**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-K**

**(Mark One)**

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

**For the fiscal year ended April 30, 2007**

**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**

(Nameof 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)          |

 

Registrant’stelephone number, including area code:**(303) 279-7900**

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

**Securitiesregistered pursuant to Section 12(g) of the Exchange Act:**

**CommonStock, no par value**

(Titleof Class)

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

Checkwhether the issuer is not required to file reports pursuant to Section 13or 15(d) of the Exchange Act: o

Checkwhether the issuer (1) filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the past twelve (12) months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days. Yes x  No o

Checkif there is no disclosure of delinquent filers in response to Item 405 ofRegulation S-K contained in this form, and no disclosure will be contained, tothe best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

Indicateby check mark whether the Registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule 12b-2).
| Large accelerated  filer o | Accelerated filer o | Non-accelerated  filer x |
|---------------------------------|--------------------------|-------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act): Yes o  No x

Theaggregate market value of the common stock held by non-affiliates of theRegistrant as of October 31, 2006 was approximately $28,775,000 based uponthe closing sale price of the Registrant’s Common Stock on such date, asreported on the Nasdaq Capital Market. Shares of Common Stock held by eachexecutive officer and director and each person owning more than 10% of theoutstanding Common Stock of the Registrant have been excluded in that suchpersons may be deemed to be affiliates of the Registrant. This determination ofaffiliate status is not necessarily a conclusive determination for otherpurposes.

Thenumber of shares outstanding of the Registrant’s Common Stock, no par value, asof July 20, 2007, was 12,658,150 shares.

The Registrant’s proxy statement is incorporated byreference into Part III of this Form 10-K.

 

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**Tableof Contents**

|                   | ** ** | ** **                                                                                                              | ** ** | **Page** | ** ** |
|-------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
|              |       | Forward-Looking  Statements                                                                                             |       | 1        |       |
| **Part I**   |       | 1                                                                                                                       |       |
| Item 1.           |       | Business                                                                                                                |       | 1        |       |
| Item 1A.          |       | Risk  Factors                                                                                                           |       | 13       |       |
| Item 1B.          |       | Unresolved Staff Comments                                                                                               |       | 22       |       |
| Item 2.           |       | Properties                                                                                                              |       | 22       |       |
| Item  3.          |       | Legal  Proceedings                                                                                                      |       | 22       |       |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                                                     |       | 22       |       |
| **Part II**  |       | 23                                                                                                                      |       |
| Item 5.           |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 23       |       |
| Item 6.           |       | Selected Financial Data                                                                                                 |       | 30       |       |
| Item 7.           |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                             |       | 31       |       |
| Item 7A.          |       | Quantitative and Qualitative Disclosures About Market  Risk                                                             |       | 50       |       |
| Item 8.           |       | Financial Statements and Supplementary Data                                                                             |       | 51       |       |
| Item 9.           |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                                   |       | 51       |       |
| Item 9A.          |       | Controls and Procedures                                                                                                 |       | 51       |       |
| Item  9B.         |       | Other  Information                                                                                                      |       | 51       |       |
| **Part III** |       | 51                                                                                                                      |       |
| Item 10.          |       | Directors, Executive Officers and Corporate Governance                                                                  |       | 51       |       |
| Item 11.          |       | Executive Compensation                                                                                                  |       | 51       |       |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters          |       | 51       |       |
| Item 13.          |       | Certain Relationships and Related Party Transactions                                                                    |       | 51       |       |
| Item 14.          |       | Principal Accountants Fees and Services                                                                                 |       | 52       |       |
| **Part IV**  |       | 52                                                                                                                      |       |
| Item 15.          |       | Exhibits and Financial Statement Schedules                                                                              |       | 52       |       |
|              |       | Signatures                                                                                                              |       | 55       |       |

 

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**FORWARD-LOOKINGSTATEMENTS**

*Certain statements in this report, other than purelyhistorical information, including estimates, projections, statements relatingto our business plans, objectives and expected operating results, and theassumptions upon which those statements are based, are “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933 and Section 21E ofthe Securities Exchange Act of 1934. These forward-looking statements generallyare identified by the words “believe,” “expect,” “intend,” “estimate,” “anticipate,”“project,” “will,” “plan,” “will continue,” “will likely result” and similarexpressions. Forward-looking statements are based on current expectations andassumptions that are subject to risks and uncertainties which may cause actualresults to differ materially from the forward-looking statements. A detaileddiscussion of these and other risks and uncertainties that could cause actualresults and events to differ materially from such forward-looking statements isincluded in the section entitled “Risk Factors” (refer to Item 1A). Weundertake no obligation to update or revise publicly any forward-lookingstatements, whether as a results of new information, future events orotherwise.*

**PART I**

**ITEM 1.**                BUSINESS

**General Discussion**

We are focused on the development and provision ofhomeland security products and services and the manufacture of 300-millimeter(and smaller diameter) silicon wafer reclaim and test products, wafer thinningand custom wafer products for the semiconductor industry. In June 2007 wesold our life sciences business (which supplied isotopes for life sciences andhealth-care applications) as it no longer fit our long-term strategy for buildinga sustainable and profitable homeland security and semiconductor company andbecause of deteriorating business conditions in the historical revenueproducing products in this business.

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.”Although our common stock is quoted on the Nasdaq Capital Market, our stock hasat times traded at prices below the $1.00 per share minimum Nasdaq maintenancerequirements. In addition, we have at times failed to meet the listingrequirement of stockholders’ equity of at least $2.5 million or market value oflisted securities of at least $35 million. While we are currently in compliancewith the Nasdaq maintenance requirements, if the price of our common stock wereto drop or if we failed to meet the minimum stockholders’ equity and marketvalue requirements, we would be at risk of Nasdaq action to remove oursecurities from its Capital Market. We cannot give any assurance that we willcontinue to meet the Nasdaq requirements to maintain our Capital Marketlisting, or that if we do, a stable trading market will develop for our stock.

Effective February 13, 2007 we implemented areverse stock split whereby every four shares of our common stock that wereissued and outstanding were automatically combined into one issued andoutstanding share without any change in the par value of such shares. Thereverse split affected all holders of our common stock uniformly and did notaffect any shareholder’s percentage ownership interest in Isonics, except tothe extent the reverse split resulted in any holder being granted a whole sharefor any fractional share that resulted from the reverse split. All shares ofour common stock and shares of common stock underlying options, warrants andconvertible debentures were proportionately reduced and the exercise prices ofany warrants or options and the conversion prices of any convertible debentureswere proportionately increased by the reverse stock split.

Our outstanding Class B and Class C commonstock warrants expired on December 29, 2006, and as a result are no longerexercisable for shares of common stock.

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

Isonics Corporation5906 McIntyre StreetGolden, Colorado 80403TelephoneNo.: (303) 279-7900Facsimile No.: (303) 279-7300

During our year ended April 30,2007, we raised over $12,800,000 (net of expenses and $4,100,000 of payments onour 8% Convertible Debentures (“8% Debentures”)) through the issuance of both13% Convertible Debentures and 6% Convertible Debentures, which weresubsequently modified to 13% Convertible Debentures. The modified 13%Convertible Debentures with a face value of $16,000,000 (the “2006 Debentures”)along with the 13% Convertible Debentures with a face value of $2,000,000issued in April 2007 (the “April 2007 Debenture”) are collectivelyreferred to as (the “13% Debentures”). As a result of this financing, webelieve we currently have enough working capital to finance our anticipatedoperations and projected negative cash flow into our quarter ending January 31,2008.

*Subsidiaries*

Wecurrently conduct some of our operations through subsidiaries. The followingchart provides some information about those subsidiaries:

| Name and Headquarters             | ** ** | ** **      | ** ** | **Place of   Formation** | ** ** | **Ownership   Percentage**                                                                                                                                                                                                                                                                                                                                   | ** ** | **Business** |
|-----------------------------------|------------|-----------------|------------|--------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|
| Isonics Homeland                  |       | Delaware,       |       | 100%                     |       | Isonics Homeland Security and Defense                                                                                                                                                                                                                                                                                                                        |
| Security and Defense  Corporation |       | USA             |       |                     |       | Corporation (“HSDC”) was formed in October 2004  and it coordinates our efforts in the homeland security market and is  attempting to commercialize the detection technology that we acquired from Institut fur  Umwelttechnologien GmbH (“IUT”).                                                                                   |
| SenseIt Corp                      |       | Delaware, USA   |       | 90% by HSDC              |       | Our joint venture with  SenseIt Corp (“SenseIt”) was formed in October 2006 with the purpose of  accelerating development and driving commercialization of next generation  infrared imaging and night vision surveillance technology in connection with  our development agreement with Lucent Technologies, Inc. (“Lucent”). |
| Protection Plus                   |       | New York,       |       | 100% by                  |       | Protection Plus Security  Corporation                                                                                                                                                                                                                                                                                                                        |
| Security Corporation         |       | USA             |       | HSDC                     |       | (“PPSC”) is a provider of advanced security and  investigative services for leading businesses and institutions.                                                                                                                                                                                                                                   |
| Isonics Vancouver, Inc.      |       | Washington, USA |       | 100%                     |       | Isonics  Vancouver, Inc. (“IVI”) operates our semiconductor operations in  Vancouver, Washington.                                                                                                                                                                                                                                             |

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| 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. |
|---------------------------------------|--------|---------|--------|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

The foregoing doesnot include our minority ownership in three companies:

·       Wehave a 30% interest in IUT, an entity based in Berlin, Germany, which performsresearch and development and manufactures 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 6% 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 identifyexplosives and drugs

The purchase and ownershipof our common stock involves a high degree of risk. See Item 1A*. “*Risk Factors”, below. We have notauthorized anyone to give you information or to make any representation otherthan those contained in this annual report.

**Trading Symbol**

| Common Stock |   | “ISON” |
|--------------|--------|------------------|

 

**Lines of Businessand Products**

During the years ended April 30, 2007, 2006 and2005, we generated sales from stable and radioactive isotopes, silicon waferreclaim and test products, wafer thinning and custom wafer products for thesemiconductor industry. Additionally, as a result of the acquisition of PPSC inMay 2005, we also generated revenues from providing security services forleading businesses and institutions in healthcare, education, retail,manufacturing, banking and the art world. For information about revenue forsimilar classes of products or services, refer to Note 16 (Business Segment,Geographic, Customer and Product 

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information) to theconsolidated financial statements located in Item 8. “Financial Statements andSupplementary Data”

In June 2007 we sold our life sciences business(which supplied isotopes for life sciences and health-care applications) as itno longer fit our long-term strategy for building a sustainable and profitablehomeland security and semiconductor company and because of deterioratingbusiness conditions in the historical revenue producing products in thisbusiness. Accounting rules required us to treat the operations of the lifesciences business as discontinued operations whereby the net financial impactof the operations of the business (including revenue) is combined into a singleline item and prior periods are reclassified for this presentation. Revenue forthe life sciences business, reported in the single line item of discontinuedoperations, was $1,803,000, $5,136,000 and $7,413,000 for the years ended April 30,2007, 2006 and 2005, respectively.

The following is a morespecific discussion of our current operations.

*Homeland Security*

HSDC focuses the majority of our efforts in thehomeland security sector. These efforts include entry into the securityservices market through our acquisition of PPSC in May 2005, acquisitionand continuing development of our Ion Mobility Spectrometry (“IMS”) baseddetection technology and our entry into an agreement with Lucent and a 90%owned joint venture named SenseIt to develop innovative infrared imaging andnight vision surveillance technology. HSDC’s ownership also includes our 30%minority interest in IUT. The following is a detail of each of our productlines within our homeland security operations:

**SecurityServices****—**In May 2005,we acquired PPSC, a provider of security services located in New York, NewYork. Since the effective date of the acquisition, PPSC has deliveredsignificant revenue to our consolidated financial statements and has providedgross margin of approximately 23.7% of revenues for the year ended April 30,2007. The segment has, however, generated an operating loss for the years endedApril 30, 2007 and 2006 of $(425,000) and $(24,000), respectively. Duringthe years ended April 30, 2007 and 2006, the operating loss includesnon-cash amortization of acquisition-related customer intangibles andstock-based compensation expense (year ended April 30, 2007 only) in theamount of $230,000 and $138,000, respectively. Included in the operating lossfor the year ended April 30, 2007, is enhanced staffing for growth in thebusiness as well as the costs incurred in relocating the office of PPSC.

During the fourth quarter of the year ended April 30,2007 and the first quarter of the subsequent fiscal year, we implemented costcutting initiatives that are expected to positively impact the results of PPSC’soperations. Additionally we initiated plans to improve operating margins atPPSC by focusing on customers that are willing to pay for premium securityservices, a market in which we believe that PPSC is able to differentiateitself from its peers. As a result, we have and will exit lower-margin businessareas for premium accounts that prefer higher quality of service. While webelieve that these cost cutting initiatives and refocused sales and marketingefforts will enable PPSC to report positive operating income for the yearending April 30, 2008, we can offer no assurance that this will actuallyoccur.

PPSC has successfully obtained its federal GovernmentContract Schedule (“GSA Schedule”) for security services. Although we haveselectively pursued and continue to pursue government contracts in addition tocommercial contracts, we have not acquired any federal government securitycontracts to date and we can offer no assurance that we will be able to do so.

**DetectionTechnology—****During**our year ended April 30,2007, we marketed our existing IMS-based products (the panel-mounted IMS andEnviroSecure), although we have not engaged in any significant marketingefforts for either product during the second half of our year ended April 30,2007. Although we continue to offer EnviroSecureTM, a system that can monitorand identify chemical weapons and toxic 

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substances in the air in avariety of venues including airports, mass transit facilities, sports venuesand public and private sector office buildings, we have not made any sales ofthis product or engaged in any significant marketing activities.

In November 2005, we signed a developmentagreement with DualDraw LLC (“Dual Draw”), a manufacturer of air qualityequipment. Under this agreement, we worked to incorporate our panel-mountedIMS-based system into the DualDraw mailroom inspection workstation, a downdraftworkstation that keeps toxic substances away from the breathing zone ofmailroom workers who are sorting or opening mail and captures such substanceswith a HEPA (high efficiency particulate air) filtration system. Theincorporation of our IMS capability provides an alarm if certain toxic orexplosive substances are detected. We completed seven commercial installations of our panel-mounted IMS-basedproduct in the AirChx system manufactured by Dual Draw during the year ended April 30,2007 as well as an additional eight units subsequent to year-end. We have notreceived any further purchase commitments for our product to be incorporatedinto the AirChx system at this time. The proceeds related to the installation of the first seven commercialunits during the year ended April 30, 2007 are primarily being classifiedas deferred revenue pending completion of certain tasks. We are continuing towork with Dual Draw to resolve any remaining issues, and we are working withIUT to prepare a version of the panel-mounted product for a test by a differentpotential customer.

During the latter half of the year ended April 30,2007, we redefined and refocused the operations of HSDC to focus on thedevelopment of partnerships with leading prime contractors in the security anddefense, industrial and transportation markets, although we have not yetdeveloped any such partnerships. By working with these types of partners, webelieve that we will be able to more effectively and efficiently complete thedevelopment of our IMS-based products with the goal of incorporating them intothe products and systems of our partners. If we are successful in developingthese types of strategic partnerships, we believe that we will be in a betterposition to compete with the current industry leaders through leveraging themarketing arms and customer bases of these partners. This change in strategicdirection will delay the time frame for significant product sales but we arehopeful that it will allow for a significant reduction in development costs anda greater penetration of the market in the future.

IMS is a “sniffer” technology originally developed byIUT. The IMS technology is designed to continuously monitor the air and almostimmediately detect and identify harmful substances at the parts per billion(ppb) level, providing, in a matter of seconds, warning of a possible threat. Throughboth our ongoing funding of research and development efforts at IUT and relateddevelopment and commercialization efforts in the United States, we arecurrently in the process of re-designing the IMS technology for low-cost,high-volume manufacturing in the United States. Additionally, we have receivedall regulatory licenses required for domestic sales of such products.

We have also investigated our ability to package ourIMS technology in a hand-held “sniffer” designed for military and firstresponder use. Although we are not actively developing a final product for thehand-held product, we may do so in the future when we determine that marketconditions for such a product are favorable and provided we have sufficientresources to do so.Although we are hopeful that our year ending April 30, 2008 will reflectsignificantly greater revenues from IMS-based products (as compared to the yearended April 30, 2007), we cannot offer any assurance that this willactually occur.

**InfraredImaging Technology—****In**December, 2005, we approved adevelopment plan that resulted in us becoming obligated under a Development andLicensing Agreement we entered into with Lucent in September 2005 (“theLucent Agreement”) which, in October 2006, we assigned to our 90% ownedsubsidiary, SenseIt, which is described in more detail below. Under the LucentAgreement, we are attempting to develop a next-generation infrared imaging andnight vision surveillance technology based on Lucent’s micro electro-mechanicalsystems (“MEMS”) technology under development at its nanotechnology fabricationfacility. Infrared technology, which converts infrared radiation in the 

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non-visiblespectrum, such as body heat, into a visible image, is commonly found in bothcommercial and military/homeland security applications including night visiongoggles and cameras, rifle scopes and threat detection devices used to identifyconcealed weapons or explosives. The MEMS approach to infrared imaging, ifsuccessful, may lead to products which we believe will at least equal theperformance of, with a lower power consumption and price than, productscurrently available in the marketplace today. Additionally, a MEMS-basedproduct may also provide for cost efficiencies in the manufacturing process. Thedevelopment plan contemplates a proof-of-concept during calendar year 2007,followed by steps towards commercialization, though we can provide no assurancethat a commercially attractive product will ultimately be available.

In October 2006, we acquired a 90% interest inSenseIt in exchange for assigning to SenseIt all of our interest under theLucent Agreement, although we will continue to be jointly and severally liablewith SenseIt to Lucent for amounts due to Lucent under the assigned Lucentagreement. The remaining 10% of SenseIt is owned by Christopher Toffales (ourChairman of the Board), who also serves as President and Chief ExecutiveOfficer of SenseIt. In addition we agreed to fund an additional $353,500 ofworking capital to SenseIt which has yet to be paid. As long as SenseItcontinues to make its quarterly $1,000,000 payments to Lucent, Lucent willcontinue to work with SenseIt to develop prototypes of its first product line, “directview” thermal imagers for weapons sights and night vision goggles andanticipates completing these prototypes during calendar year 2007. In addition,SenseIt, in conjunction with Lucent, is also pursuing a more traditional focalplane array product suitable for integration into thermal imaging cameras, aswell as an advanced solid state imager approach to create a “Multi-SpectralSensor” which can detect infrared and visible light (or two spectra of infraredlight) simultaneously.

The Lucent Agreement provides for SenseIt to receivean exclusive right, except for certain rights reserved by Lucent, to make, useand sell licensed products arising from technology developed under the LucentAgreement. In exchange for this license, we (through our obligations toSenseIt) are funding certain of Lucent’s development efforts for the projectthrough the periodic payment over a two and one-half year period of adevelopment fee totaling $12,000,000. We (through our obligations to SenseIt)paid $6,000,000 of the original $12,000,000 obligation under this agreementthrough the date of this report. The remaining balance will be paid in quarterly$1,000,000 installments.

We did not make the $1,000,000 payment that was due toLucent on July 16, 2007 as neither entity currently has sufficient workingcapital to make such payment. As a result of not making this payment (or otherpayments when due), Lucent may, after certain steps of notification and periodsto cure have been exhausted, cancel the Lucent Agreement and all licensesgranted to us thereunder or cease working on the project and then assess us a “start-up”fee if funding was to resume.

On July 26, 2007, we received officialnotification from Lucent that we failed to make the $1,000,000 payment toLucent by July 16, 2007 and that in the event such non-payment continuesfor more than ten days, Lucent may at is discretion, suspend work on thedevelopment project. We are currently seeking additional financing to allow usto fund SenseIt so that SenseIt can make its contractual development paymentsto Lucent. We cannot offer any assurance that we will be able to raise thefunds necessary to make all of the required payments to Lucent, or that thetechnology will be developed to a point where we want to continue to make suchpayments when due. Additionally, SenseIt may need to seek outside financing tomake payments to Lucent and, if so elected, such outside financing would diluteour ownership interest in SenseIt. Lastly, although we are hopeful of apositive outcome, we can offer no assurance that the development activityunderway with Lucent and SenseIt will yield technologically relevant orcommercially viable products.

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SenseIt has the right to terminate the developmentproject for any reason (including if the development work is not proceeding upto our expectations) from time-to-time, so long as termination is prior to thefirst commercial sale of a licensed product. Additionally, upon thecommencement of commercial sales, if ever, we would be obligated to payroyalties based on revenue, potentially a sales referral fee based on revenueand also an annual exclusivity payment (to Lucent) to maintain our exclusiverights to the developed technology.

We are hopeful thatSenseIt will begin to generate revenue from the next-generation infraredimaging and night vision surveillance technology during the second half of ouryear ending April 30, 2008, although we can offer no assurance that amarketable product will be developed.

*SemiconductorProducts and Services*

Our semiconductor operations, based in Vancouver,Washington, showed continued operational and financial improvement during theyears ended April 30, 2007 and 2006, generating its third consecutivequarterly operating income for the three months ended April 30, 2007.  The positive operating income resultsprimarily from our ongoing effort to reduce our reliance on low margin smalldiameter products and focus mainly on higher margin 300-millimeter products andservices, wafer thinning and custom wafer products. As a result, for the yearended April 30, 2007, the segment generated operating income in the amountof $326,000 (which includes a non-cash charge of $122,000 for stock-basedcompensation expense) as compared to an operating loss for the years ended April 30,2006 and 2005 in the amounts of $(5,151,000) and $(6,484,000), respectively. 

The large-diameter wafer segment has become one of thefastest growing segments of the silicon wafer market and the revenues and grossmargins associated with the services are greater than those associated with thesmall diameter market.  As a result ofour strategic realignment, revenue from 300-millimeter services comprisedapproximately 54% of segment revenue for the year ended April 30, 2007($7,049,000 of revenue), as compared to approximately 36% of segment revenuefor the year ended April 30, 2006 ($2,053,000 of revenue). There has alsobeen a focus on operational efficiency and effectiveness, which has resulted inincreased productivity and processing yields. Further, we continue to gain newcustomers and are also in the process of attempting to qualify our product atothers. 

While we reportedsignificant revenue and operating income growth in our semiconductor operationsfor the year ended April 30, 2007, many of our top semiconductor customershave experienced weakened business results in recent quarters. In addition,some customers have reported inventory buildup in reclaim and/or test products.As a result of these two factors, we have recently seen a slowdown in orders ofreclaim and test materials, which has had a negative impact on our operations. Theslowdown will have a significant impact on our results of operations and cashflows for our quarter ending July 31, 2007, which we expect to reflect asignificant reduction in revenue (as compared to the previous sequentialquarter) and the reporting of an operating loss for that segment. In order tominimize the effect of the slowdown, we have implemented many cost cuttingprocedures and will continue to do so. It is unclear as to when the market willrebound but we believe that this is a relatively short-term phenomenon and arehopeful that we will begin to see a recovery during our quarter ending October 31,2007. We continue to monitor the situation closely and while we believe that wewill see improving financial results in this operating segment (over thelong-term), we cannot offer any assurance that we will be able to regain orsustain operating profitability in future periods.

**Distribution Method**

Prior to the sale of ourlife sciences business in June 2007, we operated our life sciences salesoffice in Golden, Colorado. Effective December 31, 2005, we closed ourlife sciences office in Dusseldorf, Germany. We currently manufacture andreclaim various types of silicon wafers at our facilities in 

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Vancouver,Washington. PPSC provides advanced security services from our New York office. Weoperate our homeland security products division in Golden, Colorado. Weidentify customers through industry sales journals, website identification andtrade shows. In addition, many customers come to us by referral from existingcustomers. 

**SignificantCustomers**

Thefollowing tables set forth information regarding our significant customers forthe years ended April 30, 2007, 2006 and 2005 (information only listed ifpercentage is greater than 10%).

| ** **                                                       | ** ** | **Percentage of revenues  during years ended  April 30,** | ** ** |
|------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2007**                                                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Qimonda Richmond  LLC (formerly Infineon Technologies  Richmond) |       |                                                                               | 21         | % |   |   | 13 | % |   |   | 24 | % |   |
| Consolidated  Edison Company                                     |       |                                                                               | —     |   |   |   | 12 | % |   |   | — |   |   |
| Foot Locker  Retail, Inc.                                   |       |                                                                               | 14         | % |   |   | 22 | % |   |   | — |   |   |
| Citicorp North  America, Inc.                               |       |                                                                               | 11         | % |   |   | — |   |   |   | — |   |   |
| SEH America, Inc.                                           |       |                                                                               | —     |   |   |   | — |   |   |   | 11 | % |   |

 

| ** **                                                      | ** ** | **Percentage of  accounts receivable  at April 30,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2007**                                                                 | ** ** | **2006** | ** ** |
| Qimonda Richmond  LLC (formerly Infineon Technologies Richmond) |       |                                                                     | 28         | % |   |   | 14 | % |   |
| Micron  Technology, Inc                                         |       |                                                                     | 13         | % |   |   | — |   |   |
| Silicon Wafer  Enterprises, LLC                                 |       |                                                                     | 10         | % |   |   | — |   |   |
| Citicorp North  America, Inc.                              |       |                                                                     | —     |   |   |   | 11 | % |   |

 

A decision by asignificant customer to substantially decrease or delay purchases from us or aninability to collect significant amounts owed to us could have a materialadverse effect on our consolidated financial condition and results of operations.

