ** |
| Common Stock (ISON) |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| High                |       |                        | $          | 1.80 |   |   |   | $ | 5.50 |   |   |   | $ | 5.88 |   |   |   | $ | 5.09 |   |   |
| Low                 |       |                        | $          | 1.09 |   |   |   | $ | .89 |   |   |   | $ | 3.61 |   |   |   | $ | 1.81 |   |   |

 

**(b) and (c)   Shareholdersand Dividends.**

As of April 30,2006, there were approximately 80 shareholders of record of our commonstock. This does not include an indeterminate number of persons who hold ourcommon stock in brokerage accounts and otherwise in “street name.”

We have never declared or paid a cash dividend on ourcommon stock. We presently intend to retain our earnings, if any, to funddevelopment and growth of our business and, therefore, we do not anticipatepaying cash dividends in the foreseeable future.

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Themarket price of our common stock could drop if substantial amounts of sharesare sold in the public market or if the market perceives that such sales couldoccur. A drop in the market price could adversely affect holders of the stockand could also harm our ability to raise additional capital by selling equitysecurities.

**(d)**          **Securities Authorized for Issuance Under Equity Compensation Plans.**

Thefollowing is provided with respect to compensation plans (including individualcompensation arrangements) under which equity securities are authorized forissuance as of the year ended April 30, 2006.

| **Equity Compensation Plan Information(1)**    | ** ** |
|---------------------------------------------------------------|------------|
| **Plan Category and Description**                        | ** ** | ** ** | ** ** | **Number of  Securities to  be issued  upon exercise  of outstanding  options,  warrants, and  rights  (a)** | ** ** | **Weighted-  average exercise  price of  outstanding  options,  warrants, and  rights  (b)** | ** ** | **Number of Securities  remaining available for  future issuance under  equity compensation  plans (excluding securities  reflected in column (a))  (c)** | ** ** |
| *Equity  compensation plans approved by security holders*     |       |   | 2,933,932 |   |   |   | $ | 2.12 |   |   |   | 2,820,000 |   |   |
| *Equity compensation plans not approved by  security holders* |       |   | 0 |   |   |   | $ | 0 |   |   |   | 0 |   |   |
| **Total**                                                     |       |   | 2,933,932 |   |   |   | $ | 2.12 |   |   |   | 2,820,000 |   |   |

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       (1)   This does not include options or warrantsheld by management and directors that were not granted as compensation. In eachcase, the disclosure refers to options or warrants unless otherwisespecifically stated.

**(e)**   **Recent Salesof Unregistered Securities—Item 701 Disclosure.**

**Employee andDirector Offerings**

*Employee Offerings*

(a)   During the past years, we have issued sharesof common stock and options to purchase shares of common stock pursuant toexisting employee benefit plans. As noted in the following discussion, theseplans have been included within registration statements on Form S-8(file nos. 333-128592, 333-74339 and 333-52514). Thefollowing table sets forth information about the options outstanding andavailable for issuance under each of the plans as of April 30, 2006:

| **Plan Name**                               | ** ** | ** **                        | ** ** | **Issued  Options/Shares** | ** ** | **Available for Grant  or Issuance** |
|---------------------------------------------|------------|-----------------------------------|------------|----------------------------|------------|--------------------------------------|
| 1996 Stock Option Plan                      |       | 151,429 options                   |       | 0 options                  |
| 1996 Executives Equity  Incentive Plan |       | 1,349,562 options  255,000 shares |       | 0 options/shares           |
| 1996 Equity Incentive  Plan                 |       | 562,941 options  15,000 shares    |       | 0 options/shares           |
| 1998 Employee Stock  Purchase Plan          |       | 78,209 shares                     |       | 13,227 shares              |
| 2005 Stock Option Plan                      |       | 680,000 options                   |       | 2,820,000 options/shares   |

 

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As a result of theadoption of the 2005 Stock Option Plan by our shareholders on April 19,2005, we will issue no additional shares or options under either the 1996Executives Equity Incentive Plan or the 1996 Equity Incentive Plan. Effective May 1,2006, the ESPP plan was terminated.

*Issuances toOfficers or Directors Not Previously Reported*

(a)    On July 20,2005, we issued 20,000 stock options to Richard H. Hagman under the DirectorsPlan. The options are exercisable at $3.13, expire July 19, 2010 andvested immediately.

On August 1, 2005, weissued 20,000 stock options to C. Stewart Verdery, Jr. under the DirectorsPlan. The options are exercisable at $3.37, expire July 31, 2010 andvested immediately.

On October 25, 2005, weissued 10,000 stock options each to Richard Parker, Russell W. Weiss, RichardH. Hagman and C. Stewart Verdery, Jr. under the Directors Plan. The options areexercisable at $2.48, expire October 24, 2010 and vested immediately.

On February 9, 2006,we issued 100,000, 100,000 and 50,000 stock options to Boris Rubizhevsky, JamesE. Alexander and John Sakys, respectively under the 2005 Stock Option Plan. Theoptions are exercisable at $1.96, expire February 8, 2016 and vested 25%upon grant with the remaining 75% vesting ratably over a three-year period.

On May 5, 2006, weissued 75,000 stock options each to Boris Rubizhevsky, James E. Alexander andJohn Sakys along with 30,000 and 20,000 to Lindsay A. Gardner and Stephen J.Burden, respectively. The options are exercisable at $1.15, expire May 4,2016 and vested 25% upon grant with the remaining 75% vesting ratably over athree-year period.

*Applicable to theOfferings to the Employees, Officers and Directors*

(a)    Notapplicable

(b)   No underwriters were involved in the transactions.

(c)    The stockoptions issued outside of our employee benefit plans were, for the most part, issuedin consideration of services rendered and did not (therefore) involve the offeror sale of securities. In some cases they were issued to induce the performanceof services in the future.

(d)   Many of thesecurities referred to in this section were not offered or sold in a mannerthat constituted a “sale” of securities as that term is defined in Section 2(a)(3) ofthe Securities Act. Where a “sale” occurred, the transactions were exempt fromregistration under the Securities Act of 1933, as amended by reason of Sections4(2) and 4(6) of the Securities Act of 1933 or Rule 701.

(e)    There are no conversion rights or exchange rights associated withthe common stock. To the extent vested, the options are exercisable to purchaseshares of common stock as described above.

(f)    Where proceeds were received, the proceeds were utilized forworking capital purposes.

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**Purchase of EquitySecurities by Issuer and Affiliated Purchaser**

During the fiscal yearended April 30, 2006, and subsequently, neither Isonics or any executiveofficer or director purchased any shares of our common stock in a Rule 10b-18transaction or otherwise, except for purchases made through our Employee StockPurchase Plan, employee stock option plans, the redemption of our 8% Debenturesin March 2006, and of 6,666 shares of our Series A ConvertiblePreferred Stock (“Series A Stock”) completed in September 2005. Neitherthe 8% Debentures nor the Series A Stock were registered under the 1934Act, but both were convertible into shares of our common stock which areregistered under the 1934 Act.

| **Period**          | ** ** | ** **                                                                                                                                                                                  | ** ** | **Total number of shares  purchased** | ** ** | **Average  price paid  per share**                                           | ** ** | **Total number of  shares purchased as  part of publicly  announced plans or  programs** | ** ** | **Maximum number  of shares that may  yet be purchased  under the plans or  programs** |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|
| September 2005 |       | 6,666 shares of  Series A Stock (convertible into 13,332 shares of common stock),  pursuant to a redemption right granted by the statement of preferences for  the Series A Stock |       | $1.50                                 |       | None (the redemption was  not publicly announced or available to the public) |       | None                                                                                     |
| March 2006     |       | 8% convertible  debentures in a principal amount of $9,000,000 (convertible into 6,206,897  shares of common stock)                                                                         |       | $1.45                                 |       | None (the redemption was  not publicly announced or available to the public) |       | None                                                                                     |

 

The Employee StockPurchase Plan contemplated that each employee had the right to withhold aportion of his or her salary and have that portion applied to purchase ourcommon stock directly from us at a discount to the market price on June 1and December 1 of each year. Lindsay A. Gardner and John Sakys (vicepresidents), were the only executive officers that participated in our EmployeeStock Purchase Plan. (Our directors who are not employees are not eligible toparticipate.)  These officers purchased784 (at $.1.53 per share), 1,964 shares (at $1.53 per share) and 1,688 shares(at $1.10 per share) of restricted common stock on June 1, 2005, December 1,2005 and May 1, 2006, respectively. This plan was terminated on May 1,2006.

**Payment of 8% DebenturesPrincipal and Interest in Common Stock**

On April 1,May 1 and June 1, 2006, we issued 1,606,270, 1,616,433 and 1,997,265shares of our common stock to holders of our 8% Debentures as payment of ourprincipal obligation and of our interest obligation for the months endedMarch 31, April 30 and May 31, 2006, respectively. The followingsets forth the information required by Item 701 in connection with that transaction:

(a)    Thetransactions were completed effective April 1, May 1 and June 1,2006, respectively.

(b)   There wasno placement agent or underwriter for the transactions.

(c)    The shareswere not sold for cash.

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(d)   We reliedon the exemption from registration provided by Sections 4(2) and 4(6) underthe Securities Act of 1933 for this transaction. We did not engage in anypublic advertising or general solicitation in connection with this transaction.The investors had access to all of our reports filed with the Securities andExchange Commission, our press releases and other financial, business andcorporate information. Based on our investigation, we believe that theinvestors obtained all information regarding Isonics that they requested,received answers to all questions they posed and otherwise understood the risksof accepting our securities for investment purposes.

(e)    The commonstock issued in this transaction is not convertible or exchangeable. Nowarrants were issued in this transaction.

(f)    We received no cash proceeds from the issuance of the shares. Wedid receive a relief from indebtedness as described above.

**Harborview CapitalManagement LLC**

On March 20,2006, we entered into a consulting agreement with Harborview Capital ManagementLLC (“Harborview”) with an office at 850 Third Avenue, New York, NY 10022. Theagreement provided for the issuance to Harborview of 100,000 shares ofrestricted common stock in exchange for Harborview to provide financial advisoryand other services to Isonics. The following sets forth the informationrequired by Item 701 in connection with that transaction:

(a)    Thetransaction was effective March 20, 2006. We issued 100,000 shares ofrestricted common stock.

(b)   No underwriterswere involved in the transaction. The only entity who received securities fromus in this transaction was Harborview (who assigned 15,000 shares to anindividual).

(c)    Thesecurities were not sold for cash. The securities were issued to Harborview as considerationfor Harborview entering into the consulting agreement.

(d)   Theissuance of the restricted common stock was accomplished pursuant to theexemptions from registration contained in Sections 4(2) and 4(6) ofthe Securities Act of 1933. We did not engage in any public advertising orgeneral solicitation in connection with this transaction. We providedHarborview with disclosure of all aspects of our business, including providingHarborview and its management with our reports filed with the Securities andExchange Commission, our press releases, access to our auditors, and otherfinancial, business, and corporate information. Based on our investigation, webelieve that the management and the board of directors of Harborview obtainedall information regarding Isonics they requested, received answers to allquestions they posed, and otherwise understood the risks of accepting oursecurities in exchange for services to be provided.

(e)    The commonstock issued in this transaction is not convertible or exchangeable. Nowarrants were issued in this transaction.

(f)    We received no proceeds from the issuance of the restrictedcommon stock and, therefore, we have no use of proceeds.

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**Acquisition of PPSC**

On May 16,2005, we issued 506,527 shares of our restricted common stock to the formershareholders of PPSC as partial consideration for the completion of thetransaction described above. On March 30, 2006 we issued an additional200,000 shares to settle a price protection provision related to the originalcommon stock issuance. The shareholders represented that they were accreditedinvestors. The following sets forth the information required by Item 701 inconnection with that transaction:

(a)    The transactions were completed effective May 16, 2005 and March 30,2006, respectively.

(b)   There wasno placement agent or underwriter for the transactions.

(c)    The shareswere not sold for cash. The shares were issued in partial consideration for thepurchase by our wholly-owned subsidiary of the business described above. At thetime the original number of shares was calculated, the market price of ourstock was approximately $2.22 per share.

(d)   We reliedon the exemption from registration provided by Sections 4(2) and 4(6) underthe Securities Act of 1933 for this transaction. We did not engage in anypublic advertising or general solicitation in connection with this transaction.We provided the accredited investors with disclosure of all aspects of ourbusiness, including providing the accredited investors with our reports filedwith the Securities and Exchange Commission, our press releases, access to ourauditors, and other financial, business, and corporate information. Based onour investigation, we believe that the accredited investors obtained allinformation regarding Isonics they requested, received answers to all questionsthey posed, and otherwise understood the risks of accepting our securities forinvestment purposes.

(e)    The commonstock issued in this transaction is not convertible or exchangeable. Nowarrants were issued in this transaction.

(f)    We received no cash proceeds from the issuance of the shares.

**Issuance of 6%Convertible Debentures**

On May 31,2006, we completed a private placement pursuant to which we issued to oneaccredited investor, Cornell Capital Partners, L.P. (“Cornell”) a 6% Debenturewith a principal amount of $10,000,000, which is the first of three 6%Debentures, for which the aggregate principal amount will be $16,000,000, and three warrants, topurchase a total of 8,000,000 shares of 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 fora period of three years. The investor and an unaffiliated party provided usservices in connection with completing the transaction, which were valued at$825,000. To compensate these people for those services, we issued them 660,000shares of our common stock (the “Buyers Shares”). On June 5, 2006, weissued the second of the three 6% Debentures considered in the transactiondocuments. This 6% Debenture has a principal amount of $3,000,000. Thefollowing sets forth the information required by Item 701 in connection withthat transaction:

(a)    Thetransactions were completed effective May 31, 2006 and June 5, 2006with respect to two 6% Debentures totaling $13,000,000 (the net proceeds ofwhich were received in June 2006).

(b)   The 6%Debentures and accrued interest are convertible into shares of our commonstock, subject to the conditions described above, and we are entitled to redeemor pay the 6% Debentures by issuing shares of our common stock. The warrantsare exercisable to acquire shares of our common stock as described above,providing the issuance of shares does not violate certain share issuancelimitations.

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(c)    We issued660,000 Buyers Shares as described above. We paid a $715,000 commitment fee andreimbursed Cornell’s advisor $20,000 of expenses from the proceeds of thetransaction. The Buyers Shares were issued to two accredited investors. Thetotal offering is expected to be $16,000,000****in cash (ofwhich $13,000,000 has been funded by the investor).

(d)   We reliedon the exemption from registration provided by Sections 4(2) and 4(6) ofthe Securities Act of 1933 and Rule 506 promulgated thereunder for thistransaction. We did not engage in any public advertising or generalsolicitation in connection with this transaction. We provided the investorswith disclosure of all aspects of our business, including providing theInvestors with our reports filed with the Securities and Exchange Commission,our press releases, access to our auditors, and other financial, business, andcorporate information. Based on our investigation, we believe that theinvestors obtained all information regarding Isonics that they requested,received answers to all questions it posed, and otherwise understood the risksof accepting our securities for investment purposes. Each of the investorsrepresented to us that it was an accredited investor.

(e)    Eachwarrant issued in this transaction is exercisable through May 30, 2009. Thewarrants have exercise prices of $1.25 (for 2,000,000 warrants), $1.75 (for3,000,000 warrants) and $2.00 (for 3,000,000 warrants). The 6% Debentures areconvertible into common stock.

(f)    Not applicable.

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**ITEM 6.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF OPERATION

**(a)**                               Management’sDiscussion and Analysis of Financial Condition

*The statements contained in this report that are notpurely historical are forward-looking statements. “Forward looking statements”include statements regarding our expectations, hopes, intentions, or strategiesregarding the future. Forward looking statements include: statements regardingfuture products or products or product development; statements regarding futureselling, general and administrative costs and research and developmentspending, and our product development strategy; statements regarding futurecapital expenditures and financing requirements; and similar forward lookingstatements. It is important to note that our actual results could differmaterially from those in such forward-looking statements.*

**General Discussion**

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 SOI wafers to the semiconductor industry, and the supply of isotopes forlife sciences and health-care applications. See Item 1—Business for a completediscussion of our lines of business and products.

We recorded a net loss of $(32,341,000) as compared to$(15,177,000) for the years ended April 30, 2006 and 2005, respectively. Includedin the net loss for the year ended April 30, 2006 were non cash charges of$14,166,000 associated with our 8% Debentures.

Our working capital and liquidity decreased by$24,698,000 during the year ended April 30, 2006, from a working capitalsurplus of $17,991,000 at April 30, 2005 to a working capital deficit of$(6,707,000) at April 30, 2006. In order to help mitigate this deficit, weraised an additional $13,000,000 after the end of the fiscal year from theissuance of the 6% Debentures. From these proceeds, we used approximately$4,900,000 to pay the expenses of the offering and to redeem $4,100,000 of theoutstanding 8% Debentures, leaving in excess of $8,100,000 for future workingcapital expenditures. As a result of the recent financing and the commitmentfor the purchase of an additional $3,000,000 6% Debenture, we believe we haveenough cash to finance our anticipated operations and projected negative cashflow into our 2008 fiscal year.

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. We believe with the filingof this Form 10-KSB we have met the stockholders’ equity requirementand, as a result, we are in compliance with this Nasdaq Marketplace Rule.

On July 10, 2006, wereceived a second letter from Nasdaq that advised us that the minimum bid priceof our common stock had closed at less than $1.00 per share over the previous30 consecutive business days, and, as a result, did not comply with MarketplaceRule 4310(c)(4). Therefore, in accordance with Marketplace Rule 4310(c)(8)(D),we were provided 180 calendar days, or until January 8, 2007, to regaincompliance with the Rule (which consists of the bid price of our commonstock closing at $1.00 per share or more or a minimum of 10 consecutivebusiness days). If we fail to obtain compliance, as long as we meet the NasdaqCapital Market initial listing criteria as set forth in Marketplace Rule 4310(c),except for the bid price requirement, we will be granted an additional 180calendar days to obtain compliance. We cannot give any assurance that we willbe able to meet the Nasdaq requirements to maintain our Nasdaq Capital Marketlisting, or that if we do, a stable trading market will develop for our stockor our warrants.

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**Results ofOperations**

The following table sets forth operations dataexpressed as a percentage of revenues. The table and the discussion belowshould be read in conjunction with the audited financial statements and thenotes thereto appearing elsewhere in this report.

| ** **                                   | ** ** | **Year Ended** | ** ** |
|----------------------------------------------|------------|---------------------|------------|
| ** **                                   | ** ** | **April 30,**  | ** ** |
| ** **                                   | ** ** | **2006**            | ** ** | **2005** | ** ** |
| Revenues                                     |       | 100.0               | %          | 100.0 | % |
| Cost of revenues                             |       | 95.8                |       | 127.1 |   |
| Gross margin                                 |       | 4.2                 |       | (27.1 | ) |
| Operating  expenses:                         |       |                |       |   |   |
| Selling, general and administrative          |       | 50.0                |       | 74.0 |   |
| Impairment loss on assets held for sale      |       | 2.0                 |       | — |   |
| Impairment of goodwill and intangible assets |       | —              |       | 26.5 |   |
| Research and development                     |       | 22.3                |       | 12.6 |   |
| Total operating expenses                     |       | 74.3                |       | 113.1 |   |
| Operating loss                               |       | (70.1               | )          | (140.2 | ) |
| Other income  (expense), net                 |       | (66.2               | )          | (10.0 | ) |
| Net loss                                     |       | (136.3              | )%         | (150.2 | )% |

 

**Revenues**

Revenuesfrom our security services, semiconductor products and services and homelandsecurity products reflected an increase as compared to revenues from our lifesciences segment which reflected a decrease, as described in the followingtable:

| ** **                           | ** ** | **Year Ended April 30,** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|
| ** **                           | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Life sciences                        |       |                                    |       |   |   |
| Domestic                             |       | $                                       | 3,573,000  |   | $ | 4,713,000 |   |
| International                        |       | 1,563,000                               |       | 2,700,000 |   |
| Total life  sciences                 |       | 5,136,000                               |       | 7,413,000 |   |
| Homeland security  products          |       | 35,000                                  |       | — |   |
| Security services                    |       | 12,814,000                              |       | — |   |
| Semiconductor  products and services |       | 5,731,000                               |       | 2,692,000 |   |
| Total                                |       | $                                       | 23,716,000 |   | $ | 10,105,000 |   |

 

As a result of the acquisition of PPSC and theincrease in our semiconductor products and services segment, we havesignificantly increased our revenues during the year ended April 30, 2006,and thus we decreased our reliance on a few life sciences customers for asignificant portion of our revenues. During the year ended April 30, 2006,one security services customer accounted for approximately 17% of revenues andone semiconductor products and services customer accounted for approximately10% of revenues as compared to the year ended April 30, 2005, in which twolife sciences customers accounted for approximately 19% and 10%, respectively,of revenues.

Significant reductions in sales to any of these largecustomers have had, and may in the future have, an adverse effect on us byreducing our revenues, gross margins and cash flow. Present or future customerscould terminate their purchasing with us or significantly change, reduce ordelay the amount of products or services ordered from us.

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The increase in revenue from the security servicessegment for the year ended April 30, 2006, was entirely due to thepurchase of PPSC in May 2005. While we anticipate that we will continue to grow revenue in thissegment through new contracts signed by PPSC during the year ended April 30,2006 and subsequently while retaining our existing customers currently undercontract, we cannot provide any assurance that we will be able to do so.

Our semiconductor products and services segment hasexperienced an increase in revenue during fiscal year 2006. Revenues for theyear ended April 30, 2006, were 113% higher than revenues for the yearended April 30, 2005 (partially explained as the operations for the yearended April 30, 2005 include only those of a partial year as the businessand assets of EMG were acquired in June 2004). Additionally, revenuesincreased during each sequential quarter during fiscal year 2006 with thefourth quarter being $1,906,000 and they have continued to increase during thefirst quarter of fiscal year ended April 30, 2007. The increase ispredominately due to the expansion of sales of higher-margin 300-millimeterproducts. Our 300-millimeter business provided revenue of $2,053,000 forthe year ended April 30, 2006 as compared to $0 for the year ended April 30,2005. While we believe that continued expanded focus on the 300-millimeterand SOI markets will allow us to continue to increase revenues in the future,we can provide no assurances that we will be able to do so, or that anyincreased revenues will lead to eventual profitability of the semiconductoroperations.

While we continue to move forward with our developmentprogram and to pursue the establishment of a low cost supply of silicon-28,we received only minimal amounts of revenue from silicon-28 for the yearsended April 30, 2006 and 2005, and we are not aware of any plans by anycompany for the introduction of products based on silicon-28 wafers. Therefore,we do not anticipate any material amount of proceeds from silicon-28product sales during fiscal year 2007, although we could respond to customerdemand in a relatively short time frame. Our goal ultimately is to profitably (1) licenseour proprietary technology to other entities and/or (2) sell chemicalsrequired for the production of epitaxial or bulk silicon-28 wafers and/or(3) produce epitaxial or bulk silicon-28 wafers for resale. Thecosts associated with maintaining this program are not significant.

The decrease in revenue from domestic isotope productsales for the year ended April 30, 2006, was primarily the result of asignificant decrease in the unit price of our main isotope sold domestically,oxygen-18, which was partially offset by an increase in volume. Ouraverage sales price for oxygen-18 for the year ended April 30, 2006was approximately 31% less than that for the year ended April 30, 2005. Ourvolume for the year ended April 30, 2006 was approximately 10% higher thanthat for the year ended April 30, 2005 (although we believe that it maydecrease during the year ended April 30, 2007). As a result, in order toincrease our revenues from the sale of oxygen-18, we will need toincrease our volume at a rate greater than any continuing decreases that mayoccur in the future market price for that product. The market for oxygen-18in the United States is continuing to expand and we continue to actively bid tobecome the supplier for additional customers.

In an attempt to offset the degradation of the oxygen-18market, we have successfully lowered our acquisition price of oxygen-18and we are expanding into other areas, such as actinium-225 and indium-111(through our June 2005 joint production and marketing agreement with CRS).While we do not expect these isotopes to contribute significantly to ourrevenues until the third quarter of our fiscal year ending April 30, 2007,this expansion is indicative of our business goal to broaden revenue beyond theconcentration found in a few, core products (mainly oxygen-18). However, we can offer no assurance that wewill be able to increase oxygen-18 revenue or sell additional products inthe face of the domestic and international competition in this market.

Our internationalradioisotope business has also experienced rising supplier prices in a marketthat is highly price-sensitive. In an effort to reduce costs, we closed ourEuropean trading office (Chemotrade) during the second half of fiscal year 2006.During fiscal year 2006, our ability to pass on these increasing 

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supplyprices to our customers proved to be problematic as our customers had access toradioisotope supplies from other entities. In response, we concluded thatcontinuing the sales operations of our European trading office was not aneconomically viable option and we terminated sales activity with the existingcustomer base. Revenue from our international isotope trading business was$1,563,000 for the year ended April 30, 2006, as compared to $2,700,000for the year ended April 30, 2005. We do not anticipate material, if any,revenue from this business during fiscal year 2007. For our life sciences business in theaggregate, as with all our reportable segments, we continually monitor businessconditions and marketplace changes and evaluate all investment, divestiture andother strategic options.

**Gross Margin**

Ourgross margins increased for the year ended April 30, 2006, as compared tothe prior fiscal year, both on a dollar amount and on a percentage of revenuesbasis as reflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                       | 987,000    |   | $ | (2,736,000 | ) |
| Percent of revenues |       | 4.2                                     | %          | (27.1 | )% |
|                     |            |                                         |            |  |  |  |  |

 

Our gross margin for theyear ended April 30, 2006 was positive as opposed to that for the year endedApril 30, 2005. The increase in gross margin is due mainly to two factors:  (1) the impact of PPSC’s operations, whichwere acquired in May 2005 and (2) continued improvement in operations in oursemiconductor products and services segment where there were improvements togross margin on both a dollar amount and on a percentage of revenues basis,though both metrics remain negative through this period. In addition, the lifesciences segment also contributed positive gross margin, though such grossmargin as a percentage of revenue was reduced five absolute percentage pointsfrom that experienced for the year ended April 30, 2005. As a result of theclosing of our European trading offices, we except that our life sciences grossmargin on a dollar basis will continue to decrease until we are successful, ifever, in bringing new products to market.