**Research andDevelopment**

Consistentwith our product development strategy, we are seeking to identify and evaluatenew products for our homeland security operations and potential markets foreconomic and technical feasibility. During the years ended April 30, 2007,2006 and 2005, research and development expenses were as set forth in thefollowing table:

| **Year ended  April 30,** | ** ** | ** ** | ** ** | **Research and  development expenses** | ** ** |
|-------------------------------------|------------|------------|------------|--------------------------------------------------|------------|
| 2007                                |       |       | $          | 4,950,000                                        |       |   |
| 2006                                |       |       | $          | 5,018,000                                        |       |   |
| 2005                                |       |       | $          | 1,020,000                                        |       |   |

 

Our principal research and development expenses duringthe years ended April 30, 2007 and 2006 consisted of work being performedby both Lucent and IUT. We recognized research and development expense of$4,462,000 and $3,390,000 related to these two entities for the years ended April 30,2007 and 2006, respectively. We intend to continue using IUT to the extentnecessary in improving the performance of our panel-mounted IMS-based productfor our existing customer and for any new opportunities that may develop.

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During the year ending April 30, 2008, we expectto continue to focus our research and development efforts on existing and newproducts for our homeland security operations. These efforts continue theresearch and development we performed during the years ended April 30,2007, 2006 and 2005. Trace detection technology and product developmentcontinues to focus on very low-level detection of various types of explosivesutilizing IMS and other low concentration analytics techniques. Additionally,through the Pacific Northwest National Lab, in partnership with the Highly PureBiopreparation Lab in St. Petersburg, Russia we (at a minimal cost) areresearching the effectiveness of a bioremediation system for advancement ofcleanliness in our hospitals. This program is sponsored by the United StatesDepartment of Energy as a threat reduction and proliferation effort. We have,as partners to the program, specific rights to the systems developed from theseefforts. Although promising, we do not have sufficient results from testing toadvance a prognosis as to the systems overall capability at this time. 

While we continue to offersilicon-28 wafers, we did not receive significant revenues in our years ended April 30,2007, 2006 or 2005, and we are not aware of any plans by any company for theintroduction of products based on silicon-28 wafers. As a result, we do notanticipate significant proceeds from silicon-28 product sales during theyear ending April 30, 2008. We have also eliminated any furtherexpenditures on research and development related to our silicon-28 technology.

**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 1A. “Risk Factors.”

We currently have six United States patents in our ownname (US 6,653,658 dated November 2003, US 6,838,020 dated January 2005,US 6,867,459 dated March 2005, 6,926,876 dated August 2005, 6,979,630 datedDecember 2005 and 7,119,400 dated October 2006) and have filedseveral other patent applications regarding silicon-28 and other isotopicallypurified materials. 

In 1999, we entered into an exclusive licensingagreement with Yale University that entitles us to exclusive intellectualproperty rights 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 patents expires seventeen yearsafter issuance.

Several disclosuresrelated to the trace detection technology underlying IMS have been written andseveral patent applications have been filed. We can offer no assurance that anypatents will be awarded related to these developments.

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**Competition**

Many of our potentialcompetitors are larger and have significantly greater financial, technical,marketing and other resources than we. Some of our competitors may form partnershipsor alliances with other companies, with the resulting entity possessing greatermarket strength than we have. We face competition relative to many of ourproducts, including:

*Homeland Security*

A large number ofcompanies are involved in the homeland security industry, an industry thatreceived a significant impetus from the events of September 11, 2001.Many of these companies (such as OSI Systems, Inc., Smiths Heimann, Inc.and L-3 Communications Holdings, Inc.) are significantly larger than are weand generally have greater financial resources at their disposal. We believethat the technology that we have acquired from IUT may result in betterdetection products that will be attractive to the marketplace. Given the sizeand importance of the homeland security market, we anticipate that even greatercompetition will emerge. Additionally, within the services segment of homelandsecurity, there will continue to be significant additions to security servicesrequired. There will be continued pressure within this business segment bylarger service providers such as Smith Heimann, Inc., however there areniche segments that provide PPSC opportunities that otherwise could beunderrepresented. 

*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. and Rasa Industries Ltd., provide a widerange of products and services comparable to us and compete on a global basis. Thereare numerous smaller competitors that provide a more focused product or serviceoffering and compete on a local or regional basis. Customers select a supplierbased on a combination of factors including price, delivery time, and quality. 

*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. 

*Summary ofCompetition*

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.

**Manufacturing andSupply**

While we initially manufactured our IMS-based productsusing the existing IUT facilities and subcontractors, we entered into contractsfor the manufacturing of such products with independent, non-affiliatedcontractors in the United States. In each case, the contracts are withunaffiliated entities on terms that we negotiate.

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

Prior to the sale of our life sciences business, weobtained stable isotopes from a variety of isotope sources, primarily locatedin Russia. Other facilities elsewhere in the world, including the Oak RidgeNational Laboratory in Oak Ridge, Tennessee, and private andpseudo-governmental facilities in Great Britain, Germany, the Netherlands andthe Republic of South Africa, have the potential to produce stable isotopes. Thesesuppliers are no longer material to our business operations since we sold ourlife sciences business in June 2007.

Except for the agreements with our homeland securityproducts manufacturers, we do not have any written agreements with oursuppliers and processors that are material to our operations. Although weattempt to reduce our dependence on our suppliers, disruption or termination ofany of the sources could occur, and such disruptions or terminations could haveat least a temporary, materially adverse effect on our business, financialcondition, and results of operations. Moreover, a prolonged inability to obtainalternative sources for processing could have a materially adverse affect onour 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 (driven by the fast-growing solarmarket) in the silicon market has decreased the availability (and increased theprice) of raw materials for virgin test wafers.

**GovernmentRegulation**

Regulation by government authorities in the UnitedStates and other countries is a significant consideration in the research,development, production, distribution and marketing of our homeland securityproducts. In order to clinically test, manufacture, distribute, market and sellproducts, we must follow safety and other standards established by applicableregulatory authorities. We may be subject to various laws, regulations andrequirements relating to such matters as the import and export of our products,ensuring safe working conditions, laboratory and manufacturing practices, andthe use, storage and disposal of hazardous or potentially hazardous substancesused in connection with our research, development and manufacturing activities.The regulations potentially material to our business are summarized below. 

*HomelandSecurity Services.**  *Oursubsidiary, PPSC, provides armed and unarmed guard services primarily in thestates of New York, New Jersey and Connecticut. PPSC must obtain licenses fromeach state in which it operates for both armed and unarmed guard services. PPSC is current in its licensing obligations.

*HomelandSecurity Products.**  *OurIMS-based products use a radioactive sealed source to operate—similar to thesealed sources used in in-home smoke detectors. We have received all regulatorylicenses required for domestic sales of our panel-mounted IMS-based productused on the Dual Draw AirChx system, including a Sealed Source DeviceRegistration from the Nuclear Regulatory Commission (“NRC”). These regulatoryrequirements greatly slow the sales process of bringing any other IMS-basedproducts to market.

*Life Sciences Products.**  *We were not subject to any FDA regulation for ourlife sciences business because we merely supplied product and did notmanufacture any drug products or other medical devices.  We no longer participate in the life sciencesbusiness and, therefore, these issues no longer are material to us.

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**Product Liability and 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. We have, and willattempt to renew product liability insurance (which currently expires April 30, 2008) in order toprotect ourselves from such potential exposures, however there can be no guaranteethat upon expiration of our current coverage that adequate insurance coveragewill be available, or, if available, the cost will be acceptable. Furthermore,a product liability or other claim could materially and adversely affect ourbusiness or financial condition. The terms of our customer agreements providethat liability is limited to our standard warranty to replace non-conformingproduct, and liability for consequential damages caused by the improper use ofour products is limited by contractual terms. Nevertheless, one or more thirdparties could file suit against us based on product liability, breach ofwarranty or other claims. The foregoing contract clauses might effectivelylimit our liability in any such actions. Additionally, we are applying forHomeland Security product coverage under the United States Safety Act. If thisapplication is accepted, we, our manufactures and our clients would be coveredfor certain liability of that product in the event the specified product werein place during a occurrence defined as a terrorism attack.

**Financial Information About Geographic Areas**

Thefollowing table sets forth information for the last three years regardingrevenues generated from activities within the United States and othergeographic regions:

| ** **      | ** ** | **Revenues from customers in  specified geographic regions  for the year ended April 30,** | ** ** |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **      | ** ** | **2007**                                                                                                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| United States   |       | $                                                                                                                                       | 27,731,000 |   | $ | 18,580,000 |   | $ | 2,692,000 |   |
| Other Countries |       | —                                                                                                                                  |       | — |   | — |   |
|                 |            |                                                                                                                                         |            |  |  |  |  |  |  |  |

 

In January 2007, weelected to discontinue the operation of our life sciences business and put theassets and business up for sale (which was sold in June 2007). As aresult, we reclassified the operations of our life sciences business asdiscontinued operations. Prior year information has been reclassified toconform with the current year presentation. Substantiallyall of our assets are based in the United States. We have no materiallong-lived assets or other assets based outside of the United States.

**Employees**

As of June 30, 2007,****we had four employees, and with our subsidiaries we had atotal of 477 full-time employeesas described in the following table:

| **Business**                  | ** ** | ** ** | ** ** | **Number of  employees** | ** ** |
|-------------------------------|------------|------------|------------|-------------------------------|------------|
| Homeland security  operations |       |       | 3          |                          |       |
| Security Services             |       |       | 423        |                          |       |
| Semiconductor operations      |       |       | 47         |                          |       |
| Corporate office              |       |       | 4          |                          |       |

 

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.

**Securities Exchange ActReports**

We maintain an internet website at www.isonics.com. Theinformation on our website is not incorporated by reference in this annualreport on Form 10-K.

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We make available on orthrough our website certain reports and amendments to those reports that wefile with or furnish to the Securities and Exchange Commission (the “SEC”) inaccordance with the Securities Exchange Act of 1934, as amended. These includeour annual reports on Form 10-K, our quarterly reports on Form 10-Q,our current reports on Form 8-K and Section 16 filings. We make thisinformation available on our website free of charge as soon as reasonablepracticable after we electronically file the information with, or furnish itto, the SEC. Alternatively, you may read and copy any information we file withthe SEC at its public reference room at 100 “F” Street NE, Washington, D.C. 20549.You may obtain information about the operation of the public reference room bycalling 1-800-SEC-0330. You may also obtain this information fromthe SEC’s website, http://www.sec.gov.

**ITEM 1A.**        RISKFACTORS

In addition to the otherinformation set forth in this report, you should carefully consider thefollowing factors, which could materially affect our business, financialcondition or future results. The risks described below are not the only riskswe face. Additional risks and uncertainties not currently known to us or thatwe currently deem to be immaterial also may materially adversely affect ourbusiness, financial condition or results of operations.

**We have historically had working capitalshortages, even following significant financing transactions and we received anopinion from our auditors indicating a substantial doubt regarding our abilityto continue as a going concern.**

We have had working capital shortages in the past and,although we raised capital totaling more than $45,800,000 (net of expenses and$4,100,000 of payments related to our 8% Debentures) since May 1, 2004, wehave generated significant losses, which have impacted working capital. As ofApril 30, 2007, our consolidated balance sheet reflects working capital of$3,310,000. As a result of our continued operating losses and projecteddeclining working capital balances during the year ending April 30, 2008, the auditors report included with ourfinancial statements includes the following explanatory paragraph:

“The accompanying financial statements have beenprepared assuming that the Company will continue as a going concern. Asdiscussed in Note 1 to the financial statements, the Company has sufferedrecurring losses from operations and will continue to require funding frominvestors for working capital. This raises substantial doubt about theCompany’s ability to continue as a going concern. Management’s plans in regardto these matters are also described in Note 1. The financial statements do notinclude any adjustments that might result from the outcome of thisuncertainty.”

Our ability to continue as a going concern isdependent upon raising capital through debt or equity financing and ultimatelyby increasing revenue and achieving profitable operations. We can offer noassurance that we will be successful in our efforts to raise additionalproceeds or achieve profitable operations. The consolidated financial statementslocated in Item 8. “Financial Statements and Supplementary Data” have beenprepared on a going concern basis, which contemplates the realization of assetsand the settlement of liabilities in the normal course of business.

Based on the amount of capitalwe have remaining, our current negative cash flow from operations and investingactivities, we anticipate that we will continue to incur a working capitaldeficit unless we are able to substantially increase our revenue or reduce ourexpenses thereby generating positive cash flow from operations and (ultimately)operating income. Nevertheless, as a result of our fund raising activitiesduring the year ended April 30, 2007, other anticipated cash flows andcertain cost-saving measures we have instituted, we believe we have sufficientworking capital to finance our anticipated operations and projected negativecash flow into our quarter ending January 31, 2008.

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**Our ability toobtain further financing when necessary is limited.**

We have historicallyfinanced our operating losses and cash flow deficits through private placementsof our equity and debt securities. Our outstanding 13% Debentures containsignificant restrictions on our ability to raise any additional capital for solong as the convertible debentures are outstanding and ultimately, our abilityto finance our operations will depend on our ability to generate revenues thatexceed our expenses. Although we believe we are on a path to that end, wecannot offer any assurance that we will be able to succeed in reaching thatgoal.

**We may be delisted from the Nasdaq Capital Market anddelisting may adversely impact our ability to raise capital.**

During the year ended April 30, 2007, we receivedfour notifications from Nasdaq identifying listing deficiencies, which, if notcured timely, could have resulted in our delisting from the Nasdaq CapitalMarket. While we cured these deficiencies, we continue to be subject to all ofNasdaq’s continued listing requirements, including requirements for either aminimum level of stockholders’ equity or market value of listed securities andmaintenance of a $1.00 per share minimum bid price. Unless circumstanceschange, there is a significant risk that we may not meet either of the minimumstockholders’ equity or market value of listed securities requirement at July 31,2007, although we will not be able to confirm whether we meet certain of therequirements until later in August or early September 2007. Nevertheless,we are developing plans to deal with this situation should it occur, althoughwe cannot offer any assurance that we will be able to implement any such plansshould it become necessary to do so.

If we were to receive a notice from Nasdaq for failureto comply with the requirements, and if it was not cured timely, it couldresult in our delisting from the Nasdaq Capital Market. We can offer noassurance that we will be able to cure any future listing deficiencies or sustaincompliance with all continued listing requirements.

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, may raise liquidity issues for currentinvestors and may place some of our existing obligations into default.

**We have three business segments and, for the yearended April 30, 2007, two of our three segments operated at a loss.**

Forthe years ended April 30, 2007, 2006 and 2005, our operating segmentsincurred operating losses as follows:

| ** **                           | ** ** | **Year ended April 30,** | ** **  |
|--------------------------------------|------------|-----------------------------------------|-------------|
| ** **                           | ** ** | **2007**                                | ** **  | **2006** | ** ** | **2005** | ** ** |
| Homeland security  products          |       | $                                       | (6,664,000  | ) | $ | (5,989,000 | ) | $ | (1,728,000 | ) |
| Security services                    |       | (425,000                                | )           | (24,000 | ) | — |   |
| Semiconductor  products and services |       | 326,000                                 |        | (5,151,000 | ) | (6,484,000 | ) |
| Reconciling  amounts(1)              |       | (8,785,000                              | )           | (4,499,000 | ) | (3,744,000 | ) |
| Total                                |       | $                                       | (15,548,000 | ) | $ | (15,663,000 | ) | $ | (11,956,000 | ) |

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(1)          Reconciling amounts forthe operating loss information includes corporate expenses consisting primarilyof corporate salaries and benefits, professional and consulting fees, investorrelations costs, warrant amendment expense, insurance and directors’compensation. In January 2007, weelected to discontinue the operation of our life sciences business and put theassets and business up for sale (which was sold in June 2007). As aresult, we reclassified the operations of our life sciences business asdiscontinued operations. Prior year information has been reclassified toconform with the current year presentation.

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We expect that theselosses (on a consolidated basis) will continue through the remainder of ouryear ending April 30, 2008. As described in the next risk factor, unlesswe are able to develop and sell new products profitably, we may be unable toremain competitive and it is likely that our losses and negative cash flow willcontinue.

**Unless we are able to develop and sell our productsprofitably, we may be unable to remain competitive, furthering the likelihoodthat our losses and negative cash flow will continue.**

Our ability to generate positive cash flow, additionalrevenues, and ultimately net income, is dependent upon the success of ourhomeland security products, security services and semiconductor operations. While we reported significant revenue andoperating income growth in our semiconductor operations for the year ended April 30,2007, many of our top semiconductor customers have experienced weakenedbusiness results in recent quarters. In addition, some customers have reportedinventory buildup in reclaim and/or test products. As a result of these twofactors, we have recently seen a slowdown in orders of reclaim and testmaterials, which has had a negative impact on our operations. The slowdown willhave a significant impact on our results of operations and cash flows for ourquarter ending July 31, 2007, which we expect to reflect a significantreduction in revenue (as compared to the previous sequential quarter) and thereporting of an operating loss for that segment. In order to minimize theeffect of the slowdown, we have implemented many cost cutting procedures andwill continue to do so. It is unclear as to when the market will rebound but webelieve that this is a relatively short-term phenomenon and are hopeful that wewill begin to see a recovery during our quarter ending October 31, 2007. Wecontinue to monitor the situation closely and while we believe that we will seeimproving financial results in this operating segment (over the long-term), wecannot offer any assurance that we will be able to regain or sustain operatingprofitability in future periods.

We have had limitedsuccess in marketing our homeland security products, having sold to date onlyfifteen units of our panel-mounted IMS-based product. Although we continue tomarket products based on our IMS technology, we are not doing so aggressively. Weare attempting to resolve certain issues that we confronted with our earlierversion of the panel-mounted IMS-based product. Consequently, we cannot offerany assurance that our marketing efforts will result in any additional sales orthat additional sales would result in significant revenues to us. While we areconsidering the development of other IMS-based products (such as the hand-held ‘sniffer’discussed above), we do not have the capital resources necessary to develop ormanufacture these other products. We cannot offer any assurance that we will beable to do so in the future.

**We have issued securities during the years ended April 30,2007, 2006 and 2005, and subsequently which has resulted (and will in thefuture when warrant exercises or conversions occur) in dilution to our existingshareholders. This was accomplished to provide necessary working capital orobtain assets and services. We will likely issue more securities to raiseadditional capital or to obtain other services or assets, any of which mayresult in substantial additional dilution.**

During the course of thelast three fiscal years, we have raised in excess of $45,800,000 (net ofexpenses and $4,100,000 of payments related to our 8% Debentures) to financeour business operations and acquisitions. During that period and subsequently,we have also issued a number of shares, options, and warrants, to acquire servicesand assets from third parties and pursuant to our stock option plans. We expectto raise additional financing during our year ending April 30, 2008 if wecan do so on terms that we believe to be appropriate, given our financialcondition and other circumstances. We also expect to issue additional shares,options, and warrants where we can to obtain necessary services. Some of theissuances we have made in the past and are likely to make in the future havebeen issued at prices below market and (as is frequently the case withdeclining market prices) at prices below our historical market prices. Consequently,our shareholders have suffered dilution in the value of their shares and canexpect that we 

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will beissuing additional securities on similar terms. Further dilution can beexpected to occur when our outstanding options and warrants are exercised ordebentures are converted at prices below the market.

**Two former holders of a portion of the thenoutstanding 8% Debentures have asserted that a default existed.**

Two entities who held 8%Debentures (which have been paid in full as of February 1, 2007) havepreviously asserted that the issuance of the 13% Debentures constituted adefault (due to a potential variable conversion provision contained within the13% Debentures which gives the 13% Debenture holder the right to convert the13% Debentures into common stock at the lower of $5.00 or at a discount tomarket, subject to certain limitations and as defined) under the 8% Debentures.We have contested that allegation (based on such clause not surviving the finalagreement and a defense of *in pari delicto*),and will defend it in court if necessary. Although we have not had any furthercommunication from the former holders regarding this issue other than the allegationof default, any litigation would be time consuming and expensive and, althoughwe believe that we have significant grounds to contest the existence of anydefault, we cannot be assured of success. If they were to prove a default, wecould be liable for 130% of the principal amount of their 8% Debentures on theclosing date of the 13% Debenture transaction (an amount of approximately$1,200,000, including accrued interest).

**Accounting charges resulting from our issuance of the13% Debentures may lead to significant non-cash charges which would adverselyimpact future interest expense, net income and earnings per share and may alsolead to future volatility in our financial statement components.**

As a result of theissuance of the 13% Debentures, we will be required to record significantnon-cash interest charges over the life of the 13% Debentures (in addition tointerest expense relating to the 13% interest rate borne by the 13% Debentureswhich will be paid in cash or shares of our common stock, at our option). Thiswill likely result in a significant adverse impact to future net income andearnings per share and will likely introduce additional volatility to ourfuture operating results.

**Historically we depended upon few customers for asignificant portion of our revenues and our business could have been materiallyand adversely affected if we lost any one of those customers.**

We have been dependent ona few significant customers who have purchased our products or services inamounts greater than 10% of our consolidated revenues. A decision by anysignificant customer to substantially decrease or delay purchases from us or aninability to collect significant amounts owed to us could have a materialadverse effect on our consolidated financial condition and results ofoperations.

**We realized increased expenses, reduced revenues andlonger than anticipated delays in integrating past business acquisitions intoour operations, and we may face similar difficulties with future acquisitionsas well.**

We experienced increasedcosts and delays in integrating the operations of the business and assets weacquired from EnCompass Materials Group, Ltd. (“EMG”) in June 2004, and wealso realized revenues that were significantly reduced from that which we hadanticipated which adversely affected the operations of our semiconductordivision. Regardless of the extent of our planning, we may recognize increasedcosts and delays, and reduced revenues, when integrating future businessacquisitions into our business operations and strategy. While we believe thatwe have and will continue to plan for integration of acquired businessoperations to the best of our ability, we cannot offer any assurance that anyor all such efforts will proceed as anticipated.

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**Ifdemand for any of our products grows suddenly, we may lack the resources tomeet demand or we may be required to increase our capital spendingsignificantly.**

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.

**Becausewe are dependent upon our key personnel for our future success, if we fail toretain or attract key personnel, our business will be adversely affected.**

Our future success willdepend in significant part upon the continued service of our key technical,sales and senior management personnel and consultants, including ChristopherToffales, our Chairman of the Board. Currently Mr. Toffales is covered bya two-year employment agreement that is renewable on an annual basis. We believe that our future success will alsodepend upon our ability to attract and retain other qualified personnel for ouroperations. The failure to attract or retain such persons could materiallyadversely affect our business, financial condition and results of operations.

**Thereorganization of our Company and the changes in our senior management mayresult in a disruption of operations or have adverse impacts on our business.**

As part of the ourmanagement reorganization in February 2007, James E. Alexander and BorisRubizhevsky, resigned from their positions as officers and directors; Lindsay AGardner, a vice president, resigned from her position as a director and lateras vice president. Both Mr. Alexander and Mr. Rubizhevsky werefounding members of Isonics and actively managed our operations since formation,and Ms. Gardner had been a director of Isonics since 1993. We terminatedseveral other employees and officers during that period of time. The departureof these directors and officers and the introduction of new officers anddirectors to fill their positions may disrupt our operations and adverselyeffect our business operations.

**We may not be able to protect our intellectualproperty, which would reduce our competitive advantage.**

We rely primarily on acombination of patents and patent applications, trade secrets, confidentialityprocedures, and contractual provisions to protect our technology. Despite ourefforts to protect our technology, unauthorized parties may attempt to copyaspects of our products or to obtain and use information that we regard asproprietary. Policing unauthorized use of our technology and products isdifficult. In addition, the laws of many countries do not protect our rights toinformation, materials and intellectual property that we regard as proprietaryand that are protected under the laws of the United States. We may not be ableto protect our proprietary interests, or our competitors may independentlydevelop similar technology or intellectual property. If either one of thesesituations 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 

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and thecontesting party would be required to demonstrate invalidity of such patent byclear and convincing evidence. If the outcome of any such litigation wereadverse to our interests, our liquidity and business operations would bematerially and adversely affected.

**Weface technological change and intense competition both domestically andinternationally which may adversely affect our ability to sell our productsprofitably.**

The markets for ourhomeland security and semiconductor products and services are characterized byrapidly evolving technology and a continuing process of development. Our futuresuccess will depend upon our ability to develop and market products that meetchanging customer and technological needs on a cost effective and timely basis.If we fail to remain competitive by anticipating the needs of our customers andour customers contract with other suppliers, our revenues and resulting cashflow could be materially and adversely affected.

**Oursemiconductor products and services segment is dependent on the performance ofseveral key pieces of equipment. If any of these items were not to perform totheir ability or were taken out of service for any significant amount of time,our ability to produce product would be severely compromised.**

The performance of oursemiconductor products and services segment is directly tied to the performanceof several key pieces of equipment, which are typically intricate and expensive.The average time between failures is typically long and the corresponding timefor repair is typically short; as a result, most of the time the issues areroutine and are quickly repaired. However, this is not always the case andthere have been times in the past when critical tools have been out of servicefor a period of time, which had a negative impact on revenues in the short term.Further, due to our historical working capital shortages and the significanthistorical net losses, we are unable to purchase the necessary equipmentredundancy. Any future equipment issues could have a significant impact on ourability to produce and ship the products to our customers, thereby potentiallyimpacting both our revenues and related cash flows.

**Wecould be subject to environmental regulation by federal, state and localagencies, including laws that impose liability without fault, which couldproduce working capital shortages and lessen shareholders’ equity.**

Our IMS-based products useradioactive sources. As a result, we are subject to a variety of federal,state, and local environmental regulations relating to the use, storage,discharge and disposal of hazardous chemicals used during manufacturingprocesses. Regulations that become applicable to our operations in the futurecould restrict our ability to expand our facilities or could require us toacquire costly equipment or to incur other significant expenses to comply withgovernmental regulations. Historically, our costs of compliance withenvironmental regulations have not been significant because we use licensedmanufacturers in connection with the manufacture of these products.

**Weare controlled by our Board of Directors; individual purchasers of our shareswill have little ability to elect directors or control our management.**

Our shares arewidely-held, and our management beneficially owns our securities in an amountless than 10% of the outstanding votes at any shareholders’ meeting.Nevertheless, it is likely that the Board of Directors will be able toinfluence all matters submitted to stockholders for approval, including theelection and removal of directors and any merger, consolidation or sale ofsubstantially all of our assets, and to control our management and affairs.Such control may have the effect of delaying, deferring or preventing a changein control, impeding a merger, consolidation or takeover or other businesscombination involving us or discouraging a potential acquirer from making atender offer or otherwise attempting to obtain control of our business, even ifsuch a transaction would be beneficial to other stockholders.

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**We risk exposing ourselves to an above-policy limitproduct liability claim, which could adversely affect our working capital,shareholders’ equity and profitability.**

The sale and use ofexplosive and chemical detection products may expose us to potential liabilityrisks 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 is vulnerable to pricing andpurchasing 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 to quarter-to-quartervariations in our operating results, our announcements of technologicalinnovations or new products by us or our competitors, delays in our productdevelopment and marketing, and other events and factors over which we have noinfluence or control. The securities markets themselves have experiencedsignificant price and volume fluctuations that may be unrelated to theoperating performance of particular companies. Regulatory developments in theUnited States and foreign countries, public concern as to the safety ofproducts containing radioactive compounds, economic and other external factors,all affect the market price of our securities. *Inaddition, the realization of any of the risks described in these “Risk Factors”could have a significant and adverse impact on such market prices*.

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

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 onthe Nasdaq 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. When our common stock is considered to be a “pennystock,” trading is covered by Rule 15g-9 promulgated under theSecurities Exchange Act of 1934, for non-Nasdaq and non-national securitiesexchange listed securities, adding a significant amount of broker-dealercompliance to transactions in penny stocks. Many brokers are unwilling toengage in transactions in penny stocks and, therefore, if we lose our listingon the Nasdaq Capital Market, the marketability of our securities may weakensignificantly.

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 “We may be delisted from the Nasdaq Capital Market and delisting mayadversely impact our ability to raise capital” for additional riskfactors associated with potential Nasdaq listing deficiencies.

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

Our stock price has declined from a price ofapproximately $24.00 (adjusted for the reverse split) per share at thebeginning of 2005 to prices of less than $1.50 (adjusted for the reverse split)at various times since May 2006. Our stock price may decline further as aresult of future sales of our shares, the perception that such sales may occur,our financial or operational performance, or other reasons. As of July 20,2007, approximately 940,000 shares of common stock held by existingstockholders constitute “restricted shares” as defined in Rule 144 underthe Securities Act. The restricted shares may only be sold if they are 

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registered under theSecurities Act, or sold under Rule 144, or another exemption fromregistration under the Securities Act.

Approximately 90% of therestricted shares of our common stock are either eligible for sale pursuant to Rule 144or have been registered under the Securities Act for resale by the holders. Weare unable to estimate the amount, timing, or nature of future sales ofoutstanding common stock. Sales of substantial amounts of our common stock inthe 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 common stock in theforeseeable 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 13% Debentures contain restrictions on ourability to pay dividends to holders of our common stock.

**Outstanding debentures, options and warrants may makeit difficult for us to obtain additional capital on reasonable terms.**

We have a significant amount of securities outstandingthat are convertible into or exercisable for shares of our common stock, insome cases at prices below the market price for our shares. The existence ofthese convertible or exercisable securities have in the past and may in thefuture make it more difficult for us to raise any further financing because anynew investors will perceive that the securities offer a risk of substantialpotential future dilution.

In addition, thecontinuously adjustable conversion price feature of our 13% Debentures, and anysimilar features of any debentures we may subsequently issue, could require usto issue a large number of shares, which would cause dilution to our existingstockholders and may encourage investors to make short sales of our commonstock, which could depress the price of our common stock and adversely impactour ability to raise capital when necessary.

**If we fail to effect and maintain registration of thecommon stock issued or issuable pursuant to conversion of our convertibledebentures, or certain of our outstanding common stock warrants, we may beobligated to pay the investors of those securities liquidated damages.**

We have variousobligations to file and obtain the effectiveness of certain registrationstatements which include certain outstanding common stock and common stockunderlying outstanding convertible debentures and common stock warrants. Onceeffective, the prospectus contained within a registration statement can only beused for a period of time as specified by statute without there being a post-effectiveamendment filed that has become effective under the Securities Act of 1933. Ifwe are unable to meet these obligations, we may be obligated to pay liquidateddamages of 1% of the principal amount of the 13% Debentures outstanding permonth (up to $180,000 per month). We cannot offer any assurance that we will beable to maintain the currency of the information contained in a prospectus orto obtain the effectiveness of any registration statement or post-effectiveamendments that we may file.

**As a public company, we are subject to a significantamount of regulation. In the past we have received requests for informationfrom the Securities and Exchange Commission and from Nasdaq. Any such inquiryor investigation that may result may adversely affect the market for our stockor 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 2004 

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through February 2005,both Nasdaq and the SEC requested documents from us with respect to inquiriesthey were undertaking (related primarily to questions regarding our pressreleases, public relations advisors, certain other disclosures that were madepublicly and the termination of Grant Thornton LLP as our independent auditor). We also met with representatives ofNasdaq to discuss issues related to market activity, press announcements, SECfilings, status of our business and other issues.  We provided information, which we believe tobe responsive to all of the questions posed in the Nasdaq inquiry and to theSEC. We have not received any requests for additional information from eitherthe SEC or Nasdaq relating to those earlier inquiries since February 2005and while we believe these issues are behind us, if any action resulted fromthese inquiries in the future, it may adversely impact us, and our ability tocarry on our business.

**We failed to provide necessary funding to SenseIt tomake the most recent development payment to Lucent and, as a result, Lucentcould terminate the agreement and our investment in SenseIt would be impaired. Evenif we are able to make the development payment we have missed or futuredevelopment payments when due, there is no guarantee that the developmentactivity will yield technologically relevant or commercially viable products.**

SenseIt failed to make thedevelopment payment due to Lucent on July 16, 2007. SenseIt was unable tomake this payment because we were unable to provide adequate funding to SenseIt.Consequently, Lucent may in its discretion take steps to terminate theagreement and all licenses granted to us thereunder or cease working on theproject and then assess SenseIt a “start-up” fee if funding was to resume. On July 26,2007, we received official notification from Lucent that we failed to make the$1,000,000 payment to Lucent by July 16, 2007 and that in the event suchnon-payment continues for more than ten days, Lucent may at is discretion,suspend work on the development project. Because of our continuing workingcapital shortages, we may not be able to provide SenseIt funding for future (orcurrent) development payments to Lucent, and SenseIt may not be able to findthird-party investors to provide it the necessary capital. If the Lucentagreement were to be canceled, our investment in SenseIt would be impaired. Lastly,although we are hopeful of a positive outcome, we can offer no assurance thatthe development activity underway with Lucent and SenseIt will yieldtechnologically relevant or commercially viable products.

**Provisions in our charterdocuments could prevent or delay a change in control, which could delay orprevent a takeover.**

Our Articles ofIncorporation authorize the issuance of “blank check” preferred stock with suchdesignations, rights, and preferences, as may be determined by our Board ofDirectors. Accordingly, the Board of Directors may, without shareholderapproval, issue shares of preferred stock with dividend, liquidation,conversion, voting, or other rights that could adversely affect the votingpower or other rights of the holders of our common stock. Preferred stock couldalso be issued to discourage, delay, or prevent a change in our control,although we do not currently intend to issue any additional series of ourpreferred 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 payjudgments, fines, and expenses incurred by an officer or director, includingreasonable attorneys’ fees, as a result of actions or proceedings in which suchofficers and directors are involved by reason of being or having been anofficer or director. Funds paid in satisfaction of judgments, fines andexpenses may be funds we need for the operation of our business and thedevelopment of our products, thereby affecting our ability to attainprofitability. This could cause our stock price to drop.

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**We will need to make substantial financial andman-power investments in order to assess our internal controls over financialreporting and our internal controls over financial reporting may be found to bedeficient.**

Section 404 of theSarbanes-Oxley Act of 2002 requires management to assess our internal controlsover financial reporting and requires auditors to attest to that assessment.Current regulations of the Securities and Exchange Commission, or SEC, willrequire us to include this assessment and attestation in our Annual Report on Form 10-Kcommencing with the annual report for our fiscal year ending April 30,2008.  We will incur significantincreased costs in implementing and responding to these requirements. Inparticular, the rules governing the standards that must be met formanagement to assess its internal controls over financial reporting under Section 404are complex, and require significant documentation, testing and possibleremediation. Our process of reviewing, documenting and testing our internalcontrols over financial reporting may cause a significant strain on ourmanagement, information systems and resources. We may have to invest inadditional accounting and software systems. We may be required to hireadditional personnel and to use outside legal, accounting and advisoryservices. In addition, we will incur additional fees from our auditors as theyperform the additional services necessary for them to provide theirattestation. If we are unable to favorably assess the effectiveness of ourinternal control over financial reporting when we are required to, or if ourindependent auditors are unable to provide an unqualified attestation report onsuch assessment (if applicable for the fiscal year ending April 30, 2008),we may be required to change our internal control over financial reporting toremediate deficiencies. In addition, investors may lose confidence in thereliability of our financial statements causing our stock price to decline.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

None.

**ITEM 2.**                PROPERTIES

Our corporate and HSDC office is located in Golden,Colorado. In April 2007, we renewed our month-to-month lease (at a rate of$3,077 per month) with the Colorado School of Mines Research Institute tocontinue leasing office and storage space at our current location.

We conduct our semiconductoroperations in two facilities leased in Vancouver, Washington. The firstlease requires a minimum payment of $9,700 (which increases to $10,670 on September 1,2007) per month and terminates August 31, 2012 while the second leaserequires a minimum payment of $6,150 per month and terminates January 31,2008.

PPSC is located inManhattan, New York. PPSC operates under a lease agreement, which requires aminimum payment of $13,750 per month (escalating on an annual basis) andterminates September 30, 2013.

**ITEM 3.**                LEGALPROCEEDINGS

None

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

We did not hold a meeting of our shareholders duringthe fourth quarter of the year ended April 30, 2007.

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**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

**(a)   *Market Information.***

Our common stock is quoted on the Nasdaq CapitalMarket. Our Class B and C warrants expired on December 29, 2006. Asof July 20, 2007, we had outstanding 12,658,150 shares of our common stock.The trading symbol for our common stock is ISON.

Thefollowing table sets forth, for each of the fiscal periods indicated, the rangeof the high and low sale prices per share as reported by the NASDAQ CapitalMarket. These prices do not include adjustments for retail markups, markdownsor commissions. These prices have been adjusted for the reverse stocksplit that was completed in February 2007.

| ** **          | ** ** | **Three months ended**           | ** ** |
|---------------------|------------|--------------------------------------------|------------|
| ** **          | ** ** | **July 31, 2007**                | ** ** |
| ** **          | ** ** | **(through July 20, 2007)** | ** ** |
| Common Stock (ISON) |       |                                       |       |   |   |
| High                |       |                                       | $          | 1.63 |   |   |
| Low                 |       |                                       | $          | 1.20 |   |   |

 

| ** **          | ** ** | **Three months ended** | ** ** |
|---------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **July 31,  2006**          | ** ** | **October 31,  2006** | ** ** | **January 31,  2007** | ** ** | **April 30,  2007** | ** ** |
| Common Stock (ISON) |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| High                |       |                             | $          | 5.00 |   |   |   | $ | 4.44 |   |   |   | $ | 3.52 |   |   |   | $ | 2.24 |   |   |
| Low                 |       |                             | $          | 1.64 |   |   |   | $ | 2.40 |   |   |   | $ | 2.28 |   |   |   | $ | 1.05 |   |   |

 

| ** **          | ** ** | **Three months ended** | ** ** |
|---------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **July 31,  2005**          | ** ** | **October 31,  2005** | ** ** | **January 31,  2006** | ** ** | **April 30,  2006** | ** ** |
| Common Stock (ISON) |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| High                |       | $                                | 14.16      |   |   | $ | 13.48 |   |   |   | $ | 9.20 |   |   |   | $ | 8.40 |   |   |
| Low                 |       | $                                | 6.88       |   |   | $ | 7.96 |   |   |   | $ | 7.16 |   |   |   | $ | 5.04 |   |   |

 

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

As of April 30,2007, and as of the most recent practicable date there wereapproximately 80 shareholders of record of our common stock. This does notinclude an indeterminate number of persons who hold our common stock inbrokerage accounts and otherwise in “street name.”

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 foreseeablefuture.

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

The following is providedwith respect to compensation plans (including individual compensationarrangements) under which equity securities are authorized for issuance as ofthe year ended April 30, 2007.

| ** **                                                            | ** ** | **Equity Compensation Plan  Information(1)(2)(3)** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| **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*        |       |                                               | 401,000    |   |   |   | $ | 5.90 |   |   |   | 251,000 |   |   |
| *Equity compensation plans not approved by security  holders(4)* |       |                                               | 3,250,000  |   |   |   | $ | 1.82 |   |   |   | 250,000 |   |   |
| **Total**                                                             |       |                                               | 3,651,000  |   |   |   | $ | 2.54 |   |   |   | 501,000 |   |   |
|                                                                       |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          This does not includeoptions or warrants held by management and directors that were not granted ascompensation. In each case, the disclosure refers to options or warrants unlessotherwise specifically stated.

(2)          Subsequent to year-end,our Board of Directors approved an increase in the authorized shares in the2005 Stock Option Plan from 875,000 to 2,875,000. The effectiveness of thisincrease is subject to stockholder approval.

(3)          Subsequent to year-end,our Board of Directors adopted and approved the establishment of the 2007Non-Employee Directors Stock Option Plan. The plan has 1,500,000 authorized sharesand the effectiveness of such plan is subject to shareholder approval.

(4)          The2007 Restructuring Equity Plan was adopted and approved by our board ofdirectors during the year ended April 30, 2007. The effectiveness of suchplan is subject to shareholder approval.

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**(e)**           ***Performance Graph.***

The following line graphcompares cumulative total stockholder returns for the five years ended April 30,2007 for (i) our common stock, the (ii) the Russell 2000 index, and (iii) thePhiladelphia Semiconductor Index, a published industry index for thesemiconductor market. The graph assumes an investment of $100 on April 30,2002. The calculation of cumulative stockholder return on our common stock doesnot include reinvestment of dividends because we did not pay any dividendsduring the measurement period. Because of our diverse business, which includessemiconductor operations, the development of homeland security products andsecurity services, and previously life sciences operations, we did not compareour stock performance against a peer or peer group because we do not believe wecan reasonably select a peer or peer group that would provide an accuratecomparison to us. The performance shown is not necessarily indicative of futureperformance.

**COMPARISON OF FIVEYEAR CUMULATIVE TOTAL RETURN**

**AmongIsonics Corporation, the Russell 2000 Indexand the Philadelphia Semiconductor Index.**

****

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**(f)****             *Recent Sales of Unregistered Securities—Item 701 Disclosure.***

**Employee andDirector Offerings**

*Employee Offerings*

(a)   During the past years, we issued shares of common stock andoptions to purchase shares of common stock pursuant to existing employeebenefit plans. As noted in the following discussion, these plans (except the2007 Restructuring Equity Plan which has not been approved by shareholders orincluded within a registration statement) have been included withinregistration statements on Form S-8 (file nos. 333-128592,333-74339 and 333-52514). The following table sets forthinformation about the options outstanding and available for issuance under eachof the plans as of April 30, 2007:

| **Plan Name**                     | ** ** | ** **                      | ** ** | **Issued  Options/Shares** | ** ** | **Available for Grant  or Issuance** |
|----------------------------------------|------------|---------------------------------|------------|----------------------------|------------|-----------------------------------------------------|
| 1996 Stock Option Plan                 |       | 20,000 options                  |       | 0 options                  |
| 1996 Executives Equity  Incentive Plan |       | 47,500 options 63,750  shares   |       | 0 options/shares           |
| 1996 Equity Incentive  Plan            |       | 102,000 options 3,750  shares   |       | 0 options/shares           |
| 1998 Employee Stock  Purchase Plan     |       | 22,860 shares                   |       | 0 shares                   |
| 2005 Stock Option Plan                 |       | 174,000 options 450,000  shares |       | 251,000 options/shares     |
| 2007 Restructuring Equity Plan         |       | 3,250,000 stock options         |       | 250,000 options            |

 

As a result of theadoption of the 2005 Stock Option Plan by our stockholders 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. In June 2007, we issued 200,000 and150,000 shares to a key consultant and employee from the 2005 Stock Option Planand the 2007 Restructuring Equity Plan, respectively.

*Issuances toOfficers or Directors Not Previously Reported*

(a)   On October 30, 2006 we granted 5,000 stock options each toRichard H. Hagman, C. Stewart Verdery, Jr., Russell W. Weiss and RichardParker under the 1998 Directors’ Plan. The options are exercisable at $2.68,expire October 29, 2011 and vested immediately.

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

(a)          Not applicable.

(b)         No underwriters were involved in thetransactions.

(c)          The stock options issuedoutside of our employee benefit plans were, for the most part, issued inconsideration of services rendered. In some cases they were issued to encouragethe performance of services in the future.

(d)         The transactions wereexempt from registration under the Securities Act of 1933, as amended by reasonof Sections 4(2) and 4(6) of the Securities Act of 1933 or Rule 701.

(e)          There are no conversion rights or exchangerights associated with the common stock. To the extent vested, the options areexercisable to purchase shares of common stock as described above.

(f)            Whereproceeds were received, the proceeds were utilized for working capitalpurposes.

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*Purchase of EquitySecurities by Issuer and Affiliated Purchaser*

During the years ended April 30, 2007, 2006 and2005, and subsequently, neither Isonics or any executive officer or directorpurchased any shares of our common stock in a Rule 10b-18 transactionor otherwise. Certain of our officers made purchases through our Employee StockPurchase Plan or the employee stock option plans

TheEmployee Stock Purchase Plan contemplated that each employee had the right towithhold a portion of his or her salary and have that portion applied topurchase our common stock directly from us at a discount to the market price onJune 1 and December 1 of each year. Officer purchases under the ESPPare summarized as follows (the ESPP was terminated on May 1, 2006):

| **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** | ** ** |
|------------------------|------------|------------|------------|------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| June 1, 2004      |       |       | 297        |                                                 |       |                                             | $          | 3.64                                                                                                                                 |       |                                                                                                                                    |       | none |   |   |   | none |   |   |
| December 1,  2004 |       |       | 108        |                                                 |       |                                             | $          | 6.12                                                                                                                                 |       |                                                                                                                                    |       | none |   |   |   | none |   |   |
| June 1, 2005      |       |       | 196        |                                                 |       |                                             | $          | 6.12                                                                                                                                 |       |                                                                                                                                    |       | none |   |   |   | none |   |   |
| December 1,  2005 |       |       | 491        |                                                 |       |                                             | $          | 6.12                                                                                                                                 |       |                                                                                                                                    |       | none |   |   |   | none |   |   |
| May 1, 2006       |       |       | 422        |                                                 |       |                                             | $          | 4.40                                                                                                                                 |       |                                                                                                                                    |       | none |   |   |   | none |   |   |

 

*Recent Sales ofUnregistered Securities*

During the three monthsended April 30, 2007 (and subsequently) we entered into the followingtransactions that were not registered under the Securities Act of 1933, asamended:

**Clayton DunningCapital Partners, Inc.**

As considerationfor entering into a financial advisory agreement on March 4, 2007 wegranted Clayton Dunning Capital Partners, Inc. (“Clayton Dunning”) awarrant to purchase 100,000 shares of our common stock. The following is theinformation required by Item 701 of Regulation S-K.

(a)   On March 5,2007 we granted Clayton Dunning a warrant (which was simultaneously transferredto Roadrunner Capital Group) to purchase 100,000 shares of our common stock at$1.65 per share exercisable for two years.

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

(c)   The warrantwas issued in consideration for Clayton Dunning entering into a financialconsulting agreement with us.

(d)   We reliedon the exemption from registration provided by Sections 4(2) and 4(6) underthe Securities Act of 1933 and Regulation D for the issuance of the commonstock. We did not engage in any public advertising or general solicitation inconnection with this transaction. The investor represented to us that it was anaccredited investor and had access to all of our reports filed with theSecurities and Exchange Commission, our press releases and other financial,business and corporate information. Based on our investigation, we believe thatthe investor obtained all information regarding Isonics it requested, receivedanswers to all questions it posed, and otherwise understood the risks ofaccepting our securities for investment purposes.

(e)   The warrantis exercisable or exchangeable into shares of common stock.

(f)    No cash proceeds were received.

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**CEOcast Inc.**

On May 22,2007 we entered into a consulting agreement with CEOcast Inc. (“CEOcast”), andas partial consideration for the investor relation services CEOcast willprovide to us, we issued CEOcast 18,750 shares of our restricted common stock. Thefollowing is the information required by Item 701 of Regulation S-K.

(a)   On May 22,2007 we issued CEOcast 18,750 shares of our restricted common stock.

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

(c)   The shareswere issued in consideration for CEOcast entering into an agreement with us,and we received no cash therefore.

(d)   We reliedon the exemption from registration provided by Sections 4(2) and 4(6) underthe Securities Act of 1933 and Regulation D for the issuance of the common stock.We did not engage in any public advertising or general solicitation inconnection with this transaction. The investor represented to us that it was anaccredited investor had access to all of our reports filed with the Securitiesand Exchange Commission, our press releases and other financial, business andcorporate information. Based on our investigation, we believe that the investorobtained all information regarding Isonics it requested, received answers toall questions it posed, and otherwise understood the risks of accepting oursecurities for investment purposes.

(e)   The shareswere common stock and, therefore, are not exercisable or exchangeable intoshares of common stock.

(f)    No cash proceeds were received.

**Sound BusinessSolutions, Inc.**

On June 19,2007 we entered into a consulting agreement with Sound Business Solutions, Inc,a corporation controlled by Joanna Lohkamp. Ms. Lohkamp serves as theChief Operating Officer of our wholly owned subsidiary IVI. Pursuant to thatagreement we granted Sound Business Solutions, Inc. options to purchase200,000 shares of our common stock. The following is the information requiredby Item 701 of Regulation S-K.

(a)   On June 19,2007 we granted Sound Business Solutions Inc. options to purchase 200,000shares of our common stock pursuant to our 2005 Equity Plan (a portion not yetsubject to a registration statement). The options are exercisable at $1.45 andexpire on June 18, 2011. Options to acquire 66,667 shares vestedimmediately, options to acquire 66,667 shares vest on September 7, 2007,and 66,666 of the options vest on January 31, 2008.

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

(c)   The optionswere granted in consideration for Sound Business Solutions Inc. entering intothe consulting agreement by which it agreed to provide services to Isonics. Wereceived no cash for the issuance of the options.

(d)   We reliedon the exemption from registration provided by Sections 4(2) and 4(6) underthe Securities Act of 1933 for the issuance of the stock options. We did notengage in any public advertising or general solicitation in connection withthis transaction, and we provided the investor with disclosure of all aspectsof our business, including providing the investor with our reports filed withthe Securities and Exchange Commission, our press releases, access to ourauditors, and other financial, business, and corporate information. We believethat Ms. Lohkamp, the sole owner of Sound Business Solutions, is anaccredited investor. We believe that the investor obtained all informationregarding Isonics it requested, 

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received answers to allquestions it (and its advisors) posed, and otherwise understood the risks ofaccepting our securities for investment purposes.

(e)   The stockoptions are exercisable to purchase shares of common stock as described above.

(f)    No proceeds were received.

**Michael Caridi**

On June 22,2007 our wholly owned subsidiary PPSC entered into an employment agreement (the“Employment Agreement”) with Michael Caridi to serve as PPSC’s Senior VicePresident. Pursuant to the Employment Agreement, we granted Mr. Caridioptions to purchase 150,000 shares of our common stock pursuant to our 2007Restructuring Equity Plan, which plan is subject to shareholder approval. Thefollowing is the information required by Item 701 of Regulation S-K.

(a)   On June 22,2007 we granted Michael Caridi options to purchase 150,000 shares of our commonstock. The options are exercisable at $1.50 and expire on June 21, 2012. Theoptions are subject to the following vesting schedule: (i) 50,000 optionsvested immediately; (ii) 25,000 shares vest six months from the date ofthe Employment Agreement; (iii) 25,000 options vest nine months from thedate of the Employment; and (iv) 50,000 shares vest upon achieving certainoperating income levels for the fiscal year ending April 30, 2008. Optionsshall only vest if Mr. Caridi is an employee of PPSC on each vesting date.

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

(c)   The stockoptions were granted in consideration for Mr. Caridi entering into theemployment agreement with our wholly-owned subsidiary, PPSC. We received nocash for the issuance of the options.

(d)   We reliedon the exemption from registration provided by Section 4(2) under theSecurities Act of 1933 for the issuance of the stock options. We did not engagein any public advertising or general solicitation in connection with thistransaction, and we provided the investor with disclosure of all aspects of ourbusiness, including providing the investor with our reports filed with theSecurities and Exchange Commission, our press releases, access to our auditors,and other financial, business, and corporate information. We believe that theinvestor obtained all information regarding Isonics it requested, receivedanswers to all questions he (and its advisors) posed, and otherwise understoodthe risks of accepting our securities for investment purposes.

(e)   The stockoptions are exercisable to purchase shares of common stock as described above.

(f)    No proceeds were received.