On a dollar basis, our overallgross margin is expected to increase correspondingly with increases in revenue,if any, with dependencies on customer and supplier pricing. Our ability topositively impact consolidated gross margin will, in a large part, be dependentupon our ability to grow sales in our homeland security segments throughincreased sales of security services and detection products and in oursemiconductor products and services segment through increased sales of 300-millimeterproducts and services, wafer thinning and SOI products. With the realignment ofour business to focus on these higher margin products, we believe that we havegreatly enhanced our ability to increase our sales and related gross margin inthese areas. As such, we anticipate that the gross margin from sales ofsemiconductor products and services (both in dollar value and as a percentageof revenues) will continue to increase over time, though we can offer noassurance that the gross margin increase will occur.

**Selling, Generaland Administrative Expenses**

Ourselling, general and administrative expenses increased as a dollar amount forthe year ended April 30, 2006, as compared to the prior fiscal year. Ourselling, general and administrative expenses decreased as a percentage ofrevenues for the year ended April 30, 2006, as compared to the priorfiscal year, as reflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                       | 11,859,000 |   | $ | 7,473,000 |   |
| Percent of revenues |       | 50.0                                    | %          | 74.0 | % |
|                     |            |                                         |            |  |  |  |  |

 

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The approximate$4,400,000 dollar increase in selling, general and administrative expenses forthe year ended April 30, 2006 as compared to the year ended April 30,2005 is attributable to a combination of factors, including:

·       approximately$3,050,000 directly related to the addition of PPSC’s operations in May 2005;

·       acharge in the amount of $159,000 (of which $109,000 is a noncash item) relatedto the settlement of a lawsuit;

·       anoncash charge in the amount of $510,000 related to the extension of the expirationdates of certain investor-held warrants;

·       approximately$570,000 due to the increase in staffing and operations in the homelandsecurity products segment;

·       approximately$100,000 due to increased legal and accounting fees related to the filing oftwo registration statements during the year ended April 30, 2006, and tothe reaudit of the fiscal year 2004 financial statements (the work wasperformed in fiscal year 2006) required due to Grant Thornton’s unwillingnessto consent to the inclusion of its report for that fiscal year;

·       approximately$670,000 due to the increase in other corporate headquarters expenses;

·       approximately$140,000 due to the increase in semiconductor products and services expenses;

·       offsetby $669,000 in expense recognized in the prior year relating to warrantsgranted to homeland security advisory board members and other advisors andapproximately $143,000 due to decreased spending in the life sciences segment.

We anticipate that we mayincrease our selling, general and administrative expenses during fiscal year2007 through anticipated increased marketing efforts for and operations in ourhomeland security products operations, security services and semiconductorproducts and services segment. There can be no assurance that our anticipatedpossible increase in selling, general and administrative expenses will resultin increased revenues from product sales.

**Impairment Loss onAssets Held for Sale**

Ourimpairment loss on assets held for sale increased for the year ended April 30,2006, as compared to the prior fiscal year, both on a dollar amount and on apercentage of revenues basis as reflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                       | 466,000    |   |   | $ | — |   |   |
| Percent of revenues |       | 2.0                                     | %          |   | — | % |   |
|                     |            |                                         |            |  |  |  |  |  |  |

 

Impairment losses onassets held for sale resulted from operational decisions made related to theongoing review and improvements underway in our semiconductor products andservices segment. As part of this ongoing review and resulting operationalchanges, certain equipment was identified as obsolete or unnecessary to supportour more focused product portfolio and planned future operations. As a result,certain of the identified equipment whose book value exceeded estimated netrealizable were individually written down to estimated net realizable value,resulting in a cumulative impairment charge of $466,000. We expect that theequipment will be sold within the upcoming year.

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**Impairment ofGoodwill and Intangible Assets**

Our impairment loss on goodwill and intangibleassets decreased for the year ended April 30, 2006, as compared to the priorfiscal year, both on a dollar amount and on a percentage of revenues basis asreflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **  2006  **        | ** ** | **2005** | ** ** |
| Dollar amount       |       |                                    | $          | 0 |   |   | $ | 2,682,000 |   |
| Percent of revenues |       |                                    | —     | % |   | 26.5 | % |
|                     |            |                                         |            |  |  |  |  |  |  |

 

Impairment of goodwill andintangible assets for the year ended April 30, 2005 relates to the writeoff of $447,000 associated with the acquisition of the assets of EMG and$428,000 associated with the acquisition of technology from Silicon Evolution, Inc.,along with $1,807,000 of goodwill associated with our life sciences segment.

**Research andDevelopment Expenses**

Ourresearch and development expenses increased during the year ended April 30,2006, as compared to the prior fiscal year, both on a dollar amount and on apercentage of revenues basis as reflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| Dollar amount       |       | $                                       | 5,293,000  |   | $ | 1,271,000 |   |
| Percent of revenues |       | 22.3                                    | %          | 12.6 | % |
|                     |            |                                         |            |  |  |  |  |

 

The dollar increase for the year ended April 30,2006, is primarily related to an increase in research and development expensesassociated with payments made to Lucent under our infrared imaging and nightvision surveillance technology development & licensing agreement aswell as, to a lesser extent, our trace and bulk detection technology andsemiconductor research and development work related mainly to various SOIprocesses. Consistentwith our product development strategy, we are seeking to identify and evaluatenew products in the homeland security operations as well as to bring existingtechnologies, including IMS-based products and NeutroTestTM, to a production-ready state. The majorityof this research and development on trace and bulk detection technology isbeing performed by IUT and is related to IMS and neutron-based detection. In June 2004, we entered into a researchand development agreement with IUT, which contemplated the funding of certainprojects of up to $4,000,000 over several years. The work was to be funded insteps and was based upon the completion of various milestones, as defined. Wehad no obligation to fund any work under this agreement unless we had approvedsuch effort. We recognized $1,463,000 and $650,000 of expense under thisagreement during the years ended April 30, 2006 and 2005. In April 2006,this agreement was canceled and we entered into a new agreement with IUTwhereby we agreed to use the services of IUT for certain development work on aproject-by-project basis.

In December 2005, we approved a development planwith Lucent that obligated us under a development & licensingagreement. Under that Agreement, we will endeavor (with Lucent) to develop anext-generation imaging and night vision surveillance technology. Thedevelopment plan contemplates a proof-of-concept within 12 months followed bysteps towards commercialization, although we can provide no assurances that acommercially attractive product will ultimately be available. For the yearended April 30, 2006, we recorded research and development expense of$2,500,000 and we may be obligated to pay an additional $1,000,000 per quarterin development funding for the next ten quarters. We have the right toterminate the development project for any reason from time-to-time, so long astermination is prior to the first commercial sale of a licensed product. Assuch, assuming we continue with the 

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development program, weexpect our quarterly research and development expense for this purpose toremain elevated. Subsequent to year-end, we made a quarterly payment to Lucentfor $1,000,0000 in June 2006.

We believe that thedevelopment and introduction of new product applications is critical to ourfuture success. We expect that research and development expenses may increaseassuming sufficient cash remains available and we are able to procure necessarymaterials and outside services. It is likely that research and developmentexpenditures will continue to vary as a percentage of revenues because of thetiming and amount of future revenues. Except for work being performed on oursemiconductor products at our facilities in Vancouver, Washington, we operateno other facilities of our own for research and development. Significantly allother research and development work is performed by outside entities, none ofwhich we control (although we have increased our minority ownership position inIUT to 30%). Although we expend significant resources on research anddevelopment, we cannot offer any assurance that our current or future lines ofbusiness or products resulting from our research and development efforts willbe profitable or generate significant revenues.

**Operating Loss**

Ouroperating losses (in total) increased during the year ended April 30,2006, as compared to the prior fiscal year as reflected in the following table:

| ** **                           | ** ** | **Year Ended April 30,** | ** **  |
|--------------------------------------|------------|-----------------------------------------|-------------|
| ** **                           | ** ** | **2006**                                | ** **  | **2005** | ** ** |
| Homeland security  products          |       | $                                       | (3,489,000  | ) | $ | (1,728,000 | ) |
| Security services                    |       | (24,000                                 | )           | — |   |
| Semiconductor  products and services |       | (5,151,000                              | )           | (6,484,000 | ) |
| Life Sciences                        |       | (968,000                                | )           | (2,206,000 | ) |
| Reconciling  amounts(1)              |       | (6,999,000                              | )           | (3,744,000 | ) |
| Total                                |       | $                                       | (16,631,000 | ) | $ | (14,162,000 | ) |

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(1)          Reconciling amounts forthe operating loss information include corporate expenses consisting primarilyof payments to Lucent under our development agreement, corporate salaries andbenefits, professional and consulting fees, investor relations costs, insuranceand directors’ compensation.

Our homeland security products segment generated asignificant operating loss in an effort to develop and commercialize our traceand bulk detection technology into products that can be used to detect varioustypes of explosives and/or chemical agents and innovative infrared imagingtechnology. While revenues were minimal for the year ended April 30, 2006,we are hopeful that we will be able to begin to generate revenue in thissegment during our year ending April 30, 2007.

Our security services segment consists of PPSC, whichwas acquired in May 2005. The segment delivered significant revenue totaling$12,814,000 and gross margin of approximately 24%. Although the segmentgenerated an operating loss for the year ended April 30, 2006, of$(24,000), this amount is inclusive of amortization of acquisition-relatedcustomer intangibles in the amount of $138,000 and also includes incrementalinvestment in personnel specifically focused on selling to the governmentsector of the United States.

Our semiconductor products and services segment showedcontinued operational and financial improvement (due mainly to the realignmentof our business to significantly reduce our reliance on low margin smalldiameter products and focus mainly on higher margin 300-millimeterproducts and services, wafer thinning and SOI products) for the year ended April 30,2006, though still generating an operating loss of $(5,151,000) as compared to$(6,484,000) for the year ended April 30, 2005. Additionally, the 

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operating loss was reducedeach sequential quarter during fiscal year 2006 with the fourth quarter being$(777,000) and it has continued to improve in the first quarter of the yearending April 30, 2007.

Our life sciences segmentgenerated an operating loss of $(968,000) for the year ended April 30,2006 as compared to $(2,206,000) for the year ended April 30, 2005. Theoperating losses are due mainly to the significant decrease in the averageselling price of our main product, oxygen-18 over the last three years. Additionally,during the second half of fiscal year 2006, we closed our European tradingoffice (Chemotrade) as it was no longer economically viable and we terminatedsales activity with the existing customer base. In an attempt to offset the degradation ofthe oxygen-18 market, we have successfully lowered our acquisition priceof oxygen-18 and we are expanding into other areas, such as actinium-225and indium-111 (through our June 2005 joint production and marketingagreement with CRS). While we don’t expect these isotopes to contributesignificantly to our revenues until the third quarter of our fiscal year endingApril 30, 2007, this expansion is indicative of our business goal tobroaden revenue beyond the concentration found in a few, core products (mainlyoxygen-18).

**Other income(expense), net**

Otherincome (expense), net decreased during the year ended April 30, 2006, ascompared to the prior fiscal year as reflected in the following table:

| ** **    | ** ** | **Year Ended April 30,** | ** **  |
|---------------|------------|-----------------------------------------|-------------|
| ** **    | ** ** | **2006**                                | ** **  | **2005** | ** ** |
| Dollar amount |       | $                                       | (15,710,000 | ) | $ | (1,015,000 | ) |
|               |            |                                         |             |  |  |  |  |

 

For the year ended April 30, 2006, other income(expense), net includes debt conversion expense, interest charges andamortization of debt issuance costs related to our 8% Debentures issued in February 2005.Included in the amount for the year ended April 30, 2006, is noncashinterest charges of $5,662,000 related various transactions associated with the8% Debentures, a noncash charge of $7,227,000 related to the March 2006conversion of our 8% Debentures and a noncash charge for amortization of debtissuance costs of $1,260,000. Additionally, included in other expense for yearended April 30, 2006, is the nominal interest expense on the 8%Debentures, of which $949,000 was paid in common stock and $759,000 was paid incash. Lastly, interest income in the amount of $301,000 was earned thatpartially offset the cash and noncash interest expense.

For the year ended April 30, 2005, other income(expense), net includes interest income and expense and foreign currency gainsand losses and the amortization of debt issuance costs. Included for the yearended April 30, 2005 is $1,000,000 of interest expense associatedprimarily with our 8% Debentures and $166,000 related to the amortization ofdebt issuance costs associated with our convertible debentures, partiallyoffset by $117,000 in interest and other income and $34,000 from foreigncurrency gains.

We expect that our otherexpenses will be volatile based on the future timing of repayment, if ever, ofour remaining convertible debentures (see the Liquidity and Capital Resourcesdiscussion below).

**Income Taxes**

We currently operate at aloss and expect to operate at a loss until the products currently underdevelopment begin to generate sufficient revenue. The losses incurred in thecurrent year are not expected to generate an income tax benefit because of theuncertainty of the realization of the deferred tax asset. As a result, we haveprovided a valuation allowance against our net deferred tax asset because,based on available evidence including our continued operating losses, it ismore likely than not, that all of the deferred tax assets will not be realized.Additionally, due to certain “change in ownership” rules (as defined bythe IRS), utilization of our federal net operating losses may be subject tocertain annual limitations.

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**Net Loss**

Ournet losses increased during the year ended April 30, 2006 as compared tothe prior fiscal year as reflected in the following table:

| ** **    | ** ** | **Year Ended April 30,** | ** ** |
|---------------|------------|-----------------------------------------|------------|
| ** **    | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Dollar amount |       | $                                       | 32,341,000 |   | $ | 15,177,000 |   |
|               |            |                                         |            |  |  |  |  |

 

We anticipate that losses will continue until (ifever): (i) revenues from our current operations substantially increase or (ii) wegenerate substantial revenues from products introduced as a result of ourresearch and development projects. Further, the revenues must increase fasterthan any increases in operating and research and development expenses. Weexpect that our net loss will continue during at least the short term (thoughat a lower level) as we continue to pursue and transition towards a richerproduct mix, new revenue streams in our semiconductor products and servicesbusiness and as we continue our marketing and research efforts to expand salesand develop new products in the homeland security business, including thecommercialization of the IMS technology and, eventually, the infrared imagingtechnology based on our development & licensing agreement with Lucent.However, we can offer no assurances that the development and commercializationof these technologies will occur.

In accordance with theissuance of our Series E Convertible Preferred Stock, we determined thatthe value of the beneficial conversion feature (based upon a $1.24 conversionprice) to be $1,206,000, which was reported as a deemed dividend for the yearended April 30, 2005.

**Liquidity andCapital Resources**

***Working Capital***

Our working capitaldecreased by $24,698,000 during the year ended April 30, 2006, from aworking capital surplus of $17,991,000 at April 30, 2005, to a workingcapital deficit of $(6,707,000) at April 30, 2006. The decrease in workingcapital for the year ended April 30, 2006, is due to a combination offactors, or which the significant factors are set out below:

·       approximately$7,400,000 due to an increase in the current portion of the convertibledebentures (which are payable at our option in cash or common stock, assumingall contractual requirements for payment in common stock are met—see discussionof convertible debenture repayment below);

·       approximately$14,200,000 of cash consumed directly in operating activities (calculated asapproximately $15,400,000 of cash used in operating activities, netted down byapproximately $1,200,000 of the cash impact of changes in other current assetsor liabilities included therein);

·       $2,500,000of cash paid as part of the acquisition of PPSC;

·       approximately$336,000 of cash paid to purchase additional equity in IUT;

·       $1,700,000expended on purchases of fixed assets;

·       anoffsetting amount of approximately $560,000 related to assets held for salethat were reclassified to current assets from property and equipment

·       anoffsetting amount of approximately $825,000 related to the net impact ofproceeds from common stock exceeding principal repayments on debt and preferredstock dividends paid.

As a result of the recent financing and the commitmentfor the purchase of an additional $3,000,000 6% Debenture, we believe we haveenough cash to finance our anticipated operations and projected negative cashflow into our 2008 fiscal year.

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We have satisfied ourworking capital requirements primarily through financing activities in thepast, including the sale of the 8% Debentures in February 2005 and the 6%Debentures in May and June 2006. As described above, we have recentlyreceived two notifications from Nasdaq identifying listing deficiencies, which,if not cured timely (the first having been done with the filing of this 10-KSB),may result in our delisting from the Nasdaq Capital Market. Any such delisting,if it should occur, will make future financing activities significantly moredifficult.

***Convertible Debentures***

As noted above, approximately $7,400,000 of our changein working capital between April 30, 2005, and April 30, 2006, is dueto a substantial portion of the 8% Debentures being reclassified from long-termliabilities to current liabilities. Additionally, there has been substantialactivity in reducing the outstanding principal balance on the 8% Debentures.

The first of twelve monthly principal payments on our8% Debentures became due in March 2006. However, both the principal andinterest are payable, at our option, in common stock, subject to variousrequirements (which we believe we currently meet). If we choose to make ascheduled principal payment by issuing common stock, and all requirements to doso are met, the conversion price will be the lesser of the then conversionprice (currently $5.00 per share) or 88% of the average of the ten closingprices ending on the trading day immediately prior to the monthly redemptiondate. The 8% Debentures and the related warrants have certain limitations onour ability to issue shares to the holders of the 8% Debentures and warrants(the “Holders”) as described in Note 9 in the accompanying ConsolidatedFinancial Statements.

Having met allrequirements to do so, we made several interest and principal payments on the8% Debentures in shares of our common stock and we also made a temporaryconversion offer to the Holders, as follows:

·       OnSeptember 30, 2006, we made a quarterly interest payment by issuing200,600 shares of our common stock. This share issuance settled our interestobligation in the nominal amount of approximately $450,000.

·       OnMarch 1, 2006, we made the first monthly payment on the 8% Debentures byissuing 1,347,361 shares of our common stock in satisfaction of the principalpayment and accrued interest then due. We reduced the principal balance of the8% Debentures by the nominal amount of approximately $1,900,000 and settled ourinterest obligation in the nominal amount of approximately $300,000.

·       OnMarch 9, 2006, holders of our 8% Debentures converted outstandingprincipal in the amount of $9,000,000 into 6,206,897 shares of our common stock.We gave the Holders of all Debentures the right to convert a portion or theirentire principal amount into shares of our common stock at a temporaryconversion price of $1.45 per share (a reduction from the prior conversionprice of $5.00 per share). At the close of business on March 8, 2006, theclosing price for our common stock was $1.64 per share. Additionally, we issued10,036 shares of our common stock in payment of interest then due on theconverted principal amount.

·       OnApril 1, 2006, we made our monthly payment on the 8% Debentures by issuing1,606,270 shares of our common stock in satisfaction of the principal paymentand accrued interest then due. We reduced the principal balance of the 8%Debentures by the nominal amount of approximately $1,900,000 and settled ourinterest obligation in the nominal amount of approximately $80,000.

·       OnMay 1, 2006, we made our monthly payment on the 8% Debentures by issuing1,616,433 shares of our common stock in satisfaction of the principal paymentand accrued interest then due. We reduced the principal balance of the 8%Debentures by the nominal amount of approximately $1,820,000 and settled ourinterest obligation in the nominal amount of approximately $65,000.

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·       OnJune 1, 2006, we made our monthly payment on the 8% Debentures by issuing1,997,265 shares of our common stock in satisfaction of the principal paymentand accrued interest then due. We reduced the principal balance of the 8%Debentures by the nominal amount of approximately $1,650,000 and settled ourinterest obligation in the nominal amount of approximately $20,000.

In connection with the financing transaction discussedin “Additional Liquidity Considerations” below, on May 19, 2006 we enteredinto an agreement with certain of the Holders to pay their remaining principalbalance after June 1, 2006, along with a 5% premium in cash. In acceptingour offer, these Holders also agreed to limit the anti-dilution provision ontheir warrants originally issued with the 8% Debentures and to waive certainprovisions of the 8% Debentures as they related to the completion of our 6%Debentures (although we believe such contractual terms not to be in force). Approximately$5,000,000 of the then outstanding $8,200,000 8% Debentures accepted our offer.As a result, we paid these holders $4,107,102 (of which $3,880,000 related tothe repayment of principal). With the completion of the stock-based paymentsdescribed above along with the aforementioned cash payments and a July 2006principal payment in the amount of $562,500, as of July 21, 2006 we had$2,062,500 of 8% Debentures outstanding which will be paid in accordance withthe original agreement through February 1, 2007.

In June 2006, one ofthe holders of the 8% Debentures, with a remaining principal balance of$312,500 (as of July 21, 2006), informed us of its belief that theissuance of the 6% Debentures (as discussed above) constituted a default (dueto a potential variable conversion provision contained within the 6% Debenture)under the 8% Debentures. Remedies of such default (if actual) include theoption to accelerate payment of the full principal amount of the remaining 6%Debentures, together with interest and other amounts due, to the date ofacceleration. The principal amount of the 8% Debentures shall be equal to 130%of the then-principal amount of the 8% Debentures plus all interest and otheramounts due or a conversion calculation, whichever is higher. The holder hadapproximately $937,000 due on its debenture at the time we entered into the 6%Debenture. We have contested that allegation (based among other things thatsuch clause did not survive the final agreement) and will defend it in court,if necessary.

***Cash Flows***

As of April 30,2006, we had $2,117,000 of cash and cash equivalents, a decrease of $19,089,000as compared to $21,206,000 at April 30, 2005. Our principal source offunding for the year ended April 30, 2006 was from the exercise of commonstock warrants, stock options and the issuance of common shares under our ESPPwhereby we received $1,761,000. Our principal source of funding for the yearended April 30, 2005 was from:

·       theissuance of 8% Debentures completed in February 2005 whereby we received$22,000,000 ($21,340,000 net of placement fees),

·       theprivate placement of shares of our Series E Convertible Preferred Stockcompleted in October 2004 whereby we received $3,300,000 ($3,049,000 netof due diligence fees and related expenses), and

·       theexercise of common stock warrants whereby we received $6,708,000.

Cash used in operating activities of $15,410,000 and$9,363,000 during the years ended April 30, 2006 and 2005, respectively,was primarily the result of a net loss of $32,341,000 (offset by $15,843,000 ofdepreciation, amortization and debt conversion expense) and $15,177,000,respectively.

Investing activities used cash of $4,504,000 and$3,790,000 for the years ended April 30, 2006 and 2005, respectively. Cashused in investing activities for the year ended April 30, 2006, consistedof the purchase of PPSC in May 2005 (which included a net cash payment of$2,468,000) along with $1,700,000 expended on additions of property andequipment and $336,000 expended on increasing our ownership 

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share of IUT to 30%. Cashused in investing activities for the year ended April 30, 2005 resultedprimarily from purchases of property and equipment.

Financing activitiesprovided cash of $825,000 and $30,668,000 for the years ended April 30,2006 and 2005, respectively. Cash provided by financing activities for the yearended April 30, 2006 resulted primarily from the exercise of common stockwarrants, stock options and the issuance of common shares under our ESPPwhereby we received $1,761,000 offset by principal payments on borrowings of$791,000. Cash provided by financing activities for the year ended April 30,2005 resulted primarily from the issuance of the 8% Debentures completed in February 2005whereby we received $22,000,000 ($21,340,000 net of placement fees), theprivate placement completed in October 2004 whereby we received $3,300,000($3,049,000 net of due diligence fees and related expenses) and the exercise ofcommon stock warrants whereby we received $6,708,000.

**AdditionalLiquidity Considerations**

On February 24, 2005,we completed a private placement pursuant to which we issued to accreditedinvestors our 8% Debentures in the aggregate principal amount of $22,000,000and 1,540,000 common stock warrants, each of which can be exercised for $6.25per share for a period of three years. In addition to the 8% Debentures andwarrants issued to the investors, we paid a placement agent a 6.5% feeconsisting of $660,000, a $770,000 8% Debenture and 53,900 warrants. The termsof both the 8% Debentures and the warrants are the same as those for theaccredited investors, as described above. The 8% Debentures were required to bereduced by 1¤12th per month beginning March 1, 2006. Boththe principal and interest are payable, at our option in common stock or cash,subject to various requirements.

On May 31, 2006 and June 5,2006 we completed a private placement by which we issued to an accreditedinvestor 6% Debentures in the aggregate principal amount of $13,000,000 andwarrants to purchase a total of 8,000,000 shares of our common stock atexercise 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) for a period ofthree years. In addition, the purchaser of our 6% Debentures has an obligationto purchase an additional $3,000,000 6% Debenture two days before theregistration statement underlying the 6% Debentures is declared effective. Theaccredited investor and an unaffiliated third party provided us services inconnection with completing the transaction (which were valued at $825,000) andas a result, we issued 660,000 shares of restricted common stock ascompensation. The accredited investor may convert the 6% Debenture into sharesof our common stock at any time at a conversion price of $1.25 per share. AfterSeptember 27, 2006 (and subject to an effective registration statement),the holder may convert the 6% Debentures into common stock at the lower of $1.25or a discount to the then market price (as defined), subject to certainconversion limitations (see Note 17 to the accompanying Consolidated FinancialStatements).

As a result of the 6%Debenture transaction, anti-dilution provisions associated with the 1,593,900common stock warrants issued in the 8% Debenture transaction were triggeredwhereby we issued an additional 6,375,600 common stock warrants to theseholders and reduced the exercise price on all related warrants to $1.25. As aresult, as of July 21, 2006 we have 7,969,500 common stock warrantsexercisable at $1.25 related to the 8% Debenture transaction. As a result ofthe May 18, 2006 agreement (as discussed above), 4,557,000 of these commonstock warrants have been modified to reduce their anti-dilution provisions to aprice-protection provision only. If we were to enter into a financing agreementin the future with an effective price less then $1.25, the remaining 3,412,500common stock warrants that have a full anti-dilution provision, would ratchetinto a great number of common stock warrants at a lower exercise price.

Effective June 17,2005 the expiration date of our Class B and C warrants was extended from December 31,2005, to December 29, 2006. Effective December 29, 2005, theexpiration date of 

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232,500 warrantsgranted to an investor was extended from December 31, 2005, to December 29,2006. There were no other changes in the terms or conditions of the warrants.

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

Our future commitmentshave increased due to the agreement and development plan with Lucent, underwhich we endeavor to develop a next-generation imaging and night visionsurveillance technology (although we can provide no assurances that acommercially attractive product will ultimately be available). We have paidLucent $3,000,000 through July 21, 2006, and to maintain our rights underthe agreement we are obligated to make an additional nine payments in theamount of $1,000,000 approximately every three months thereafter. This amountprovides development funding required under the agreement. We have the right toterminate the development project for any reason from time-to-time, so long astermination is prior to the first commercial sale of a licensed product. Assuch, assuming we continue the development program, we expect our quarterlyresearch and development funding for this purpose to remain elevated.

The assumptions underlyingthe above statements include, among other things, that there will be nomaterial adverse developments in the business or market in general. There canbe no assurances however that those assumed events will occur. If our plans arenot achieved, there may be further negative effects on the results ofoperations and cash flows, which could have a material adverse effect on ourfinancial position.

**Contractual Cash Obligations**

Thefollowing summarizes our contractual cash obligations and commercialcommitments at April 30, 2006, and the effect such obligations areexpected to have on liquidity and cash flows in future periods. Included in thetable below are purchase obligations under which we have legal obligations forpayments in specific years.

| ** **                                                                            | ** ** | **Payments Due by Period(a)** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                            | ** ** | **Total**                                    | ** ** | **Less than 1 Year** | ** ** | **2-3 Years** | ** ** | **4-5 Years** | ** ** | **After 5 Years** | ** ** |
| Long-term debt(b)                                                                     |       | $                                            | 1,009,000  |   |   | $ | 823,000 |   |   | $ | 164,000 |   | $ | 22,000 |   |   | $ | 0 |   |   |
| Capital lease  obligations                                                            |       | 57,000                                       |       |   | 19,000 |   |   | 38,000 |   | 0 |   |   | 0 |   |   |
| Operating lease  obligations(c)                                                       |       | 1,645,000                                    |       |   | 323,000 |   |   | 455,000 |   | 374,000 |   |   | 493,000 |   |   |
| Purchase  obligations(d)                                                              |       | 6,570,000                                    |       |   | 2,670,000 |   |   | 2,400,000 |   | 1,500,000 |   |   | 0 |   |   |
| Other long-term  obligations reflected in the balance sheet at April 30, 2006(e) |       | 520,000                                      |       |   | 520,000 |   |   | 0 |   | 0 |   |   | 0 |   |   |
| Total contractual  obligations                                                        |       | $                                            | 9,801,000  |   |   | $ | 4,355,000 |   |   | $ | 3,057,000 |   | $ | 1,896,000 |   |   | $ | 493,000 |   |   |

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(a)           Paymentsare included in the period by which they are contractually required to be made.Actual payments may be made prior to the contractually required date.

(b)          Amountconsists primarily of (1) a note payable to Silver Silicon, Ltd. with aremaining principal balance of $653,000 and related interest at 6% and a noteto a commercial bank with a remaining principal amount of $259,000 and relatedinterest at 6.9%. Amount does not include convertible debentures with aremaining principal balance of $9,975,000 or related interest payments, asamounts are payable in common stock (at a discount to the then current marketprice) or cash at our election, assuming the existence of an effectiveregistration statement. If such amounts were paid in cash, the commitment onprincipal and interest repayment would be for less than one year.

(c)           Representsour commitments associated with operating leases and includes contracts thatexpire in various fiscal years through 2014. Payments due reflect minimum leasepayments.

(d)          Purchaseobligations include payments for isotopes (including oxygen-18) andcapital equipment.

(e)           Amountconsists of the guaranteed portion of three employment agreements if suchemployees are terminated without cause.

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Subsequent to year end, weissued the aforementioned 6% Debentures in the aggregate principal amount of$13,000,000 with a maturity date of May 31, 2009.

**Off-Balance SheetArrangements**

In addition to thepurchase obligations discussed above, see Note 9 to the accompanyingConsolidated Financial Statements for a discussion of letters and lines ofcredit.

**Critical AccountingEstimates**

We consider an accounting estimate to be critical if1) the accounting estimate requires us to make assumptions about matters thatwere highly uncertain at the time the accounting estimate was made, and 2)changes in the estimate that are reasonably likely to occur from period toperiod, or use of different estimates that we reasonably could have used in thecurrent period, would have a material impact on our financial condition orresults of operations.

Management has discussedthe development and selection of these critical accounting estimates with theAudit Committee of our Board of Directors and the Audit Committee has reviewedthe foregoing disclosure. In addition, there are other items within ourfinancial statements that require estimation, but are not deemed critical asdefined above. Changes in estimates used in these and other items could have amaterial impact on our financial statements.

*Goodwill andIntangible Assets*

Goodwill is recorded on our books for acquisitionswhere the purchase price is in excess of the cumulative fair values of theidentified tangible and intangible assets. The assignment of fair value to the identifiedtangible and intangible assets requires significant judgment and may requireindependent valuations of certain identified assets. Once goodwill and otherintangible assets are established on our balance sheet, we evaluate the assetsfor impairment as described in the following paragraphs.

In accordance with SFAS No. 142 Goodwill andOther Intangible Assets, goodwill is not amortized, but instead is tested forimpairment on an annual basis or more frequently if the presence of certaincircumstances indicates that impairment may have occurred. The impairmentreview process, which is subjective and requires significant judgment at manypoints during the analysis, compares the fair value of the reporting unit inwhich goodwill resides to its carrying value. If the carrying value of areporting unit exceeds its fair value, then the amount of the impairment lossmust be measured. The impairment loss is calculated by comparing the impliedfair value of reporting unit goodwill to its carrying amount. In calculatingthe implied fair value of reporting unit goodwill, the fair value of thereporting unit is allocated to all of the other assets and liabilities of thatunit based on their fair values. The excess of the fair value of a reportingunit over the amount assigned to its other assets and liabilities is theimplied fair value of goodwill. An impairment loss would be recognized when thecarrying amount of goodwill exceeds its implied fair value. We have goodwill inthe amount of $3,631,000 on our consolidated balance sheet as of April 30,2006, related to the acquisition of PPSC in May 2005. We performed ourannual impairment review on the aforementioned goodwill during our third fiscalquarter and concluded that the goodwill is not impaired.

For intangible assetsother than goodwill, SFAS No. 144 Accounting for the Impairment orDisposal of Long-Lived Assets is the authoritative standard on the accountingfor the impairment of such intangible assets. As required, we perform tests forimpairment of intangible assets other than goodwill whenever events orcircumstances suggest that such assets may be impaired. To evaluate potentialimpairment, SFAS No. 144 requiresus to assess whether the future cash flows related to these assets will begreater than their carrying value at the time of the test. Accordingly, whileour cash flow assumptions are consistent with the plans and estimates we areusing to manage the underlying businesses, there is 

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significantjudgment in determining the cash flows attributable to our other intangibleassets over their respective estimated useful lives. We have remaining othernet intangible assets in the amount of $491,000 on our balance sheet as of April 30,2006, comprised of our trace and bulk detection technology acquired in December 2002,for customer lists acquired in our acquisition of the business and assets ofEMG in June 2004 and the customer base acquired in our acquisition of PPSCin May 2005. We are required to periodically evaluate our other intangibleassets balances for impairments. If we were to incur additional impairments toour other intangible assets, it could have an adverse impact on our futureearnings, if any.

*Valuation of EquityTransactions*

We value transactionsassociated with common or preferred stock that is convertible into common stockbased on the market value of the underlying common stock on the date of thesigning of the agreement. We value transactions associated with common stockwarrants at the appropriate measurement date utilizing the Black-Scholespricing model, with assumptions as to volatility (100% for fiscal years 2006and 2005), risk-free interest rate (4.0%) and estimated life of the warrantsbased on historical information. If the assumptions used, as they relate tovolatility, risk-free interest rate and estimated life of the warrants, werematerially different, the overall valuation of these transactions could changesignificantly.

**Recently IssuedAccounting Standards**

In December 2004, the Financial AccountingStandards Board (“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 for SFAS 123(R).The SEC previously required companies to adopt this standard no later than July 1,2005, but the new rules now require us to adopt FAS 123(R) startingwith our first quarter of our fiscal year beginning May 1, 2006. Additionally,in March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB No. 107),which summarizes the staff’s views regarding share-based payment arrangementsfor public companies. We are evaluating the impact of the new standards and,although we have not completed our analysis, we anticipate that the expensewould not exceed the amounts disclosed in *Accountingfor Stock-Based Compensation*had we been expensing under the newrule.

In September 2005, the FASB ratified theconsensus reached by the Emerging Issues Task Force (“EITF”) on EITF Issue No. 05-08*Income Tax Consequences of IssuingConvertible Debt with a Beneficial Conversion Feature*(“EITF 05-08”).The EITF consensus noted that for the purpose of applying SFAS No. 109,Accounting for Income Taxes, (1) the issuance of convertible debt with abeneficial conversion feature results in a basis difference, (2) the basisdifference is a temporary difference and (3) the recognition of deferredtaxes for the temporary difference of the convertible debt with a beneficialconversion feature should be recorded as an adjustment to additional paid-incapital. The EITF also reached a consensus that the guidance in EITF 05-08should be applied to financial statements beginning in the first interim orannual reporting period beginning after December 15, 2005. The guidanceshould be applied by retrospective application pursuant to SFAS No. 154, *Accounting Changes and Error Corrections*,to all instruments with a beneficial conversion feature accounted for underEITF Issue No. 00-27, Application of Issue No. 98-5 toCertain Convertible Instruments. The adoption of EITF 05-08 has not had amaterial impact on our consolidated financial statements.

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 

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extinguished. Theconsensus also requires subsequent recognition of interest expense for anychange in the fair value of the embedded conversion option resulting from amodification of a convertible debt instrument. EITF 05-07 is effectivebeginning in the first interim or annual reporting period beginning 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. Thelegal agreements related to our 8% Debentures include a freestandingregistration rights agreement. Once the FASB ratifies the then-completedconsensus of the EITF on EITF 05-04, we will assess the impact on ourconsolidated financial statements of adopting the standard and, if an impactexists, follow the transition guidance for implementation.

In February 2006, the FASB issued SFAS No. 155,*Accounting for Certain Hybrid Financial Instruments*(“SFAS 155”), which amends SFAS No. 133, *Accountingfor Derivative Instruments and Hedging Activities* and SFAS No. 140,*Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities*. SFAS 155 simplifiesthe accounting for certain derivatives embedded in other financial instrumentsby allowing 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 clarifies andamends certain other provisions of SFAS No. 133 and SFAS No. 140.SFAS 155 is effective for all financial instruments acquired, issued, orsubject to a remeasurement event occurring in fiscal years beginning after September 15,2006. We do not expect the adoption of SFAS 155 to have an impact on ourresults of operations or financial condition.

In March 2006, the FASB issued SFAS No. 156,*Accounting for Servicing of Financial Assets—anamendment to FASB Statement No. 140* (“SFAS 156”). SFAS 156requires that all separately recognized servicing rights be initially measuredat fair value, if practicable. In addition, this statement permits an entity tochoose between two measurement methods (amortization method or fair valuemeasurement method) for each class of separately recognized servicing assetsand liabilities. This new accounting standard is effective January 1, 2007.We do not expect the adoption of SFAS 156 to have an impact on our resultsof operations or financial condition.

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 Interpretation No. 48, *Accounting for Uncertainty in Income Taxes—an interpretation of FASBStatement No. 109 (“FIN 48”).* This interpretation clarifies theapplication of SFAS 109 by defining a criterion than an individual taxposition must meet for any part of the benefit of that position to berecognized in an enterprise’s financial statements and also provides guidanceon measurement, derecognition, classification, interest and penalties,accounting in interim periods and disclosure. FIN 48 is effective for ourfiscal year commencing May 1, 2007. At this time, we have not completed ourreview and assessment of the impact of adoption of FIN 48.

We have reviewed all otherrecently issued, but not yet effective, accounting pronouncements and do notbelieve any such pronouncements will have a material impact on our financialstatements.

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**(b)**                               RiskFactors

*An investment in and ownership of our common stock,Class B or Class C Warrants, or any other of our convertiblesecurities is one of high risk. Youshould carefully consider the risks described below before deciding whether toexercise your warrants, or to invest in or continue to hold our common stock.If any of the contingencies discussed in the following paragraphs or othermaterially adverse events actually occur, the business, financial condition andresults of operations could be materially and adversely affected. In such case,the trading price of our common stock could decline, and you could lose all orpart of your investment.*

**We havehistorically had severe working capital shortages, even following significantfinancing transactions.**

Although we raised capital totaling more than$32,900,000 (net of expenses and prior to the 6% Debenture transactioncompleted after fiscal year end) during the last two fiscal years, we have hadworking capital shortages in the past and our consolidated financial statementsfor the year ended April 30, 2006, indicate that we have a working capitaldeficit of $(6,707,000).

We issued the 6% Debentures in May andJune 2006. The total principal amount of these 6% Debentures issued was$13,000,000 which netted approximately $8,160,000 in proceeds after expensesand $4,100,000 of payments related to our 8% Debentures. The purchaser has anobligation to purchase an additional $3,000,000 6% Debenture two days beforethe registration statement underlying the 6% Debentures is declared effective.

Based on the amount of capital we have remaining, ourcurrent negative cash flow from operations and investing activities, weanticipate that we may incur a working capital deficit sometime after thecompletion of fiscal year 2007 unless we are able to substantially increase ourrevenue or reduce our expenses thereby generating positive cash flow fromoperations and (ultimately) operating income.

As a result of the recentfinancing and the commitment to purchase an additional $3,000,000 6% Debentureimmediately prior to the effectiveness of the registration statement underlyingthe 6% Debentures, we believe we have sufficient working capital to finance ouranticipated operations and projected negative cash flow into our 2008 fiscalyear.

**Our ability toobtain further financing when necessary is limited and we may be delisted fromthe Nasdaq CapitalMarket.**

We have historically financed our operating losses andcash flow deficits through private placements of our equity and debtsecurities. Both of our outstanding 8% and 6% Debentures contain significantrestrictions on our ability to raise any additional capital for so long as theconvertible debentures are outstanding and ultimately, our ability to financeour operations will depend on our ability to generate revenues that exceed ourexpenses. Although we believe we are on a path to that end, we cannot offer anyassurance that we will be able to succeed in reaching that goal.

Inaddition, as described above we have recently received two notifications fromNasdaq identifying listing deficiencies, which, if not cured timely, may resultin our delisting from the Nasdaq Capital Market. Because our financingactivities are dependent to a large extent on eventual liquidity for theinvestors, any such delisting, if it should occur, will make future financingactivities significantly more difficult and may raise liquidity issues forcurrent investors.

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**We have fourbusiness segments and, during our 2006 fiscal year each of our segmentsoperated at a loss, insome cases significant losses.**

For the year ended April 30,2006, and as reflected in the following table, our consolidated financialstatements show that each of our four operating segments have been operating ata loss (amounts in thousands):

| ** **                          | ** ** | **Year Ended** | ** ** |
|-------------------------------------|------------|---------------------|------------|
| ** **                          | ** ** | **April 30,**  | ** ** |
| ** **                          | ** ** | **2006**            | ** ** | **2005** | ** ** |
| 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                 |       |                | (6,999     | ) |   | (3,744 | ) |
| Total                               |       |                | $          | (16,631 | ) |   | $ | (14,162 | ) |

 

We expect that theselosses (on a consolidated basis) will continue through our 2007 fiscal year(albeit at significantly lower levels for semiconductor products and services).Previously our life sciences segment operated profitably, but reductions inprices paid for our products have led to operating losses during the currentfiscal year. As described in the next risk factor, unless we are able todevelop and sell new products profitably, we may be unable to remaincompetitive and it is likely that our losses and negative cash flow willcontinue. Reconciling amounts include corporate expenses consisting primarilyof payments to Lucent under our development agreement, corporate salaries and benefits,professional and consulting fees, investor relations costs, insurance anddirectors’ compensation.

**Unless we are ableto develop and sell new products profitably, we may be unable to remaincompetitive, furtheringthe likelihood that our losses and negative cash flow will continue.**

We have not operated profitably since our 1996 fiscalyear, and as discussed in the preceding risk factor, none of our segments iscurrently operating profitably. We recognized net income for the year ended April 30,2000, only because of the gain recognized on the sale of our depleted zincassets to Eagle-Picher Technologies, LLC.

Our ability to generate additional revenues (andultimately net income) is dependent upon the success of our homeland securityproducts, security services and semiconductor operations and our ability todevelop new products, including those that use stable and radioactive isotopes,while marketing and selling those products profitably. Historically, oursemiconductor operations have been a significant cash drain and, while we arecontinuing to take steps to reduce the costs of the operation and to increasethe revenues (including the launch and growth of our 300-millimeterproduct line), we cannot offer any assurance that the measures we have takenwill be successful or that the silicon wafer operations will ever be profitable.In addition, our life sciences operations were not profitable for the yearended April 30, 2006, because of competitive conditions and, due to theloss of substantially all of our former Chemotrade radioisotope customers in January 2006,it will be difficult to become profitable in this segment as well.

We have had limited success in marketing our homelandsecurity products, having sold only two units of the first generation of ourNeutroTest portable, neutron-based explosive detection device and no units ofour IMS technology for the detection of chemical weapons and other toxicsubstances or the second generation of our NeutroTest device. Although we havecommenced marketing these products, we cannot offer any assurance that ourmarketing efforts will result in any sales or that any sales will result insignificant revenues to us.

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We are currently dependent on our continuing revenuesand increasing orders to improve our operating results, and cash payments fromour customers to provide working capital. To the extent orders and deliveriesare reduced because of changing customer needs or our inability to supplyproduct, or to the extent payments from customers are reduced because ofadverse financial conditions affecting our customers, our financial conditionwill be adversely affected.

It is possible thatthe following circumstances may develop and may adversely impact our availableworking capital and materially impact our ability to continue our business operations:

·       unanticipatedexpenses in developing our new products or in producing or marketing ourexisting products;

·       thenecessity of having to protect and enforce our intellectual property rights;

·       technologicaland market developments; or

·       acorporate decision to expand our production capacity through capital investmentor acquisition.

We may not be able toobtain equity or debt financing on reasonable terms when we need such financing.The unavailability of additional financing, when needed, could have a materialadverse effect on our business.

**We have raisedcapital and issued securities during the years ended April 30, 2006 and2005, and subsequentlywhich has resulted (and will in the future when warrant exercises orconversions occur result) in dilution to our existing shareholders. This wasaccomplished to provide necessary working capital or obtain assets and services.We will likely issue more securities to raise additional capital or to obtainother services or assets, any of which may result in substantial additionaldilution.**

During the course of the last two fiscal yearsand the current 2007 fiscal year, we have raised in excess of $41,0000,000 (net of expenses and $4,100,000of payments related to our 8% Debentures) to finance our business operationsand acquisitions. We have raised this capital by issuing convertibledebentures, shares of common stock, convertible preferred stock, common stockwarrants to accredited investors and as compensation to investment bankersmaking introductions to the accredited investors and the exercise of previouslyissued common stock warrants and stock options. During this same period oftime, we issued common stock warrants and shares of common stock to severalpersons in exchange for their promises to perform investment banking andfinancial advisory services to us. In many cases, these issuances were belowthe then-current market prices and can be considered dilutive to our existingshareholders—both as a reduction of their percentage ownership in Isonics and becauseof issuances that will be, when warrants are exercised or debentures areconverted, at prices below the market.

The 8% Debentures issuedin February 2005 and the 6% Debentures issued in May and June 2006,have significant restrictions on our ability to raise any additional capital. Ifwe raise additional working capital, we will likely have to issue additionalshares of our common stock and common stock warrants at prices that may dilutethe interests of our existing shareholders.

**A holder of a portionof the remaining 8% Debentures has asserted that a default exists.**

One of the two holders ofthe 8% Debentures that did not accept our prior offer to all holders hasasserted that the issuance of the 6% Debentures constituted a default (due to apotential variable conversion provision contained within the 6% Debenture)under the 8% Debentures. We have contested that allegation (based among otherthings that such clause did not survive the final agreement), and will defendit in court if necessary. Any such litigation will be time consuming andexpensive and, although we believe that we have significant grounds to contestthe existence of any default, we cannot be assured of success. If they prove adefault, we could be liable to them for 130% of the principal amount of their 

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8% debentures(a cost of up to $281,250, plus accrued interest in addition to the currentlyoutstanding principal of $312,500).

**We have aninsufficient number of shares of common stock authorized, and if ourshareholders do not increaseour authorized capital at the next shareholders’ meeting, we will be in defaultof our obligations to the holders of our 6% Debentures and the relatedwarrants.**

We currently have75,000,000 shares of common stock authorized, but that number is insufficientfor us to meet our obligations to certain persons, including the holders of our6% Debentures and related warrants. We have agreed to seek shareholder approvalof an increase in our authorized capitalization to at least 175,000,000 by October 31,2006, but we cannot provide any assurance that we will be able to obtain thenecessary shareholder approval. If we fail to obtain shareholder approval forthe increase in authorized capitalization, we may be in default under the termsof the 6% Debentures and related warrants as well as pursuant to certain otherobligations.

**Accounting chargesresulting from our issuance of the 6% Debentures may lead to significantnon-cash charges whichwould adversely impact future interest expense, net income and earnings pershare and may also lead to future volatility in our financial statementcomponents.**

While our accountingevaluation of the 6% Debentures issued in May and June 2006 is notcomplete, because of certain contractual provisions in the 6% Debenturesand accompanying transaction documents together with certain provisions ofUnited States Generally Accepted Accounting Principles, we will likely berequired to record significant non-cash interest charges over the life of the6% Debentures (in addition to interest expense relating to the 6% interest rateborne by the 6% Debentures which will be paid in cash or shares of our commonstock, at our option). Additionally, we will likely be required to initiallyrecord the accompanying warrants and the embedded conversion feature of the 6%Debentures as derivative liabilities, which will be required to be marked tomarket on a quarterly basis. The combination of these two factors will likelyresult in a significant adverse impact to future net income and earnings pershare and will likely introduce additional volatility to our future operatingresults.

**Operations inRussia may be disrupted because of a volatile political and economic climatebeyond our control,which could adversely affect our supply of raw materials.**

Operations in Russia entail risks. The formerrepublics of the Soviet Union from time to time experience political, socialand economic change as they adjust to independence from the former centralgovernment in Moscow. Some of the republics, including Russia are attempting totransition from a central-controlled economy toward a market-based economy. Thesechanges have involved, in some cases, armed conflict, and the risk of continuedinstability has increased since the terrorist attacks on the United States of September 11,2001 and the commencement of the wars in Iraq and Afghanistan. Political oreconomic instability in these republics may continue or worsen. The price,availability, quality, quantity, ability to export and supply of stable andradioactive isotopes could be directly affected by political and economicconditions in Russia.

We are dependent onsuppliers from Russia for substantially all of our stable isotopes and ourradioisotopes. Accordingly, our operations could be materially adversely affectedif hostilities in Russia should occur, if trade between Russia and the UnitedStates were interrupted or ceased, if political conditions in Russia disrupttransportation or processing of our goods, if laws or government policiesconcerning foreign business operations in Russia change substantially, or iftariffs are introduced.

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**Historically wedepended upon few customers for a significant portion of our revenues and ourbusiness could have beenmaterially and adversely affected if we lost any one of those customers.**

As a result of theacquisition of PPSC, we have significantly increased our revenues for the yearended April 30, 2006 as compared to the year ended April 30, 2005. Asa result, we decreased our reliance on a few customers for a significant portionof our revenues. For the year ended April 30, 2006 one security servicescustomer accounted for 17% of total revenues and one semiconductor materialsand products customer accounted for 10% of revenues, while two life sciencescustomers accounted for 19% and 10%, respectively, of revenues for the yearended April 30, 2005. However, significant reductions in sales to any ofthese large customers have had, and may in the future have, an adverse effecton us by reducing our revenues and our gross margins. Present or futurecustomers could terminate their purchasing patterns with us or significantlychange, reduce or delay the amount of isotopes or other products ordered fromus.

**We realizedincreased expenses, reduced revenues, and longer than anticipated delays inintegrating past businessacquisitions into our operations, and we may face similar difficulties withfuture acquisitions as well.**

We experienced increasedcosts and delays in integrating the operations of the business and assets weacquired from EMG, in June 2004, and we also realized revenues that weresignificantly reduced from that which we had anticipated. Regardless of theextent of our planning, we may recognize increased costs and delays, andreduced revenues, when integrating future business acquisitions into ourbusiness operations and strategy. While we believe that we have and willcontinue to plan for integration of business operations to the best of ourability, we cannot offer any assurance that any or all such efforts willproceed as anticipated. While the integration of PPSC (acquired in May 2005)has been more successful than that of EMG, if efforts at integrating otherbusinesses and assets that we may acquire in the future achieve similardifficulties as we realized in the integration of the EMG business and assets,we may have unanticipated expenses, delays and revenue reductions.