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**ITEM 6.**                SELECTEDFINANCIAL DATA

The following selectedfinancial data should be read in conjunction with Item 7. “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andconsolidated financial statements and notes thereto contained in Item 8. “FinancialStatements and Supplementary Data” of this report. The historical results arenot necessarily indicative of results to be expected in any future period. In January 2007,we elected to discontinue the operation of our life sciences business and toput the assets and business up for sale. As a result, we reclassified theoperations of our life sciences business as discontinued operations. Prior yearinformation has been reclassified to conform with the current yearpresentation.

| ** **                                                                                                      | ** ** | **Year Ended**                                          | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **April 30,  2007**                                     | ** ** | **April 30,  2006** | ** ** | **April 30,  2005** | ** ** | **April 30,  2004** | ** ** | **April 30,  2003** | ** ** |
| ** **                                                                                                      | ** ** | **(in thousands, except share amounts)** | ** ** |
| **Summary of Operations**                                                                                       | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                                                        |       | $                                                            | 27,731     |   | $ | 18,580 |   | $ | 2,692 |   | $ | 519 |   | $ | 197 |   |
| Operating loss                                                                                                  |       | $                                                            | (15,548    | ) | $ | (15,663 | ) | $ | (11,956 | ) | $ | (4,658 | ) | $ | (3,655 | ) |
| Loss from  continuing operations                                                                                |       | $                                                            | (12,941    | ) | $ | (31,381 | ) | $ | (13,024 | ) | $ | (4,675 | ) | $ | (2,055 | ) |
| Income (loss)  from discontinued operations, net of income taxes                                                |       | $                                                            | (224       | ) | $ | (960 | ) | $ | (2,153 | ) | $ | (512 | ) | $ | 949 |   |
| Net loss  attributable to common stockholders                                                                   |       | $                                                            | (13,165    | ) | $ | (32,442 | ) | $ | (16,515 | ) | $ | (7,025 | ) | $ | (1,106 | ) |
| Life sciences segment revenue included in income  (loss) from discontinued operations, net of income taxes |       | $                                                            | 1,803      |   | $ | 5,136 |   | $ | 7,413 |   | $ | 8,202 |   | $ | 8,854 |   |
| **Per  Share Data**                                                                                             | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss per  share—basic and diluted attributable to common stockholders                                  |       | $                                                            | (1.11      | ) | $ | (4.00 | ) | $ | (2.95 | ) | $ | (2.12 | ) | $ | (0.38 | ) |
| Weighted average  common shares used in computing per share information                                         |       | 11,898                                                       |       | 8,103 |   | 5,596 |   | 3,313 |   | 2,929 |   |
| **Balance  Sheet Data**                                                                                         | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                      |       | $                                                            | 1,566      |   | $ | 1,586 |   | $ | 20,598 |   | $ | 3,213 |   | $ | 199 |   |
| Working capital  (deficit)                                                                                      |       | $                                                            | 3,310      |   | $ | (6,445 | ) | $ | 18,203 |   | $ | 6,571 |   | $ | 1,056 |   |
| Total assets                                                                                                    |       | $                                                            | 18,960     |   | $ | 17,863 |   | $ | 31,181 |   | $ | 8,681 |   | $ | 5,747 |   |
| Long-term debt                                                                                                  |       | $                                                            | 9,344      |   | $ | 174 |   | $ | 15,740 |   | $ | — |   | $ | — |   |
| Preferred stock                                                                                                 |       | $                                                            | —     |   | $ | — |   | $ | 4,033 |   | $ | 5,613 |   | $ | 745 |   |
| Stockholders’ equity                                                                                       |       | $                                                            | 3,555      |   | $ | 2,643 |   | $ | 9,588 |   | $ | 7,711 |   | $ | 4,308 |   |

 

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**General Discussion**

We are focused on the development and provision ofhomeland security products and services and the manufacture of 300-millimeter(and smaller diameter) silicon wafer reclaim and test products, wafer thinningand custom wafer products for the semiconductor industry. During the pastseveral years, our operations have been characterized by working capital andcash flow shortfalls, and the need for a significant amount of third partyinvestment to enable us to meet our financial obligations. Although we have metour obligations to date (except for the $1,000,000 payment that was due toLucent on July 16, 2007), we have frequently been required to allocate ouravailable cash among various obligations. During the year ended April 30,2007 and subsequently, we have also refocused our operations and we haveattempted to reduce significantly our expenses, including the cash flownecessary to pay our overhead.

We redefined and refocused the operations of HSDC tofocus on the development of partnerships with leading prime contractors in thesecurity and defense, industrial and transportation markets, although we havenot yet developed any such partnerships. By working with these types ofpartners, we believe that we will be able to more effectively and efficientlycomplete the development of our IMS-based products with the goal ofincorporating them into the products and systems of our partners. If we aresuccessful in developing these types of strategic partnerships, we will be in abetter position to compete with the current industry leaders through leveragingthe marketing arms and customer bases of these partners. This change instrategic direction will delay the time frame for significant products salesbut we are hopeful that it will allow for a significant reduction indevelopment costs and a greater penetration of the market in the future.

We have continued to pursue our development projectwith Lucent through our 90%-owned subsidiary, SenseIt. We (partially throughour obligations to SenseIt) paid $6,000,000 of the original $12,000,000obligation under this agreement through the date of this report.

We did not make the $1,000,000 payment that was due toLucent on or before July 16, 2007 as neither entity currently hassufficient working capital to make such payment. As a result of not making thispayment (or other payments when due), Lucent may, after certain steps ofnotification and periods to cure have been exhausted, cancel the LucentAgreement and all licenses granted to us thereunder or cease working on theproject and then assess us a “start-up” fee if funding was to resume.

On July 26, 2007, we received officialnotification from Lucent that we failed to make the $1,000,000 payment toLucent by July 16, 2007 and that in the event such non-payment continuesfor more than ten days, Lucent may at is discretion, suspend work on thedevelopment project. We are currently seeking additional financing to allow usto fund SenseIt so that SenseIt can make its contractual development paymentsto Lucent. We cannot offer any assurance that we will be able to raise thefunds necessary to make all of the required payments to Lucent, or that thetechnology will be developed to a point where we want to continue to make suchpayments when due. Additionally, SenseIt may need to seek outside financing tomake payments to Lucent and, if so elected, such outside financing would diluteour ownership interest in SenseIt. Lastly, although we are hopeful of apositive outcome, we can offer no assurance that the development activityunderway with Lucent and SenseIt will yield technologically relevant orcommercially viable products.

During the fourth quarter of the year ended April 30,2007 and the first quarter of the subsequent fiscal year, we implemented costcutting initiatives that are expected to positively impact the results of PPSC’soperations and reduce expenses at our corporate offices. Additionally weinitiated plans to improve operating margins at PPSC by focusing on customersthat are willing to pay for premium security services, a market in which webelieve that PPSC is able to differentiate itself from its peers. As a result,we have 

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and will continue to exitlower-margin business areas for premium accounts that prefer higher quality ofservice. While we believe that these cost cutting initiatives and refocusedsales and marketing efforts will enable PPSC to report positive operatingincome for the year ending April 30, 2008, we can offer no assurance thatthis will actually occur.

Many of the more significant cost-cutting steps weretaken late in the year ended April 30, 2007 and the beneficial impact isonly partially reflected in the results of operations for the year ended April 30,2007. While we believe that these measures may have a significant beneficialimpact during our year ended April 30, 2008, this cannot be assured and,as discussed above and below, certain negative impacts to the semiconductormarket may offset any beneficial impacts of our restructuring and cost-cuttingmeasures.

In June 2007 we sold our life sciences business(which supplied isotopes for life sciences and health-care applications) as itno longer fit our long-term strategy for building a sustainable and profitablehomeland security and semiconductor company and because of deterioratingbusiness conditions in the historical revenue producing products in thisbusiness.

We recorded a net loss of $(13,165,000) for the yearended April 30, 2007 as compared to $(32,341,000) and $(15,177,000) forthe years ended April 30, 2006 and 2005, respectively. Our net loss isimproved as compared to the years ended April 30, 2006 and 2005 partly dueto increasing revenues and improved gross margins, as described below. Includedin the net loss for the year ended April 30, 2007 were net non-cash gainsof $2,643,000 associated with our convertible debentures. Included in the netloss 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 increased by$9,755,000 during the year ended April 30, 2007, from a working capitaldeficit of $(6,445,000) at April 30, 2006 to positive working capital of$3,310,000 at April 30, 2007. This improvement was due mostly to thecapital raising that occurred during our year ended April 30, 2007. However,due to continuing operating losses and projected declining working capitalbalances during the year ending April 30, 2008, the auditors report includedwith our financial statements includes the following explanatory paragraph:

“The accompanying financial statements have beenprepared assuming that the Company will continue as a going concern. Asdiscussed in Note 1 to the financial statements, the Company has sufferedrecurring losses from operations and will continue to require funding frominvestors for working capital. This raises substantial doubt about the Company’sability to continue as a going concern. Management’s plans in regard to thesematters are also described in Note 1. The financial statements do not includeany adjustments that might result from the outcome of this uncertainty.”

Our ability to continue as a going concern isdependent upon raising capital through debt or equity financing and ultimatelyby increasing revenue and achieving profitable operations. We can offer noassurance that we will be successful in our efforts to raise additionalproceeds or achieve profitable operations. The consolidated financialstatements located in Item 8. “Financial Statements and Supplementary Data”have been prepared on a going concern basis, which contemplates the realizationof assets and the settlement of liabilities in the normal course of business.

Based on the amount ofcapital we have remaining, our current and projected negative cash flow fromoperations, we anticipate that we may incur a working capital deficit unless weare able to substantially increase our revenue or reduce our expenses further,thereby generating positive cash flow from operations and (ultimately)operating income. Nevertheless, as a result of our fund raising activitiesduring the year ended April 30, 2007, other anticipated cash flows andcertain cost-saving measures we have instituted, we believe we have sufficientworking capital to finance our anticipated operations and projected negativecash flow into our quarter ending January 31, 2008.

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**Critical AccountingEstimates**

Our consolidated financial statements are prepared inaccordance with generally accepted accounting principles in the Unites States,which require management to make estimates, judgments and assumptions thataffect the amounts reported in the consolidated financial statements andaccompanying notes. We consider an accounting estimate to be critical if 1) theaccounting estimate requires us to make assumptions about matters that werehighly uncertain at the time the accounting estimate was made, and 2) changesin the estimate that are reasonably likely to occur from period to period, oruse of different estimates that we reasonably could have used in the currentperiod, would have a material impact on our financial condition or results ofoperations.

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.****Webelieve that our most critical accounting policies and estimates are asfollows:

*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 theidentified tangible and intangible assets requires significant judgment and mayrequire independent valuations of certain identified assets. Once goodwill andother intangible assets are established on our balance sheet, we evaluate theassets for impairment as described in the following paragraphs.

In accordance with SFAS No. 142 *Goodwill and Other Intangible Assets*,goodwill is not amortized, but instead is tested for impairment on an annualbasis or more frequently if the presence of certain circumstances indicatesthat impairment may have occurred. The impairment review process, which issubjective and requires significant judgment at many points during theanalysis, compares the fair value of the reporting unit in which goodwillresides to its carrying value. If the carrying value of a reporting unitexceeds its fair value, then the amount of the impairment loss must bemeasured. The impairment loss is calculated by comparing the implied fair valueof reporting unit goodwill to its carrying amount. In calculating the impliedfair value of reporting unit goodwill, the fair value of the reporting unit isallocated to all of the other assets and liabilities of that unit based ontheir 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. We have goodwill in the amount of$3,631,000 on our consolidated balance sheet as of April 30, 2007, relatedto the acquisition of PPSC in May 2005. We performed our annual impairmentreview on the aforementioned goodwill during our third fiscal quarter andconcluded that the goodwill is not impaired.

For intangible assetsother than goodwill, SFAS No. 144 *Accounting for theImpairment or Disposal of Long-Lived Assets* (“SFAS 144”) is theauthoritative standard on the accounting for the impairment of such intangibleassets. As required, we perform tests for impairment of intangible assets otherthan goodwill whenever events or circumstances suggest that such assets may beimpaired. To evaluate potential impairment, SFAS No. 144 requires us toassess whether the future cash flows related to these assets will be greaterthan their carrying value at the time of the test. Accordingly, while our cashflow assumptions are consistent with the plans and estimates we are using tomanage the underlying businesses, there is significant judgment in determiningthe cash flows attributable to our other intangible assets over theirrespective estimated useful lives. We have remaining other net intangibleassets in the amount of $303,000 on our consolidated balance sheet as of April 30,2007, comprised of our IMS-based detection technology 

33

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acquiredin December 2002, for customer lists acquired in our acquisition of thebusiness and assets of EMG in June 2004 and the customer base acquired inour acquisition of PPSC in May 2005. We are required to periodicallyevaluate our other intangible assets balances for impairments. If we were toincur additional impairments to our other intangible assets, it could have anadverse impact on our future earnings, 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 (or, sometimes, at the date of conversion). We valuetransactions associated with common stock warrants at the appropriatemeasurement date utilizing at a minimum, the Black-Scholes pricing model, withassumptions as to volatility, risk-free interest rate and estimated life of thewarrants based on historical information related to the life of the underlyingwarrant. If the assumptions used, as they relate to volatility, risk-freeinterest rate and estimated life of the warrants, were materially different,the overall valuation of these transactions could change significantly.

*Stock-BasedCompensation Expense*

We account for stock-basedcompensation in accordance with SFAS 123(R). Under the fair value recognitionprovisions of SFAS 123(R), stock-based compensation cost is estimated at thegrant date based on the fair value of the award and is recognized as expenseratably over the requisite service period of the award. Determining theappropriate fair value model and calculating the fair value of stock-basedawards, which includes estimates of stock price volatility, forfeiture ratesand expected lives, requires judgment that could materially impact ouroperating results.

**Recent AccountingPronouncements**

See Note 1 to the consolidated financial statementslocated in Item 8. “Financial Statements and Supplementary Data” for adescription of certain other recent accounting pronouncements including theexpected dates of adoption and effects on our results of operations andfinancial condition.

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**Results ofOperations**

Thefollowing table sets forth, for the periods indicated, consolidated statementsof operations data expressed as a percentage of revenues. The table and thediscussion below should be read in conjunction with the consolidated financialstatements and notes thereto appearing elsewhere in this report. In January 2007,we elected to discontinue the operation of our life sciences business and putthe assets and business up for sale (which was sold in June 2007). As aresult, we reclassified the operations of our life sciences business asdiscontinued operations. Prior year information has been reclassified toconform with the current year presentation.

| ** **                                                                 | ** ** | **Year Ended April 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                 | ** ** | **2007**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues                                                                   |       | 100.0                              | %          |   | 100.0 | % |   | 100.0 | % |
| Cost of revenues                                                           |       | 78.6                               |       |   | 96.9 |   |   | 242.6 |   |
| Gross margin                                                               |       | 21.4                               |       |   | 3.1 |   |   | (142.6 | ) |
| Operating  expenses:                                                       |       |                               |       |   |   |   |   |   |   |
| Selling, general and administrative                                        |       | 59.6                               |       |   | 57.9 |   |   | 231.1 |   |
| Impairment loss on assets held for sale                                    |       | —                             |       |   | 2.5 |   |   | — |   |
| Impairment of goodwill and intangible assets                               |       | —                             |       |   | — |   |   | 32.5 |   |
| Research and development                                                   |       | 17.9                               |       |   | 27.0 |   |   | 37.9 |   |
| Total operating expenses                                                   |       | 77.5                               |       |   | 87.4 |   |   | 301.5 |   |
| Operating loss                                                             |       | (56.1                              | )          |   | (84.3 | ) |   | (444.1 | ) |
| Other income (expense), net                                                |       | 9.6                                |       |   | (84.6 | ) |   | (39.7 | ) |
| Loss from  continuing operations before income taxes and minority interest |       | (46.5                              | )          |   | (168.9 | ) |   | (483.8 | ) |
| Income tax  expense                                                        |       | —                             |       |   | — |   |   | — |   |
| Minority interest  in operations of consolidated subsidiary                |       | (.2                                | )          |   | — |   |   | — |   |
| Loss from  continuing operations                                           |       | (46.7                              | )          |   | (168.9 | ) |   | (483.8 | ) |
| Loss from discontinued operations, net of income  taxes                    |       | (.8                                | )          |   | (5.2 | ) |   | (80.0 | ) |
| NET LOSS                                                                   |       | (47.5                              | )%         |   | (174.1 | )% |   | (563.8 | )% |

 

**Revenues**

Revenuesfrom our security services and semiconductor products and services increasedover the past three years while revenues from homeland security products wereminimal, as reflected in the following table:

| ** **                           | ** ** | **Year Ended April 30,** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|
| ** **                           | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Homeland security  products          |       | $                                       | 28,000     |   | $ | 35,000 |   | $ | — |   |
| Security services                    |       | 14,682,000                              |       | 12,814,000 |   | — |   |
| Semiconductor  products and services |       | 13,021,000                              |       | 5,731,000 |   | 2,692,000 |   |
| Total                                |       | $                                       | 27,731,000 |   | $ | 18,580,000 |   | $ | 2,692,000 |   |

 

The revenue for our security services segment isgenerated by PPSC, a business that we acquired in May 2005. Pro formarevenue for the year ended April 30, 2006 would have been approximately$13,361,000 if the PPSC acquisition had occurred on the first day of thatquarter. The increase in revenue fromthe security services segment for the year ended April 30, 2007, is due tothe net addition of additional security services contracts since theacquisition of PPSC. Whilewe anticipate that we will continue to grow revenue in this segment by securingadditional new security contracts in our PPSC 

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subsidiaryand retaining existing customers under contract currently with PPSC, we cannotprovide any assurance that we will be able to do so.

Our semiconductor products and services segment hasexperienced a rapid increase in revenue during the past two years. Revenue forthe years ended April 30, 2007 and 2006, was 127% and 113% higher thanrevenue for the years ended April 30, 2006 and 2005, respectively. Theincreases are predominately due to the expansion of sales of higher-margin 300-millimeterproducts and services. Our 300-millimeter business provided revenue of $7,049,000,$2,053,000 and $0 for the years ended April 30, 2007, 2006 and 2005,respectively. While we believe that continued expanded focus on the 300-millimeter,wafer thinning and other semiconductor products and services markets will allowus to continue to increase revenue over the long-term, we can provide noassurance that we will be able to do so.

While we reported significant revenue and operatingincome growth in our semiconductor operations for the year ended April 30,2007, many of our top semiconductor customers have experienced weakenedbusiness results in recent quarters. In addition, some customers have reportedinventory buildup in reclaim and/or test products. As a result of these twofactors, we have recently seen a slowdown in orders of reclaim and testmaterials, which has had a negative impact on our operations. The slowdown willhave a significant impact on our results of operations and cash flows for ourquarter ending July 31, 2007, which we expect to reflect a significantreduction in revenue (as compared to the previous sequential quarter) and thereporting of an operating loss for that segment. In order to minimize theeffect of the slowdown, we have implemented many cost cutting procedures andwill continue to do so. It is unclear as to when the market will rebound but webelieve that this is a relatively short-term phenomenon and are hopeful that wewill begin to see a recovery during our quarter ending October 31, 2007. Inaddition, due to this slowdown in orders of reclaim and/or test wafers duringour quarter ending July 31, 2007, it is unclear if we will be successfulin maintaining or increasing our revenue in our semiconductor products andservices segment for the year ending April 30, 2008. We continue tomonitor the situation closely and while we believe that we will see improvingfinancial results in this operating segment (over the long-term), we cannotoffer any assurance that we will be able to regain or sustain operatingprofitability in future periods.

Our homeland security products segment has recordedminimal or no revenue for the years ended April 30, 2007, 2006 and 2005.The proceeds related to the installation of the first seven commercial unitsduring the year ended April 30, 2007 are primarily being classified asdeferred revenue pending completion of certain tasks. Although we haveinstalled an additionaleight units subsequent to year-end, we have not received any further purchasecommitments for our product to be incorporated into the AirChx system at thistime. Consequently, our ability to generate significant revenue related to thesale of our IMS-based products is highly dependent to our success in obtainingthe strategic partnerships discussed in Item 1. “Business”. Althoughwe are hopeful that our year ending April 30, 2008 will reflectsignificantly greater revenues from IMS-based products (as compared to fiscalyear 2007), we cannot offer any assurance that this will actually occur.

Althoughwe have diversified our sources of revenue, we continue to have concentrationsof revenue with certain customers as reflected in the following table(information only listed if percentage is greater than 10%):

| ** **                                                      | ** ** | **Percentage of revenues during  years ended April 30,** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **   2007   **                                           | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
| Qimonda Richmond  LLC (formerly Infineon Technologies Richmond) |       |                                                                                   | 21         | % |   |   | 13 | % |   |   | 24 | % |   |
| Consolidated  Edison Company                                    |       |                                                                                   | —     |   |   |   | 12 | % |   |   | — |   |   |
| Foot Locker  Retail, Inc.                                  |       |                                                                                   | 14         | % |   |   | 22 | % |   |   | — |   |   |
| Citicorp North  America, Inc.                              |       |                                                                                   | 11         | % |   |   | — |   |   |   | — |   |   |
| SEH America, Inc.                                          |       |                                                                                   | —     |   |   |   | — |   |   |   | 11 | % |   |

 

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A decision by asignificant customer to substantially decrease or delay purchases from us or aninability to collect significant amounts owed to us could have a materialadverse effect on our consolidated financial condition and results ofoperations.

**Gross Margin**

Ourgross margins increased for the past two years, both on a dollar amount and ona percentage of revenues basis as reflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                       | 5,921,000  |   | $ | 571,000 |   | $ | (3,839,000 | ) |
| Percent of revenues |       | 21.4                                    | %          | 3.1 | % | (142.6 | )% |
|                     |            |                                         |            |  |  |  |  |  |  |  |

 

The increase in gross margin for the year ended April 30,2007 is due mainly to continued improvement in the operations of oursemiconductor products and services segment where there were significantimprovements to gross margin on a dollar amount and on a percentage of revenuesbasis. The increase in gross margin for the year ended April 30, 2006 wasdue mainly to two factors: (1) the impact of PPSC’s operations, which wereacquired in May 2005 and (2) 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. Asa result of the slowdown in orders of reclaim and/or test wafers during our quarterending July 31, 2007 (as discussed above) it is currently unclearif we will be successful in maintaining or increasing gross margins (on adollar basis) in our semiconductor products and services segment for the yearending April 30, 2008.

On a dollar basis, overall gross margin is expected toincrease correspondingly with increases in revenue, if any, with dependencieson customer and supplier pricing. Our ability to positively impact consolidatedgross margin will in large be dependent upon our ability to grow sales in ourhomeland security segments through increased sales of security services anddetection products and in our semiconductor products and services segmentthrough increased sales of 300-millimeter products and services and waferthinning services.

On a percentage ofrevenues basis, in general we anticipate that the gross margin percentage inour security services segment will remain relatively stable. As a result of thecurrent downturn which may lead to increased competition and lower prices, oursemiconductor products and services segment will most likely experience adecrease in gross margins as a percentage of revenues during the year ending April 30,2008 as compared to the year ended April 30, 2007. In addition, due tofixed facility costs included in cost of revenues in the semiconductor productsand services segment, the gross margin percentage is particularly sensitive tochanges in revenue. Lastly, the gross margin percentage on our homelandsecurity products segment is likely to be volatile as well as we attempt toincrease revenue in that segment, though we can offer no assurances that wewill be able to do so.

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**Selling, Generaland Administrative Expenses**

Ourselling, general and administrative expenses increased as a dollar amount forthe last two years ended April 30, 2007. Our selling, general andadministrative expenses as a percentage of revenues remained fairly constantduring the year ended April 30, 2007 (as compared to the year ended April 30,2006) but decreased significantly as compared to the year ended April 30,2005 as reflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                       | 16,519,000 |   | $ | 10,750,000 |   | $ | 6,222,000 |   |
| Percent of revenues |       | 59.6                                    | %          | 57.9 | % | 231.1 | % |
|                     |            |                                         |            |  |  |  |  |  |  |  |

 

Selling, general and administrative expenses increasedon a dollar and percentage basis for the year ended April 30, 2007 ascompared to the year ended April 30, 2006 primarily due to severance costs(mostly non-cash) associated with the termination of several key executives,increases in staffing and commissions at PPSC due to the pursuit of newcontracts, personnel and related expenses in our homeland security productssegment, the consolidation of operating expenses at SenseIt and significantnon-cash charges associated with registration rights penalties, amendments tothe number of shares issuable and the exercise price of certain warrants withratchet provisions, the retention of a 10% equity interest in SenseIt by itschief executive officer and stock based compensation expense associated withour adoption of SFAS 123(R) (significantly offset by an increase inrevenues as it relates to the percentage increase). The total costs incurredduring the year ended April 30, 2007 associated with severance andcompensation expense related to the adoption of SFAS 123(R) approximates$3,930,000 (of which approximately $3,330,000 is non-cash) of which zero wasincurred in either of the years ended April 30, 2006 or 2005.

Both the dollar and percentage increase for the yearended April 30, 2005 is attributable to an increase in consulting andother professional services expenses, an increase in headcount and facilitycosts related to the expansion of our semiconductor operations (primarily dueto the acquisition of the business and assets of EMG in June 2004) and anincrease in headcount in our homeland security and corporate operations(partially offset by an increase in revenues as it relates to the percentageincrease).

As a result of ourrestructuring activities completed during the end of the year ended April 30,2007 and the first quarter of the year ending April 30, 2008 and therefocusing of our homeland security product development operations, we arehopeful (although we can offer no assurance) that selling, general and administrativecosts will be reduced during the year ending April 30, 2008 (as comparedto the prior year).

**Impairment Loss onAssets Held for Sale**

Werecognized an impairment loss on assets held for sale during the year ended April 30,2006 as reflected in thefollowing table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       |                                    | $          | — |   |   | $ | 466,000 |   |   | $ | — |   |   |
| Percent of revenues |       |                                    | —     | % |   | 2.5 | % |   | — | % |   |
|                     |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

During the year ended April 30,2006, as part of a review of our semiconductor products and services segment thatresulted in operational changes, certain equipment was identified asunnecessary for our planned future operations. As a result, certain of theidentified equipment whose book value exceeded estimated net realizable valuewere individually written down to estimated net realizable value, resulting ina cumulative impairment charge of $466,000. We subsequently sold this equipmentin February 2007 for $672,000.

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**Impairment ofGoodwill and Intangible Assets**

Werecognized an impairment loss on goodwill and intangible assets during the yearended April 30, 2005 asreflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       |                                    | $          | — |   |   |   | $ | — |   |   | $ | 875,000 |   |
| Percent of revenues |       |                                    | —     | % |   |   | — | % |   | 32.5 | % |
|                     |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

Impairment of goodwill andintangible assets for the year ended April 30, 2005 relates to thewrite-off 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.

**Research andDevelopment Expenses**

Researchand development expenses for the years ended April 30, 2007, 2006 and 2005on both a dollar amount and as a percentage of revenues are reflected in thefollowing table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                       | 4,950,000  |   | $ | 5,018,000 |   | $ | 1,020,000 |   |
| Percent of revenues |       | 17.9                                    | %          | 27.0 | % | 37.9 | % |
|                     |            |                                         |            |  |  |  |  |  |  |  |

 

The majority of research and development expenses forthe years ended April 30, 2007 and 2006 relate primarily to thedevelopment of next-generation infrared technology through our Lucentrelationship and SenseIt subsidiary and our IMS technology. The majority ofresearch and development expenses for fiscal year 2005 relates primarily to thedevelopment of our IMS technology and other bulk detection technologies.

A significant amount of the research and developmenton IMS technology was performed by IUT. We funded $1,099,000, $1,312,000 and$496,000 under our agreement with IUT during the years ended April 30,2007, 2006 and 2005, respectively. While we expect to significantly reduce ourresearch and development expenses performed by IUT during the year ending April 30,2008 as we continue to focus on our new strategic, customer-based focus insteadof a product orientation, we do intend to continue using IUT to the extentnecessary to improve the performance of our panel-mounted IMS-based product forour existing customer and any new opportunities that may develop.

In December 2005, we approved a development planwith Lucent that obligated us under the Lucent Agreement. Under the LucentAgreement, we are attempting to develop a next-generation imaging and nightvision surveillance technology. In October 2006, we acquired a 90% interest in SenseIt in exchangefor assigning to SenseIt all of our interest under the Lucent Agreement (suchassignment was approved by Lucent) and we also entered into a new statement ofwork with Lucent (which was also transferred to SenseIt). SenseIt willcoordinate the development of the next-generation infrared imaging technologyand work towards commercialization of any resultant products. Thedevelopment plan contemplates for prototype products to be available duringcalendar year 2007, although we can provide no assurance that a commerciallyattractive product will ultimately be available.

For the year ended April 30, 2007, we recognizedresearch and development expense related to the Lucent Agreement of $3,000,000as compared to $2,500,000 recognized for the year ended April 30, 2006.Under the Lucent agreement, SenseIt must provide funding of $1,000,000 perquarter in development funding for the next five quarters (in addition tofunding the payment not made that was due on or before July 16, 2007) orrisk losing its rights under the Lucent Agreement. Although the funding is anobligation 

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of SenseIt, we have a rightof first refusal to provide SenseIt the necessary funding by purchasingadditional shares of SenseIt Series A Common Stock at $10 per share. Webelieve that our interest in SenseIt could be significantly diluted wereSenseIt to seek funding from third parties at this stage. Also under the LucentAgreement, SenseIt has the right to terminate the development project for anyreason from time-to-time, so long as termination is prior to the firstcommercial sale of a licensed product. As such, assuming SenseIt continues withthe development program, we expect our quarterly research and developmentexpense for this purpose to remain elevated. If we are unable to provide SenseIt with thefunds necessary to make the quarterly Lucent payments due to Lucent, SenseItwill be required to seek funding from outside sources.

We believe that thedevelopment and introduction of new product applications is critical to ourfuture success. While we expect to continue to incur significant research anddevelopment expenses over time (assuming sufficient cash remains available andwe are able to procure necessary materials and outside services), we anticipatethat expenditures on research and development with IUT will decrease. However,research and development expenses are expected to increase at SenseIt as workcontinues under the Lucent Agreement and in ancillary efforts to produce amarketable infrared imaging product. It is likely that research and developmentexpenditures will continue to vary as a percentage of revenues because of thetiming and amount of future revenues and the timing of research and developmentexpenses. Except for work being performed on our semiconductor products at ourfacilities in Vancouver, Washington, we operate no other facilities of our ownfor research and development. Significantly all other research and developmentwork is performed by outside entities, none of which we control (although wehave an ownership position in IUT of 30%). Although we expend significantresources on research and development, we cannot offer any assurance that ourcurrent or future lines of business or products resulting from our research anddevelopment efforts will be profitable or generate significant revenues.

**Operating Income(Loss)**

Ouroperating income (loss) for the years ended April 30, 2007, 2006 and 2005is reflected in the following table:

| ** **                           | ** ** | **Year Ended April 30,** | ** **  |
|--------------------------------------|------------|-----------------------------------------|-------------|
| ** **                           | ** ** | **2007**                                | ** **  | **2006** | ** ** | **2005** | ** ** |
| Homeland security  products          |       | $                                       | (6,664,000  | ) | $ | (5,989,000 | ) | $ | (1,728,000 | ) |
| Security services                    |       | (425,000                                | )           | (24,000 | ) | — |   |
| Semiconductor  products and services |       | 326,000                                 |        | (5,151,000 | ) | (6,484,000 | ) |
| Reconciling  amounts(1)              |       | (8,785,000                              | )           | (4,499,000 | ) | (3,744,000 | ) |
| Total                                |       | $                                       | (15,548,000 | ) | $ | (15,663,000 | ) | $ | (11,956,000 | ) |

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(1)          Reconciling amounts forthe operating loss information includes corporate expenses consisting primarilyof corporate salaries and benefits, professional and consulting fees, investorrelations costs, warrant amendment expense, insurance and directors’compensation. In January 2007, weelected to discontinue the operation of our life sciences business and put theassets and business up for sale (which was sold in June 2007). As aresult, we reclassified the operations of our life sciences business asdiscontinued operations. Prior year information has been reclassified toconform with the current year presentation.

Our homeland security products segment has generatedsignificant operating losses in an effort to develop and commercialize our IMStechnology into products that can be used to detect various types of explosivesand/or chemical agents and innovative infrared imaging technology. Whilerevenues were minimal for the years ended April 30, 2007, 2006 and 2005,we are hopeful that we will be able to begin to generate more substantialrevenue in this segment during our year ending April 30, 2008.

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Our security services segment consists of PPSC, whichwas acquired in May 2005. For the years ended April 30, 2007 and2006, this segment delivered revenue of $14,682,000 and $12,814,000,respectively. The operating loss for the year ended April 30, 2007, is dueprimarily to an increase in selling, general and administrative expenses ascompared to the comparable period in the prior year. This increase is due toincreased marketing spending, a write-off of a single customer’s accountsreceivable balance in the amount of approximately $90,000, the inclusion of a$86,000 non-cash charge related to stock-based compensation expense (due to ouradoption of SFAS 123(R) during the year ended April 30, 2007) and$90,000 in increased rent due to a relocation and incremental investment inpersonnel to support future revenue growth in both the governmental andcommercial markets. Although we continue to pursue selected domestic governmentcontracts, we have taken steps to reduce our spending on sales and marketing in this area.

During the fourth quarter of the year ended April 30,2007 and the first quarter of the year ending April 30, 2008, weimplemented significant cost cutting initiatives that are expected topositively impact the results of PPSC’s operations. Additionally we initiatedplans to improve operating margins at PPSC by focusing on customers that arewilling to pay for premium security services, where PPSC is able todifferentiate itself from its peers. As a result, we have and will continue toexit lower-margin business areas in lieu of premium accounts that prefer higherquality of service. While we believe that these cost cutting initiatives andrefocused sales and marketing efforts will enable PPSC to report positiveoperating income for the year ending April 30, 2008, we can offer noassurance that this will actually occur.

Oursemiconductor products and services segment showed continued operational andfinancial improvement (due mainly to the realignment of our business tosignificantly reduce our reliance on low margin small diameter products andfocus mainly on higher margin 300-millimeter products and services, waferthinning and custom wafer products) for the year ended April 30, 2007,recording our third consecutive quarterly operating income for the three monthsended April 30, 2007. Additionally, the operating income (loss) hasgenerally improved each sequential quarter during the years ended April 30,2007 and 2006, as reflected in the following table:

| **Three months ended** | ** ** | ** ** | ** ** | **Semiconductor products and services  operating income(loss)** | ** ** |
|----------------------------------|------------|------------|------------|-------------------------------------------------------------------------------------|------------|
| July 31,  2005              |       |       | $          | (2,054,000                                                                          | )(1)       |   |
| October 31,  2005           |       |       | $          | (1,420,000                                                                          | )          |   |
| January 31,  2006           |       |       | $          | (900,000                                                                            | )          |   |
| April 30,  2006             |       |       | $          | (777,000                                                                            | )          |   |
| July 31,  2006              |       |       | $          | (199,000                                                                            | )          |   |
| October 31,  2006           |       |       | $          | 151,000                                                                             |       |   |
| January 31,  2007           |       |       | $          | 88,000                                                                              |       |   |
| April 30, 2007              |       |       | $          | 286,000                                                                             |       |   |

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(1)          Includes an impairmentcharge on assets held for sale of approximately $400,000.

While we reportedsignificant revenue and operating income growth in our semiconductor operationsfor the year ended April 30, 2007, many of our top semiconductor customershave experienced weakened business results in recent quarters. In addition,some customers have reported inventory buildup in reclaim and/or test products.As a result of these two factors, we have recently seen a slowdown in orders ofreclaim and test materials, which has had a negative impact on our operations. Theslowdown will have a significant impact on our results of operations and cashflows for our quarter ending July 31, 2007, which we expect to reflect asignificant reduction in revenue (as compared to the previous sequentialquarter) and the reporting of an operating loss for that segment. In order tominimize the effect of the slowdown, we have implemented many cost cuttingprocedures and will continue to do so. It is unclear as to when the market willrebound but we believe that this is a relatively short-term phenomenon and arehopeful that we 

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willbegin to see a recovery during our quarter ending October 31, 2007. Wecontinue to monitor the situation closely and while we believe that we will seeimproving financial results in this operating segment (over the long-term), wecannot offer any assurance that we will be able to regain or sustain operatingprofitability in future periods.

**Other income(expense), net**

Otherincome (expense), net for fiscal years 2007, 2006 and 2005 on both a dollaramount and as a percentage of revenues is reflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                       | 2,651,000  |   | $ | (15,718,000 | ) | $ | (1,068,000 | ) |
| Percent of revenues |       | 9.6                                     | %          | (84.6 | )% | (39.7 | )% |
|                     |            |                                         |            |  |  |  |  |  |  |  |

 

For the year ended April 30, 2007, other income(expense), net consists primarily of gains on derivative instruments of$5,905,000 related to the change in the fair value and reclassification ofcertain derivative liabilities (see Note 9 in our consolidated financialstatements located at Item 8. “Financial Statements and Supplementary Data” foradditional discussion) and the extinguishment of debt of $227,000 partiallyoffset by interest expense of $3,320,000 and the amortization of debt issuancecosts of $232,000. Included in interest expense for fiscal year 2007 arenon-cash charges of $3,129,000 related primarily to the amortization of thediscount and the accrual of interest on the 13% Debentures.

For the year ended April 30, 2006, other income(expense), net includes debt conversion expense, interest expense 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, are non-cashinterest charges of $5,662,000 related to various transactions associated withthe 8% Debentures, a non-cash charge of $7,227,000 related to the March 2006conversion of our 8% Debentures and a non-cash 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 $285,000 was earned thatpartially offset the cash and non-cash interest expense.

For the year ended April 30, 2005, other income(expense), net includes interest income and expense and the amortization ofdebt issuance costs. Included for the year ended April 30, 2005 is$993,000 of interest expense associated primarily with our 8% Debentures and$166,000 related to the amortization of debt issuance costs associated with our8% Debentures partially offset by $91,000 in interest and other income.

We expect that our otherexpenses will be volatile based on the future timing of repayment , if ever, ofthe remaining 13% Debentures (see the Liquidity and Capital Resourcesdiscussion below) and the fluctuations in fair value of and classification ofthe instruments underlying our derivative liabilities.

**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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**Minority Interestin Operations of Consolidated Subsidiary**

Minorityinterest in operations of consolidated subsidiary for the years ended April 30,2007, 2006 and 2005 is reflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                       | (44,000    | ) |   | $ | — |   |   |   | $ | — |   |   |
| Percent of revenues |       | (.2                                     | )%         |   | — | % |   |   | — | % |   |
|                     |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

The amount of minorityinterest in operations of consolidated subsidiary recorded for the year ended April 30,2007, relates to our purchase of a 90% interest in SenseIt in October 2006and the subsequent operation of the business. The amount is expected tofluctuate in future periods dependent upon the development and, potentially,financing activities of SenseIt in future reporting periods.

**Loss FromDiscontinued Operations, net of Income Taxes**

Lossfrom discontinued operations, net of income taxes for the years ended April 30,2007, 2006 and 2005 is reflected in the following table:

| ** **          | ** ** | **Year Ended April 30,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                       | (224,000   | ) | $ | (960,000 | ) | $ | (2,153,000 | ) |
| Percent of revenues |       | (.8                                     | )%         | (5.2 | )% | (80.0 | )% |
|                     |            |                                         |            |  |  |  |  |  |  |  |

 

In January 2007, wedecided to discontinue operations of our life sciences business and to put theassets and business up for sale (which was sold in June 2007). We decidedto sell this business as it no longer fit our long-term strategy and because ofdeteriorating business conditions in the historical revenue producing productsin the segment. Accounting rules required us to treat the operations ofthe life sciences business as discontinued operations whereby the net financialimpact of the operations of the business is combined into a single line itemand prior periods are reclassified for this presentation. Revenue for the lifesciences business, reported in discontinued operations, was $1,803,000,$5,136,000 and $7,413,000 for the years ended April 30, 2007, 2006 and2005, respectively.

**Net Loss**

Netloss for the years ended April 30, 2007, 2006 and 2005 is reflected in thefollowing table:

| ** **          | ** ** | **Year Ended April 30,** | ** **  |
|---------------------|------------|-----------------------------------------|-------------|
| ** **          | ** ** | **2007**                                | ** **  | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                       | (13,165,000 | ) | $ | (32,341,000 | ) | $ | (15,177,000 | ) |
| Percent of revenues |       | (47.5                                   | )%          | (174.1 | )% | (563.8 | )% |
|                     |            |                                         |             |  |  |  |  |  |  |  |

 

We anticipate thatconsolidated losses will continue until (if ever): (i) revenues from ourcurrent operations substantially increase or (ii) we generate substantialrevenues from products introduced as a result of our research and developmentprojects. Further, the revenue increases must increase faster than anyincreases in operating and research and development expenses. Additionally, weexpect that our consolidated net loss will continue during at least the shortterm as we continue to work through the downturn in the semiconductor marketand as we continue our marketing and research efforts to expand sales anddevelop new products in the homeland security business, including thecommercialization of the IMS technology and, eventually, the infrared imagingtechnology based on the Lucent Agreement and the operations of our 90% owned subsidiary,SenseIt. However, we can offer no assurance that the development andcommercialization of these technologies will occur.

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**Liquidity andCapital Resources**

Includedin the following table are consolidated balance sheet and cash flow items forthe years ended April 30, 2007, 2006 and 2005:

| ** **                                                   | ** ** | **Year Ended**      | ** ** |
|--------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                   | ** ** | **April 30,  2007** | ** ** | **Change** | ** ** | **April 30,  2006** | ** ** | **Change** | ** ** | **April 30,  2005** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**  | ** ** |
| Cash and cash  equivalents                                   |       |                     | $          | 1,556 |   |   | $ | (30 | ) | $ | 1,586 |   | $ | (19,012 | ) | $ | 20,598 |   |
| Working capital (deficit)                                    |       |                     | 3,310      |   |   | 9,755 |   | (6,445 | ) | (24,648 | ) | 18,203 |   |
| Current convertible debentures, net of discount              |       |                     | —     |   |   | (10,432 | ) | 10,432 |   | 7,407 |   | 3,025 |   |
| Convertible  debentures, net of discount and current portion |       |                     | 8,634      |   |   | 8,634 |   | — |   | (15,040 | ) | 15,040 |   |
| Total convertible debentures, net of discount                |       |                     | $          | 8,634 |   |   | $ | (1,798 | ) | $ | 10,432 |   | $ | (7,633 | ) | $ | 18,065 |   |
| Total convertible  debentures, face value outstanding        |       |                     | $          | 18,000 |   |   | $ | 8,025 |   | $ | 9,975 |   | $ | (12,795 | ) | $ | 22,770 |   |
| Net cash used in operating activities                        |       |                     | $          | (9,817 | ) |   | $ | 5,583 |   | $ | (15,400 | ) | $ | (5,680 | ) | $ | (9,720 | ) |
| Net cash used in  investing activities                       |       |                     | (1,135     | ) |   | 3,303 |   | (4,438 | ) | (875 | ) | (3,563 | ) |
| Net cash provided  by (used in) financing activities         |       |                     | 10,922     |   |   | 10,096 |   | 826 |   | (29,842 | ) | 30,668 |   |
| Net (decrease) increase  in cash and cash equivalents        |       |                     | $          | (30 | ) |   | $ | 18,982 |   | $ | (19,012 | ) | $ | (36,397 | ) | $ | 17,385 |   |

 

**Working Capital**

Our working capital was$3,310,000 at April 30, 2007, as compared to a working capital deficit of$(6,445,000) at April 30, 2006. This $9,755,000 increase in workingcapital for the year ended April 30, 2007, is due to a combination offactors, of which the significant factors are set out below:

*Factors whichincreased working capital*

·       $16,930,000due to the issuance of the 13% Debentures, which are classified as long-termliabilities;

·       $5,648,000due to a decrease in the current portion of the 8% Debentures related toprincipal payments made in shares of our common stock (see discussion of 8%Debenture repayment below);

·       cash of $112,000 receivedin excess of carrying amount upon the sale of assets held for sale at April 30,2007.

*Factors whichdecreased working capital*

·       $9,893,000of cash consumed directly in operating activities (calculated as $9,817,000 ofcash used in operating activities, increased by $76,000 of the cash impact of changesin other current assets or liabilities included therein);

·       $1,707,000related to purchases of fixed assets;

·       approximately$325,000 representing the current portion of capital lease entered into duringthe year ended April 30, 2007;

·       $100,000related to an investment into a business (subsequently written off in itsentirety);

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·       Netimpact of $1,021,000 related to warrants reclassified from equity to derivativeliabilities;

·       approximately$100,000 in reclassification of notes payable from long term to current.

Our working capitaldecreased by $24,648,000 during the year ended April 30, 2006, from aworking capital surplus of $18,203,000 at April 30, 2005, to a workingcapital deficit of $(6,445,000) 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:

*Factors whichincreased working capital*

·       $560,000related to assets held for sale that were reclassified to current assets fromproperty and equipment;

·       $1,761,000 related toproceeds from issuance of common stock.

*Factors whichdecreased working capital*

·       $7,407,000due to an increase in the current portion of the convertible debentures (whichare payable at our option in cash or common stock, assuming all contractualrequirements for payment in common stock are met—see discussion of convertibledebenture repayment below);

·       $14,200,000of cash consumed directly in operating activities (calculated as $15,400,000 ofcash used in operating activities, netted down by $1,200,000 of the cash impactof changes in other current assets or liabilities included therein);

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

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

·       approximately$785,000 in reclassification of notes payable from long term to current;

·       $1,634,000expended on purchases of fixed assets.

As a result of our fund raising activities during theyear ended April 30, 2007, other anticipated cash flows and certaincost-saving measures we have instituted, we believe we have sufficient workingcapital to finance our anticipated operations and projected negative cash flowinto our quarter ending January 31, 2008.

We have satisfied ourworking capital requirements primarily through financing activities in thepast, including the issuance of the 8% Debentures in February 2005 and the13% Debentures in May, June and November 2006 and April 2007.During our year ended April 30, 2007, we cured several listingdeficiencies with Nasdaq.  We may receiveadditional deficiency notifications, which, if not cured timely, may result inour delisting from the Nasdaq Capital Market. Any such delisting, if it shouldoccur, will make future financing activities significantly more difficult.

**8% ConvertibleDebentures**

We repaid our outstanding 8% Debentures in full duringthe year ended April 30, 2007 by issuing 1,502,526 shares of our commonstock (amounting to $4,970,000 in nominal principal and $112,250 in interest)and $5,005,000 in cash

Two former holders of the8% Debentures have at various times asserted that the issuance of the 6% Debenturesconstituted a default (due to a potential variable conversion provisioncontained within the 6% Debentures) underthe 8% Debentures. We have contested that allegation on several bases and willdefend against any further allegation of default as necessary.  Remedies for an event of default include theoption to accelerate payment of the full principal amount of the debentures,together with interest and other 

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amounts due, to the date of acceleration. The principalamount of the debentures shall be equal to 130% of the then-principal amount ofthe debentures plus all interest and other amounts due or a conversioncalculation, whichever is higher. If they prove a default, we could beliable for an amount of approximately $1,200,000, including accrued interest.

**2006 ConvertibleDebentures**

On May 31, 2006, we completed a private placementby which we issued to an accredited investor the 2006 Debentures in theaggregate principal amount of $16,000,000 (including debentures of $3,000,000each purchased in June and November 2006) and warrants to purchase atotal of 2,000,000 shares of our common stock at exercise prices of $5.00 pershare (500,000 warrants), $7.00 per share (750,000 warrants) and $8.00 pershare (750,000 warrants) for a period of three years. The 2006 Debentures mature on May 31, 2009. In April 2007,the interest rate was adjusted from 6% to 13% (though the rate decreasesperiodically down to 7.75% immediately prior to maturity). 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 165,000 shares of restricted common stock ascompensation. The accredited investor may convert the 2006 Debenture intoshares of our common stock at any time at a conversion price of $5.00 per share.The holder may convert the 2006 Debentures into common stock at the lesser of $5.00 or 80% of the average ofthe two lowest daily volume weighted average prices of our stock during thefive trading days immediately preceding the conversion date (the “MarketConversion Price”), subject to certain conversion limitations including, due toan amendment to the 2006 Debentures which was effected in April 2007. Becauseof the amendment, the holder cannot convert the 2006 Debentures without ourwritten consent until after February 28, 2008, provided however that thislimitation will not apply if either the average volume weighted average price (“VWAP”)of the our common stock for five consecutive trading days is $3.00 or greateror an Event of Default has occurred (see Note 9 to the accompanyingconsolidated financial statements located at Item 8. “Financial Statements andSupplementary Data”). If the holder converts using the Market ConversionPrice, the holder is limited to converting no more than $400,000 of theprincipal or accrued interest on the 6% Debentures into shares of our commonstock in any seven calendar day period.

Interest is payable on May 31, 2009, 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.

In February 2007, we entered into a waiverAgreement with the holder that, among other terms, waived certain compliancedeficiencies and amended certain clauses of the 2006 Debenture transactiondocuments. In return for the waivers granted and other amendments to thetransaction documents, we agreed to provide a one-time ratchet to the $7.00warrant and the $8.00 warrant, each exercisable for 750,000 shares. Theone-time ratchet will occur upon the first conversion by a holder of a 2006Debenture and the exercise price of the aforementioned warrants will beautomatically adjusted to the average of the two lowest daily VWAP’s of ourcommon stock during the five trading days prior to such conversion (to theextent that the new exercise price is lower than the then existing exerciseprice).

Additionally, otherevents, as defined in the 2006 Debenture agreement, may also allow the 2006Debenture holders to declare us in default. Remedies for an event of default,include the option to accelerate payment of the full principal amount of theDebentures, together with interest and other amounts due, to the date ofacceleration and Cornell will have the right to request such payment in cash orin shares of our common stock. We are not obligated to pay liquidated damagesfor more than a total of 365 calendar days. We may elect to pay any liquidateddamages in cash or shares of our common stock if registered.  Failure to comply with our registrationobligations may, subsequent to any grace periods and opportunities to cure, bedeemed an event of default.

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**April 2007Convertible Debenture**

In April 2007, we completed a private placementby which we issued, to the same accredited investor who holds the 2006 Debentures,the April 2007 Debenture in the principal amount of $2,000,000 andwarrants to purchase 250,000 shares of our common stock at exercise prices of$5.00 per share for a period of three years. The April 2007 Debenture matures on May 30, 2009 and bears interestat 13% per annum. The accredited investor, to which we paid fees of$175,000 upon closing, may convert the April 2007 Debenture into shares ofour common stock at any time at a conversion price of $5.00 per share. Theholder may convert the April 2007 Debenture into common stock at the lesser of $5.00 or 80% of the average ofthe two lowest daily volume weighted average prices of our stock during thefive trading days immediately preceding the conversion date (the “MarketConversion Price”), subject to certain conversion limitations, includingwithout our written consent until after February 28, 2008, providedhowever that this limitation will not apply if either the average VWAPs of theour common stock for five consecutive trading days is $3.00 or greater or anEvent of Default has occurred (see Note 9 to the accompanying consolidatedfinancial statements located at Item 8. “Financial Statements and SupplementaryData”).  Both the April 2007Debenture and the related warrants bear a one-time ratchet to the conversion orexercise price, respectively. The one-time ratchet will occur upon the firstconversion by a holder of a 2006 Debenture or April 2007 Debenture and theconversion or exercise price, respectively, will be automatically adjusted tothe average of the two lowest daily VWAP’s of our common stock during the fivetrading days prior to such conversion (to the extent that the new exerciseprice is lower than the then existing exercise price).