**If demand for anyof our products grows suddenly, we may lack the resources to meet demand or wemay be required toincrease our capital spending significantly.**

If we are able to developand market our products successfully, we may experience periods of rapid growththat place a significant strain on our financial and managerial resources. Throughour research and development efforts we are also attempting to developadditional products and lines of business. Our ability to manage growtheffectively, particularly given our increasing scope of operations, willrequire us to continue to implement and improve our management, operational andfinancial information systems, and will require us to develop the managementskills of our personnel and to train, motivate and manage our employees. Ourfailure to effectively manage growth could increase our costs of operations andreduce our margins and liquidity, which could have a material adverse effect onour business, financial condition and results of operations.

**Because we aredependent upon our key personnel for our future success, if we fail to retainor attract key personnel,our business will be adversely affected.**

Our future success will depend in significant partupon the continued service of our key technical, sales and senior managementpersonnel, including James E. Alexander, our President and Chief ExecutiveOfficer and Boris Rubizhevsky, our Senior Vice President and President of HSDC.Currently both Mr. Alexander and Mr. Rubizhevsky are covered byemployment agreements that are renewable on an annual basis.

We believe that our futuresuccess will also depend upon our ability to attract and retain other qualifiedpersonnel for our operations. The failure to attract or retain such personscould materially adversely affect our business, financial condition and resultsof operations.

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**We may not be ableto protect our intellectual property, which would reduce our competitiveadvantage.**

We rely primarily on a combination of patents andpatent applications, trade secrets, confidentiality procedures, and contractualprovisions to protect our technology. Despite our efforts to protect ourtechnology, unauthorized parties may attempt to copy aspects of our products orto obtain and use information that we regard as proprietary. Policingunauthorized use of our technology and products is difficult. In addition, thelaws of many countries do not protect our rights to information, materials andintellectual property that we regard as proprietary and that are protectedunder the laws of the United States. We may not be able to protect ourproprietary interests, or our competitors may independently develop similartechnology or intellectual property. If either one of these situations occurs,we may lose existing customers and our business may suffer.

The validity of any of thepatents licensed to us, or that may in the future be owned by us, may not beupheld if challenged by others in litigation. Further, our products ortechnologies, even if covered by our patents, may infringe upon patents ownedby others. We could incur substantial costs in defending suits brought againstus, or any of our licensors, for infringement, in suits by us against othersfor infringement, or in suits contesting the validity of a patent. Any suchproceeding may be protracted. In any suit contesting the validity of a patent,the patent being contested would be entitled to a presumption of validity andthe contesting party would be required to demonstrate invalidity of such patentby clear and convincing evidence. If the outcome of any such litigation wereadverse to our interests, our liquidity and business operations would bematerially and adversely affected.

**We facetechnological change and intense competition both domestically andinternationally which may adverselyaffect our ability to sell our products profitably.**

Although we do not believe that any entity produces acomplete range of stable enriched isotopes for commercial sale, many of ourcompetitors have significantly greater funding than do we and may be able todevelop products which are competitive with our products.

Further, it is possiblethat future technological developments may occur. The market for our homelandsecurity products and our isotope products is characterized by rapidly evolvingtechnology and a continuing process of development. Our future success willdepend upon our ability to develop and market our homeland security and isotopeproducts that meet changing customer and technological needs on a costeffective and timely basis. If we fail to remain competitive by anticipatingthe needs of our customers and our customers contract with other suppliers, ourrevenues and resulting cash flow could be materially and adversely affected.

**We could be subjectto environmental regulation by federal, state and local agencies, includinglaws that imposeliability without fault, which could produce working capital shortages andlessen shareholders’ equity.**

We could become subject toa variety of federal, state, and local environmental regulations relating tothe use, storage, discharge and disposal of hazardous chemicals used duringmanufacturing processes, although we do not believe that there is any suchregulation directly applicable to our current operations. Regulations thatbecome applicable to our operations in the future could restrict our ability toexpand our facilities or could require us to acquire costly equipment or to incurother significant expenses to comply with governmental regulations. Historically,our costs of compliance with environmental regulations have not beensignificant.

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**We are controlledby only a few officers and directors and, consequently, purchasers of ourshares will have littleability to elect or control our management.**

Our shares are widely-held.Consequently, even though our management beneficially owns our securitiesequivalent to approximately 11% of the outstanding votes at any shareholders’meeting (assuming zero conversions of common stock warrants, options or the 6%or 8% Debentures), it is likely that they will be able to continue tosubstantially influence all matters submitted to stockholders for approval,including the election and removal of directors and any merger, consolidationor sale of substantially all of our assets, and to control our management andaffairs. Such concentration of ownership may have the effect of delaying,deferring or preventing a change in control, impeding a merger, consolidationor takeover or other business combination involving us or discouraging apotential acquirer from making a tender offer or otherwise attempting to obtaincontrol of our business, even if such a transaction would be beneficial toother stockholders.

**We risk exposingourselves to an above-policy limit product liability claim, which couldadversely affect our workingcapital, shareholders’ equity and profitability.**

The use of ourradioisotopes in radiopharmaceuticals and in clinical trials may expose us topotential product liability risks that are inherent in the testing,manufacture, marketing, and sale of human diagnostic and therapeutic products. Additionally,the use of explosive and chemical detection products may expose us to potentialliability risks that are inherent with the operation of these types of products(including, but not limited to failed detection). We currently have productliability insurance; however, there is a risk that our insurance would notcover completely or would fail to cover a claim, in which case we may not havethe financial resources to satisfy such claims, and the payment of claims wouldrequire us to use funds that are otherwise needed to conduct our business andmake our products.

**Our common stock isvulnerable to pricing and purchasing actions that are beyond our control and, therefore, personsacquiring or holding our shares or warrants may be unable to resell theirshares at a profit as a result of this volatility.**

The trading price of oursecurities has been subject to wide fluctuations in response toquarter-to-quarter variations in our operating results, our announcements oftechnological innovations or new products by us or our competitors, and otherevents and factors. The securities markets themselves have from time to timeand recently experienced significant price and volume fluctuations that may beunrelated to the operating performance of particular companies. Announcementsof delays in our testing and development schedules, technological innovationsor new products by us or our competitors and developments or disputesconcerning patents or proprietary rights could have a significant and adverseimpact on such market prices. Regulatory developments in the United States andforeign countries, public concern as to the safety of products containingradioactive compounds, economic and other external factors, all affect themarket price of our securities. *In addition,the realization of any of the risks described in these “Risk Factors” couldhave a significant and adverse impact on such market prices.*

**SEC penny stockregulations may limit the ability to trade our securities on the Nasdaq CapitalMarket.**

Although our common stock is currently quoted on theNasdaq Capital Market, our common stock has in the past been subject toadditional disclosure requirements for penny stocks mandated by the SecuritiesEnforcement Remedies and Penny Stock Reform Act of 1990. The SEC Regulationsgenerally define a penny stock to be an equity security that is not traded on theNasdaq Stock Market and has a market price of less than $5.00 per share. Wehave, at times in the past, been included within the SEC Rule 3a-51definition of a penny stock, and we are currently subject to two notificationsfrom Nasdaq which may place us in that status again. When our common stock isconsidered to be a “penny stock,” 

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trading is covered by Rule 15g-9promulgated under the Securities Exchange Act of 1934, for non-Nasdaq andnon-national securities exchange listed securities.

Under this rule,broker-dealers who recommend such securities to persons other than establishedcustomers and accredited investors must make a special written disclosure to,and suitability determination for, the purchaser and receive the purchaser’swritten agreement to a transaction prior to sale. The regulations on pennystocks limit the ability of broker-dealers to sell our common stock and thusthe ability of purchasers of our common stock to sell their securities in thesecondary market. To the extent we are able to maintain our listing on theNasdaq Capital Stock Market, we will not be subject to these penny stock rules.Reasons for being unable to maintain our listing on the Nasdaq Capital Marketinclude:

·       theinability to maintain a bid price for our common stock of $1.00 for therequisite period of time, and

·       theinability to maintain either the minimum stockholders’ equity, marketcapitalization or net income along with the required number of market makersand shareholders necessary for listing.

We cannot give anyassurance that we will be able to meet the Nasdaq requirements to maintain ourCapital Market listing, or that if we do, a stable trading market will developfor our stock or our warrants. See “our ability to obtain further financingwhen necessary is limited” for additional risk factors associated with ourcurrent Nasdaq listing deficiencies.

**Future sales of ourcommon stock may cause our stock price to decline.**

Our stock price has declined from a price ofapproximately $6.00 per share at the beginning of 2005 to a price of $0.45 pershare at July 21, 2006. Our stock price may decline further as a result offuture sales of our shares, the perception that such sales may occur or otherreasons. As of July 21, 2006,approximately****5,700,000****sharesof common stock held by existing stockholders constitute “restricted shares” asdefined in Rule 144 under the Securities Act. The restricted shares mayonly be sold if they are registered under the Securities Act, or sold under Rule 144,or another exemption from registration under the Securities Act.

Approximately 85%****ofthe restricted shares of our common stock are either eligible for sale pursuantto Rule 144 or have been registered under the Securities Act for resale bythe holders. We are unable to estimate the amount, timing, or nature of futuresales of outstanding common stock. Sales of substantial amounts of our commonstock in the public market may cause the stock’s market price to decline.

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

We have never declared orpaid a cash dividend on our common stock. We presently intend to retain ourearnings, if any, to fund development and growth of our business and,therefore, we do not anticipate paying cash dividends in the foreseeable future.Additionally, the terms of the 6% and 8% Debentures contain restrictions on ourability to pay dividends to holders of our common stock.

**If we fail toeffect and maintain registration of the common stock issued or issuablepursuant to conversionof our convertible debentures, or certain of our outstanding common stockwarrants, we may be obligated to pay the investors of those securitiesliquidated damages.**

We have various obligations to file and obtain theeffectiveness of certain registration statements which include certainoutstanding common stock and common stock underlying outstanding convertibledebentures and common stock warrants. Once effective, the prospectus containedwithin a registration statement can only be used for a period of time asspecified by statute without there being a post-effective amendment filed thathas become effective under the Securities Act of 1933.

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If we fail to meet anyobligations we have to have effective and current registration statementsavailable (including the current registration statement related to the commonstock underlying our Class B and C warrants), we may become obligated topay damages to investors to the extent they may be entitled to damages. Wecannot offer any assurances that we will be able to maintain the currency ofthe information contained in a prospectus or to obtain the effectiveness of anyregistration statement or post-effective amendments that we may file.

**As a publiccompany, we are subject to a significant amount of regulation. In the past wehave received requestsfor information from the Securities and Exchange Commission and from Nasdaq. Anysuch inquiry or investigation that may result may adversely affect the marketfor our stock or our Company.**

Regulators of publiccompanies such as Isonics have the authority to commence inquiries andinvestigations where the regulators have concerns. The investigations, whileinvolving the company, may not have anything to do with actions taken by thecompany or our failure to act. Furthermore, the regulators may not inform uswhen the issues they were addressing are resolved. From October 2004through February 2005, both Nasdaq and the SEC requested documents from uswith respect to inquiries they were undertaking (related primarily to questionsregarding our press releases, public relations advisors, certain otherdisclosures that were made publicly and the termination of Grant Thornton LLPas our independent auditor). We also met with representatives of Nasdaq todiscuss various issues. We provided information, which we believe to beresponsive to all of the questions posed in the Nasdaq inquiry and to the SEC. Wehave not received any requests for additional information from either the SECor Nasdaq relating to those earlier inquiries since February 2005 andwhile we believe these issues are behind us, if any action resulted from theseinquiries in the future, it may adversely impact us, and our ability to carryon our business. As discussed above, we have received two notifications fromNasdaq advising us that we are not in compliance with Nasdaq’s listingstandards.

**Provisions in ourcharter documents could prevent or delay a change in control, which could delayor prevent a takeover.**

Our Articles of Incorporation authorize the issuanceof “blank check” preferred stock with such designations, rights, andpreferences, as may be determined by our Board of Directors. Accordingly, theBoard of Directors may, without shareholder approval, issue shares of preferredstock with dividend, liquidation, conversion, voting, or other rights thatcould adversely affect the voting power or other rights of the holders of ourcommon stock. Preferred stock could also be issued to discourage, delay, orprevent a change in our control, although we do not currently intend to issueany additional series of our preferred stock.

Provisions in our bylaws provide for indemnificationof officers and directors to the full extent permitted by California law, whichcould require us to direct funds away from our business and products.

Our Bylaws provide forindemnification of officers and directors to the full extent permitted byCalifornia law, our state of incorporation. We may be required to pay judgments,fines, and expenses incurred by an officer or director, including reasonableattorneys’ fees, as a result of actions or proceedings in which such officersand directors are involved by reason of being or having been an officer ordirector. Funds paid in satisfaction of judgments, fines and expenses may befunds we need for the operation of our business and the development of ourproducts, thereby affecting our ability to attain profitability. This couldcause our stock price to drop.

**ITEM 7.**                FINANCIALSTATEMENTS

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

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**ITEM 8.     CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE**

Our Audit Committee selected the independentaccounting firm of Grant Thornton LLP (“Grant Thornton”) with respect to theaudit of our consolidated financial statements for the year ended April 30,2005, as well as many prior fiscal years. However, the Audit Committeeunanimously approved of the dismissal of Grant Thornton on November 24,2004.

On November 24, 2004, the Audit Committeedismissed Grant Thornton as our independent registered public accounting firmeffective immediately and informed Hein & Associates LLP (“Hein &Associates”), certified public accountants, that such firm was appointed as ourindependent registered public accounting firm effective immediately. Weauthorized Grant Thornton to respond fully to inquiries by our new auditors inconnection with the retention of the new auditors.

Grant Thornton’s reports on our financial statementsfor the fiscal years ended April 30, 2003 and 2004 did not contain anadverse opinion or disclaimer of opinion and were not qualified or modified asto uncertainty, audit scope, or accounting principle, except for the matterdiscussed in the next sentence. There was an explanatory paragraph in GrantThornton’s report on our financial statements included in Form 10-KSBfor the year ended April 30, 2003, indicating that the accompanyingconsolidated financial statements had been prepared assuming that we wouldcontinue as a going concern, and Grant Thornton identified certain factors thatraised substantial doubt about our ability to continue as a going concern. Thatexplanatory paragraph was not contained in Grant Thornton’s report on ourfinancial statements included in our Form 10-KSB for the year ended April 30,2004.

In connection with the audits of our financialstatements for each of the last two fiscal years ended April 30, 2004 and2003, and as of November 24, 2004, there were no disagreements between usand Grant Thornton on any matter of accounting principles or practices,consolidated financial statement disclosures, or auditing scope and procedures,which, if not resolved to the satisfaction of Grant Thornton, would have causedthem to make a reference thereto in connection with their report on thefinancial statements, except for the following disagreement regarding auditingscope and procedures: Grant Thornton informed us that they required additionalauditing procedures to be performed with respect to the Nasdaq inquiry whichcommenced in October 2004 and that they needed to obtain additionalinformation from Nasdaq regarding the Nasdaq inquiry prior to issuing a consentallowing the inclusion, within a Form SB-2, of Grant Thornton’sopinion on our financial statements as of April 30, 2004 and 2003 and forthe years then ended, and prior to completing a review of our financialstatements to be included in the Form 10-QSB for the period ended October 31,2004. Grant Thornton believed that if the additional auditing procedures wereperformed and additional information was obtained there may be a materialimpact on the fairness or reliability of our financial statements; however, dueto Grant Thornton’s dismissal before the termination of the Nasdaq inquiry,they did not conduct such procedures or obtain such information. The additionalprocedures required by Grant Thornton could not be performed until Nasdaq hadnotified us that the Nasdaq inquiry was terminated. We did not agree with GrantThornton that the Nasdaq inquiry was material or that the Nasdaq inquiry impactedthe financial statements, disclosure, or auditing scope or procedures. OurAudit Committee has discussed this matter with Grant Thornton, and GrantThornton was authorized to fully respond to inquiries made by Hein &Associates concerning this matter.

In December 2004, we received an informal requestfor information from the Securities and Exchange Commission (“SEC’). GrantThornton informed us that they also require additional auditing procedures tobe performed and that they need to obtain additional information from the SECregarding the informal request for information prior to issuing a consentallowing the inclusion, within a Form SB-2, of Grant Thornton’sopinion on our financial statements as of April 30, 2004 and 2003 and forthe years then ended.

We provided Grant Thornton a copy of the Form 8-Kdisclosure of Grant Thornton’s dismissal and requested Grant Thornton tofurnish us with a letter addressed to the Securities and Exchange 

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Commission stating whetherGrant Thornton agreed with the statements by us in the Form 8-Kpreviously filed by Isonics, and Grant Thornton’s response was attached to the Form 8-Kas an exhibit.

During our past two fiscalyears and prior to the engagement of Hein & Associates, we did notconsult Hein & Associates regarding the application of accountingprinciples to a specific transaction, either contemplated or proposed, or thetype of audit opinion that might be rendered on our consolidated financialstatements, or any other matter or reportable event that would be required tobe reported in this Form 10-KSB.

**ITEM 8A.**        CONTROLSAND PROCEDURES.

With the participation of our management, includingthe Chief Executive Officer and Chief Financial Officer, we have evaluated theeffectiveness of our disclosure controls and procedures as required by ExchangeAct Rule 13a-15(b) as of the end of the period covered by thisreport. Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer have concluded that these disclosure controls and proceduresare effective. There were no changes in our internal control over financialreporting during the quarter ended April 30, 2006, that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

Disclosure controls and procedures are controls andother procedures that are designed to ensure that information required to bedisclosed in our reports filed or submitted under the Securities Exchange Actis recorded, processed, summarized and reported, within the time periodsspecified in the Securities and Exchange Commission’s rules and forms. Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed in our reportsfiled under the Exchange Act is accumulated and communicated to management,including our principal executive officer and our principal financial officer,as appropriate, to allow timely decisions regarding required disclosure.

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**PART III**

**ITEM 9.     DIRECTORS, EXECUTIVE OFFICERS, PROMOTERSAND CONTROL PERSONS, COMPLIANCEWITH SECTION 16(a) OF THE EXCHANGE ACT**

**(a) and (b)   Identificationof Directors and Executive Officers**

Thefollowing table sets forth the names and ages of all the Directors andExecutive Officers of Isonics, and the positions held by each such person as ofApril 30, 2006. Each of the directors holds office until the next annualmeeting of shareholders and until his or her successor is elected and qualifiedor until his or her earlier death, resignation, or removal. Each officer servesat the discretion of the Board.

| **Name**                           | ** ** | ** ** | ** ** | **Age**                                                                  | ** ** | **Position** |
|------------------------------------|------------|------------|------------|--------------------------------------------------------------------------|------------|--------------|
| James E. Alexander                 |       | 57         |       | President, Chief  Executive Officer, Treasurer and Chairman of the Board |
| Boris Rubizhevsky                  |       | 55         |       | Senior Vice  President, Vice Chairman and Director                       |
| Stephen J. Burden                  |       | 57         |       | Vice President,  Semiconductor Materials and Products                    |
| John Sakys                         |       | 37         |       | Vice President,  Chief Financial Officer and Secretary                   |
| Hans Walitzki                      |       | 50         |       | Vice President,  Advanced Wafer Technology                               |
| Lindsay A. Gardner                 |       | 55         |       | Vice President,  Corporate Development and Life Sciences and Director    |
| Richard Parker(1)(2)(3)            |       | 62         |       | Director                                                                 |
| Russell W.  Weiss(1)(2)(3)         |       | 59         |       | Director                                                                 |
| Richard H.  Hagman(1)(2)(3)        |       | 59         |       | Director                                                                 |
| C. Stewart Verdery, Jr.(2)(3) |       | 39         |       | Director                                                                 |

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(1)        Member of the Audit Committee.

(2)        Member of the Compensation Committee.

(3)        Member of the Nominating Committee

***James E. Alexander***isour co-founder with Mr. Rubizhevsky. He has served as our President, ChiefExecutive Officer and as a director since our inception. Mr. Alexander hasworked full-time for Isonics since January 1994. From June 1972 to December 1993,he worked in a variety of technology positions at General Electric Corporationin the aircraft engine and nuclear power divisions, most recently as Manager ofTechnology Programs. Mr. Alexander received his Bachelors degree inMetallurgical Engineering from the University of Cincinnati and performedgraduate work in materials science there. He earned a Masters degree inBusiness Administration from Santa Clara University.

***Boris Rubizhevsky***isour co-founder with Mr. Alexander. He has served as our Senior VicePresident and a director since our inception. In October 2004, Mr. Rubizhevskywas named President of our wholly owned subsidiary, Homeland Security DefenseCorporation. Mr. Rubizhevsky became Vice Chairman in March 1997 andhas worked exclusively for Isonics during this time. From November 1986through December 1994, he owned and operated SAR Marketing, a consultingfirm providing business advice and services to large multinationalcorporations. From June 1977 to May 1986, Mr. Rubizhevsky workedat General Electric Corporation as Business Development Manager in variousinternational locations. He received his Bachelors degree in Engineering fromStevens Institute of Technology.

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***Dr. Stephen J.Burden***joined us in January 1997 as Directorof Research & Development. He was promoted to Vice President,Semiconductor Materials effective January 1, 1999. From 1993 to 1997, Dr. Burdenwas Director of Product Development at SP3, Inc., a manufacturer ofdiamond-coated tools. From 1984 to 1993, he was Manager of Advanced MaterialsR&D at GTE Valenite, a subsidiary of GTE Corporation, a manufacturerof cutting tools. From 1974 to 1984, Dr. Burden was employed by GeneralElectric Corporation in various capacities. Dr. Burden received his Ph.D.and Masters of Science degrees in Materials Science and Engineering from DrexelUniversity, and his Bachelors degree in Science Engineering from NorthwesternUniversity. Dr. Burden also has an MBA from the University of Michigan.

***John Sakys*** joined us in May 2001 as Controller. Hewas promoted to Vice President, Chief Financial Officer effective September 3,2001, and he serves as corporate Secretary. From September 2000 to April 2001Mr. Sakys was controller of AuraServ Communications. From July 1998to September 2000 Mr. Sakys was Director of Financial Reporting forMedia One, Inc. From December 1994 to July 1998 Mr. Sakyswas an audit manager at Ernst and Young LLP. Mr. Sakys received hisBachelors degree in Business Economics with an emphasis in accounting from theUniversity of California at Santa Barbara and is a Certified Public Accountant.

***Dr. HansWalitzki***joined us in November 2001 as VicePresident, Advanced Wafer Technology. He was employed as a vice president,chief technology officer, and Chairman of the Board of Directors of SiliconEvolution, Inc. (of Vancouver, Washington) from its formation in February 1999until November 2001. Silicon Evolution filed a petition for relief underchapter 7 (liquidation) of the United States Bankruptcy Code in December 2001.Before that (from March 1982 until February 1999), Dr. Walitzkiwas employed at Wacker Siltronic Corporation in Portland, Oregon and its parentWacker Siltronic AG in Germany. Dr. Walitzki received his Masters degreein Physics from Bonn University, Germany in 1980 and he received his Ph.D. inPhysics from Bonn University in 1982.

***Lindsay A. Gardner***hasserved as a director since September 1993. Ms. Gardner became ourVice President for Corporate Development and Life Sciences in October 2004and November 2004, respectively. From 2001 until September 2004, Ms. Gardnerwas Director, Corporate Development and Strategic Planning for Menasha Corporation.From 1991 to 2001, Ms. Gardner was President of LG Associates, aU.S.-based management consulting firm providing strategic planning andmaterials management expertise to foreign company affiliates of U.S. companiesin developing countries. During her tenure at LG Associates, Ms. Gardnerresided in Moscow, Russia from September 1991 to January 1994, andBeijing, China from January 1994 to April 2000. From 1977 to 1991, Ms. Gardnerworked for General Electric Corporation in a variety of management and functionalpositions including international marketing, quality assurance and supply chainmanagement. Ms. Gardner received a Bachelors degree in InternationalEconomics from The George Washington University Elliott School of InternationalAffairs and earned a Masters of Business Administration from the University ofLouisville.

***Richard Parker***hasserved as a director since August 1998. Mr. Parker previously wasVice-President of Distribution Sales for Cypress Semiconductor and he held thatposition since December 1997 until his retirement, which was effective December 31,2002. Previously, Mr. Parker was Director of Sales for Cypress from April 1984to December 1997. Prior to joining Cypress, he held various sales andmarketing management positions at Fairchild Semiconductor from 1973 to 1984. Hereceived a Bachelors degree in Education from the University of North Dakota.

***Russell W. Weiss***hasserved as a director since January 2004. Mr. Weiss has 33 yearsof experience in the Semiconductor Industry and is currently Vice President andGeneral Manager of the worldwide Sales Operations for KLA-Tencor. From April 2002through February 2003, Mr. Weiss was President and RepresentativeDirector of KLA-Tencor Japan Ltd. From 1996 through April 2002, Mr. Weissheld various positions with KLA-Tencor. From 1991-1996 Mr. Weissheld various positions with Schlumberger 

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with the most recent beingVice President and General Manager of Schlumberger ATE test equipment division.Mr. Weiss received his BSEE from Missouri University and his MBA fromBabson College.

***Dr. Richard H.Hagman***has served as a director and a member ofour Audit Committee since July 2005. From 2001 to the present time, and from 1994through 1998, Dr. Hagman has been the owner of R.H. Hagman &Company, a company that provides management consulting, CEO and seniormanagement coaching, investment banking (M&A), turnarounds, negotiationsand mediation, and capital sourcing services to businesses in a wide variety ofindustries. Dr. Hagman has more than 20 years of corporate management andtop-tier executive experience in several Fortune 500 companies. He was Chairmanand CEO of WENR Corp. (formerly Western Energy Inc.), and served as VicePresident and Corporate Officer of Cyprus Amax Minerals Co. Dr. Hagmanalso held senior investment and government affairs positions for such companiesas Amoco Corp. He has also served as Administrative Director of GraduateStudies and Lecturer at the University of Chicago; Assistant Dean forUndergraduate Curriculum at Northwestern University, and as Rapporteur for theFellows’ Meetings at the Adlai Stevenson Institute of International Affairs.Dr. Hagman has received masters and doctorate degrees from The Universityof Chicago, and completed his post-doctoral studies at The University of Chicago working specifically inmanagement theory, organizational theory and labor relations.