Interest is payable on May 31, 2009, 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 April 2007Debenture includes certain conditions, which would constitute an event ofdefault under the agreement. Remedies for an event of default include theoption to accelerate payment of the full principal amount of the debentures,together with interest and other amounts due, to the date of acceleration. Theprincipal amount of the debentures shall be equal to 130% of the then-principalamount of the debentures plus all interest and other amounts due or aconversion calculation, whichever is higher.

**Cash Flows**

As of April 30, 2007, we had $1,556,000 of cashand cash equivalents, a decrease of $30,000 as compared to $1,586,000 at April 30,2006. The balance of cash and cash equivalents at April 30, 2006, was$19,012,000 decreased from the balance of $20,598,000 at April 30, 2005. Ourprincipal source of funding for the year ended April 30, 2007 was from theissuance of the 13% Debentures for which we received cumulative net proceeds of$16,930,000. Our principal source of funding for the year ended April 30,2006 was from cash and cash equivalents on hand at the start of the periodrelated to the issuance of 8% Debentures completed in February 2005whereby we received net proceeds of $21,340,000.

Cash used in operating activities of $(9,817,000),$(15,400,000) and $(9,720,000) for the years ended April 30, 2007, 2006and 2005, respectively, was primarily the result of net losses of $(13,165,000)(which included noncash expenses and gains in the net amount of approximately a$3,251,000 expense), $(32,341,000) (which included noncash expenses and gainsin the aggregate amount of approximately a $18,125,000 expense) and$(15,177,000) (which included noncash expenses of approximately a $3,481,000), respectively.

Investing activities used cash of $(1,135,000),$(4,438,000) and $(3,563,000) for the years ended April 30, 2007, 2006 and2005, respectively. Cash used in investing activities for the year ended April 30,2007, consisted of $1,707,000 expended on additions of property and equipmentand $100,000 expended on a minority investment in a business (which wassubsequently written off in its entirety). Cash used in 

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investing activities forthe year ended April 30, 2006 resulted primarily from the purchase of PPSCin May 2005 (which purchase price included a net cash outflow of$2,468,000) as well as purchases of property and equipment of $1,634,000. Cashused in investing activities for the year ended April 30, 2005 resultedprimarily from the purchase of property and equipment of $3,514,000.

Financing activitiesprovided cash of $10,922,000, $826,000 and $30,668,000 for the years ended April 30,2007, 2006 and 2005, respectively. Cash provided by financing activities forthe year ended April 30, 2007 resulted primarily from the issuance of the13% Debentures, which yielded cumulative net proceeds of $16,930,000 offsetprimarily by principal payments on borrowings of $5,889,000. Cash provided byfinancing activities for the year ended April 30, 2006, resulted primarilyfrom the exercise of common stock options and warrants in the amount of$1,723,000 offset primarily by debt repayments of $790,000 and dividendpayments on our outstanding Series E Convertible Preferred Stock in theamount of $101,000. Cash provided by financing activities for the year ended April 30,2005, resulted primarily from the issuance of the 8% Debentures for netproceeds of $21,340,000, the exercise of common stock options and warrants inthe amount of $6,819,000 and the issuance of Series E ConvertiblePreferred Stock for net proceeds of $3,069 offset by repayments of borrowingsand payment of dividends on the Series E Convertible Preferred Stock.

**AdditionalLiquidity Considerations**

As a result of the issuance of the 2006 Debentures,anti-dilution provisions associated with the 398,475 common stock warrantsissued in the 8% Debenture transaction were triggered whereby we issued anadditional 1,593,900 common stock warrants to these holders and reduced theexercise price on all related warrants to $5.00. As a result, as of April 30,2007, we have 1,992,377 common stock warrants exercisable at $5.00 related tothe 8% Debenture transaction. In May 2006, 1,139,250 of these common stockwarrants were 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 $5.00 (or of the holder of our2006 Debentures and our April 2007 Debentures was to convert a portion ofthe outstanding debenture at a conversion rate less than $5.00), the remaining853,125 common stock warrants that have a full anti-dilution provision, wouldratchet into a greater number of common stock warrants at a lower exerciseprice. There were no other changes in the terms or conditions of the warrants.

As of April 30, 2007, we had commitmentsoutstanding for capital expenditures of approximately $2,450,000, althoughsubsequent to year-end we cancelled $1,700,000 of this commitment related toone piece of semiconductor equipment. Further, in May 2008 we entered intoa capital lease in the amount of approximately $630,000 underlying a capitalcommitment existing at April 30, 2007.

Our other future commitments have increased due to theLucent Agreement, under which we endeavor to develop a next-generation imagingand night vision surveillance technology and the related investment in SenseIt,in which we acquired a90% interest in exchange for assigning to SenseIt all of our interest under theLucent Agreement. We did notmake the $1,000,000 payment that was due to Lucent on or before July 16,2007 as neither entity currently has sufficient working capital to make suchpayment. As a result of not making this payment (or other payments when due),Lucent may, after certain steps of notification and periods to cure have beenexhausted, cancel the Lucent Agreement and all licenses granted to usthereunder or cease working on the project and then assess us a “start-up” feeif funding was to resume.

On July 26, 2007, we received officialnotification from Lucent that we failed to make the $1,000,000 payment toLucent by July 16, 2007 and that in the event such non-payment continuesfor more than ten days, Lucent may at is discretion, suspend work on thedevelopment project. We are currently seeking additional financing to allow usto fund SenseIt so that SenseIt can make its contractual development paymentsto Lucent. We cannot offer any assurance that we will be able to raise thefunds necessary to 

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make all of the requiredpayments to Lucent, or that the technology will be developed to a point wherewe want to continue to make such payments when due. Additionally, SenseIt mayneed to seek outside financing to make payments to Lucent and, if so elected,such outside financing would dilute our ownership interest in SenseIt.

The assumptions underlyingthe above statements include, among other things, that there will be nomaterial adverse developments in the business or market in general (see Item 1.“Business” in this Form 10-K for discussion of current market conditionsimpacting our operations). There can be no assurances however that thoseassumed events will occur. If our plans are not achieved, there may be furthernegative effects on the results of operations and cash flows, which could havea material adverse effect on our financial position.

**Contractual CashObligations**

Thefollowing summarizes our contractual cash obligations and commercialcommitments at April 30, 2007, and the effect such obligations areexpected to have on liquidity and cash flows in future periods. Included in thetable below (in thousands) are purchase obligations under which we have legalobligations for payments 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)               |       | $                                            | 18,186     |   |   | $ | 151 |   |   | $ | 18,025 |   |   | $ | 10 |   |   |   | $ | — |   |   |
| Capital lease  obligations      |       | 1,303                                        |       |   | 487 |   |   | 816 |   |   | — |   |   |   | — |   |   |
| Operating lease  obligations(c) |       | 1,598                                        |       |   | 368 |   |   | 545 |   |   | 392 |   |   |   | 293 |   |   |
| Purchase  obligations(d)        |       | 2,450                                        |       |   | 2,450 |   |   | — |   |   | — |   |   |   | — |   |   |
| Other long-term  obligations(e) |       | 1,345                                        |       |   | 1,345 |   |   | — |   |   | — |   |   |   | — |   |   |
| Total contractual  obligations  |       | $                                            | 24,882     |   |   | $ | 4,801 |   |   | $ | 19,386 |   |   | $ | 402 |   |   |   | $ | 293 |   |   |

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(a)           Payments are includedin the period by which they are contractually required to be made. Actualpayments may be made prior to the contractually required date.

(b)          Amount consistsprimarily of the principal outstanding on the 13% Debentures, a note to acommercial bank with a remaining principal amount of $134,000 and relatedinterest at 6.9% and a note with a remaining principal amount of $39,000 andrelated interest at 9.7% (this note was repaid in full in May 2007).Amount does not include interest payments on the 13% Debentures as amounts arepayable in common stock (at a discount to the then current market price) orcash at our election, assuming the existence of an effective registrationstatement. If such amounts were paid in cash, the commitment on the interestrepayment would be included in the heading “2-3 years.”

(c)           Represents ourcommitments associated with operating leases and includes contracts that expirein various fiscal years through 2014. Payments due reflect minimum leasepayments.

(d)          Purchase obligationsinclude payments for capital equipment, although a capital equipment commitmentin the amount of approximately $1,700,000 related to a single piece ofsemiconductor equipment was canceled subsequent to April 30, 2007.

(e)           Amountconsists of the guaranteed portion of two employment agreements if suchemployees are terminated without cause as well as the next development paymentdue to Lucent by SenseIt.

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**Off-Balance SheetArrangements**

From time-to-time, weenter into off-balance sheet arrangements and transactions that can give riseto off-balance sheet obligations. As of April 30, 2007, the off-balancesheet arrangements and transactions into which we have entered includeoperating lease agreements. Subsequent to April 30, 2007, we entered intoa performance bond required by a customer of our security services segment. Wedo not believe that these arrangements are reasonably likely to materiallyaffect liquidity or availability of, or requirements for, capital resources.

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to marketrisk related to changes in interest rates, equity security market values,foreign currency rates and the market price of our common stock. 

*Interest Rates*

Our investment portfolioconsists of cash and cash equivalents (in the amount of $1,556,000 at April 30,2007), all of which is exposed to interest rate fluctuations. The primaryobjective of our investments is to earn a market rate of return whilepreserving principal and maximizing liquidity. The interest earned on theseinvestments (with a blended yield of 0.5% at April 30, 2007) may varybased on fluctuations in the prevailing interest rate.

*Equity Securities*

We do not hold anyinvestments in marketable equity securities. However, we hold interests invarious wholly- and partially-owned subsidiaries as described in Item 1. “Business”above. These securities are non-marketable. Our investment in thesesubsidiaries may be impacted by the underlying economic conditions of theentity, including the ability to raise additional capital and the likelihood ofour being able to realize our investments through liquidity events such asinitial public offerings, mergers or private sales. This investment involves agreat deal of market risk, and there can be no assurances that a specificcompany will grow or become successful. Consequently, we could lose all or partof our investment. Additionally, because IUT is located in Germany, ourinvestment in the entity (and our share of their earnings or losses) may beimpacted by changes in foreign currency rates. The carrying amount of thisinvestment was $382,000 as of April 30, 2007.

*DerivativeInstruments*

We do not purchasederivative instruments on the open market. However, in accordance with currentUS GAAP, we have classified certain warrants and the embedded conversionfeature in our 6% Debentures as derivative instruments (a $1,021,000current liability at April 30, 2007). Classification as derivativeliabilities was required because, for each instrument, there is (or was at thetime of initial classification) a possibility that the instrument could berequired to be settled on a net cash basis. We are required to mark theseinstruments to market as of the end of each reporting period and to recognizethe change in fair value in our condensed consolidated statements of operations.Our stock price has been historically volatile and the fair values of theseinstruments are sensitive to changes in our underlying stock price. As such,the carrying amount of these instruments may be volatile from period to period.For the year ended April 30, 2007, we recorded a gain on derivativeinstruments in the aggregate amount of $5,905,000, such amount representing thechange in fair value between the date of the respective initial recording asderivatives and the date of the reclassification back to equity or April 30,2007, as applicable. See Note 9 to the consolidated financial statementslocated in Item 8. “Financial Statements and Supplementary Data” for a moredetailed discussion of the derivative instruments.

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**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

Included following thesignature page hereof.

**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

**ITEM 9A.**        CONTROLSAND PROCEDURES.

Our management, with the participation of ourprincipal executive officer and our principal financial officer have evaluatedthe effectiveness of our disclosure controls and procedures as required byExchange Act Rule 13a-15(b) as of April 30, 2007 (the end of theperiod covered by this report). Based on that evaluation, our principalexecutive officer and our principal financial officer have concluded that thesedisclosure controls and procedures are effective as of such date.

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 our management,including our principal executive officer and our principal financial officer,as appropriate, to allow timely decisions regarding required disclosure.

There were no changes inour internal control over financial reporting during the quarter ended April 30,2007, that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting. 

**ITEM 9B.**       OTHERINFORMATION

Not applicable

**PART III**

**ITEM 10.**         DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE 

Incorporated by referencefrom the definitive proxy statement or an amendment to this Form 10-K tobe filed no later than August 28, 2007 as permitted by General InstructionG(3) to Form 10-K.

**ITEM 11.**         EXECUTIVECOMPENSATION

Incorporated by referencefrom the definitive proxy statement or an amendment to this Form 10-K tobe filed no later than August 28, 2007 as permitted by General InstructionG(3) to Form 10-K.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

Incorporated by referencefrom the definitive proxy statement or an amendment to this Form 10-K tobe filed no later than August 28, 2007 as permitted by General InstructionG(3) to Form 10-K.

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED PARTY TRANSACTIONS

Incorporated by referencefrom the definitive proxy statement or an amendment to this Form 10-K tobe filed no later than August 28, 2007 as permitted by General InstructionG(3) to Form 10-K.

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**ITEM 14.**         PRINCIPALACCOUNTANTS FEES AND SERVICES

Incorporated by referencefrom the definitive proxy statement or an amendment to this Form 10-K tobe filed no later than August 28, 2007 as permitted by General InstructionG(3) to Form 10-K.

**PART IV**

**ITEM 15.**         EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

The followingdocuments are files as part of this report:

1.                FinancialStatements: See Index to Consolidated Financial Statements under Item 8 of this report.

2.                FinancialStatements Schedules have been omitted since they are either not required, notapplicable or the information is otherwise included.

3.                Exhibits:
| Exhibit   Number | ** ** | ** **                                                                                                                               | ** ** | **Title** |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------|
| 3.01             |       | Restated Articles of Incorporation.(1)                                                                                                   |
| 3.02             |       | Registrant’s Amended and Restated Bylaws.(2)                                                                                        |
| 10.01            |       | Registrant’s 1996 Stock Option Plan.(3)                                                                                             |
| 10.02            |       | Registrant’s 1998 Directors’ Stock Option Plan.(4)                                                                             |
| 10.03            |       | Registrant’s 1996 Executives Equity Incentive  Plan.(3)                                                                             |
| 10.04            |       | Registrant’s 1996 Equity Incentive Plan.(3)                                                                                         |
| 10.05            |       | Registrant’s 2005 Stock Option Plan(4)                                                                                              |
| 10.06            |       | Registrant’s 2007 Restructuring Equity Plan.(5)                                                                                     |
| 10.07            |       | Option Agreement between the Registrant and Yale  University.(3)                                                                         |
| 10.08            |       | Letter from Yale University to Registrant dated  February 10, 1996.(3)                                                              |
| 10.09            |       | Form of Indemnity Agreement between Registrant  and its directors.(6)                                                               |
| 10.10            |       | Agreement dated June 7, 2004 between Isonics  Corporation, Isonics Vancouver, Inc., and Encompass Materials Group  Limited.(7) |
| 10.11            |       | Assignment of Intellectual Property Rights agreement  between Isonics and IUT dated April 27, 2006.(6)                              |
| 10.12            |       | Research and Development Agreement between Isonics  and IUT dated April 27, 2006.(6)                                                |
| 10.13            |       | Cancellation  Agreement and Assignment between Isonics and IUT dated April 27,  2006.(6)                                            |
| 10.14            |       | Letter from Yale University to Registrant dated  January 28, 1997.(3)                                                               |
| 10.15            |       | Securities Purchase Agreement dated May 30,  2006, between Isonics and Cornell Capital Partners, L.P.(8)                            |
| 10.16            |       | Investor Registration Rights Agreement dated  May 30, 2006, between Isonics and Cornell Capital Partners, L.P.(8)                   |
| 10.17            |       | Irrevocable Transfer Agent Instructions dated  May 30, 2006.(8)                                                                     |
| 10.18            |       | Voting Agreement dated May 30, 2006.(8)                                                                                             |
| 10.19            |       | Surrender and Reissuance Agreement, dated  June 13, 2006.(9)                                                                        |
| 10.20            |       | Amended and Restated 6% Secured Convertible  Debenture no. CCP-3: $10,000,000 principal.(9)                                         |
| 10.21            |       | Amended and Restated 6% Secured Convertible  Debenture no. CCP-4: $3,000,000 principal.(9)                                               |
| 10.22            |       | Amended and Restated Warrant no. CCP-002 ($1.25  exercise price).(9)                                                                     |
| 10.23            |       | Amended and Restated Warrant no. CCP-003 ($1.75  exercise price).(9)                                                                     |
| 10.24            |       | Amended and Restated Warrant no. CCP-004 ($2.00  exercise price).(9)                                                                     |

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| 10.25  |   | Security Agreement dated May 30, 2006,  between Isonics as grantor and Cornell Capital Partners, L.P as secured  party.(8)                                            |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.26  |   | Security Agreement dated May 30, 2006,  between Isonics Homeland Security and Defense Corporation; as grantor  and Cornell Capital Partners, L.P as secured party.(8) |
| 10.27  |   | Security Agreement dated May 30, 2006,  between Isonics Vancouver, Inc. as grantor and Cornell Capital  Partners, L.P as secured party.(8)                       |
| 10.28  |   | Security Agreement dated May 30, 2006,  between Protection Plus Security Corporation as grantor and Cornell  Capital Partners, L.P. as secured party.(8)              |
| 10.29  |   | Class A. Common Stock Purchase Agreement, dated  as of October 26, 2006.(10)                                                                                          |
| 10.30  |   | Employment Agreement between SenseIt Corp. and  Christopher Toffales, dated as of October 27, 2006.(10)                                                                    |
| 10.31  |   | Stockholders’ Agreement between Isonics, SenseIt  Corp, and Mr. Toffales, dated as of October 27, 2006.(10)                                                      |
| 10.32  |   | 6% Secured Convertible Debenture no. CCP-5;  $3,000,000 principal.(11)                                                                                                          |
| 10.33  |   | Waiver Agreement with Cornell Capital Partners, L.P.(5)                                                                                                                         |
| 10.34  |   | Settlement Agreement and Mutual Releases between  Isonics and Mr. Alexander.(5)                                                                                            |
| 10.35  |   | Settlement Agreement and Mutual Releases between  Isonics and Mr. Rubizhevsky.(5)                                                                                          |
| 10.36  |   | Employment Agreement between Isonics and Christopher  Toffales dated as of February 16, 2007.(5)                                                                           |
| 10.37  |   | Document Amendment Agreement between Isonics and  Cornell Capital Partners, L.P.(12)                                                                                            |
| 10.38  |   | Securities Purchase Agreement with Cornell Capital  Partners, L.P, dated as of April 10, 2007.(12)                                                                         |
| 10.39  |   | Registration Rights Agreement with Cornell Capital  Partners, L.P, dated as of April 10, 2007.(12)                                                                         |
| 10.40  |   | Pledge and Escrow Agreement, dated as of  April 10, 2007.(12)                                                                                                              |
| 10.41  |   | Irrevocable Transfer Agent Instructions.(12)                                                                                                                                    |
| 10.42  |   | 13% Secured Convertible Debenture no. CCP-2007-1:  $2,000,000 principal.(12)                                                                                                    |
| 10.43  |   | Warrant no. CCP-2007-1-1 ($5.00 exercise price).(12)                                                                                                                            |
| 10.44* |   | Registrant’s 2007 Non-Employee Directors Stock  Option Plan                                                                                                                |
| 10.45* |   | Registrant’s Amended and Restated 2005 Stock Option  Plan                                                                                                                  |
| 10.46  |   | Registration Rights Agreement between Isonics and  Encompass Materials Group Limited.(7)                                                                                        |
| 10.47  |   | Registration Rights Agreement between Isonics with  Asset Managers, Ltd.(14)                                                                                                    |
| 14.0   |   | Code of Ethics(13)                                                                                                                                                              |
| 21.1*  |   | List of subsidiaries                                                                                                                                                            |
| 23.10* |   | Consent of independent registered public accounting  firm                                                                                                                       |
| 31.1*  |   | Certification of the Chief Executive Officer  pursuant to Rule 13a-14(a)                                                                                                   |
| 31.2*  |   | Certification of the Chief Financial Officer  pursuant to Rule 13a-14(a)                                                                                                   |
| 32*    |   | Certification pursuant to 18 U.S.C. §1350                                                                                                                                  |

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                 * Filed herewith. All other documents have beenpreviously filed.

       (1) Filed with Isonics’ Current Report on Form 8-K (File No. 001-12531),dated June 13, 2007 and filed on June 25, 2007, and incorporatedherein by reference.

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

       (3) Incorporatedherein by reference to exhibit filed with Isonics’ Registration Statement on Form SB-2(“Registration Statement”) (Commission file No. 333-13289) in which thisexhibit bears the same number except exhibit 3.01, which was numbered 3.03 inthat registration statement.

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       (4) Filed with Isonics’ Registration Statement on Form S-8 (fileno. 333-128592) filed on September 26, 2005.

       (5) Filed with Isonics’ Current Report on Form 8-K (file no.000-12531) dated February 13, 2007, filed February 20, 2007, andincorporated herein by reference.

       (6) Incorporatedby reference from Isonics’ annual report on Form 10-KSB for the year endedApril 30, 2006.

       (7) Filed with Isonics’ Current Report on Form 8-K (file no.000-12531) dated June 11, 2004, and incorporated herein by reference.

       (8) Filed with Isonics’ Current Report on Form 8-K (file no.000-12531) dated May 31, 2006, filed June 6, 2006, and incorporatedherein by reference.

       (9) Filedwith Isonics’ Current Report on Form 8-K (file no. 001-12531) dated June 21,2006, filed on June 21, 2006, and incorporated herein by reference.

(10) Filed with Isonics’ Current Report on Form 8-K (file no. 000-12531) dated October 26, 2006,filed November 1, 2006, and incorporated herein by reference.

(11) Filed with Isonics’ Current Report on Form 8-K (file no. 000-12531) dated November 14, 2006,filed November 17, 2006, and incorporated herein by reference.

(12) Filed with Isonics’ Current Report on Form 8-K (file no.000-12531) dated April 5, 2007, filed April 11, 2007, andincorporated herein by reference.

(13) Incorporated by reference from Isonics’ annual report on Form 10-KSBfor the year ended April 30, 2004.

(14) Filed with Isonics’ Current Report on Form 8-K (file no.000-12531) dated October 4, 2004.

54

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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 30, 2007 |
|--------------------|
| ** **         | **ISONICS CORPORATION,** |
|               | a California Corporation |
|               | By: | /s/  JOHN SAKYS |
|               | John Sakys |
|               | *Chief Executive Officer* |
|                    |  |  |

 

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 30,  2007 |     | John Sakys                    |       | /s/ JOHN SAKYS                    |
|                |     | Principal Executive  Officer  |       |                              |
|                |     | Chief Operating Officer       |       |                              |
|                |     | Director                      |       |                              |
| July 30,  2007 |     | Christopher  Toffales         |       | /s/ CHRISTOPHER  TOFFALES         |
|                |     | Chairman of the Board         |       |                              |
| July 30,  2007 |     | Richard Parker                |       | /s/ RICHARD  PARKER               |
|                |     | Director                      |       |                              |
| July 30,  2007 |     | Russell W. Weiss              |       | /s/ RUSSELL W.  WEISS             |
|                |     | Director                      |       |                              |
| July 30,  2007 |     | Richard H. Hagman             |       | /s/ RICHARD H.  HAGMAN            |
|                |     | Director                      |       |                              |
| July 30,  2007 |     | C. Stewart  Verdery, Jr. |       | /s/ C. STEWART  VERDERY, JR. |
|                |     | Director                      |       |                              |
| July 30,  2007 |     | Kenneth Deane                 |       | /s/ KENNETH  DEANE                |
|                |     | Principal Financial  Officer  |       |                              |
| July 30,  2007 |     | Greg Meadows                  |       | /s/ GREG  MEADOWS                 |
|                |     | Corporate Controller          |       |                              |

 

55

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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**

Tothe Board of Directors

IsonicsCorporation

Golden, Colorado

We have audited the consolidated balance sheets ofIsonics Corporation and subsidiaries (the “Company”) as of April 30, 2007and 2006, and the related consolidated statements of operations, stockholders’equity and cash flows for each of the three years in the period ended April 30,2007. 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, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Isonics Corporation and subsidiaries as of April 30, 2007 and2006, and the results of their operations and their cash flows for each of thethree years in the period ended April 30, 2007, in conformity with U.S.generally accepted accounting principles.