***C. Stewart Verdery, Jr.***hasserved as a director since August 2004. Mr. Verdery is currently aprincipal at the Washington consulting firm Mehlman Vogel Castagnetti, Inc.,and an Adjunct Fellow at the Center for Strategic and International Studies intheir Homeland Security division. Mr. Verdery was nominated by PresidentBush and confirmed by the U.S. Senate in 2003 as Assistant Secretary forHomeland Security for Border and Transportation Security Policy and Planning. Inthat position, he oversaw policy development for key Department of HomelandSecurity (“DHS”) agencies, including U.S. Customs and Border Protection and the Transportation Security Administration, and worked closely withother DHS components and the rest of the executive branch. Mr. Verdery wasgeneral counsel to Senate Assistant Majority Leader Don Nickles (R-OK) from1998 until 2002 and also served as counsel to two Senate Committees and SenatorJohn Warner (R-VA). He is a graduate of Williams College and the University ofVirginia School of Law.

**(b) and (c)  **SignificantEmployees and Family Relationships.

There are no significant employees who are not also directors orexecutive officers. There were and are no family relationships among theofficers, directors or any person chosen by Isonics to become a director orofficer. No arrangement exists between any of the above officers and directorspursuant to which any one of those persons was elected to such office orposition. None of our directors is also a director of another company which hasa class of securities registered under Section 12 of the SecuritiesExchange Act of 1934, or which is subject to the reporting requirements of Section 15(d) ofthat act. There are no proposed transactions in which a director, directornominee, executive officer, 5% or more beneficial owner or immediate familymember of any of the foregoing has a direct or indirect material interest.

**(d)   Involvementin Certain Legal Proceedings**

Based on information submitted by the directors andexecutive officers, none of the directors or executive officers is involved in,or has been involved in, legal proceedings during the past five years that arematerial to an evaluation of the ability or integrity of any director orexecutive officer.

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Noneof our directors, executive officers, affiliates or beneficial owners of morethan 5% of any class of voting securities is adverse to us or has a materialinterest adverse to us.

**(e)   AuditCommittee Financial Expert**

Wehave not named an “audit committee financial expert” serving on our AuditCommittee. Our Audit Committee consists of three directors, all of whom arefinancially literate, have experience with public companies, and are veryknowledgeable about our business and financial position. Due to the nature ofour operations, our Board of Directors does not believe that it needs to namean audit committee financial expert at this time.

**(f)   Identificationof Audit Committee**

We have aseparately-designated standing audit committee established in accordance with Section 3(a)(58)(A) ofthe Exchange Act**.**The following persons serve onour Audit Committee: Richard H. Hagman, Richard Parker and Russell W.Weiss, all of whom are considered “independent” as that term is defined in Rule 4200(a)(15)of the Nasdaq listing standards.

**(g)   Proceduresby which security holders may recommend nominees to the board of directors.**

We have not changed our nominating procedures duringthe past fiscal year or subsequently. We have a standing Nominating Committee (“NominatingCommittee”) to direct and oversee the process by which individuals may benominated to our board of directors. The following persons serve on ourNominating Committee:****Russell W.Weiss, Richard Parker, Richard H. Hagman and C. Stewart Verdery Jr., all ofwhom are independent directors as required by Nasdaq Marketplace Rule 4350(c)(4).Our Nominating Committee’s charter was adopted by the board of directors on January 27,2004, and is available on our web site at www.isonics.com. Each member of theNominating Committee must qualify as “independent” as defined under NasdaqMarketplace Rule 4200(a)(15) and be free of any relationship that, in theopinion of the Board, would interfere with his or her exercise of independentjudgment.

The functions performed by the Nominating Committee includeidentifying potential directors and making recommendations as to the size,functions and composition of the Board and its committees. In makingnominations, our Nominating Committee is required to submit candidates who havethe highest personal and professional integrity, who have demonstratedexceptional ability and judgment and who shall be most effective, inconjunction with the other nominees to the board, in collectively serving thelong-term interests of the shareholders.

The Nominating Committee will consider nomineesproposed by our shareholders. To recommend a prospective nominee for theNominating Committee’s consideration, you may submit the candidate’s name bydelivering notice in writing to Isonics’ Nominating Committee isonics@nuvox.netor c/o Chair, Nominating Committee, via first class U.S. mail, at IsonicsCorporation, 5906 McIntyre Street, Golden, CO 80403.

A shareholdernomination submitted to the nomination committee must include at least thefollowing information (and can include such other information the personsubmitting the recommendation desires to include), and must be submitted toIsonics by the date mentioned in the most recent proxy statement under theheading “*Proposal From Shareholders*” as such datemay be amended in cases where the annual meeting has been changed ascontemplated in SEC Rule 14a-8(e), Question 5:

(i)                   Thename, address, telephone number, fax number and e-mail address of the personsubmitting the recommendation;

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(ii)               Thenumber of shares and description of Isonics voting securities held by theperson submitting the nomination and whether such person is holding the sharesthrough a brokerage account (and if so, the name of the broker-dealer) ordirectly;

(iii)           Thename, address, telephone number, fax number and e-mail address of the personbeing recommended to the nominating committee to stand for election at the nextannual meeting (the “proposed nominee”) together with information regardingsuch person’s education (including degrees obtained and dates), businessexperience during the past ten years, professional affiliations during the pastten years, and other relevant information.

(iv)             Informationregarding any family relationships of the proposed nominee as required by Item 401(c) ofSEC Regulation S-B.

(v)                 Informationwhether the proposed nominee or the person submitting the recommendation has(within the ten years prior to the recommendation) been involved in legalproceedings of the type described in Item 401(d) of SEC Regulation S-B(and if so, provide the information regarding those legal proceedings requiredby Item 401(d) of Regulation S-B).

(vi)             Informationregarding the share ownership of the proposed nominee required by Item 403 ofRegulation S-B.

(vii)         Informationregarding certain relationships and related party transactions of the proposednominee as required by Item 404 of Regulation S-B.

(viii)     Thesigned consent of the proposed nominee in which he or she

a.                  consentsto being nominated as a director of Isonics if selected by the nominating committee;

b.                 stateshis or her willingness to serve as a director if elected for compensation notgreater than that described in the most recent proxy statement;

c.                  stateswhether the proposed nominee is “independent” as defined by Nasdaq Marketplace Rule 4200(a)(15);and

d.                 atteststo the accuracy of the information submitted pursuant to paragraphs (i), (ii),(iii), (iv), (v), (vi), and (vii), above.

Although the information may be submitted by fax,e-mail, mail or courier, the nominating committee must receive the proposednominee’s signed consent, in original form, within ten days of making thenomination.

When the information required above has been received,the nominating committee will evaluate the proposed nominee based on thecriteria described below, with the principal criteria being the needs ofIsonics and the qualifications of such proposed nominee to fulfill those needs.

The process forevaluating a director nominee is the same whether a nominee is recommended by ashareholder or by an existing officer or director. The Nominating Committeewill:

1.                Establish criteriafor selection of potential directors, taking into consideration the followingattributes which are desirable for a member of our Board of Directors:leadership; independence; interpersonal skills; financial acumen; businessexperiences; industry knowledge; and diversity of viewpoints. We willperiodically assess the criteria to ensure it is consistent with best practicesand the goals of Isonics.

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2.                Identifyindividuals who satisfy the criteria for selection to the Board and, afterconsultation with the Chairman of the Board, make recommendations to the Boardon new candidates for Board membership.

3.                Receive andevaluate nominations for Board membership which are recommended by existing directors,corporate officers, or shareholders in accordance with policies set by theNominating Committee and applicable laws.

The Nominating Committee held no formal meetings during the year ended April 30, 2006. On August 29, 2005 by unanimous written consent the NominatingCommittee nominated all seven directors currently serving on our board ofdirectors to stand for reelection.

Isonics has not engagedthe services of or paid a fee to any third party or parties to identify orevaluate or assist in identifying or evaluating potential nominees. NeitherIsonics nor our Nominating Committee has received a recommended nominee fromany shareholder that beneficially own more than 5% of Isonics common stock orgroup of shareholders that beneficially own more than 5% of our common stock.

**(h)  **Section 16(a) BeneficialOwnership Reporting Compliance

Section 16(a) of the Securities Exchange Actof 1934 (the “1934 Act”) requires our directors, executive officers and personswho own more than ten percent of a registered class of our equity securities,to file with the SEC initial reports of ownership and reports of changes inownership of common stock and other equity securities of Isonics. Officers,directors and greater than ten percent shareholders are required by SECregulation to furnish us with copies of all Section 16(a) forms theyfile.

To our knowledge, basedupon a review of the copies of such reports furnished to us and based uponwritten representations that no other reports were required, all Section 16(a) filingrequirements applicable to our officers, directors and greater than ten percentbeneficial owners were complied with during the fiscal year ended April 30,2006 and subsequently. Cornell, holders of our 6% Debentures, has taken theposition that, because provisions within the 6% Debentures that prevent themfrom converting shares of such stock at any time when the results of theconversion would result in ownership of more than 4.99% of the outstandingIsonics common stock, they are not subject to the reporting requirements of Section 16(a).*See “Security Ownership of Certain BeneficialHolders and Management” above.*

**(i)   Code ofEthics**

On January 27, 2004, our Board of Directorsadopted a code of ethics that applies to all of our officers and employees,including our principal executive officer, principal financial officer,principal accounting officer and controller. Our Code of Ethics establishesstandards and guidelines to assist our directors, officers, and employees incomplying with both Isonics’ corporate policies and with the law and is postedat our website: www.isonics.com.

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**ITEM10.   EXECUTIVE COMPENSATION**

**(a) and (b)   Summary Compensation Table**

Thefollowing table sets forth information regarding compensation awarded, paid to,or earned by the chief executive officer and the other principal officers ofIsonics for the three years ended April 30, 2006. No other executiveofficer earned salary and bonus compensation exceeding $100,000 during any ofthose years. This includes all compensation paid to each by Isonics and anysubsidiary.

|                                             | ** ** | ** ** | ** ** | ** **                   | ** ** | **Long-term**                | ** ** | ** ** | ** ** | ** **     | ** ** |
|---------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------|------------|------------|------------|----------------|------------|
| ** **                                  | ** ** | ** ** | ** ** | **Annual compensation** | ** ** | **Compensation Awards** | ** ** | ** ** | ** ** | ** **     | ** ** |
| ** **                                  | ** ** | ** ** | ** ** | ** **                   | ** ** | ** **                   | ** ** | ** ** | ** ** | **Awards**     | ** ** | ** ** | ** ** | **Payout** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | ** ** | ** ** | ** **                   | ** ** | ** **                   | ** ** | ** ** | ** ** | ** **     | ** ** | **Securities** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | ** ** | ** ** | ** **                   | ** ** | ** **                   | ** ** | ** ** | ** ** | **($)**        | ** ** | **Underlying** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **Fiscal** | ** ** | **($)**                      | ** ** | **($)**                      | ** ** | **($)**    | ** ** | **Restricted** | ** ** | **Options &** | ** ** | ** ** | ** ** | **All Other** | ** ** |
| **Name and  Principal  Position** | ** ** | ** ** | ** ** | **Year**                     | ** ** | **Salary**                   | ** ** | **Bonus**  | ** ** | **Other**(a)   | ** ** | **Awards** | ** ** | **SARs (#)** | ** ** | **LTIP** | ** ** | **Compensation** | ** ** |
| James E. Alexander                          |       |       | 2004       |                         |       | 240,000                      |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| President & CEO*                   |       |       | 2005       |                         |       | 250,000                      |       | 50,000     |       |           | 0          |   |   |   | 0 |   |   |   | 140,000 | (d) |   |   | 0 |   |   |   | 0 |   |   |
|                                             |       |       | 2006       |                         |       | 257,750                      |       | 26,367     |       |           | 0          |   |   |   | 0 |   |   |   | 100,000 | (e) |   |   | 0 |   |   |   | 0 |   |   |
| Boris Rubizhevsky,                          |       |       | 2004       |                         |       | 216,000                      |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Senior Vice President*                      |       |       | 2005       |                         |       | 225,000                      |       | 50,000     |       |           | 0          |   |   |   | 0 |   |   |   | 340,000 | (f) |   |   | 0 |   |   |   | 0 |   |   |
|                                        |       |       | 2006       |                         |       | 232,350                      |       | 23,780     |       |           | 0          |   |   |   | 0 |   |   |   | 100,000 | (g) |   |   |   |   |   |   |   |   |   |
| John Sakys,                                 |       |       | 2004       |                         |       | 132,492                      |       | 30,000     |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Vice President*                             |       |       | 2005       |                         |       | 142,917                      |       | 20,000     |       |           | 0          |   |   |   | 0 |   |   |   | 75,000 | (h) |   |   | 0 |   |   |   | 0 |   |   |
|                                             |       |       | 2006       |                         |       | 181,250                      |       | 18,983     |       |           | 0          |   |   |   | 0 |   |   |   | 50,000 | (i) |   |   | 0 |   |   |   | 0 |   |   |
| Hans Walitzki,                              |       |       | 2004       |                         |       | 160,000                      |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Vice President*                             |       |       | 2005       |                         |       | 178,933                      |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
|                                        |       |       | 2006       |                         |       | 176,667                      |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Lindsay A. Gardner,                         |       |       | 2004       |                         |       | 0                            |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Vice President*(b)                          |       |       | 2005       |                         |       | 85,865                       |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 140,000 | (j) |   |   | 0 |   |   |   | 0 |   |   |
|                                             |       |       | 2006       |                         |       | 150,667                      |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Peter Christensen(c)                        |       |       | 2004       |                         |       | 0                            |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
|                                        |       |       | 2005       |                         |       | 0                            |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
|                                        |       |       | 2006       |                         |       | 191,748                      |       | 0          |       |           | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
|                                             |            |            |            |                              |            |                              |            |            |            |                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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*       Executive officer

(a)     Excludes other compensation, the aggregate amount ofwhich does not exceed the lesser of $50,000 or 10% of such named ExecutiveOfficers’ annual compensation.

(b)    Ms. Gardner joined Isonics as an executive officerin October 2004.

(c)     Mr. Christensen joined PPSC as Vice President ofSales in May 2005.

(d)    Options to purchase 100,000 shares of common stock weregranted in February 2005 with an exercise price of $4.64 (of which 40,000have vested as of April 30, 2006) and an expiration date of February 21,2015. Options to purchase 40,000 shares of common stock were granted in April 2005,are currently exercisable at $2.04 per share and expire April 18, 2010.

(e)     Options to purchase 100,000 shares of common stock weregranted in February 2006 with an exercise price of $1.96 (of which 25,000have vested as of April 30, 2006) and an expiration date of February 8, 2016.

(f)     Options to purchase 300,000 shares of common stock weregranted in February 2005 with an exercise price of $4.64 (of which 120,000have vested as of April 30, 2006) and an expiration date of February 21,2015. Options to purchase 40,000 shares of common stock were granted in April 2005,are currently exercisable at $2.04 per share and expire April 18, 2010.

(g)     Options to purchase 100,000 shares of common stock weregranted in February 2006 with an exercise price of $1.96 (of which 25,000have vested as of April 30, 2006) and an expiration date of February 8, 2016.

(h)    Options to purchase 75,000 shares of common stock weregranted in February 2005 with an exercise price of $4.64 (of which 37,500have vested as of April 30, 2006) and an expiration date of February 21,2015.

(i)     Options to purchase 50,000 shares of common stock weregranted in February 2006 with an exercise price of $1.96 (of which 12,500have vested as of April 30, 2006) and an expiration date of February 8, 2016.

(j)     Options to purchase 100,000 shares of common stock weregranted in October 2004 with an exercise price of $1.52 (of which 50,000have vested as of April 30, 2006) and an expiration date of October 5,2014. Options to purchase 40,000 shares of common stock were granted in April 2005,are currently exercisable at $2.04 per share and expire April 18, 2010.

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In October 1996, we adopted an employee benefitplan under Internal Revenue Code Section 401(k). The 401(k) plan is aprofit sharing plan under which both employees and Isonics are entitled tocontribute a portion of compensation and earnings, respectively, to investmentfunds to supplement employee retirement benefits.

We do not have written plans to pay bonuses ordeferred compensation to our employees except those expressly stated in thefollowing sections.

We have adopted medical,dental, and life insurance plans for our employees and their dependents partlyat our cost. In some cases, we also provide discretionary disability and otherinsurance plans for the benefit of our employees.

**(c)**           Options/SARGrants

**Stock Options andOption Plans**

We grant options toexecutive officers, employees and consultants under the following plans(collectively the “Plans”):

(a)          *2005 StockOption Plan.  *The 2005 Plan authorizes the grant of options topurchase 3,500,000 stock options. The options granted may be either incentivestock options, if they meet the requirements of Section 422 of theInternal Revenue Code, or non-qualified stock options. The options grantedpursuant to this plan are subject to a registration statement on Form S-8,Commission file no. 333-128592. As of April 30, 2006, options to purchase 680,000 shares were outstanding under this plan.

(b)         *1996 StockOption Plan.  *Although this plan has been terminated, there areoptions outstanding. The options granted pursuant to this plan are subject to aregistration statement on Form S-8, Commission file nos. 333-74339which has been incorporated into file no. 333-128592 pursuant to Rule 429.As of April 30, 2006,options to purchase 151,429****shares were outstanding under this plan. No further optionswill be issued under this plan.

(c)          *1996Executives’ Equity Incentive Plan.  *The Executives’ Planauthorized the grant of options to purchase 2,000,000 stock options. Theoptions granted may be either incentive stock options, if they meet therequirements of Section 422 of the Internal Revenue Code, or non-qualifiedstock options. The options granted pursuant to this plan are subject to aregistration statement on Form S-8, Commission files nos. 333-52514and 333-74339, which, have been incorporated into file no. 333-128592pursuant to Rule 429. As of April 30,2006, options to purchase 1,349,562****shares wereoutstanding under this plan. No further options will be issued under this plan.

(d)         *1996 EquityIncentive Plan.  *The Employees’ Plan authorized the grant ofoptions to purchase 1,000,000 stock options. The options granted may be eitherincentive stock options, if they meet the requirements of Section 422 ofthe Internal Revenue Code, or non-qualified stock options. The options grantedpursuant to this plan are subject to a registration statement on Form S-8,Commission files nos. 333-52514 and 333-74339, which, have beenincorporated into file no. 333-128592 pursuant to Rule 429. Asof April 30, 2006, optionsto purchase 562,941****shares wereoutstanding under this plan. No further options will be issued under this plan.

(e)          *1998Employee Stock Purchase Plan.  *The Stock Purchase Planauthorizes employee purchase of up to 200,000 shares of Isonics common stock. Asof April 30, 2006,employees had purchased a total of 78,209****shares of Isonics common stock pursuant to this plan, andemployees purchased an additional 13,227****shares in May 2006. The shares included in this planare subject to a registration statement on Form S-8, Commission fileno. 333-74339, which, have been 

58

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incorporated into file no.333-128592 pursuant to Rule 429. This plan was terminated effective May 1,2006.

Except for the Director’sPlan described below, we have not adopted any other stock option or stockappreciation rights plan. *See “Compensation ofDirectors.”*

**Options/SAR Grantsin Last Fiscal Year**

Wegranted stock options to the executive officers named in the compensation table(above) during the fiscal year ended April 30, 2006. We did not grant anystock appreciation rights to any person during fiscal year 2006.

| ** **          | ** ** | **Number of shares of  common stock  underlying Options  (and percentage of all  options granted to all  employees during  the year)** | ** **  | **Exercise Price** | ** ** | **Expiration Date** | ** ** |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|-------------------------|------------|--------------------------|------------|
| James E.  Alexander |       |                                                                                                                                                                                                    | 100,000(19) | %                       |       |                     | $          | 1.96 |   |   | February 8, 2016 |   |
| Boris Rubizhevsky   |       |                                                                                                                                                                                                    | 100,000(19) | %                       |       |                     | $          | 1.96 |   |   | February 8, 2016 |   |
| John Sakys          |       |                                                                                                                                                                                                    | 50,000(10)  | %                       |       |                     | $          | 1.96 |   |   | February 8, 2016 |   |

 

On May 5, 2006, weissued 75,000 stock options each to James E. Alexander, Boris Rubizhevsky andJohn Sakys along with 30,000 and 20,000 to Lindsay A. Gardner and Stephen J.Burden, respectively. The options have a ten-year life and are exercisable at$1.15 per share. We have not granted any additional stock options to theexecutive officers named in the compensation table subsequent to April 30,2006.

**(d)**          AggregatedOption Exercises in Last Fiscal Year and Fiscal Year End Option Values

Oneexecutive officer, Lindsay A. Gardner, exercised 1,400 employee stock optionsduring the year ended April 30, 2006.  No other executive officer exercised employeestock options during the year end April 30, 2006, or subsequently. Thefollowing table sets forth information regarding the year-end value of optionsbeing held by the Chief Executive Officer and the other such named executiveofficers on April 30, 2006.

| **Name and  Principal Position**    | ** ** | ** ** | ** ** | **Shares  acquired on  exercise (#)** | ** ** | **Value  realized** | ** ** | **Number of securities  underlying unexercised  options/stock appreciation  rights at April 30, 2006  Exercisable/Unexercisable** | ** **        | **Value of unexercised**

**in-the-money options/stock**

**appreciation rights at April 30, 2006**

**Exercisable/Unexercisable** | ** ** |
|-----------------------------------------------|------------|------------|------------|-------------------------------------------------|------------|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|-------------------|------------------------------------------------------------------------------------------------------------------------------------|------------|
| James E.  Alexander  President & CEO |       |       | 0          |                                            |       | 0                   |       |                                                                                                                              | 225,000 / 135,000 |                                                                                                                               |       |   | $ | 12,800 / $0 |   |   |
| Boris Rubizhevsky  Senior Vice President      |       |       | 0          |                                            |       | 0                   |       |                                                                                                                              | 303,750 / 255,000 |                                                                                                                               |       |   | $ | 12,750 / $0 |   |   |
| Lindsay A.  Gardner  Vice President           |       |       | 1,400      |                                            |       | <$5,000          |       |                                                                                                                              | 123,014 / 50,000  |                                                                                                                               |       |   | $ | 5,682 / $0 |   |   |
| Stephen J. Burden  Vice President             |       |       | 0          |                                            |       | 0                   |       |                                                                                                                              | 270,429 / 0       |                                                                                                                               |       |   | $ | 44,540 / $0 |   |   |
| John V. Sakys  Vice President                 |       |       | 0          |                                            |       | 0                   |       |                                                                                                                              | 182,812 / 75,000  |                                                                                                                               |       |   | $ | 11,000 / $0 |   |   |
| Hans Walitzki  Vice President                 |       |       | 0          |                                            |       | 0                   |       |                                                                                                                              | 204,000 / 0       |                                                                                                                               |       |   | $ | 56,640 / $0 |   |   |

 

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**(e)**           LongTerm Incentive Compensation Plans, and Defined Benefit and Actuarial Plans

Isonics has no long termincentive compensation plans, defined benefit plans or actuarial plans.

**(f)**             Compensationof Directors

We reimburse directors for travel and related expensesassociated with Board of Directors’ meetings. Historically we compensatednon-employee directors $2,000 for attending Board of Directors’ meetings inperson, and $500 for attending Board of Directors’ meetings telephonically.Effective May 1, 2006, we compensate non-employee directors $2,000 for attendingBoard of Directors’ meetings in person, $1,000 for attending Board of Directors’meetings telephonically and we pay an additional $500 to the chair person forrequired preparation time.

The 1998 Directors’ Plan (the “Directors’ Plan”)authorized each person serving as a member of the Board who is not an employeeof ours to receive options to purchase 20,000 shares of our common stock whensuch person accepts his position as a Director and to receive an additionaloption to purchase 10,000 shares of common stock when such person is re-electedas a Director provided such person is not an employee of Isonics. The exerciseprice for the options is the Fair Market Value (as defined in the Executives’Plan) on the date such person becomes a director and the options areexercisable for five years from such date. The options granted under theDirectors’ Plan vest immediately upon the date of the grant. In the event aDirector resigns or is not re-elected to the Board, his or her failure toexercise the options in three months results in the options’ termination priorto the expiration of their term. We amended the Directors Plan effective May 1,2006 so that we now grant each Director an option to purchase 20,000 shares ofcommon stock when such person is re-elected as a Director provided such personis not an employee of Isonics. On September 9, 2005, the Board ofDirectors approved, and we entered into indemnity agreements with each of ourdirectors.