Theaccompanying financial statements have been prepared assuming that the Companywill continue as a going concern. As discussed in Note 1 to the financialstatements, the Company has suffered recurring losses from operations and willcontinue to require funding from investors for working capital. This raisessubstantial doubt about the Company’s ability to continue as a going concern. Management’splans in regard to these matters are also described in Note 1. The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.
| /s/ HEIN &  ASSOCIATES LLP |   |
|-------------------------------------|--------|
| Denver, Colorado                    |
| July 30, 2007                  |

 

F-2

----

**Isonics Corporation and SubsidiariesCONSOLIDATED BALANCE SHEETS(In thousands, except share amounts)**

| ** **                                                                                                                                  | ** ** | **April 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                                  | ** ** | **2007**           | ** ** | **2006** | ** ** |
| **ASSETS**                                                                                                                                  |       |               |       |   |   |
| CURRENT ASSETS:                                                                                                                             |       |               |       |   |   |
| Cash and cash equivalents                                                                                                                   |       | $                  | 1,556      |   | $ | 1,586 |   |
| Accounts receivable (net  of allowances of $146 and $51, respectively)                                                                      |       | 3,678              |       | 3,066 |   |
| Inventories                                                                                                                                 |       | 1,259              |       | 630 |   |
| Prepaid expenses and  other current assets                                                                                                  |       | 1,388              |       | 1,046 |   |
| Assets of discontinued  operations                                                                                                          |       | 491                |       | 1,713 |   |
| Assets held for sale                                                                                                                        |       | —             |       | 560 |   |
| Total current  assets                                                                                                                       |       | 8,372              |       | 8,601 |   |
| LONG-TERM ASSETS:                                                                                                                           |       |               |       |   |   |
| Property and equipment,  net                                                                                                                |       | 5,666              |       | 4,562 |   |
| Goodwill                                                                                                                                    |       | 3,631              |       | 3,631 |   |
| Intangible assets, net                                                                                                                      |       | 303                |       | 491 |   |
| Equity in net assets of  investee                                                                                                           |       | 382                |       | 386 |   |
| Other assets                                                                                                                                |       | 606                |       | 192 |   |
| Total long-term  assets                                                                                                                     |       | 10,588             |       | 9,262 |   |
| TOTAL ASSETS                                                                                                                                |       | $                  | 18,960     |   | $ | 17,863 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                              |       |               |       |   |   |
| CURRENT LIABILITIES:                                                                                                                        |       |               |       |   |   |
| Accounts payable                                                                                                                            |       | $                  | 973        |   | $ | 2,169 |   |
| Accrued liabilities                                                                                                                         |       | 2,522              |       | 1,598 |   |
| Derivative liabilities                                                                                                                      |       | 1,021              |       | — |   |
| Liabilities of  discontinued operations                                                                                                     |       | 72                 |       | 61 |   |
| Current portion of  obligations under capital lease                                                                                         |       | 340                |       | 14 |   |
| Current portion of notes  payable                                                                                                           |       | 134                |       | 772 |   |
| Current portion of  convertible debentures, net of discount                                                                                 |       | —             |       | 10,432 |   |
| Total current  liabilities                                                                                                                  |       | 5,062              |       | 15,046 |   |
| Obligations under capital  lease, net of current portion                                                                                    |       | 710                |       | 34 |   |
| Notes payable, net of  current portion                                                                                                      |       | —             |       | 140 |   |
| Other long-term  liabilities                                                                                                                |       | 888                |       | — |   |
| Convertible debentures,  net of discount and current portion                                                                                |       | 8,634              |       | — |   |
| TOTAL LIABILITIES                                                                                                                           |       | 15,294             |       | 15,220 |   |
| Minority interest in  consolidated subsidiary                                                                                               |       | 111                |       | — |   |
| Commitments and  Contingencies (See Notes 9 and 10)                                                                                         |       |               |       |   |   |
| STOCKHOLDERS’ EQUITY:                                                                                                                  |       |               |       |   |   |
| Preferred Stock; shares  authorized—7,650,000; no par value, no shares issued and outstanding                                          |       | —             |       | — |   |
| Common stock—no par  value; 175,000,000 shares authorized; shares issued   and outstanding: 2007—12,639,400; 2006—10,517,780 |       | 64,319             |       | 57,061 |   |
| Additional paid in  capital                                                                                                                 |       | 20,705             |       | 13,910 |   |
| Deferred compensation                                                                                                                       |       | —             |       | (24 | ) |
| Accumulated deficit                                                                                                                         |       | (81,469            | )          | (68,304 | ) |
| Total  stockholders’ equity                                                                                                            |       | 3,555              |       | 2,643 |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                             |       | $                  | 18,960     |   | $ | 17,863 |   |

 

See Notes to Consolidated Financial Statements.

F-3

----

**Isonics Corporation and SubsidiariesCONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share amounts)**

| ** **                                                                 | ** ** | **Year Ended April 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                 | ** ** | **2007**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                                  |       |                               |       |   |   |   |   |
| Products                                                                   |       | $                                  | 6,513      |   | $ | 2,885 |   | $ | 1,448 |   |
| Services                                                                   |       | 21,218                             |       | 15,695 |   | 1,244 |   |
| Total revenues                                                             |       | 27,731                             |       | 18,580 |   | 2,692 |   |
| Cost of revenues:                                                          |       |                               |       |   |   |   |   |
| Products                                                                   |       | 5,541                              |       | 4,158 |   | 3,467 |   |
| Services                                                                   |       | 16,269                             |       | 13,851 |   | 3,064 |   |
| Total cost of revenues                                                     |       | 21,810                             |       | 18,009 |   | 6,531 |   |
| Gross margin                                                               |       | 5,921                              |       | 571 |   | (3,839 | ) |
| Operating  expenses:                                                       |       |                               |       |   |   |   |   |
| Selling, general and administrative                                        |       | 16,519                             |       | 10,750 |   | 6,222 |   |
| Impairment loss on assets held for sale                                    |       | —                             |       | 466 |   | — |   |
| Impairment of goodwill and intangible assets                               |       | —                             |       | — |   | 875 |   |
| Research and development                                                   |       | 4,950                              |       | 5,018 |   | 1,020 |   |
| Total operating expenses                                                   |       | 21,469                             |       | 16,234 |   | 8,117 |   |
| Operating Loss                                                             |       | (15,548                            | )          | (15,663 | ) | (11,956 | ) |
| Other income  (expense):                                                   |       |                               |       |   |   |   |   |
| Amortization of debt issuance costs                                        |       | (232                               | )          | (1,260 | ) | (166 | ) |
| Debt conversion expense                                                    |       | —                             |       | (7,227 | ) | — |   |
| Interest and other income                                                  |       | 64                                 |       | 285 |   | 91 |   |
| Interest expense                                                           |       | (3,320                             | )          | (7,546 | ) | (993 | ) |
| Foreign exchange                                                           |       | 11                                 |       | — |   | — |   |
| Gain on extinguishment of debt                                             |       | 227                                |       | — |   | — |   |
| Gain on derivative instruments                                             |       | 5,905                              |       | — |   | — |   |
| Equity in net (loss) income of investee                                    |       | (4                                 | )          | 30 |   | — |   |
| Total other income (expense), net                                          |       | 2,651                              |       | (15,718 | ) | (1,068 | ) |
| Loss from continuing operations before income taxes  and minority interest |       | (12,897                            | )          | (31,381 | ) | (13,024 | ) |
| Income tax expense                                                         |       | —                             |       | — |   | — |   |
| Minority interest in operations of consolidated  subsidiary                |       | (44                                | )          | — |   | — |   |
| Loss from continuing operations                                            |       | (12,941                            | )          | (31,381 | ) | (13,024 | ) |
| Loss from discontinued operations, net of income  taxes                    |       | (224                               | )          | (960 | ) | (2,153 | ) |
| Net loss                                                                   |       | $                                  | (13,165    | ) | $ | (32,341 | ) | $ | (15,177 | ) |
| Deemed dividend on preferred stock                                         |       | $                                  | —     |   | $ | — |   | $ | (1,206 | ) |
| Dividend on Series E Convertible Preferred Stock                      |       | $                                  | —     |   | $ | (101 | ) | $ | (132 | ) |
| Net loss attributable to common stockholders                               |       | $                                  | (13,165    | ) | $ | (32,442 | ) | $ | (16,515 | ) |
| **Net loss  per share—basic and diluted:**                            | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Continuing operations                                                      |       | $                                  | (1.09      | ) | $ | (3.87 | ) | $ | (2.33 | ) |
| Discontinued operations                                                    |       | $                                  | (0.02      | ) | $ | (0.12 | ) | $ | (0.38 | ) |
| Attributable to common stockholders                                        |       | $                                  | (1.11      | ) | $ | (4.00 | ) | $ | (2.95 | ) |
| Weighted average  common shares used in computing per share information    |       | 11,898                             |       | 8,103 |   | 5,596 |   |

 

See Notes to Consolidated Financial Statements.

F-4

----

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

| ** **                                                                                                    | ** ** | ** **               | ** ** | ** ** | ** **            | ** ** | ** ** | ** **       | ** ** | ** **   | ** ** | ** **       | ** ** | **Additional** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|------------|-----------------------|------------|------------|------------------|------------|--------------|------------|------------------|------------|----------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                                                    | ** ** | **Preferred Stock** | ** ** | ** ** | **Common Stock** | ** ** | ** ** | **Paid in** | ** ** | **Deferred** | ** ** | **Accumulated**  | ** ** | ** **     | ** ** |
| ** **                                                                                                    | ** ** | **Shares**               | ** ** | **Amount** | ** **            | **Shares** | ** ** | **Amount**       | ** ** | **Capital**  | ** ** | **Compensation** | ** ** | **Deficit**    | ** ** | **Total**  | ** ** |
| Balances as of  April 30, 2004                                                                           |       | 1,005,616                |       |       | $                     | 5,613      |       |             | 3,836,228  |         |       | $                | 14,817     |           |       |       | $          | 6,732      |       |       |       | $          | (104       | )          |       |   | $ | (19,347 | ) |   | $ | 7,711 |   |
| Exercise of common stock  warrants                                                                            |       | —                   |       |       | —                |       |       | 1,341,550        |       |         | 6,708      |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 6,708 |   |
| Cashless exercise of  common stock warrants                                                                   |       | —                   |       |       | —                |       |       | 90,930           |       |         | 45         |             |       |           | (45        | )          |       |       | —     |       |       |       | —     |       |       | — |   |
| Common stock issued in  legal settlement                                                                      |       | —                   |       |       | —                |       |       | 1,064            |       |         | 20         |             |       |           |       |       |       |       | —     |       |       |       | —     |       |       | 20 |   |
| Exercise of common stock  options                                                                             |       | —                   |       |       | —                |       |       | 23,250           |       |         | 111        |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 111 |   |
| Fair value of common  stock issued for the acquisition of the  assets of Encompass Materials Group, Ltd.      |       | —                   |       |       | —                |       |       | 182,982          |       |         | 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                  | )          |       | 478,500          |       |         | 740        |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | — |   |
| Series C                                                                                                 |       | (9,000                   | )          |       | (1,141                | )          |       | 236,842          |       |         | 1,141      |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | — |   |
| Series D                                                                                                 |       | (32,150                  | )          |       | (3,637                | )          |       | 730,682          |       |         | 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                                                    |       | —                   |       |       | —                |       |       | 2,172            |       |         | 11         |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 11 |   |
| Amortization of deferred  compensation                                                                        |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | —     |       |       |       | 40         |       |       |       | —     |       |       | 40 |   |
| Net loss                                                                                                      |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | —     |       |       |       | —     |       |       |       | (15,177    | )          |       | (15,177 | ) |
| Balances as of  April 30, 2005                                                                           |       | 40,466                   |       |       | 4,033                 |       |       | 6,924,200        |       |         | 28,401     |             |       |           | 13,080     |       |       |       | (64        | )          |       |       | (35,862    | )          |       | 9,588 |   |
| Exercise of common stock  warrants                                                                            |       | —                   |       |       | —                |       |       | 253,128          |       |         | 1,367      |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 1,367 |   |
| Cashless exercise of  common stock Warrants                                                                   |       | —                   |       |       | —                |       |       | 2,500            |       |         | 13         |             |       |           | (13        | )          |       |       | —     |       |       |       | —     |       |       | — |   |
| Fair value of common  stock warrants issued in legal settlements                                              |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | 110        |       |       |       | —     |       |       |       | —     |       |       | 110 |   |
| Exercise of common stock  options                                                                             |       | —                   |       |       | —                |       |       | 104,779          |       |         | 356        |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 356 |   |
| Fair value of common  stock issued for the acquisition of  Protection Plus Security Corporation               |       | —                   |       |       | —                |       |       | 176,632          |       |         | 1,228      |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 1,228 |   |
| Fair value of extension  of warrant expiration dates                                                          |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | 510        |       |       |       | —     |       |       |       | —     |       |       | 510 |   |
| Common stock issued in  payment of convertible debenture  interest                                            |       | —                   |       |       | —                |       |       | 112,901          |       |         | 949        |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 949 |   |
| Common stock issued in  payment of convertible debenture principal                                            |       | —                   |       |       | —                |       |       | 678,166          |       |         | 4,313      |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 4,313 |   |
| Conversion of convertible  debentures into common stock                                                       |       | —                   |       |       | —                |       |       | 1,551,724        |       |         | 16,227     |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 16,227 |   |
| Preferred stock dividends                                                                                     |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | —     |       |       |       | —     |       |       |       | (101       | )          |       | (101 | ) |
| Conversion of convertible  preferred stock into common stock:                                                 |       |                     |       |       |                  |       |       |             |       |         |       |             |       |           |       |       |       |       |       |       |       |       |       |       |       |   |   |
| Series D                                                                                                 |       | (800                     | )          |       | (90                   | )          |       | 18,182           |       |         | 90         |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | — |   |
| Series E                                                                                                 |       | (33,000                  | )          |       | (3,938                | )          |       | 665,322          |       |         | 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                                                               |       | —                   |       |       | —                |       |       | 25,000           |       |         | 140        |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 140 |   |
| Common stock issued under  Employee Stock Purchase Program                                                    |       | —                   |       |       | —                |       |       | 5,246            |       |         | 39         |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 39 |   |
| Amortization of deferred  compensation                                                                        |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | —     |       |       |       | 40         |       |       |       | —     |       |       | 40 |   |
| Net loss                                                                                                      |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | —     |       |       |       | —     |       |       |       | (32,341    | )          |       | (32,341 | ) |
| Balances as of  April 30, 2006                                                                           |       | —                   |       |       | —                |       |       | 10,517,780       |       |         | 57,061     |             |       |           | 13,910     |       |       |       | (24        | )          |       |       | (68,304    | )          |       | 2,643 |   |
| Issuance of detachable  common stock warrants in convertible debenture offerings                              |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | 2,887      |       |       |       | —     |       |       |       | —     |       |       | 2,887 |   |
| Common stock issued for  fee related to convertible debenture issuance                                        |       | —                   |       |       | —                |       |       | 165,000          |       |         | 601        |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 601 |   |
| Net incremental common  shares issued for fractional shares in reverse stock split                            |       | —                   |       |       | —                |       |       | 787              |       |         | —     |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | — |   |
| Fair value of amendment  to warrant terms                                                                     |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | 949        |       |       |       | —     |       |       |       | —     |       |       | 949 |   |
| Common stock issued in  payment of convertible debenture  interest                                            |       | —                   |       |       | —                |       |       | 31,968           |       |         | 136        |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 136 |   |
| Common stock issued in  payment of convertible debenture principal                                            |       | —                   |       |       | —                |       |       | 1,470,558        |       |         | 5,648      |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 5,648 |   |
| Fair value of common  stock warrants issued for services or lease financing                                   |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | 188        |       |       |       | —     |       |       |       | —     |       |       | 188 |   |
| Common stock issued under  Employee Stock Purchase Program                                                    |       | —                   |       |       | —                |       |       | 3,307            |       |         | 14         |             |       |           | —     |       |       |       | —     |       |       |       | —     |       |       | 14 |   |
| Net reclassifications  between derivative liability and equity                                                |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | 366        |       |       |       | —     |       |       |       | —     |       |       | 366 |   |
| Amortization of deferred  compensation                                                                        |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | —     |       |       |       | 24         |       |       |       | —     |       |       | 24 |   |
| Stock-based compensation                                                                                      |       | —                   |       |       | —                |       |       | 450,000          |       |         | 859        |             |       |           | 2,405      |       |       |       | —     |       |       |       | —     |       |       | 3,264 |   |
| Net loss                                                                                                      |       | —                   |       |       | —                |       |       | —           |       |         | —     |             |       |           | —     |       |       |       | —     |       |       |       | (13,165    | )          |       | (13,165 | ) |
| Balances as of  April 30, 2007                                                                           |       | —                   |       |       | $                     | —     |       |             | 12,639,400 |         |       | $                | 64,319     |           |       |       | $          | 20,705     |       |       |       | $          | —     |       |       |   | $ | (81,469 | ) |   | $ | 3,555 |   |

 

**See Notes to Consolidated Financial Statements.**

F-5

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**Isonics Corporation and SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**

| ** **                                                                                                                             | ** ** | **Year Ended  April 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                             | ** ** | **2007**                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                                                                                 |       |                                |       |   |   |   |   |
| Net loss                                                                                                                               |       | $                                   | (13,165    | ) | $ | (32,341 | ) | $ | (15,177 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:                                                           |       |                                |       |   |   |   |   |
| Depreciation and amortization of intangible and other  assets                                                                          |       | 2,260                               |       | 1,677 |   | 1,185 |   |
| Amortization of debt discount and debt issuance costs                                                                                  |       | 2,404                               |       | 6,939 |   | 732 |   |
| Debt conversion expense                                                                                                                |       | —                              |       | 7,227 |   | — |   |
| Interest paid in shares of common stock                                                                                                |       | 136                                 |       | 949 |   | — |   |
| Impairment of investment in cost method investee                                                                                       |       | 100                                 |       | — |   | — |   |
| Impairment of goodwill and intangible assets                                                                                           |       | —                              |       | — |   | 875 |   |
| Impairment of property and equipment (including  assets held for sale)                                                                 |       | 8                                   |       | 498 |   | — |   |
| Accounting charge for amendment of warrant terms                                                                                       |       | 949                                 |       | 510 |   | — |   |
| Fair value of common stock and warrants issued for  non-employee services, amortization of deferred compensation and legal  settlement |       | 260                                 |       | 355 |   | 689 |   |
| Equity in net loss (income) of investee                                                                                                |       | 4                                   |       | (30 | ) | — |   |
| Minority interest in operations of consolidated  subsidiary                                                                            |       | 44                                  |       | — |   | — |   |
| Stock-based compensation                                                                                                               |       | 3,330                               |       | — |   | — |   |
| Gain on derivative instruments                                                                                                         |       | (5,905                              | )          | — |   | — |   |
| Gain on sale of assets held for sale                                                                                                   |       | (112                                | )          | — |   | — |   |
| Gain on extinguishment of debt                                                                                                         |       | (227                                | )          | — |   | — |   |
| Changes  in operating assets and liabilities:                                                                                          |       |                                |       |   |   |   |   |
| Accounts receivable                                                                                                                    |       | (612                                | )          | (1,261 | ) | (63 | ) |
| Inventories                                                                                                                            |       | (629                                | )          | (153 | ) | (126 | ) |
| Prepaid expenses and other current assets                                                                                              |       | (435                                | )          | (784 | ) | (2 | ) |
| Accounts payable                                                                                                                       |       | (1,201                              | )          | 849 |   | 551 |   |
| Accrued liabilities                                                                                                                    |       | 945                                 |       | (372 | ) | 349 |   |
| Assets of discontinued operations                                                                                                      |       | 1,159                               |       | 736 |   | 1,634 |   |
| Liabilities of discontinued operations                                                                                                 |       | 19                                  |       | (199 | ) | (367 | ) |
| Other long-term liabilities                                                                                                            |       | 851                                 |       |   |   |   |   |
| Net cash used in operating activities                                                                                                  |       | (9,817                              | )          | (15,400 | ) | (9,720 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                                                 |       |                                |       |   |   |   |   |
| Purchases of property and equipment                                                                                                    |       | (1,707                              | )          | (1,634 | ) | (3,514 | ) |
| Proceeds from sale of assets held for sale                                                                                             |       | 672                                 |       | — |   | — |   |
| Equity investment in a business                                                                                                        |       | (100                                | )          | (336 | ) | — |   |
| Acquisition of assets of a business, net of cash  acquired                                                                             |       | —                              |       | (2,468 | ) | (49 | ) |
| Net cash used in investing activities                                                                                                  |       | (1,135                              | )          | (4,438 | ) | (3,563 | ) |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                                                                 |       |                                |       |   |   |   |   |
| Principal payments under capital lease obligations                                                                                     |       | (134                                | )          | (44 | ) | (64 | ) |
| Principal payments on borrowings                                                                                                       |       | (5,889                              | )          | (790 | ) | (375 | ) |
| Proceeds from the issuance of preferred stock and  related warrants                                                                    |       | —                              |       | — |   | 3,069 |   |
| Proceeds from the issuance of convertible debentures  and related warrants                                                             |       | 16,930                              |       | — |   | 21,340 |   |
| Proceeds from issuance of common stock                                                                                                 |       | 15                                  |       | 1,761 |   | 6,830 |   |
| Preferred stock dividends                                                                                                              |       | —                              |       | (101 | ) | (132 | ) |
| Net cash provided by financing activities                                                                                              |       | 10,922                              |       | 826 |   | 30,668 |   |
| Net (decrease) increase in cash and cash equivalents                                                                                   |       | (30                                 | )          | (19,012 | ) | 17,385 |   |
| Cash and cash equivalents at beginning of year                                                                                         |       | 1,586                               |       | 20,598 |   | 3,213 |   |
| Cash and cash  equivalents at end of year                                                                                              |       | $                                   | 1,556      |   | $ | 1,586 |   | $ | 20,598 |   |

 

See Notes to Consolidated Financial Statements.

F-6

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**Isonics Corporation and SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1—ORGANIZATIONAND SIGNIFICANT ACCOUNTING POLICIES**

**Organization**

We are focused on thedevelopment of homeland security products and services and themanufacture of 300-millimeter (and smaller diameter) silicon waferreclaim and test products, wafer thinning and custom wafer products for thesemiconductor industry. The consolidated financial statements (the “financialstatements”) include our accounts and those of our wholly-owned subsidiaries,including Protection Plus Security Corporation (“PPSC”), Isonics HomelandSecurity and Defense Corporation (“HSDC”), Isonics Vancouver, Inc. (“IVI”)and Chemotrade GmbH (“Chemotrade”) as well as the operations of our 90%-ownedsubsidiary, SenseIt Corp (“SenseIt”). We sold our life sciences business in June 2007.In all periods presented, the operations of the life sciences business havebeen accounted for as discontinued operations. See Note 18.

As discussed in moredetail in Note 13, on February 13, 2007, we effected a one-for-fourreverse stock split of our common shares upon the filing of a Certificate ofAmendment to our Articles of Incorporation with the California Secretary ofState. All impacted amounts included in the consolidated financial statementsand notes thereto have been restated for the stock split.

**Going Concern**

While as of April 30, 2007, we have workingcapital of $3,310,000 and stockholders’ equity of  $3,555,000, we incurred significant lossesfrom operations and used significant cash flow to fund operations for thefiscal years presented. Historically, we have relied upon outside investorfunds to maintain our operations and develop our business. We anticipate wewill continue to require funding from investors for working capital as well asbusiness expansion during the upcoming fiscal year and we can provide noassurance that additional investor funds will be available on terms acceptableto us. These conditions raise substantial doubt about our ability to continue operationsas a going concern.

During the year ended April 30, 2007, werestructured our management team with the goal of refocusing our product lines,seeking joint venture partners and improving operating performance at thebusiness segments through a focus on strategic products, increased efficienciesin business processes and improvements to the cost structure of each segment. Additionally,in June 2007, we completed the sale of the assets of our life sciencesbusiness for gross proceeds of $850,000 (net proceeds of $700,000 afterretirement of debt and expenses of the sale). See Note 18 for additionalinformation.

Our ability to continue asa going concern is dependent upon raising capital through debt or equityfinancing and ultimately by increasing revenue and achieving profitableoperations. We can offer no assurance that we will be successful in our effortsto raise additional proceeds or achieve profitable operations. The accompanyingconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the settlement of liabilitiesin the normal course of business.

**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.

F-7

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

**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 accompanyingnotes, including (but not limited to) those related to impairment of goodwilland intangible assets, impairment of equity investments and assets held forsale, recoverability of inventory and accounts receivable, the recording ofvarious accruals, the useful lives of long-lived assets, income tax, thevaluation of stock-based compensation, the valuation of convertible debenturesand related warrants, the valuation of derivative liabilities and potentiallosses from contingencies. These estimates are based upon management’s bestfindings, after considering past and current events and assumptions about futureevents. Actual results could differ from those estimates.

**Cash Equivalents**

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

**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, $110,000 and $531,000 at April 30, 2007 and 2006,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.

F-8

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

**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 five 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 if the presence of certain circumstancesindicates that impairment may have occurred. The impairment review processcompares the fair value of the reporting unit in which goodwill resides to itscarrying value. If the carrying amount of a reporting unit exceeds its fairvalue, then the amount of the impairment loss must be measured. The impairmentloss would be calculated by comparing the implied fair value of reporting unitgoodwill to its carrying amount. In calculating the implied fair value ofreporting unit goodwill, the fair value of the reporting unit is allocated toall of the other assets and liabilities of that unit based on their fairvalues. The excess of the fair value of a reporting unit over the amountassigned to its other assets and liabilities is the implied fair value ofgoodwill. 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 be recoverable.We measure the carrying amount of the asset against the estimated undiscountedfuture cash flows associated with it. Should the sum of the expected future netcash flows be less than the carrying value of the asset being evaluated, animpairment loss would be recognized. The impairment loss would be calculated asthe amount by which the carrying value of the asset exceeds its fair value (seeNote 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 (loss) income of investee.”  The carrying value of the investment isreflected in the consolidated balance sheet in the caption “Equity in netassets of 

F-9

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

investee.”  We evaluate the recoverability of equitymethod investments whenever events or changes in circumstance indicate that itscarrying amount may not be recoverable. A loss in value which is deemed otherthan temporary would result in recognition of an impairment loss.

**Debt 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 impairment has occurred, it is calculated based on thedifference between the asset’s carrying value and the underlying discountedfuture cash flows it is expected to generate.