Underthe Directors’ Plan the following individuals have been granted options throughApril 30, 2006:

| Name                | ** ** | ** ** | ** ** | **Shares Under Option** | ** ** | **Exercise Price** | ** ** | **Expiration** | ** ** |
|---------------------|------------|------------|------------|-----------------------------------|------------|-------------------------|------------|----------------|------------|
| Lindsay A. Gardner* |       |       | 10,000     |                              |       |                    | $          | 1.06           |       |   | November 12,  2006 |   |
|                     |       |       | 10,000     |                              |       |                    | $          | 1.00           |       |   | November 19,  2007 |   |
|                     |       |       | 10,000     |                              |       |                    | $          | 1.42           |       |   | April 27,  2009 |   |
| Richard Parker**    |       |       | 10,000     |                              |       |                    | $          | 1.06           |       |   | November 12, 2006 |   |
|                |       |       | 10,000     |                              |       |                    | $          | 1.00           |       |   | November 19,  2007 |   |
|                |       |       | 10,000     |                              |       |                    | $          | 1.42           |       |   | April 27,  2009 |   |
|                |       |       | 10,000     |                              |       |                    | $          | 2.04           |       |   | April 18,  2010 |   |
|                |       |       | 10,000     |                              |       |                    | $          | 2.48           |       |   | October 24,  2010 |   |
| Russell W. Weiss    |       |       | 20,000     |                              |       |                    | $          | 1.17           |       |   | January 5, 2009 |   |
|                     |       |       | 10,000     |                              |       |                    | $          | 1.42           |       |   | April 27,  2009 |   |
|                     |       |       | 10,000     |                              |       |                    | $          | 2.04           |       |   | April 18,  2010 |   |
|                     |       |       | 10,000     |                              |       |                    | $          | 2.48           |       |   | October 24,  2010 |   |
| Richard H. Hagman   |       |       | 20,000     |                              |       |                    | $          | 3.13           |       |   | July 19, 2010 |   |
|                |       |       | 10,000     |                              |       |                    | $          | 2.48           |       |   | October 24,  2010 |   |
| C. Stewart Verdery  |       |       | 20,000     |                              |       |                    | $          | 3.37           |       |   | July 31, 2010 |   |
|                     |       |       | 10,000     |                              |       |                    | $          | 2.48           |       |   | October 24, 2010 |   |

 

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*                    Ms. Gardnerbecame an officer of Isonics in October 2004 and is no longer eligible toparticipate in the Directors’ Plan. These options were granted to her at a timewhen she was eligible to participate in the Directors’ Plan.

60

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**             On April 19, 2005,the Board of Directors also granted Mr. Parker options to purchase 40,000shares of common stock at $2.04 per share exercisable through April 18,2010. These options were not granted under the Directors’ Plan, but weregranted under the 2005 Stock Option Plan.

We do not have any otherarrangements pursuant to which we compensate the Directors for acting in theircapacities as such.

**(g)**           EmploymentAgreements, Termination of Employment and Change In Control Agreements

Currently both Mr. Alexanderand Mr. Rubizhevsky are covered by employment agreements that arerenewable on an annual basis. We have employment agreements with Dr. StephenJ. Burden, Dr. Hans Walitzki, Ms. Lindsay A. Gardner and Mr. JohnSakys. The agreements have an indefinite term (except for the agreement with Dr. Walitzkiwhich expires November 2006) and provide for at-will employment,terminable at any time by either party. The agreements provide for a rate ofannual compensation, which we will review annually. Under each agreement, Dr. Burden,Dr. Walitzki, Ms. Gardner and Mr. Sakys are entitled toparticipate in our standard plans and policies. The agreements also includeconfidentiality and invention assignment provisions.

**(h)**          Reporton Repricing of Options/SARs

We did not reprice any options or stock appreciationrights during the fiscal year ended April 30, 2006, or subsequently.

 

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**ITEM 11.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS.

**(a) and (b)**  Ownership of Certain Beneficial Ownersand Management.

Thefollowing table sets forth information regarding the ownership of our common stockas of April 30, 2006****by:  (i) eachdirector or nominee for director; (ii) each of the executive officersnamed in the Summary Compensation Table; (iii) all executive officers anddirectors of the Company as a group; and (iv) all those known by us to bebeneficial owners of more than 5% of our common stock.

| ** **                                                                                                                                                                          | ** ** | **Beneficial Ownership** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| **Beneficial Owner**                                                                                                                                                           | ** ** | ** **                    | ** ** | **Number of  Shares** | ** ** | **Percent of  Total** | ** ** |
| James E.  Alexander(1)                                                                                                                                                              |       | 2,261,167                     |       |   | 5.3 | % |   |
| Boris  Rubizhevsky(2)                                                                                                                                                               |       | 1,881,455                     |       |   | 4.4 | % |   |
| Stephen J.  Burden(3)                                                                                                                                                               |       | 402,425                       |       |   | <1 | % |   |
| Hans Walitzki(4)                                                                                                                                                                    |       | 404,000                       |       |   | <1 | % |   |
| Lindsay A.  Gardner(5)                                                                                                                                                              |       | 423,562                       |       |   | 1.0 | % |   |
| Richard Parker(6)                                                                                                                                                                   |       | 92,927                        |       |   | <1 | % |   |
| John Sakys(7)                                                                                                                                                                       |       | 261,836                       |       |   | <1 | % |   |
| Russell W.  Weiss(8)                                                                                                                                                                |       | 50,000                        |       |   | <1 | % |   |
| Richard H.  Hagman(9)                                                                                                                                                               |       | 30,000                        |       |   | <1 | % |   |
| C. Stewart  Verdery, Jr.(10)                                                                                                                                                   |       | 30,000                        |       |   | <1 | % |   |
| All executive officers  and directors as a group (10 persons). The address for all of the above  directors and executives officers is: 5906 McIntyre Street, Golden, CO  80403 |       | 5,837,372                     |       |   | 13.2 | % |   |
|                                                                                                                                                                                     |            |                               |            |  |  |  |  |  |  |

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(1)          Includes:(i) 360,000 shares of common stock underlying stock options of which225,000 are vested as of April 30, 2006 and which are currentlyexercisable; (ii) 100,000 shares of common stock underlying 100,000warrants to purchase common stock of Isonics; (iii) 135,455 shares ofcommon stock held in the name of The James & Carol Alexander FamilyFoundation; and (iv) 500,000 shares held by wife Carol Alexander.

(2)          Includes: (i) 1,067,372 shares of common stock held jointly withwife Nancy Eiden Rubizhevsky; (ii) 558,750 shares of common stockunderlying stock options of which 303,750 are vested as of April 30, 2006and which are currently exercisable; (iii) 100,000 shares of common stockunderlying 100,000 warrants to purchase common stock of Isonics; (iv) 33,333shares of common stock held by wife Nancy Eiden Rubizhevsky; (v) 61,000shares of common stock held by son Zachary Rubizhevsky; and (vi) 61,000shares of common stock held by son Ryan Rubizhevsky.

(3)          Includes 270,429 shares of common stock underlying stock options thatare currently exercisable.

(4)          Includes (i) 200,000 shares of common stock of which 140,000shares are vested as of April 30, 2006 and (ii) 204,000 shares ofcommon stock underlying stock options that are currently exercisable.

(5)          Includes 173,014 shares of common stock underlying stock options ofwhich 123,014 are vested as of April 30, 2006 and which are currentlyexercisable.

(6)          Includes 92,927 shares of common stock underlying stock options thatare currently exercisable.

(7)          Includes 257,812 shares of common stock underlying stock options ofwhich 182,812 are vested as of April 30, 2006 and which are currentlyexercisable.

(8)          Includes 50,000 shares of common stock underlying stock options thatare currently exercisable.

(9)          Includes 30,000 shares of common stock underlying stock options thatare currently exercisable.

(10)   Includes 30,000 shares of common stock underlying stock options thatare currently exercisable.

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As of April 30, 2006,there are no shares of our Series A, Series B, Series C, Series Dor Series E Convertible Preferred Stock outstanding.

**(c)**           No Change of Control Arrangements.

We know of no plans orarrangement that will result in a change of control at Isonics.

**(d)**          EquityCompensation Plan Information

| Plan Category                                                   | ** ** | ** ** | ** ** | **Number of Securities to  be Issued upon  Exercise of  Outstanding, Options,  Warrants and Rights  (a)** | ** ** | **Weighted-average  Exercise Price of  Outstanding Options,  Warrants and Rights  (b)** | ** ** | **Number of Securities  Remaining Available  for Future Issuance  under Equity  Compensation Plans  (excluding securities  reflected in column (a)  (c)** | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Equity Compensation Plans Approved by Security Holders**           |       |       | 2,933,932  |                                                                                                                                                   |       |                                                                                                             | $          | 2.12                                                                                                                                                                                                             |       |   |   | 2,820,000 |   |   |
| **Equity Compensation Plans Not Approved by  Security Holders** |       |       | 0          |                                                                                                                                                   |       |                                                                                                             | 0          |                                                                                                                                                                                                             |       |   | 0 |   |   |
| **Total**                                                            |       |       | 2,933,932  |                                                                                                                                                   |       |                                                                                                             | $          | 2.12                                                                                                                                                                                                             |       |   |   | 2,820,000 |   |   |

 

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

We provide the followinginformation regarding transactions among officers, directors and significantshareholders of Isonics during the most recent two fiscal years and during thesubsequent fiscal year.

**Corporate Loans toOfficers**

We have not made anycorporate loans to our officers, directors, or shareholders in fiscal years2006, 2005 or subsequently. The Sarbanes-Oxley Act of 2002 prohibits any loansto corporate officers or directors.

**Corporate Loansfrom Officers and Employees**

We did not borrow any funds from our officers ordirectors during the years ended April 30, 2006 and April 30, 2005 orsubsequently. When funds are owed to our executive officers, we have agreed tokeep them advised with respect to our cash receipts and expenditures.

 

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**ITEM 13.   EXHIBITS AND REPORTS ON FORM 8-K.**

**(a)**                                Exhibits Pursuant to Item 601 ofRegulation S-B:

| Exhibit   Number | ** ** | ** **                                                                                                                                                                                    | ** ** | **Title** |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------|
| 3.01             |       | Registrant’s Amended and  Restated Articles of Incorporation (dated May 5, 1997).(1)                                                                                                |
| 3.02             |       | Registrant’s Amended and  Restated Bylaws.(5)                                                                                                                                            |
| 3.03             |       | Officers’ Certificate  Relating To Amendments To The Certificate Of Determination Of The Preferences  And Rights Of Series A Convertible Preferred Stock Of Isonics  Corporation(6) |
| 3.04             |       | Officers’ Certificate  Relating To Amendments To The Certificate Of Determination Of The Preferences  And Rights Of Series B Convertible Preferred Stock Of Isonics  Corporation(6) |
| 3.05             |       | Officers’ Certificate  Relating To Amendments To The Certificate Of Determination Of The Preferences  And Rights Of Series C Convertible Preferred Stock Of Isonics  Corporation(6) |
| 3.06             |       | Officers’ Certificate  Relating To Amendments To The Certificate Of Determination Of The Preferences  And Rights Of Series D Convertible Preferred Stock Of Isonics  Corporation(6) |
| 3.07             |       | Officers’ Certificate  Relating To Amendments To The Certificate Of Determination Of The Preferences  And Rights Of Series E Convertible Preferred Stock Of Isonics  Corporation(6) |
| 3.08             |       | Certificate of Amendment  to Articles of Incorporation (dated November 15, 2001)(13)                                                                                                     |
| 3.09             |       | Certificate of Amendment  to Articles of Incorporation (dated April 29, 2005)(28)                                                                                                        |
| 4.01             |       | Form of warrant  Agreement between the Registrant and Continental Stock Transfer &  Trust Company.(8)                                                                           |
| 4.02             |       | Specimen Class B  Warrant Certificate (see exhibits 4.06 and 4.07).                                                                                                                      |
| 4.03             |       | Specimen Class C  Warrant Certificate (see exhibits 4.06 and 4.07).                                                                                                                      |
| 4.04             |       | Amendment No. 1 to  warrant Agreement between the Registrant and Continental Stock  Transfer & Trust Company.(7)                                                                |
| 4.05             |       | Amended and Restated  Warrant Agreement effective as of January 15, 2001, between the  Registrant and Continental Stock Transfer and Trust Company, Inc.(8)                         |
| 4.06             |       | Amended and Restated  Warrant Agreement between the Registrant and Continental Stock Transfer and  Trust Company dated July 26, 2001.(11)                                                |
| 4.07             |       | Amendment No. 1  (dated June 10, 2005) to the Amended and Restated Warrant Agreement  dated July 26, 2001(23)                                                                  |
| 10.01            |       | Registrant’s 1996 Stock  Option Plan.(1)                                                                                                                                                 |
| 10.02            |       | Registrant’s 1998  Directors’ Stock Option Plan(19)                                                                                                                                 |
| 10.03            |       | Registrant’s 1996  Executives Equity Incentive Plan.(1)                                                                                                                                  |
| 10.04            |       | Registrant’s 1996 Equity  Incentive Plan.(1)                                                                                                                                             |
| 10.05            |       | Registrant’s 2005 Stock  Option Plan(19)                                                                                                                                                 |
| 10.06            |       | Option Agreement between  the Registrant and Yale University.(1)                                                                                                                              |
| 10.07            |       | Letter from Yale  University to Registrant dated February 10, 1996.(1)                                                                                                                   |
| 10.08            |       | Stock Purchase Agreement  between Isonics Corporation and Protection Plus Security  Consultants, Inc.(24)                                                                                |
| 10.09*           |       | Form of Indemnity  Agreement between Registrant and its directors.                                                                                                                       |
| 10.10            |       | Agreement dated  June 7, 2004 between Isonics Corporation, Isonics Vancouver, Inc.,  and Encompass Materials Group Limited(18)                                                      |
| 10.11            |       | Registration Rights  Agreement between Isonics Corporation and Encompass Materials Group Limited(18)                                                                                          |

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| 10.12  |   | Registration Rights  Agreement with Asset Managers International, Ltd.(20)                                                                                                                     |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13* |   | Assignment of  Intellectual Property Rights agreement between Isonics and IUT dated April 27,  2006.                                                                                      |
| 10.14  |   | Share Purchase and  Assignment Agreement dated December 23, 2002 between Isonics and IUT.(3)                                                                                              |
| 10.15* |   | Research and Development  Agreement between Isonics and IUT dated April 27, 2006.                                                                                                              |
| 10.16* |   | Cancellation Agreement and Assignment between  Isonics and IUT dated April 27, 2006.                                                                                                           |
| 10.17  |   | Letter from Yale  University to Registrant dated January 28, 1997.(1)                                                                                                                     |
| 10.18  |   | Intentionally omitted.                                                                                                                                                                         |
| 10.19  |   | Development and  Licensing Agreement dated September 28, 2005, by and between Lucent  Technologies, Inc. and Isonics Corporation (confidential treatment  requested).(25)            |
| 10.20  |   | Securities Purchase  Agreement for February 2005 Convertible Debenture Transaction(21)                                                                                                         |
| 10.21  |   | Registration Rights  Agreement for February 2005 Convertible Debenture Transaction(21)                                                                                                    |
| 10.22  |   | Escrow Agreement for  February 2005 Convertible Debenture Transaction(21)                                                                                                                      |
| 10.23  |   | Voting Agreement for  February 2005 Convertible Debenture Transaction(21)                                                                                                                      |
| 10.24  |   | Form of 8% Convertible Debenture for February 2005 Convertible  Debenture Transaction(21)                                                                                                 |
| 10.25  |   | Form of Warrant for February 2005 Convertible Debenture  Transaction(21)                                                                                                                  |
| 10.26  |   | Intentionally Omitted.                                                                                                                                                                         |
| 10.27  |   | Agreement between  Isonics Corporation and State Scientific Center of Russian Federation—Institute  for Physics and Power Engineering, Obninsk, Russia for the supply of actinium-225(22) |
| 10.28  |   | Intentionally omitted.                                                                                                                                                                         |
| 10.29  |   | Intentionally Omitted                                                                                                                                                                          |
| 10.30  |   | Technology License  Agreement dated September 14, 2001, between Silicon Evolution, Inc.  and Isonics Corporation(12)                                                                 |
| 10.31  |   | Intentionally Omitted                                                                                                                                                                          |
| 10.32  |   | Intentionally Omitted                                                                                                                                                                          |
| 10.33  |   | Securities Purchase  Agreement dated May 30, 2006, between Isonics and Cornell Capital  Partners, L.P.(26)                                                                                |
| 10.34  |   | Investor Registration  Rights Agreement dated May 30, 2006, between Isonics and Cornell Capital  Partners, L.P.(26)                                                                       |
| 10.35  |   | Irrevocable Transfer  Agent Instructions dated May 30, 2006(26)                                                                                                                           |
| 10.36  |   | Voting Agreement dated  May 30, 2006(26)                                                                                                                                                  |
| 10.37  |   | Surrender and Reissuance  Agreement(27)                                                                                                                                                        |
| 10.38  |   | Amended and Restated 6%  Secured Convertible Debenture no. CCP-3:  $10,000,000 principal(27)                                                                                              |
| 10.39  |   | Amended and Restated 6%  Secured Convertible Debenture no. CCP-4: $3,000,000 principal(27)                                                                                                     |
| 10.40  |   | Amended and Restated  Warrant no. CCP-002 ($1.25 exercise price)(27)                                                                                                                           |
| 10.41  |   | Amended and Restated  Warrant no. CCP-003 ($1.75 exercise price)(27)                                                                                                                           |
| 10.42  |   | Amended and Restated  Warrant no. CCP-004 ($2.00 exercise price)(27)                                                                                                                           |
| 10.43  |   | Security Agreement dated  May 30, 2006, between  Isonics as grantor and Cornell Capital  Partners, L.P as secured party(26)                                                          |
| 10.44  |   | Security Agreement dated  May 30, 2006, between  Isonics Homeland Security and Defense  Corporation; as grantor and Cornell Capital Partners, L.P as secured party(26)               |
| 10.45  |   | Security Agreement dated  May 30, 2006, between  Isonics Vancouver, Inc. as grantor and  Cornell Capital Partners, L.P as secured party(26)                                     |

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| 10.46  |   | Security Agreement dated  May 30, 2006, between  Protection Plus Security Corporation as  grantor and Cornell Capital Partners, L.P as secured party(26) |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 14.0   |   | Code of Ethics(2)                                                                                                                                                  |
| 21.1*  |   | List of subsidiaries.                                                                                                                                              |
| 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                                                                                                                     |

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*                    Filedherewith. All other documents have been previously filed.

(1)          Incorporated herein byreference to exhibit filed with Isonics’ Registration Statement on Form SB-2(“Registration Statement”) (Commission file No. 333-13289) in whichthis exhibit bears the same number except exhibit 3.01, which was numbered 3.03in that registration statement.

(2)          Incorporated byreference from Isonics’ annual report on Form 10-KSB for the yearended April 30, 2004.

(3)          Filed with Isonics’ Current Report on Form 8-K(File No. 001-12531), dated December 23, 2002 and filed February 5,2003, and incorporated herein by reference.

(4)          Filed with Isonics’ Current Report on Form 8-K(File No. 001-12531), dated July 29 and filed August 12,1999, and incorporated herein by reference.

(5)          Filed with Isonics’ Current Report on Form 8-K(File No. 001-12531) dated March 27, 2006, and filed March 31,2006, and incorporated herein by reference.

(6)          Filed with Isonics’ Amended Current Report onForm 8-K (File No. 001-12531) dated March 27, 2006,and filed July 14, 2006, and incorporated herein by reference.

(7)          Filed with Isonics’ Current Report on Form 8-K(File No. 001-12531) dated August 17, 2000, and filed August 18,2000, and incorporated herein by reference.

(8)          Filed with Isonics’ registration statement onForm S-4 (File No. 333-37696) or the amendments thereto,and incorporated herein by reference.

(9)          Filed with Isonics’ Current Report on Form 8-K(File No. 001-12531) dated February 1, 2001, and incorporatedherein by reference.

(10)   Filed with Isonics’ annual report on Form 10-KSB(File No. 001-12531) for the year ended April 30, 2001, andincorporated herein by reference.

(11)   Filed with Isonics’ Form 8-A/12(g) filedon August 1, 2001.

(12)   Filed with Amendment no. 2 to registrationstatement (File No. 333-56562) and incorporated herein by reference.

(13)   Filed with Isonics’ current report on Form 8-K(File No. 001-12531) dated January 8, 2002 and incorporatedherein by reference.

(14)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated March 22, 2002, and incorporated hereinby reference.

(15)   Filed with Isonics’ quarterly report on Form 10-QSB(file no. 001-12531) for the quarter ended October 31, 2002.

(16)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated January 28, 2004.

(17)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated April 6, 2004.

66

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(18)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated June 11, 2004.

(19)   Filed with Isonics’ registration statement onForm S-8 (file no. 333-128592) filed on September 26,2005.

(20)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated October 4, 2004.

(21)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated February 24, 2005.

(22)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated January 7, 2005.

(23)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated June 10, 2005 filed on June 14,2005.

(24)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated May 16, 2005.

(25)   Filed with Isonics’ amended current report onForm 8-K (file no. 001-12531) dated December 5, 2005,filed on March 31, 2006.

(26)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated May 31, 2006, filed on June 6, 2006.

(27)   Filed with Isonics’ current report on Form 8-K(file no. 001-12531) dated June 21, 2006, filed on June 21,2006

(28)   Incorporated by reference from Isonics’ annual report on Form 10-KSBfor the year ended April 30, 2005.

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

We dismissed GrantThornton as our principal auditors on November 24, 2004, and retained Hein &Associates as our principal auditor on that date. We had no relationship withHein & Associates before we retained them on November 24, 2004.

**(a)**          AuditFees.

During our 2006 fiscal year, our principal accountant,Hein & Associates, billed us aggregate fees in the amount ofapproximately $158,000. Theseamounts were billed for professional services that Hein & Associatesprovided during our fiscal 2006 for the audit of our annual financialstatements, review of the financial statements included in our report on 10-QSB,review of our securities offerings and other services typically provided by anaccountant in connection with statutory and regulatory filings or engagementsfor that fiscal year.

During our 2005 fiscalyear, our former accountant, Grant Thornton, billed us aggregate fees in the amountof approximately $158,000. Duringour 2005 fiscal year, Hein & Associates, our principal accountant,billed us aggregate fees of approximately $141,000. In both cases, theseamounts were billed for professional services that the accountants provided forthe audit of our annual financial statements, review of the financialstatements included in our reports on 10-QSB, and other servicestypically provided by an accountant in connection with statutory and regulatoryfilings or engagements for that fiscal year. In the case of Grant Thornton,such services also involved a review of registration statements. In the case ofHein & Associates, such services also involved the commencement of areaudit of our 2004 fiscal year.

**(b)**          Audit-Related Fees.

Hein & Associatesbilled us aggregate fees in the amount of $0 for the fiscal years ended April 30,2006 and 2005 for assurance and related services that were reasonably relatedto the performance of the audit or review of our financial statements.

67

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**(c)**           TaxFees

Hein & Associatesbilled us aggregate fees in the amount of $0****forthe fiscal years ended April 30, 2006 and 2005 for tax compliance, taxadvice, and tax planning.

**(d)**          All Other Fees

Hein & Associates billed us aggregate fees inthe amount of $53,000 and $14,000 for the fiscal years ended April 30,2006 and 2005 for other fees, including services for due diligence proceduresrelated to the acquisition of PPSC.

Grant Thornton billed usaggregate fees in the amount of $0 and $3,000 for the fiscal years ended April 30,2006 and 2005, respectively for other fees, including services for duediligence procedures.

**(e)**           AuditCommittee’s Pre-Approval Practice

Section 10A(i) of the Securities ExchangeAct of 1934 prohibits our auditors from performing audit services for us aswell as any services not considered to be “audit services” unless such servicesare pre-approved by the Audit Committee of the Board of Directors, or unlessthe services meet certain *de minimis*standards.   The Audit Committee’scharter (as amended May 18, 2006) provides that the Audit Committee must:

Preapprove all audit services that the auditor mayprovide to us or any subsidiary (including, without limitation, providingcomfort letters in connection with securities underwritings or statutory audits)as required by §10A(i)(1)(A) of the Securities Exchange Act of 1934 (asamended by the Sarbanes-Oxley Act of 2002).

Preapprove all non-audit services (other than certain *de minimis* services described in §10A(i)(1)(B) of theSecurities Exchange Act of 1934 (as amended by the Sarbanes-Oxley Act of 2002))that the auditors propose to provide to us or any of its subsidiaries.

The Audit Committeeconsiders at each of its meetings whether to approve any audit services or non-auditservices. In some cases, management may present the request; in other cases,the auditors may present the request. At its annual meeting in October 2005,our Audit Committee approved Hein & Associates performing our auditfor the 2006 fiscal year. In November 2004 the Audit Committee approvedHein & Associates performing the reaudit of our 2004 fiscal year andthe audit of our 2005 fiscal year.

Thepercentage of the fees for audit, audit-related, tax and other services were asset forth in the following table:

| ** **          | ** ** | **Percentage of total fees paid to  Grant Thornton  (2004 and 2005) and to  Hein & Associates (2006)** | ** ** |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **          | ** ** | **Fiscal Year 2006**                                                                                                                                    | ** ** | **Fiscal Year 2005** | ** ** |
| Audit fees          |       |                                                                                                                                                              | 75         | % |   |   | 91 | % |   |
| Audit-related  fees |       |                                                                                                                                                              | 0          | % |   |   | 0 | % |   |
| Tax fees            |       |                                                                                                                                                              | 0          | % |   |   | 4 | % |   |
| All other fees      |       |                                                                                                                                                              | 25         | % |   |   | 5 | % |   |

 

According to information provided by our principalaccountants, all services were performed by persons who were their full timeemployees.

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**SIGNATURES**

Inaccordance 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.

| July 26, 2006 | ** ** |                            |
|--------------------|------------|---------------------------------|
|               |       | **ISONICS****CORPORATION****,** |
|               |       | a California Corporation        |
|                    |       | By:                             | /s/ JAMES E. ALEXANDER |
|               |       |                            | James E.  Alexander |
|               |       | * *                        | President, Chief Executive Officer and Chairman of  the Board |
|                    |            |                                 |  |  |

 

Pursuantto the requirement of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated:
|                     | **Date** | ** **                                  | ** ** | ** **                        | **Name and Title** | ** ** | ** ** | ** ** | **Signature** | ** ** |
|---------------------|----------|---------------------------------------------|------------|-----------------------------------|--------------------|------------|------------|------------|---------------|------------|
| July 26,  2006 |     | James E. Alexander                          |       | /s/ JAMES E.  ALEXANDER           |
|                |     | Principal Executive  Officer                |       |                              |
|                |     | Chairman of the Board                       |       |                              |
|                |     | Director                                    |       |                              |
| July 26,  2006 |     | Boris Rubizhevsky                           |       | /s/ BORIS  RUBIZHEVSKY            |
|                |     | Vice Chairman                               |       |                              |
|                |     | Director                                    |       |                              |
| July 26,  2006 |     | Lindsay A.  Gardner                         |       | /s/ LINDSAY A.  GARDNER           |
|                |     | Officer and Director                        |       |                              |
| July 26,  2006 |     | Richard Parker                              |       | /s/ RICHARD  PARKER               |
|                |     | Director                                    |       |                              |
| July 26,  2006 |     | Russell W. Weiss                            |       | /s/ RUSSELL W.  WEISS             |
|                |     | Director                                    |       |                              |
| July 26,  2006 |     | Richard H. Hagman                           |       | /s/ RICHARD H.  HAGMAN            |
|                |     | Director                                    |       |                              |
| July 26,  2006 |     | C. Stewart  Verdery, Jr.               |       | /s/ C. STEWART  VERDERY, JR. |
|                |     | Director                                    |       |                              |
| July 26,  2006 |     | John Sakys                                  |       | /s/ JOHN SAKYS                    |
|                |     | Principal Financial and  Accounting Officer |       |                              |

 

 

69

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**ISONICS CORPORATIONAND SUBSIDIARIES**

**Indexto Financial Statements**

|                                                          | ** ** | **Page** |
|----------------------------------------------------------|------------|----------|
| Report of Independent  Registered Public Accounting Firm |       | F-2      |
| Consolidated  Financial Statements                       |       |     |
| Consolidated  Balance Sheets                             |       | F-3      |
| Consolidated  Statements of Operations                   |       | F-4      |
| Consolidated  Statements of Stockholders’ Equity    |       | F-5      |
| Consolidated  Statements of Cash Flows                   |       | F-6      |
| Notes to Consolidated  Financial Statements              |       | F-7      |

 

F-1

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**REPORT OFINDEPENDENT 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). Thosestandards 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, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Isonics Corporation andsubsidiaries as of April 30, 2006 and 2005, and the results of theiroperations and their cash flows for each of the two years in the period ended April 30,2006, in conformity with U.S. generally accepted accounting principles.

Denver, ColoradoJuly 19, 2006

F-2

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**IsonicsCorporation and Subsidiaries**

**CONSOLIDATEDBALANCE SHEETS**

**(Inthousands, except share 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

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**Isonics Corporationand SubsidiariesCONSOLIDATED 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

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**Isonics Corporationand SubsidiariesCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands, except share amounts)**

| ** **                                                                                                         | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional  Paid in** | ** ** | **Deferred  Comp-** | ** ** | **Accum-  ulated** | ** ** | ** **   | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|------------------------------|------------|---------------------|------------|--------------------|------------|--------------|------------|
| ** **                                                                                                         | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**                   | ** ** | **Amount**          | ** ** | **Capital**        | ** ** | **ensation** | ** ** | **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

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**Isonics Corporationand SubsidiariesCONSOLIDATED STATEMENTS 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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1—ORGANIZATIONAND SIGNIFICANT ACCOUNTING POLICIES**

**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. Theconsolidated financial statements (the “financial statements”) include ouraccounts and those of our wholly-owned subsidiaries, including: Protection PlusSecurity Corporation (“PPSC”), Isonics Homeland Security and DefenseCorporation (“HSDC”), Isonics Vancouver, Inc. (“IVI”), Chemotrade GmbH(“Chemotrade”) and IUT Detection Technologies, Inc. (“IUTDT”).

We incurred significantlosses from operations for the fiscal years presented and, as of April 30,2006, have a working capital deficit of $6,707,000. Additionally, barring arestructuring of our company, it is likely that we will also incur operatinglosses in fiscal year 2007 as we continue to fund research and development ofnew and existing products and cover operating costs. Should losses be greaterthan anticipated, we may encounter liquidity problems which could require us tocurtail development projects, seek joint venture partners, sell assets and/orobtain additional financing with terms that may not be as favorable as mightotherwise be available. However, subsequent to year end (see Note 17) we raisedadditional financing, through long-term debt with a single investor, in theamount of $13,000,000. That investor has committed an additional $3,000,000pending the successful registration with the Securities and Exchange Commissionof the securities underlying the convertible debentures issued. We believe thatbased on our financial position at April 30, 2006, the subsequent financing(including the additional $3 million commitment by the investor) and ourprojections of future operations, we will be able to continue operations intofiscal year 2008.

**Principles ofConsolidation **

These financial statementshave been prepared in conformity with accounting principles generally acceptedin the United States of America. Intercompany accounts andtransactions have been eliminated in consolidation.

**Use of Estimates inthe Financial Statements**

In preparing financialstatements in conformity with accounting principles generally accepted in theUnited States of America, we are required to make estimates and assumptionsthat affect the amounts reported in the financial statements and accompanying notes,including those related to impairment of goodwill and intangible assets,impairment of equity investments and assets held for sale, recoverability ofinventory and accounts receivable, the recording of various accruals, theuseful lives of long-lived assets, income tax and potential losses fromcontingencies. These estimates are based upon management’s best findings, afterconsidering past and current events and assumptions about future events. Actualresults could differ from those estimates.

**Cash Equivalents**

Cash equivalents includeinvestments purchased with an original maturity of less than ninety days.

F-7

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Concentration ofCredit Risk**

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 thatpotentially subject us to concentrations of credit risk consist principally oftrade receivables, for which our accounting policies are discussed in *Accounts Receivable*.

**Accounts Receivable**

The majority of ouraccounts receivable are due from customers of our security services segment andour semiconductor products and services segment. Credit is extended based onevaluation of a customer’s financial condition and, generally, collateral isnot required. Accounts receivable are generally due within 30 days and arestated at amounts due from customers net of an allowance for doubtful accounts.Accounts outstanding longer than the contractual payment terms are consideredpast due. We determine our allowance by considering a number of factors,including length of time trade accounts receivable are past due, our previousloss history, our customer’s current ability to pay their obligation to us andthe condition of the general economy and the industry as a whole. We write-offaccounts receivable when they become uncollectible, and payments subsequentlyreceived on such receivables are credited to the allowance for doubtfulaccounts. Interest accrues beginning on the day after the due date of thereceivable. Interest accruals are discontinued on accounts past due 90 days ormore, and all interest previously accrued but not collected is reversed againstcurrent interest income. Interest income is subsequently recognized on theseaccounts only to the extent cash is received, or when the future collection ofinterest and the receivable balance is considered probable by management.

**Inventories**

Inventories are stated atthe lower of cost (first-in, first-out) or market. We perform periodicassessments to determine the existence of obsolete, slow moving and non-salableinventories, and record provisions to reduce such inventories to net realizablevalue when necessary.

**Property andEquipment**

Property and equipment arestated at cost. Depreciation is computed using the straight-line method overthe estimated useful lives of the assets.  The estimated useful lives for officefurniture and equipment range from three to seven years, for productionequipment range from three to seven years and for vehicles are three years.  Leasehold improvements are depreciated overthe shorter of their estimated useful lives or 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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

if the presence of certaincircumstances indicates that impairment may have occurred. The impairmentreview process compares the fair value of the reporting unit in which goodwillresides to its carrying value. If the carrying amount of a reporting unitexceeds its fair value, then the amount of the impairment loss must bemeasured. The impairment loss would be calculated by comparing the implied fairvalue of reporting unit goodwill to its carrying amount. In calculating theimplied fair value of reporting unit goodwill, the fair value of the reportingunit is allocated to all of the other assets and liabilities of that unit basedon their fair values. The excess of the fair value of a reporting unit over theamount assigned to its other assets and liabilities is the implied fair valueof goodwill. An impairment loss would be recognized when the carrying amount ofgoodwill exceeds its implied fair value (see Note 3).

Acquired identifiedintangible assets (other than goodwill) are amortized on a straight-line basisover the periods of benefit, ranging from three to ten years. We evaluate therecoverability of identifiable intangible assets whenever events or changes incircumstances indicate that an intangible asset’s carrying amount may not berecoverable. We measure the carrying amount of the asset against the estimatedundiscounted future cash flows associated with it. Should the sum of theexpected future net cash flows be less than the carrying value of the assetbeing evaluated, an impairment loss would be recognized. The impairment losswould be calculated as the amount by which the carrying value of the assetexceeds its fair value (see Note 3).

**Equity MethodInvestments**

Investee companies thatare not consolidated, but over which we exercise significant influence, areaccounted for under the equity method of accounting. Whether or not we exercisesignificant influence with respect to an investee depends on an evaluation ofseveral factors including, among others, representation on the investee company’sboard of directors and ownership level, which is generally a 20% to 50%interest in the voting securities of the investee company. Under the equitymethod of accounting, our share of the earnings or losses of the investeecompany is recognized and is reflected in the consolidated statements ofoperation in the caption “Equity in net income of investee.”  The carrying value of the investment isreflected in the condensed consolidated balance sheet in the caption “Equity innet assets of investee.”  We evaluate therecoverability of equity method investments whenever events or changes incircumstance indicate that its carrying amount may not be recoverable. A lossin value which is deemed other than temporary would result in recognition of animpairment loss.

**Debt Issuance Costs**

Debt issuance costs arecapitalized, included in other assets and amortized over the term of therelated debt issuance using the effective interest method. If the underlyingdebt instrument related to the debt issuance costs is a convertible debenture,upon conversion of such instrument by its holder the related unamortized debtissuance cost would be recognized as an expense immediately upon conversion.

**Long-Lived Assets**

Our policy is to recordlong-lived assets at cost, amortizing these costs over the expected usefullives of the related assets. In accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 144 *Accountingfor the Impairment or Disposal of Long-Lived Assets*, these assetsare reviewed on a periodic basis for impairment whenever events or changes incircumstances indicate that the carrying amounts of the assets may not berealizable. Furthermore, assets held and used in operations are evaluated forcontinuing value and proper useful lives by comparison to expected undiscountedfuture cash flows. If 

F-9

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

impairmenthas occurred, it is calculated based on the difference between the asset’scarrying value and the underlying discounted future cash flows it is expectedto generate.

**Income Taxes**

We account for incometaxes using an asset and liability approach for financial accounting andreporting purposes. A valuation allowance is provided when, based on the weightof available evidence, it is more likely than not that some portion or all ofthe deferred tax assets will not be realized.

**Revenue Recognition**

We recognize revenue whenthe following criteria are met: 1) persuasive evidence of an arrangementexists; 2) delivery has occurred or services have been rendered; 3) the salesprice is fixed or determinable; and 4) collectibility is probable. Revenue fromproduct sales is recognized upon shipment if all other revenue recognitioncriteria have been met. Customers are not granted return rights for reasonsother than warranty claims and product returns have not been material in anyperiod. Revenue for silicon wafer reclamation services is recognized when allservices have been rendered and the reclaimed wafer is shipped back to thecustomer, if all other revenue recognition criteria have been met. Revenue forsecurity services is recognized upon delivery of the services, if all otherrevenue recognition criteria have been met.

**Warranty**

We accrue for our productwarranty costs at the time of shipment. Product warranty costs are estimatedbased upon our historical experience and specific identification of theproducts’ requirements. Warranty costs have not been material in any period.

**Shipping Costs**

Our shipping and handlingcosts for product sales are included in cost of sales for all periodspresented.

**Research andDevelopment Expenditures**

Costs related to theresearch, design, and development of products are charged to research anddevelopment expenses as incurred.

**Fair Values ofFinancial Instruments**

The fair value of cash andcash equivalents, trade receivables, trade payables and capital leaseobligations approximates carrying value due to the short maturity of suchinstruments.

**Translation ofForeign Currencies**

We conduct substantiallyall of our transactions in U.S. dollars, except for certain transactions ofChemotrade that are conducted in Euros. The financial statements of Chemotradeare prepared in Euros and remeasured into U.S. dollars for purposes ofconsolidation, with the U.S. dollar as the functional currency. Gains andlosses from remeasurement and transaction gains and losses are included in thestatement of operations.

F-10

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Accounting forStock-Based Compensation**

We account for stock-basedcompensation to employees and directors using the intrinsic value method inaccordance with Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*and related interpretations, as permitted bySFAS No. 123 *Accounting for Stock-BasedCompensation*, as amended bySFAS No. 148 *Accounting for Stock-basedCompensation—Transition and Disclosure*. Compensation expense for stock options is measured as theexcess, if any, of the quoted market price of our stock at the date of grantover the amount an employee must pay to acquire the stock. No stock-basedemployee compensation costs relating to options is reflected within our netloss as all options granted had an exercise price equal to or greater than themarket value of the underlying common stock on the date of grant (though wehave recognized expense for warrants granted to external parties for servicesas disclosed in Note 12). We record compensation expense for restricted stockawards based on the quoted market price of our stock at the date of the grantand the vesting period.

Thefollowing table illustrates the effect on net loss and net loss per share if wehad applied 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. Contingentlyissuable shares are included in the computation of basic net income (loss) pershare when the related conditions are satisfied. Diluted net income (loss) pershare is computed using the weighted average number of common shares andpotentially dilutive securities outstanding during the period. Potentiallydilutive securities consist of contingently issuable shares, the incrementalcommon shares issuable upon conversion of preferred stock or convertible debt(using the “if converted” method) and shares issuable upon the exercise ofstock options and warrants (using the “treasury stock” method). Potentiallydilutive securities are excluded from the computation if their effect isanti-dilutive.

F-11

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

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 beanti-dilutive. As of April 30, 2005, (a) a total of 2,846,647outstanding stock options, (b) a total of 5,404,510 common stock warrants,(c) 6,666, 800 and 33,000 outstanding shares of Series A, D and EConvertible Preferred Stock, respectively, and (d) the unissued sharesunderlying our outstanding convertible debentures were excluded from thediluted net loss per share calculations, as their inclusion would be anti-dilutive.

**Recently IssuedAccounting Standards**

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (revised 2004) *Share-Based Payments*(“SFAS 123(R)”). Thisstatement requires that we record all share-based payment expense in our financialstatements based on a fair value methodology.  On April 14, 2005, the Securities andExchange Commission (“SEC”) announced amended compliance dates for SFAS 123(R).The SEC previously required companies to adopt this standard no later than July 1,2005, but the new rules now require us to adopt FAS 123(R) startingwith our first quarter of our fiscal year beginning May 1, 2006. Additionally,in March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB No. 107),which summarizes the staff’s views regarding share-based payment arrangementsfor public companies. We are evaluating the impact of the new standards and,although we have not completed our analysis, we anticipate that the expensewould not exceed the amounts disclosed in *Accountingfor Stock-Based Compensation*had we been expensing under the newrule.

In September 2005, the FASB ratified theconsensus reached by the Emerging Issues Task Force (“EITF”) on EITF Issue No. 05-08*Income Tax Consequences of IssuingConvertible Debt with a Beneficial Conversion Feature*(“EITF 05-08”).The EITF consensus noted that for the purpose of applying SFAS No. 109,Accounting for Income Taxes, (1) the issuance of convertible debt with abeneficial conversion feature results in a basis difference, (2) the basisdifference is a temporary difference and (3) the recognition of deferredtaxes for the temporary difference of the convertible debt with a beneficialconversion feature should be recorded as an adjustment to additional paid-incapital. The EITF also reached a consensus that the guidance in EITF 05-08should be applied to financial statements beginning in the first interim orannual reporting period beginning after December 15, 2005. The guidanceshould be applied by retrospective application pursuant to SFAS No. 154,Accounting Changes and Error Corrections, to all instruments with a beneficialconversion feature accounted for under EITF Issue No. 00-27, *Application of Issue No. 98-5 to Certain ConvertibleInstruments*. The adoption of EITF 05-08 has not had a materialimpact on our consolidated financial statements.

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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

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. Thelegal 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 issued SFAS No. 155,*Accounting for Certain Hybrid Financial Instruments*(“SFAS 155”), which amends SFAS No. 133, *Accountingfor Derivative Instruments and Hedging Activities* and SFAS No. 140,*Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities*. SFAS 155 simplifiesthe accounting for certain derivatives embedded in other financial instrumentsby allowing 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 and SFAS No. 140.SFAS 155 is effective for all financial instruments acquired, issued, orsubject to a remeasurement event occurring in fiscal years beginning after September 15,2006. We do not expect the adoption of SFAS 155 to have an impact on ourresults of operations or financial condition.

In March 2006, the FASB issued SFAS No. 156,*Accounting for Servicing of Financial Assets—anamendment to FASB Statement No. 140* (“SFAS 156”). SFAS 156requires that all separately recognized servicing rights be initially measuredat fair value, if practicable. In addition, this statement permits an entity tochoose between two measurement methods (amortization method or fair valuemeasurement method) for each class of separately recognized servicing assetsand liabilities. This new accounting standard is effective January 1, 2007.We do not expect the adoption of SFAS 156 to have an impact on our resultsof operations or financial condition.

In June 2006, the FASB ratified the consensusreached by the EITF on EITF Issue No. 05-01, *Accounting for the Conversion of an Instrument That BecomesConvertible Upon the Issuer’s Exercise of a Call Option*(“EITF 05-01”).The EITF consensus applies to the issuance of equity securities to settle adebt instrument that was not otherwise currently convertible but becameconvertible upon the issuer’s exercise of call option when the issuance ofequity securities is pursuant to the instrument’s original conversion terms. Theadoption of EITF 05-01 is not expected to have an impact on our resultsof operations or financial condition.

In July 2006, the FASBissued Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes—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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 2—FINANCIALSTATEMENT 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 equipmentconsists of the following (in thousands):

| ** **                                 | ** ** | **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 ended April 30,2006 and 2005, was $1,496,000 and $1,106,000, respectively. Such amountsinclude amortization on equipment under capital lease of $23,000 and $50,000for 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 issued 10,000 shares of common stock in a cashless exercise of acommon stock warrant, issued 2,734,017 shares of common stock upon conversionof convertible preferred stock and issued 6,206,897 shares of common stock uponconversion of convertible debentures. In the year ended April 30, 2005, wealso issued 363,719 shares of common stock in cashless exercises of 

F-14

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

commonstock warrants and issued 5,784,094 shares of common stock upon conversion ofconvertible preferred 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—GOODWILL AND OTHER INTANGIBLE ASSETS**

**Goodwill**

Changesin the carrying 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.

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Other IntangibleAssets**

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 in May 2005(see Note 4).

On September 14, 2001 we entered into a perpetual,exclusive technology license agreement with Silicon Evolution, Inc. (“SEI”)whereby we issued 500,000 shares of common stock (valued at $590,000) for theright to indefinitely use intellectual property assets owned or leased by SEI. Inour fiscal year 2005 and in connection with our ongoing business review of oursemiconductor operations, we determined that over the years SOI technology hadbeen substantially modified to adapt to our current manufacturing plant andthat the current processes are substantially removed from those acquired fromSEI. As a result, an impairment loss for the then unamortized balance of$428,000 was recognized in the impairment of goodwill and intangible assetscaption during the year ended April 30, 2005. The estimated fair value wasdetermined using the expected present value of future cash flows. The impairedintangible asset relates to the semiconductor products and services reportablesegment.

Amortizationexpense for the years ended April 30, 2006 and 2005, was $181,000 and $87,000,respectively. Estimated amortization expense for the intangible assets on our April 30,2006 balance sheet for the fiscal years ended April 30, is as follows (inthousands):

| 2007   |   | $   | 188    |   |
|--------|--------|-----|--------|--------|
| 2008   |   | 172 |   |
| 2009   |   | 34  |   |
| 2010   |   | 27  |   |
| 2011   |   | 27  |   |
|   |   | $   | 448    |   |

 

F-16

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 4—SIGNIFICANTACQUISITIONS AND COMBINATIONS**

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

On June 11, 2004, weacquired the business and assets of EMG, which was engaged in the business ofmanufacture and reclamation of silicon wafers. The results of the operationsassociated with the acquired assets have been included in the consolidatedfinancial statements since that date. The aggregate purchase price was$2,920,000, which consisted of a $1,700,000 promissory note, 731,930 shares ofour restricted common stock (valued at $1,171,000 based upon the fair marketvalue of the common stock on June 11, 2004) and $49,000 of legal andaccounting 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 accounting fees.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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Thefollowing table summarizes (in thousands) the final fair values of the assetsacquired and liabilities assumed at the date of acquisition.

| 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 thesecurity services 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 of April 30,2006, the unamortized balance of the intangible asset is $293,000. There was noin-process research and development acquired in this transaction.

Thefollowing table summarizes our results of operations (in thousands) for theyears ended April 30, 2006 and 2005, as if the acquisition of PPSC hadoccurred on May 1, 2005 and 2004, respectively. There have been noadjustments made to the 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 informationis presented for informational purposes only and is not necessarily indicativeof the results of operations that actually would have been achieved had theacquisition been consummated as of that time, nor is it intended to be aprojection of future results.

**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 TransferAgreement also 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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

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

**NOTE 6—DEVELOPMENTAND LICENSING AGREEMENT**

On December 5, 2005,we approved a development plan that resulted in us becoming obligated under aDevelopment & Licensing Agreement (the “Agreement”) entered into withLucent Technologies, 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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

developmentfee totaling $12,000,000. We paid $2,000,000 under this agreement during theyear ended April 30, 2006 and have charged $2,500,000 to research anddevelopment expense during the corresponding period. The balance will be paidin $1,000,000 increments approximately every three months thereafter (includinga payment of $1,000,000 made on June 2, 2006). These development paymentswill continue to be expensed to research and development expense as theexpenses are incurred. We have the right to terminate the development projectfor any reason from time-to-time, so long as termination is prior to the firstcommercial sale of a licensed product. When, if ever, commercial sales ofdeveloped products commence, a royalty payment based on revenue will be dueLucent (subject to a minimum semi-annual cumulative royalty payment amount). Additionally,if Lucent expends substantial sales effort to accomplish a sale, we will alsopay them a sales referral fee based on revenue. Lastly, in order to retain theexclusivity of our license for the developed technology, we have agreed to payan annual exclusivity payment commencing the October 1 following the firstcommercial sale or the end of the development project.

**NOTE 7—ASSETS HELDFOR SALE**

During the first quarterof fiscal year 2006, management committed to a plan to sell specific productionequipment in our semiconductor products and services segment. Based on ongoinganalysis of the semiconductor operations, these assets were deemed to beobsolete, unnecessary to support a more focused product portfolio orincompatible with the future direction of the segment’s operations. We havelisted these assets for sale and are actively attempting to sell them.Immediately prior to the decision to sell the assets, the equipment had acumulative net book value of approximately $1,026,000. In the first and fourthquarters of fiscal year 2006, certain assets have been written down to theirfair value, less selling costs, yielding a cumulative impairment loss on assetsheld for sale in the amount of $466,000. The assets held for sale are nowclassified in current assets at the lower of their book value or fair value,less selling costs, in the cumulative amount of $560,000. During the year endedApril 30, 2006, none of the assets held for 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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

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 threeactive lending facilities with financial institutions. Upon acquisition of PPSCin May 2005, there remained $376,000 on a bank term loan PPSC held withHSBC Bank USA, which is payable monthly through April 2008 and bears aninterest rate of 6.90%. As of April 30, 2006, the outstanding balance onthe loan is $259,000, of which $125,000 is a current liability. The note is notsecured by collateral and bears no significant financial covenants. A line ofcredit bearing an interest rate of 10.1% is available to Chemotrade in theamount of 100,000 Euros (approximately $128,000). There were no borrowingsunder the line of credit during the years ended April 30, 2006 and 2005,respectively. A letter of credit for $50,000 formerly held by Chemotrade andrelating to imports and exports expired on April 30, 2006. In March 2006,we entered into a note payable in the amount of $49,000 to fund the purchase ofa fixed 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 theacquisition of  the business and assetsof EMG in June 2004, we issued a $1,700,000 promissory note that iscollateralized by the assets acquired by us and certain other assets owned byus relating to our pre-existing semiconductor operations. The note wasoriginally payable over 33months, through March 2007, with an interestrate of 6% and has a current outstanding balance as of April 30, 2006, of$653,000. The note is payable by our subsidiary, IVI. In accordance with theterms of the acquisition of the business and assets of EMG, we have guaranteedall payments of such loan should IVI be in default at any point over the lifeof 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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

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 to April 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 the twentyfinal bid prices ending on the trading day immediately prior to the applicableinterest payment date or (ii) 90% of the average of the twenty final bidprices ending on the trading day immediately prior to the date the applicableinterest payment shares are issued and delivered if after the interest paymentdate.

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 on February 24,2005) unless our shareholders have approved the transaction as required by theNasdaq rules. As our shareholders approved the transaction on October 25,2005, the 19.999% contractual limitation as to the number of shares that can beissued is no longer be applicable, although the 4.99% limitation will continue 

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

to be applicable until (ifever) 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 each instrument.The $3,525,000 allocated to the Warrants was recorded as additional paid-incapital and as a corresponding reduction to the carrying value of the 8%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 withcompleting the financing arrangement, we paid a placement agent (i) a 6.5%fee consisting of $660,000 and a $770,000 convertible debenture and (ii) aCommon Stock Purchase Warrant granting the right to purchase 53,900 shares ofcommon stock (valued at $142,000 using the Black-Scholes pricing model). Theconvertible debenture and related debt issuance cost was measured at the fairvalue of the convertible debenture, $745,000. The total debt issuance costs of$1,547,000 were capitalized and are 

F-23

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

beingamortized to amortization of debt issuance costs over the life of the convertibledebenture using the effective interest method. During year ended April 30,2006, $1,260,000 of the capitalized debt issuance costs was amortized toexpense. At April 30, 2006, the unamortized debt issuance cost is $121,000.The terms of both the convertible debenture and the warrant are the same asthose for the accredited investors, as described above. The discount on theconvertible debenture is being amortized to interest expense over the term ofthe convertible debenture using the effective interest method.

*Payment of Principal and Interest inShares of Common Stock*

In our third fiscal quarter of our year ended April 30,2006, we determined that it had become probable that we would repay theprincipal portion of the 8% Debentures in common stock instead of cash. Assuch, we commenced accreting the aggregate 8% Debentures balance in ourconsolidated balance sheet to the fixed monetary amount of the obligation whensettled in common stock. If paid in common stock, the fixed monetary amount ofprincipal repayment would have been $25,875,000, as compared to $22,770,000 ifpaid 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 ended April 30,2006, we recorded additional interest expense of $1,392,000, representing theincreased accretion resulting from the probable repayment of the 8% Debenturesprincipal 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 ended September 30,2005. A charge in the amount of $506,000 was recorded as interest expenserelated to the share issuance, an amount that represents the fixed monetaryamount of the interest obligation when settled in stock (as opposed to a fixedmonetary amount of $455,000 if the interest payment had been made 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 ending February 2006and the one month of March 2006, respectively. In our statement ofoperations for the year ended April 30, 2006, charges in the amount of$337,000 and $89,000, respectively, were recorded as interest expense relatedto the share issuance, an amount that represents the fixed monetary amount ofthe interest obligation when settled in stock (as compared to a fixed monetaryamounts of $304,000 and $79,000, respectively, if the interest payments hadbeen made in cash).

See Note 17—SubsequentEvents for additional information about payments on our Debentures made inshares of our common stock.

*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 common stock.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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

temporary conversion priceof $1.45 per share (a reduction from the prior conversion price of $5.00 pershare). At the close of business on March 8, 2006, the closing price forour common stock was $1.64 per share. Additionally, we issued 10,036 shares ofour 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 conversion terms.As a result, for the year ended April 30, 2006, we recognized debtconversion expense in the amount of $7,227,000.

Thefollowing represents the scheduled maturities of long-term debt, excludingcapital leases, 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 |   |

 

**NOTE 10—COMMITMENTSAND CONTINGENCIES**

As of April 30, 2006we had commitments outstanding 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.

Werent additional office and production facilities under operating leasesexpiring through September 2013. Rent expense for operating leases was$468,000 and $308,000 for the years ended April 30, 2006 and 2005,respectively. Future minimum 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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Purchase commitment**

In December 2003 weextended our production, marketing and sales agreement with our supplier ofoxygen—18 through July 2010.  Theagreement originally required the purchase of certain quantities at prices tobe determined as a percentage of the then prevailing market price. In June 2006,we renegotiated 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 $5,100,000through the end of the agreement. During fiscal years 2006 and 2005, we madepurchases under this agreement of $2,638,000 and $3,380,000, respectively.

**Other contingencies**

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, wereceived notification from Nasdaq that we have failed to meet certain listingrequirements (including stockholders’ equity of at least $2.5 million or marketvalue of listed securities of at least $35 million). We were provided until July 26,2006 to regain compliance or face delisting procedures. Compliance can beobtained by, among other things, having stockholders’ equity in excess of $2.5million in a company’s most current filing with the SEC. Within theseconsolidated financial statements, our stockholders equity as of April 30,2006, is $2,643,000, which we believe will be sufficient to satisfy the issuesraised by Nasdaq in June 2006. On July 10, 2006, we received a secondletter from Nasdaq that advised us that the minimum bid price of our commonstock had closed at less than $1.00 per share over the previous 30 consecutivebusiness days, 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 to obtaincompliance.

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 11—INCOMETAXES**

Deferredtax assets (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                      |       | —             |       | — |   |
|                                               |       | $                  | —     |   | $ | — |   |

 

Incometax expense (benefit) consists of the following (in thousands):

| ** ** | ** ** | **April 30,** | ** ** |
|------------|------------|--------------------|------------|
| ** ** | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Current    |       |               |       |   |   |   |   |   |   |
| Federal    |       |               | $          | — |   |   |   | $ | — |   |   |
| State      |       |               | —     |   |   |   | — |   |   |
| Foreign    |       |               | —     |   |   |   | — |   |   |
|       |       |               | —     |   |   |   | — |   |   |
| Deferred   |       |               |       |   |   |   |   |   |   |
| Federal    |       |               | —     |   |   |   | — |   |   |
| State      |       |               | —     |   |   |   | — |   |   |
| Foreign    |       |               | —     |   |   |   | — |   |   |
|       |       |               | —     |   |   |   | — |   |   |
|       |       |               | $          | — |   |   |   | $ | — |   |   |

 

Areconciliation of our effective tax rate to the federal statutory tax rate of34% follows (in thousands):

| ** **                                                 | ** ** | **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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

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 is limitedto 1 million Euros of net income in a given year without restriction. Anyremaining loss can be offset against up to 60% of the net income exceeding thelimit.

We have established a fullvaluation allowance against the deferred tax assets because, based on theweight of available evidence including our continued operating losses, it ismore likely than not that all of 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 financialadvisory services agreement with Harborview Capital Management LLC, whereby weissued 100,000 shares of restricted common stock (valued at $140,000 based onthe market price of our common stock on the date of grant). The common stockwas recorded 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, weentered into a financial advisory services agreement with Clayton DunningCapital Partners, Inc., whereby we issued a common stock warrant  (valued at $152,000 using the Black-Scholespricing model) to purchase 100,000 shares of common stock at $2.81 per share. Thecommon stock warrant vested immediately, expires on September 8, 2007, andwas recorded as prepaid consulting expense, to be amortized ratably over theexpected service period of one year. As of April 30, 2006, $101,000 hasbeen expensed to selling, general and administrative expenses. In May 2006,we granted Clayton Dunning Capital Partners, Inc. a warrant to purchase anadditional 50,000 shares 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 theBlack-Scholes pricing model) to purchase 50,000 shares of common stock at $2.84per share. The common stock warrant vested immediately, expires on August 16,2007, and was recorded as prepaid consulting expense, to be amortized ratablyover the expected service period of eight months. As of April 30, 2006,the entire $75,000 has been expensed to selling, general and administrativeexpenses.

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 

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

immediately, areexercisable at $4.00 per share, expire on November 1, 2007 and wereexpensed to selling, general and administrative expenses during the year ended April 30,2005. In May 2005 (see the discussion of PPSC in Note 4) we acquired anentity 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 againstus in the United States District Court for the District of Colorado (Civil CaseNo. 05-F-562 (BNB). On October 31, 2006, a settlementagreement was signed in which no liability or wrongdoing was admitted. Inreturn for dismissal of the complaint, we paid the Plaintiff $50,000 and issueda common stock warrant (valued $109,000 using the Black-Scholes pricing model)to purchase 120,000 shares of common stock at $2.40 per share. The common stockwarrant vested immediately, expires on December 29, 2006, and was recordedas a selling, general and administrative expense in the three months ended October 31,2005. Further, the common stock warrant included a registration rights clausewhereby we agreed to use our best efforts to include the common stockunderlying the warrant in a registration statement by not later than May 31,2006. We included the shares underlying the warrant in a registration statementwhich was declared effective in April 2006.

**NOTE 13—STOCKHOLDERS’EQUITY**

**Preferred StockAuthorized**

Originally 10,000,000shares of preferred stock were authorized for issuance, while at April 30,2006, there were 7,650,000 shares remaining which may be issued. As of April 30,2006, there are nooutstanding shares of any series of our preferred stock, but there remain 2,500,000shares designated as Series B Preferred Stock, 22,000 shares designated asSeries C Preferred Stock, 32,950 shares designated as Series DPreferred Stock and 33,000 shares designated as Series E Preferred Stock. Thedesignation of rights, preferences, privileges and restrictions of the Series CPreferred Stock, Series D Preferred Stock, and Series E PreferredStock will be cancelled by filing an amendment to our articles of incorporationwith the California Secretary of State and thereby the shares will be returnedto undesignated “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 toAsset Managers International, Ltd. (“AMI”) for $3,300,000. In addition, we paidAMI $251,000 in due diligence fees and related expenses. Each common stockwarrant is 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 

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

$1.24 per share whilethe remaining half (307,000) of the common stock warrants had an exercise priceof $1.35 per share. As of April 30, 2006, common stock warrants exercisablefor a total of 153,500 shares of common stock remain outstanding. On July 27,2005, 23,000 shares of  Series EStock were converted into 1,854,838 shares of common stock. On October 19,2005, the remaining 10,000 shares of Series E Stock were converted into806,452 shares of common stock. As a result, as of April 30, 2006, therewere zero shares of Series 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 proceedsreceived between the Series E Stock and related warrants based on therelative fair value of each instrument. In addition, in accordance with EITF 00-27“Application of Issue No. 98-5 to Certain Convertible Instruments”we calculated the intrinsic value of the conversion option by using theeffective conversion price based on the proceeds allocated to the convertibleinstrument. As a result, we determined that the value of the beneficialconversion feature (based upon a $1.24 conversion price) contained in our Series EStock to be $1,206,000, which has been reported as a deemed dividend onpreferred stock for the year ended April 30, 2005.

**Series DConvertible Preferred Stock**

On April 5, 2004 wecompleted a financing arrangement whereby we issued 32,950 shares of our Series DConvertible Preferred Stock (“Series D Stock”) and 600,000 common stockwarrants to accredited investors who are affiliated with Mercator AdvisoryGroup, LLC (“MAG”) for $3,295,000. In addition, we paid MAG $230,000 in duediligence fees and related expenses and issued them a common stock warrant to acquire2,400,000 shares of our common stock. The common stock warrants, which wereexercisable for one share of common stock for between $1.10 and $1.30 pershare, were exercised in their entirety during the year ended April 30,2005. During the year ended April 30, 2005, 32,150 shares of Series DStock were converted into 2,922,726 shares of common stock. On May 19,2005, the remaining 800 shares of Series D Stock were converted into72,727 shares of common stock. As a result, as of April 30, 2006, there werezero shares of Series D Stock outstanding.

**Series CConvertible Preferred Stock**

On January 27, 2004we completed a financing arrangement whereby we issued 22,000 shares of our Series CConvertible Preferred Stock (“Series C Stock”) and 200,000 common stockwarrants to accredited investors who are affiliated with MAG for $2,200,000. Inaddition, we paid MAG $200,000 in due diligence fees and related expenses andissued them a common stock warrant to acquire 227,701 shares of our commonstock. Each common 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 CStock were converted (at $.95 per share) into 947,368 shares of common stock. Asa result of these conversions, there were no shares of Series C Stockoutstanding as of April 30, 2005.

F-30

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Series AConvertible Preferred Stock**

The Series A Stockoriginally consisted of 1,830,000 shares issued with a liquidation preferenceof $1.50 per share. During the year ended April 30, 2005, 957,000 sharesof Series A Convertible Preferred Stock (“Series A Stock”) wereconverted into 1,914,000 shares of common stock. As of April 30, 2005,there were 6,666 shares of Series A Stock outstanding convertible into13,332 shares of common stock based upon the current conversion ratio. On August 9,2005, we redeemed the remaining 6,666 outstanding shares of the Series AStock. As a result, the holder no longer is able to convert the shares and therights and preferences associated with the Series A Stock have beenterminated. 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 Planauthorized the grant to our key employees, officers, consultants or advisors ofincentive and nonqualified stock options to purchase shares of our authorizedbut unissued common stock. The maximum number of shares of our common stockavailable for issuance under this plan is 3.5 million shares. As of April 30,2006, there are 680,000 options outstanding and the maximum number of sharesavailable for future grants under this plan is 2,820,000 shares. The exerciseperiod shall not exceed ten years from the date of grant or three monthsfollowing the date of termination of employment, whichever occurs earlier. Theoption price shall not be less than the fair market value of the common stockon the date of grant.

*1996 Stock Option Plan*

The 1996 Stock Option Planauthorized the grant of incentive and nonqualified stock options to our keyemployees, directors or consultants. The options generally expire ten yearsfrom the date of grant. In September 1997, the Board of Directorsterminated the 1996 Stock Option Plan. As of April 30, 2006, there remain151,429 options outstanding and zero shares are available for grant under the1996 Stock Option Plan.

*Directors’ Stock Option Plan*

The 1998 Directors’ Planprovides that each person serving as a member of the Board, who is not anemployee of Isonics, receive options to purchase 20,000 shares of common stockwhen such person accepts his position as a director and to receive anadditional option to purchase 10,000 shares when such person is re-elected as adirector provided such person is not an employee of Isonics at the time ofelection (such amount was increased to 20,000 shares upon reelection as a directoreffective May 1, 2006). The exercise price for the options is the quotedmarket price on the date of grant and the options are exercisable for fiveyears from such date. The options granted under the directors’ plan vestimmediately. In the event a director resigns or is not re-elected to the Board,failure to exercise the options within three months results in the options’termination. As of April 30, 2006, options to purchase a total of 190,000shares were outstanding under the directors’ plan.

*Executive and Incentive Stock OptionPlans*

In November 1996 (andmodified subsequently), the Board of Directors adopted the Executives’Incentive and Incentive Stock Option Plans authorizing the granting of up to1,000,000 and 500,000 

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

incentiveand nonqualified stock options, respectively, to our key employees, directorsor consultants. 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. Optionsare exercisable when vested, typically over four to five years and expire fiveto ten years after the date of grant. In April 2005, the Board ofDirectors terminated the Executives’ Incentive and Incentive Stock Option Plans.As of April 30, 2006, options to purchase a total of 1,912,503 sharesremain outstanding and zero shares are available for grant under the Executive’sIncentive and Incentive Stock Option Plans.

*Employee Stock Purchase Plan*

The employee stockpurchase plan has reserved 200,000 shares of our common stock for sale to allpermanent employees who have met minimum employment criteria. Employees who donot own 5% or more of the outstanding shares are eligible to participatethrough payroll deductions. At the end of each offering period, shares arepurchased by the participants at 85% of the lower of the fair market value ofour common stock at the beginning or the end of the offering period. As of April 30,2006, 78,209 shares have been issued under the plan. As of May 1, 2006,the Employee Stock Purchase 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 SFAS No. 123disclosure-only provision information included in Note 1.

Forpurposes of the pro forma disclosures, the fair value of each option grant isestimated on the date of grant using the Black-Scholes option pricing modelwith the following weighted average assumptions for the years endedApril 30, 2006 and 2005, respectively; no expected dividends, volatilityof 100%; risk-free interest rate of 4.0%; and expected lives of three to fiveyears. A summary of the status of our stock option plans as of April 30,2006 and 2005, and changes during the years ended on these dates is presentedbelow.

| ** **                        | ** ** | ** **         | ** ** | **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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

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.

Thefollowing information 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 inconnection with debt offerings, private placements of both common andconvertible preferred stock, our IPO, services, legal settlements and asconsideration for concessions from lenders and vendors. A summary of theactivity 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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Theoutstanding warrants 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)          The expiration date ofthe Class B Warrants and Class C Warrants was extended from December 31,2005, to December 29, 2006, in June 2005.

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

**Extension ofWarrant Expiration Dates**

On June 17, 2005, we extended the expiration dateof the Class B Warrants and the Class C Warrants from December 31,2005, to December 29, 2006, via an amendment to the Warrant Agreement. Therewere no other changes made to the terms and conditions of the Warrant Agreement.The holders of these warrants had been unable to exchange the warrants forregistered shares of our common stock since October 2004, at which timethe underlying registration statement was no longer current. We attempted tofile a post-effective amendment to the respective registration statement, butwe were unable to do so because our former auditor, Grant Thornton LLP, wasunwilling to consent to the inclusion of its report on our April 30, 2004and 2003, financial statements in the post-effective amendment. In the firstquarter of our fiscal year 2006, we recorded a non-cash charge in the statementof operations in the amount of approximately $300,000, such charge representingthe excess of the fair value of the amended warrant over the fair value of theoriginal warrant immediately prior to amendment.

On December 29, 2005,we extended the expiration date of certain warrants to purchase 232,500 sharesof common stock at an exercise price of $1.25. The warrants were initiallyissued in a financing transaction and the holder of the warrants had, for aperiod of time as described in the Class B and C Warrant disclosure above,an inability to exercise the warrants for registered shares of our common stock.The expiration date of the warrants was extended from December 31, 2005,to December 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 amulti-employer retirement savings plan qualified under section 401(k) ofthe Internal Revenue Code. The plan is a defined contribution plan, coveringsubstantially all of our non-PPSC employees. Our contributions to the planaggregated approximately $104,000 and $82,000 for the years ended April 30,2006 and 2005, respectively.

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 15—BUSINESS SEGMENT, GEOGRAPHIC, CUSTOMER ANDPRODUCT INFORMATION**

**Segment information**

We currently have fourreportable segments: homeland security products, security services,semiconductor products and services and life sciences. Our homeland securityproducts segment is currently marketing and developing certain trace and bulkdetection technologies. Our security services segment provides advancedsecurity and investigative services and is substantially comprised of theoperations of PPSC which was acquired in May 2005. Our semiconductorproducts and services segment (formerly called the “semiconductor materials andproducts” segment) manufactures and reclaims silicon wafers, sells SOI wafersand is involved in several research and development projects including silicon-28.Our life sciences segment sells stable and radioisotopes in elemental andsimple compound forms for use in life sciences applications. Our segments arestrategic business units, each of which consists of similar products orservices. They are managed separately because each segment requires differenttechnology and marketing strategy and because each segment sells to differentcustomers. Reconciling items consist primarily of corporate assets or expensesthat have not been allocated to a specific reportable segment. Prior periodamounts have been reclassified to conform to current period presentation.

Information by segment isset forth below (in thousands):

| ** **                               | ** ** | **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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

(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 ouroperations by geographic area is presented 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 ofnet revenue from external sources is based on the Isonics sales locationgenerating the respective sales. The shipment locations corresponding to therespective customers may be outside that geographic area. The geographicsummary of long-lived and total assets is based on physical location. Duringthe year ended April 30, 2006, we elected to close the Chemotrade officedue to increasing supplier prices causing the loss of substantially all of ourradioisotope customers.

**CustomerInformation**

Two customers (Foot LockerRetail, Inc.and Qimonda Richmond LLC, formerly Infineon TechnologiesRichmond) accounted for approximately 17% and 10% of revenues, respectively,for the year ended April 30, 2006. Two customers (Eastern Isotopes, Inc.and  PerkinElmer, Inc.) accountedfor approximately 19% and 10% of revenues, respectively, for the year ended April 30,2005. As of April 30, 2006, three customers accounted for approximately30% of total net accounts receivable. As of April 30, 2005, threecustomers accounted for approximately 29% of total net accounts receivable. Adecision by a significant customer to substantially decrease or delay purchasesfrom us or an inability to collect significant amounts owed to us could have amaterial adverse effect on our consolidated financial condition and results ofoperations.

**Product Information**

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

F-36

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**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 on December 31,2002 and required a monthly payment of 5,500 Euros (approximately $7,000)for the services to be provided. The consulting agreement was renewed for termsof one year on January 1, 2005 and 2004 and required monthly payments of5,500 Euros. The consulting agreement was not renewed for calendar year 2006.

PPSC continues to leasepremises partially owned by a former owner who is a current employee of PPSC.  The lease term was originally for thefour-year period ended May 15, 2009. Annual rent payments were originally$48,000 in each of the four years of the lease term. In March 2006, weamended the lease from a fixed term to a month-to-month term and increased themonthly base rent to $4,500 per month. Additionally, we reimburse the landlord80% of the costs incurred by the landlord for taxes, maintenance of commonareas and fire and hazard insurance as well as the entire amount of the premiumincurred for rental loss insurance.

**NOTE 17—SUBSEQUENTEVENTS**

**Investment in ISCONVideo Imaging, Inc.**

ISCON Video Imaging, Inc.(“ISCON”) is a company that is attempting to develop patent-pending infraredimaging-based technologies for the non-invasive detection of objects hiddenunder clothing as well as technology for the determination of the chemicalcomposition of such objects to identify explosives and drugs. On May 12,2006, we signed a stock purchase agreement with ISCON that provides us theoption, but not the obligation, to purchase authorized but unissued shares of Series Bcommon stock 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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

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 on May 31,2006, we paid approximately $4.1 million from the proceeds of the financing tothe holders accepting our offer. This payment resulted in a reduction in theprincipal balance of the 8% Debentures of $3,880,000.

As a result of enteringthe financing transaction discussed below, which includes a fixed conversionprice of $1.25, the warrants associated with the 8% Debentures were amended perthe warrant such that the warrant exercise price was reduced from $6.25 pershare of common stock to $1.25 per share of common stock. Simultaneously, thenumber of shares purchasable under the warrants increased from 1,593,900 to7,969,500. Due to our offer made on May 18, 2006, to the holders of the 8%Debentures and the acceptance of the offers by certain holders, of thecurrently outstanding warrants associated with the 8% Debentures, warrants topurchase 4,557,000 shares of common stock have a price ratchet only whereby nochange to the number of shares purchasable will occur and warrants to purchase3,412,500 shares of commons stock continue to retain the original ratchetprovisions.

Having met allrequirements to allow us to do so, we elected to make the monthly principal andinterest payments due for our 8% Debentures on May 1, 2006, andJune 1, 2006, in shares of our common stock. Accordingly, we issued atotal of 1,616,433 and 1,997,265 shares of common stock, respectively, insettlement of (1) principal amounts owed on the 8% Debentures in theamounts of $1,822,500 and $1,647,500, respectively and (2) interestobligations for the months of April 2006 and May 2006 in the nominalamounts of $66,500 and $21,250, respectively. As discussed in Note 9—Borrowings,as the payments were made in stock in lieu of cash, the fixed monetary amountsof the principal and interest payments will have a larger impact on theconsolidated financial statements as compared to the nominal amounts disclosed.This difference is due to applicationof the fixed discount applied to the price of our common stock in thecalculation of the number of common shares due for each principal payment andinterest payment when made in shares of our common stock, as defined. Weelected to make our monthly principal and interest payment due on July 1,2006 in cash. This payment included a reduction to outstanding principal of$562,000 and interest in the amount of $17,500. Subsequent to this payment, the outstanding principal balanceon the 8% Debentures was $2,062,500.

In June 2006, one ofthe two remaining holders of our 8% Debentures, with remaining principaloutstanding in the amount of $312,500, asserted that the issuance of the 6%Convertible Debentures (see discussion below) constituted a default (due to apotential variable conversion provision contained within the 6% ConvertibleDebenture agreement) under the 8% Debentures. We have contested that allegationon several bases and will defend against any further allegation of default asnecessary.  As outline in Note 9—Borrowings,remedies for an event of defaultinclude the option to accelerate payment of the full principal amount of thedebentures, together with interest and other amounts due, to the date ofacceleration. The principal amount of the debentures shall be equal to 130% ofthe then-principal amount of the debentures plus all interest and other amountsdue or a conversion 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

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**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. TheFixed Conversion Price will be adjusted to mirror the conversion, exchange orpurchase 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.

·       Weare prohibited from issuing shares of our common stock to the holders of the 6%Debentures (upon conversion or payment of interest) and the 6% DebentureWarrants (upon exercise) if the 

F-39

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

issuance would result inCornell beneficially owning more than 4.99% of our outstanding common stock(although Cornell can waive this provision upon more than 65 days’ noticeto us).

·       Until(and if) the shareholders approve the transaction as required by Nasdaq rules,the number of shares issuable upon conversion of the 6% Debentures shall not begreater than 6,075,785, which along with the Buyers Shares and the 2,000,000warrant shares exercisable at $1.25 represent less than 19.99% of the totalnumber of shares outstanding on May 31, 2006.

·       Cornellis prohibited from selling shares related to the 6% Debentures until the laterof the related registration statement achieving effectiveness or September 28,2006 (120 days subsequent to the issuance of the first 6% Debenture).

·       BetweenSeptember 29, 2006, and January 26, 2007, if converting using theMarket Conversion Price, Cornell is limited to converting no more than $200,000of the principal or accrued interest on the 6% Debentures into shares of ourcommon stock in any seven calendar day period.  Subsequent to January 26, 2007, ifconverting using the Market Conversion Price, Cornell is limited to convertingno more than $400,000 of the principal or accrued interest on the 6% Debenturesinto shares of our common stock in any seven calendar day period.

·       Themaximum number of shares that may be issued upon conversion of the principalamount 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 file an initialregistration statement to register 8,735,785 shares of common stock underlingno later than August 7, 2006 (a registration statement was filed on June 7,2006) and to have the initial registration statement declared effective bySeptember 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 

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

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 topay liquidated 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) securitiesissued in connection with a strategic partnership or joint venture, (2) securitiesissued as consideration for a merger or consolidation or the acquisition of abusiness, product, license or other asset of another person or entity, (3) options(priced not less than at the market) provided to employees within the firstthirty days of employment, (4) securities issued pursuant to an approvedstock plan, (5) up to 1 million shares (priced not less than market) whichmay be issued as long as no registration rights are included and as long as notpursuant to a Form S-8 and (6) any other issuances to holdersof other pre-existing securities if such issuances are provided for in theterms 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 the then-existingwarrant exercise price. If an adjustment is triggered, the warrant exerciseprice for the warrant for 2,000,000 shares at an exercise price of $1.25 pershare and the warrant for 3,000,000 shares at an exercise price of $1.75 pershare will be adjusted to a price determined by multiplying such exercise priceby a fraction of which (a) the numerator shall be the number of shares ofcommon stock outstanding immediately before such issuance plus the number ofshares of common stock that the aggregate consideration received by us for suchissuance would purchase at the warrant exercise price then in effect and (b) thedenominator shall be the number of shares of common stock outstandingimmediately prior to such issuance plus the number of new shares to be issuedin the triggering event. Concurrently, the number of shares issuable upon exercise of the warrantwill be adjusted such that the aggregate exercise price would be equal to theaggregate exercise price prior to adjustment. The warrant for 3,000,000 sharesexercisable at $2.00 per share has a different adjustment calculation whereby asubsequent 

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**Isonics Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

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.

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