**Asset RetirementObligation**

The Company follows SFAS No. 143,*Accounting for Asset Retirement Obligations*,which requires that the fair value of a liability for an asset retirement obligation  be recognized in the period in which it wasincurred if a reasonable estimate of fair value could be made. The associatedasset retirement costs are capitalized as part of the carrying amount of thelong-lived asset. The increase in carrying value of a property associated withthe capitalization of an asset retirement cost is included in the correspondingproperty and equipment category of the respective underlying asset. The assetretirement liability will be allocated to operating expense by using asystematic and rational method. The Company has recorded a net liability ofapproximately $37,000 (using a 20 % discount rate and a 2.5% inflation rate) inthe consolidated balance sheet caption “other long-term liabilities.”  Prior to April 30, 2007, the liabilitywas not significant.

**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 when the following criteria aremet: 1) persuasive evidence of an arrangement exists; 2) delivery has occurredor services have been rendered; 3) the sales price is fixed or determinable;and 4) collectibility is probable. Revenue from product sales is recognizedupon shipment if all other revenue recognition criteria have been met. Customersare not granted return rights for reasons other than warranty claims andproduct returns have not been material in any period. Revenue for silicon wafer

F-10

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

reclamation services isrecognized when all services have been rendered and the reclaimed wafer isshipped back to the customer, if all other revenue recognition criteria havebeen met. Revenue for security services is recognized upon delivery of theservices, if all other revenue recognition criteria have been met.

In our homelandsecurity products business, we may enter into revenue arrangements to sellproducts and services for which we are obligated to deliver multiple productsand/or services.  We apply the guidancein Emerging Issues Task Force Issue No. (“EITF”) 00-21, *Revenue Arrangements with Multiple Deliverables*(“EITF00-21”). Under EITF 00-21, multiple-element arrangements areassessed to determine whether they can be separated into more than one unit ofaccounting. In performing the assessment, we first apply the separationcriteria within FTB 90-1, *Accountingfor Separately Priced Extended Warranty and Product Maintenance Contracts*(“FTB 90-1”) to separate the deliverables falling within the scope of FTB90-1. Multiple-element arrangements are separated into more than oneelement if all of the following criteria are all met:

·       Thedelivered item(s) has value to the customer on a standalone basis.

·       Thereis objective and reliable evidence of the fair value of the undelivereditem(s).

·       Ifthe arrangement includes a general right of return relative to the delivereditem, delivery or performance of the undelivered item(s) is consideredprobable and substantially within our control.

If all of the abovecriteria are not met, revenue associated with the arrangement is deferred untilthe criteria are met on all undelivered elements, or the entire arrangement hasbeen delivered. If objective and reliable evidence of fair value is availablefor all elements of the arrangement, revenue is allocated to each element basedupon the relative fair value of each element to the total arrangement value.The price charged when an element is sold separately generally determines fairvalue. In the absence of fair value for a delivered element, we allocaterevenue first to the fair value of the undelivered elements and then allocatethe residual value to the delivered elements. In the absence of fair value foran undelivered element, the entire arrangement is accounted for as a singleunit of accounting and revenue for the delivered elements is deferred until theundelivered elements have been delivered.

**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.

F-11

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

**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 historicaltransactions of Chemotrade that were conducted in Euros. The financialstatements of Chemotrade were prepared in Euros and remeasured into U.S.dollars for purposes of consolidation, with the U.S. dollar as the functionalcurrency. Gains and losses from remeasurement and transaction gains and losseswere included in the statement of operations. The operations of Chemotradeceased in December 2005.

**Accounting for Stock-BasedCompensation**

Commencing May 1,2006, we adopted SFAS No. 123 (revised 2004) *Share-Based Payments*(“SFAS 123(R)”). This statementrequires that we record all share-based payment expense in our financialstatements based on a fair value methodology. We selected the Black-Scholesoption-pricing model as the most appropriate fair-value method for our awardsand will recognize compensation cost on a straight-line basis over our awards’vesting periods. We previously accounted for awards granted under our equityincentive plans under the intrinsic value method prescribed by AccountingPrinciples Board Opinion No. 25, Accounting for Stock Issued to Employeesand related interpretations, as permitted by SFAS 123, as amended by SFAS No. 148*Accounting for Stock-based Compensation—Transitionand Disclosure*, and provided pro forma disclosure required by thosestatements, as if the fair value based method defined in SFAS 123 had beenapplied. See Note 14 for further detail.

**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.

As of April 30, 2007,a total of 401,000 outstanding stock options, a total of 4,554,500 outstandingcommon stock warrants and the unissued shares underlying our outstandingconvertible debentures were excluded from the diluted net loss per sharecalculations, as their inclusion would be anti-dilutive. As of April 30,2006, a total of 733,483 outstanding stock options, a total of 1,251,252outstanding common stock warrants and the unissued shares underlying ouroutstanding convertible debentures were excluded from the diluted net loss pershare calculations, as their inclusion would be anti-dilutive. As of April 30,2005, a total of 711,662 outstanding stock options, a total of 1,351,128 commonstock warrants, 6,666, 800 and 33,000 outstanding shares of Series A, Dand E Convertible Preferred Stock, respectively, and the unissued sharesunderlying our outstanding convertible debentures were excluded from thediluted net loss per share calculations, as their inclusion would beanti-dilutive.

F-12

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

**Recently IssuedAccounting Standards**

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 FASBissued Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes—an interpretation of FASB Statement No. 109* (“FIN48”). This interpretation clarifies the application of SFAS 109 bydefining a criterion that an individual tax position must meet for any part ofthe benefit of that position to be recognized in an enterprise’s financialstatements and also provides guidance on measurement, derecognition,classification, interest and penalties, accounting in interim periods anddisclosure. FIN 48 is effective for our fiscal year commencing May 1, 2007. Wedo not expect the adoption of FIN 48 to have an impact on our results ofoperations or financial condition.

In September 2006, the SEC released Staff AccountingBulletin No. 108, *Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements* (“SAB 108”). SAB 108 provides interpretive guidance onthe SEC’s views regarding the process of quantifying materiality of financialstatement misstatements. SAB 108 is effective for fiscal years ending afterNovember 15, 2006, and early application for the first interim period of thesame fiscal year is encouraged. The application of SAB 108 in the first quarterof fiscal 2007 did not have a material effect on our results of operations orfinancial position.

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements* (“SFAS 157”). SFAS 157 definesfair value, establishes a framework and gives guidance regarding the methodsused for measuring fair value, and expands disclosures about fair valuemeasurements. SFAS 157 is effective for financial statements issued for fiscalyears beginning after November 15, 2007, and interim periods within thosefiscal years. We are currently evaluating the impact of adopting SFAS 157 onour consolidated financial statements.

In November 2006, the FASB ratified the consensusreached by the EITF on EITF Issue No. 06-7, *Issuer’sAccounting for a Previously Bifurcated Conversion Option in a Convertible DebtInstrument When the Conversion Option No Longer Meets the Bifurcation Criteriain FASB Statement No. 133, Accounting for Derivative Instruments and HedgingActivities* (“EITF 06-07”). The consensus provides that a previouslybifurcated conversion option in a convertible debt instrument for which theembedded conversion option no longer meets the bifurcation criteria in SFAS No. 133,*Accounting for Derivative Instruments and HedgingActivities* (“SFAS 133”), should be reclassified (at its fair valueon the date of reclassification) to stockholders’ equity. Any debt discountrecognized when the conversion option was bifurcated from the convertible debtinstrument should continue to be amortized. EITF 06-07 should be appliedto all previously bifurcated conversion options in convertible debt instrumentsthat no longer meet the bifurcation criteria in SFAS 133, in interim or annualperiods beginning after December 15, 2006. We applied this consensus to atransaction occurring in April 2007. See Note 9 for further detail.

In December 2006, the FASB issued FASB Staff PositionEITF 00-19-2, *Accounting forRegistration Payment Arrangements* (“FSP EITF 00-19-2”).FSP EITF 00-19-2 specifies that the contingent obligation to makefuture payments or otherwise transfer consideration under a registrationpayment arrangement, whether issued as a separate agreement or included as aprovision of a financial instrument or other 

F-13

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

agreement, should beseparately recognized and measured in accordance with FASB Statement No. 5, *Accounting for Contingencies*. A registration paymentarrangement is defined in FSP EITF 00-19-2 as an arrangement withboth of the following characteristics: (1) the arrangement specifies that theissuer will endeavor (a) to file a registration statement for the resale ofspecified financial instruments and/or for the resale of equity shares that areissuable upon exercise or conversion of specified financial instruments and forthat registration statement to be declared effective by the Securities andExchange Commission (“SEC”) within a specified grace period, and/or (b) tomaintain the effectiveness of the registration statement for a specified periodof time (or in perpetuity); and (2) the arrangement requires the issuer totransfer consideration to the counterparty if the registration statement forthe resale of the financial instrument or instruments subject to thearrangement is not declared effective or if effectiveness of the registrationstatement is not maintained. FSP EITF 00-19-2 is effective forregistration payment arrangements and the financial instruments subject tothose arrangements that are entered into or modified subsequent to December 21,2006. For registration payment arrangements and financial instruments subjectto those arrangements that were entered into prior to the issuance of FSPEITF 00-19-2, early adoption for interim or annual periods forwhich financial statements or interim reports have not been issued ispermitted. As allowed, we adopted FSP EITF 00-19-2 in the quarterended January 31, 2007. The adoption of FSP EITF 00-19-2 did nothave a material effect on our results of operations or financial position.

In February 2007, theFASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities* (“SFAS159”). SFAS 159 provides the option to report certain financial assets andliabilities at fair value, with the intent to mitigate volatility in financialreporting that can occur when related assets and liabilities are recorded ondifferent bases.  SFAS 159 also amendsSFAS No. 115, *Accounting for CertainInvestments in Debt and Equity Securities*,” by providing the optionto record unrealized gains and losses on held-for-sale and held-to-maturitysecurities currently. The implementation of FAS 159 is not expected to have amaterial impact on our results of operations or financial position.

**NOTE 2—FINANCIALSTATEMENT COMPONENTS**

Inventoriesconsist of the following (in thousands):

| ** **              | ** ** | **April 30,** | ** ** |
|-------------------------|------------|--------------------|------------|
| ** **              | ** ** | **2007**           | ** ** | **2006** | ** ** |
| Finished goods          |       | $                  | 497        |   | $ | 163 |   |
| Work in process         |       | 47                 |       | 34 |   |
| Materials and  supplies |       | 715                |       | 433 |   |
|                    |       | $                  | 1,259      |   | $ | 630 |   |

 

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

Propertyand equipment consists of the following (in thousands):

| ** **                      | ** ** | **April 30,** | ** ** |
|---------------------------------|------------|--------------------|------------|
| ** **                      | ** ** | **2007**           | ** ** | **2006** | ** ** |
| Office furniture  and equipment |       | $                  | 331        |   | $ | 126 |   |
| Production  equipment           |       | 7,613              |       | 5,673 |   |
| Vehicles                        |       | 191                |       | 175 |   |
| Construction in  process        |       | 854                |       | 608 |   |
| Leasehold improvements          |       | 1,215              |       | 646 |   |
|                            |       | 10,204             |       | 7,228 |   |
| Accumulated  amortization:      |       | (4,538             | )          | (2,666 | ) |
|                            |       | $                  | 5,666      |   | $ | 4,562 |   |

 

Depreciation expense forthe years ended April 30, 2007, 2006 and 2005, was  $1,770,000, $1,486,000 and $1,101,000,respectively. Such amounts include amortization on equipment under capitallease of $108,000, $23,000 and $50,000 for the years ended April 30, 2007,2006 and 2005, respectively.

Supplementaldisclosure of non-cash investing and financing activities (in thousands):

| ** **                                                                                                                                    | ** ** | **Year Ended April 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2007**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Deemed dividends  associated with beneficial conversion feature on issued Preferred Stock                                                     |       | $                                  | —     |   | $ | — |   | $ | 1,206 |   |
| Capital lease  obligation for property and equipment addition                                                                                 |       | $                                  | 1,137      |   | $ | — |   | $ | 70 |   |
| Warrant issued in  capital lease transaction                                                                                                  |       | $                                  | 66         |   | $ | — |   | $ | — |   |
| Capitalized  non-cash debt issuance costs associated with issuance of convertible  debenture and common stock warrants for services |       | $                                  | 601        |   | $ | — |   | $ | 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                                                                           |       | $                                  | 5,648      |   | $ | 4,313 |   | $ | — |   |
| Note payable issued for  equipment                                                                                                            |       | $                                  | —     |   | $ | 49 |   | $ | — |   |

 

In the year ended April 30, 2006, we also issued2,500 shares of common stock in a cashless exercise of a common stock warrant,issued 683,504 shares of common stock upon conversion of convertible preferredstock and issued 1,551,724 shares of common stock upon conversion ofconvertible debentures. In the year ended April 30, 2005, we also issued90,930 shares of common stock in cashless exercises of common stock warrantsand issued 1,446,024 shares of common stock upon conversion of convertiblepreferred stock.

Supplementaldisclosures of cash flow information (in thousands):

| ** **                        | ** ** | **Year Ended April 30,** | ** ** |
|-----------------------------------|------------|------------------------------------|------------|
| ** **                        | ** ** | **2007**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Cash paid during  the period for: |       |                               |       |   |   |   |   |
| Interest                          |       | $                                  | 191        |   | $ | 850 |   | $ | 276 |   |
| Income taxes                      |       | $                                  | —     |   | $ | — |   | $ | — |   |

 

F-15

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

**NOTE 3—GOODWILL ANDOTHER 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** | ** ** | **Total** | ** ** |
|------------------------------------|------------|----------------------------------|------------|------------------------|------------|------------------------------------------------|------------|-----------|------------|
| Balance as of  April 30, 2004 |       |                             | $          | —                 |       |                                           |       | $         | —     |   |   |   | $ | — |   |   | $ | — |   |
| Goodwill acquired  during the year |       |                             | —     |                   |       |                                           | —     |      |       |   | 447 |   |   | 447 |   |
| Impairments                        |       |                             | —     |                   |       |                                           | —     |      |       |   | (447 | ) |   | (447 | ) |
| 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 |   |
| Goodwill acquired  during the year |       |                             | —     |                   |       |                                           | —     |      |       |   | — |   |   | — |   |
| Impairments                        |       |                             | —     |                   |       |                                           | —     |      |       |   | — |   |   | — |   |
| Balance as of  April 30, 2007 |       |                             | $          | —                 |       |                                           |       | $         | 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 thesemiconductor products and services segment resulted from the acquisition ofthe silicon wafer manufacturing and reclamation assets of Encompass MaterialsGroup, Ltd. (see Note 4) in June 2004. Due to significant operating lossesof the segment subsequent to the acquisition, we determined that there had beena significant 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,** | ** ** |
|---------------------------------------------------------|------------|--------------------|------------|
| ** **                                              | ** ** | **2007**           | ** ** | **2006** | ** ** |
| Gross carrying amount:                                  |       |               |       |   |   |
| Trace and bulk detection technology                     |       | $                  | 273        |   | $ | 273 |   |
| Customer lists—Semiconductor products and services |       | 50                 |       | 50 |   |
| Customer base—Security services                    |       | 431                |       | 431 |   |
|                                                    |       | 754                |       | 754 |   |
| Accumulated amortization:                               |       |               |       |   |   |
| Trace and bulk detection technology                     |       | (121               | )          | (93 | ) |
| Customer lists—Semiconductor products and services |       | (49                | )          | (32 | ) |
| Customer base—Security services                    |       | (281               | )          | (138 | ) |
|                                                    |       | (451               | )          | (263 | ) |
|                                                    |       | $                  | 303        |   | $ | 491 |   |

 

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 aperpetual, exclusive technology license agreement with Silicon Evolution, Inc.(“SEI”) whereby we issued 125,000 shares of common stock (valued at $590,000)for the right to indefinitely use intellectual property assets owned or leasedby SEI. In our fiscal year 2005 and in connection with our ongoing businessreview of our semiconductor operations, we determined that over the years SOItechnology had been substantially modified to adapt to our currentmanufacturing plant and that the current processes are substantially removedfrom those acquired from SEI. As a result, an impairment loss for the thenunamortized balance of $428,000 was recognized in the impairment of goodwilland intangible assets caption during the year ended April 30, 2005. Theestimated fair value was determined using the expected present value of futurecash flows. The impaired intangible asset relates to the semiconductor productsand services segment.

Amortizationexpense for the years ended April 30, 2007, 2006 and 2005, was $188,000,$181,000 and $87,000, respectively. Estimated amortization expense for theintangible assets on our April 30, 2007, balance sheet for the fiscalyears ending April 30, is as follows (in thousands):

| **Year ending April 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|
| 2008                                     |       | $          | 172        |       |
| 2009                                     |       | 34         |       |
| 2010                                     |       | 27         |       |
| 2011                                     |       | 27         |       |
| 2012                                     |       | 27         |       |
|                                     |       | $          | 287        |       |

 

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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 Encompass Materials Group, Ltd. (“EMG”),which was engaged in the business of manufacture and reclamation of siliconwafers. The results of the operations associated with the acquired assets havebeen included in the consolidated financial statements since that date. Theaggregate purchase price was $2,920,000, which consisted of a $1,700,000promissory note, 182,983 shares of our restricted common stock (valued at$1,171,000 based upon the fair market value of the common stock on June 11,2004) and $49,000 of legal and accounting fees.

**Acquisition ofProtection Plus Security Corporation**

On May 16, 2005, wesigned and completed an agreement to acquire PPSC, a New York City basedcorporation that provides advanced security services. The results of PPSC’soperations have been included in the consolidated financial statements sincethat date.  We acquired all of the outstanding equity securities of PPSCfor a total price of $3,842,000, which consisted of $2,500,000 in cash, 126,632shares of our restricted common stock (valued at $1,292,000 based upon the fairmarket value of our common stock on May 16, 2005) and $98,000 of legal andaccounting fees, offset by a minimal amount due from the seller.

**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, 2007, noadditional capital contributions have occurred.

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, 2007, the differencebetween the carrying value of the IUT investment and the amount of underlyingequity in the net assets of IUT is a deficit of approximately $100,000. Wemonitor our investment in IUT and will recognize, if ever existing, a loss invalue which is deemed to be other than temporary.

In June 2004, we entered into a research anddevelopment agreement with IUT. We funded $1,312,000 and $496,000 under thisagreement during the years ended April 30, 2006 and 2005, respectively. InApril 2006, the then existing agreement was canceled and we entered into anew research and development agreement with IUT whereby we agreed to use theservices of IUT for certain development work on a project-by-project basis. During the year ended April 30, 2007, wefunded $1,099,000 under the new agreement. As of April 30, 2007, we have abalance payable with IUT of 

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

approximately$70,000 related to work performed in fiscal year 2007. All funded payments havebeen included as research and development in the consolidated statements ofoperations.

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. No material sales have been made by IUT under this agreement.

In April 2006, in exchange for the 15% of IUTDetection Technologies, Inc. (“IUTDT”) formerly owned by IUT and forcontractually clarifying our ownership of certain trace and bulk detectiontechnology, we granted IUT a royalty of 2% of the net selling price of productproduced through technology developed under the research and developmentagreement. Subsequent to this transaction we owned 100% of IUTDT, an entitywhich held intellectual property related to trace and bulk detection technologybut which had no operations. During the year ended April 30, 2007, welegally terminated the entity and all intellectual property formerly held byIUTDT is now held by HSDC.

Additionally, IUT has, inprior years, produced carbon-14 precursors for us that we resold in themarket place. Total purchases from IUT for this product during the years ended April 30,2007, 2006, and 2005 were $0, $279,000 and $353,000, respectively. With thecessation of operations at our Chemotrade subsidiary in December 2005 andthe divesture of the life sciences segment (see Note 18) subsequent to April 30,2007, no further carbon-14 purchases are expected to be made from IUT.

**NOTE 6—DEVELOPMENTAND LICENSING AGREEMENT AND INVESTMENT IN SENSEIT CORP**

**Development andLicensing Agreement**

On December 5, 2005, we approved a developmentplan that resulted in us becoming obligated under a Development &Licensing Agreement (the “Lucent Agreement”) entered into with LucentTechnologies, Inc. (“Lucent”) in September 2005. As noted in thisfootnote below, the Lucent Agreement was assigned in October 2006. Underthe Lucent Agreement, we will endeavor to develop a next-generation infraredimaging and night vision surveillance technology at Lucent’s microelectro-mechanical systems and nanotechnology fabrication facility. The LucentAgreement 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 Lucent Agreement. In exchange for this license,we will fund Lucent’s development efforts for the project through the periodicpayment over a two and one-half year period of a development fee totaling$12,000,000, of which $6,000,000 has been funded as of April 30, 2007. Thisfunding resulted in recognition of research and development expense of$3,000,000 and $2,500,000 during the years ended April 30, 2007 and 2006,respectively. The development payments are expensed to research and developmentexpense as the respective expenses are incurred. We have the right to terminatethe development project for any reason from time-to-time, so long astermination is prior to the first commercial sale of a licensed product. When,if ever, commercial sales of developed products commence, a royalty paymentbased on revenue will be due Lucent (subject to a minimum semi-annualcumulative royalty payment amount). Additionally, if Lucent expends substantialsales effort to accomplish 

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

a sale, we will also paythem 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.

We did not make the $1,000,000payment that was due to Lucent on or before July 16, 2007. As a result ofnot making this payment, Lucent may, after certain steps of notification andperiods to cure have been exhausted, cancel the Lucent Agreement and alllicenses granted to us thereunder or cease working on the project and thenassess us a “start-up” fee if funding was to resume. Effective July 26,2007, we received official notification from Lucent that we failed to make the$1,000,000 payment to Lucent by July 16, 2007 and that in the event suchnon-payment continues for more than ten days, Lucent may at is discretion,suspend work on the development project. We are currently seeking additionalfinancing to allow us to make our contractual development payments to Lucent. Wecannot offer any assurance that we will be able to raise the funds necessary tomake all of the required payments to Lucent, or that the technology will bedeveloped to a point where we want to continue to make such payments when due. Additionally,SenseIt may need to seek outside financing to make payments to Lucent and, ifso elected, such outside financing would dilute our ownership interest inSenseIt (see subsequent discussion regarding SenseIt within this footnote).

**Investment inSenseIt Corp**

On October 26, 2006, we entered into a Class ACommon Stock Purchase Agreement (the “Purchase Agreement”) with SenseIt Corp, aDelaware corporation, with the intent of accelerating next generation infraredimaging and night vision surveillance technology development and drivingrelated commercialization activities in connection with the Lucent Agreement. Thejoint venture was established through our acquisition of an initial 90%ownership interest in SenseIt in exchange for assigning to SenseIt all of ourinterest under the Lucent Agreement, although we will continue to be jointlyand severally liable with SenseIt to Lucent for amounts due to Lucent under theassigned Lucent Agreement. The assignment was approved by Lucent.

Pursuant to the Purchase Agreement, on October 27,2006, we purchased shares of the Class A common stock of SenseIt inexchange for cash and other consideration, including, but not limited to, anassignment of all of our rights, title and interest in the Lucent Agreement. Asdescribed above, we now have a 90% ownership interest in SenseIt. Our ownershipinterest will be adjusted if SenseIt receives additional financing from thirdparties and upon the occurrence of a Threshold Event. The term “Threshold Event”is described in SenseIt’s Certificate of Incorporation, as amended, as thereceipt by SenseIt of cumulative $20 million in certain equity financing. Atthat time, the Class A common stock and Class B common stock will beconverted into common stock, and the holder of the Class B common stock(held by the chief executive officer of SenseIt who also serves as the Chairmanof the Board of Isonics Corporation) will be entitled to a 10% ownershipinterest. The remaining 90% of the common stock outstanding will be allocatedamong the prior holders of common stock and Class A common stock.

Under the PurchaseAgreement, we acquired 664,650 shares of Class A common stock of SenseItfor total consideration of $6.65 million paid as follows:

·       Wereceived a $4 million credit for payments made to Lucent, as required by theLucent Agreement and for the assignment of our rights, title and interest inthe Lucent Agreement, for 400,000 shares of Class A common stock; and

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

·       $250,000working capital was paid to SenseIt upon signing the Purchase Agreement for25,000 shares of Class A common stock; and

·       $250,000working capital was paid to SenseIt in November 2006 for 25,000 shares of Class Acommon stock, which payment we were obligated to make no later than December 31,2006; and

·       $1,000,000was paid to SenseIt in January 2007 for 100,000 shares of Class Acommon stock, which payment was subsequently made to Lucent by SenseIt asrequired under the Lucent Agreement; and

·       $1,000,000was paid to SenseIt in April 2007 for 100,000 shares of Class Acommon stock, which payment was subsequently made to Lucent by SenseIt asrequired under the Lucent Agreement; and

·       wereceived 14,650 shares of Class A Common Stock as credit for legal costsin the amount of approximately $146,000 incurred related to entering into theSenseIt joint venture.

Additionally, we have an obligation to make anadditional $353,500 payment to SenseIt. We will be entitled to receive oneshare of Class A common stock for each $10 investment.

In connection with the Purchase Agreement, we alsoentered into a Stockholders’ Agreement with SenseIt and its chief executiveofficer. The Stockholders’ Agreement includes certain share transferrestrictions such as right of first refusal, as well as drag-along andtag-along rights. The Stockholders’ Agreement does not currently impose anymaterial obligations on us. If at some time in the future (after we meet ourremaining $353,500 obligation), SenseIt needs additional funding, we will havethe right, but not the obligation, to provide that additional funding.

At the closing of the Purchase Agreement, SenseItentered into an amended and restated employment agreement with the chiefexecutive officer of SenseIt (the “Employment Agreement”). The EmploymentAgreement has an initial term of two years, plus automatic two-year extensionsunless SenseIt or the chief executive officer chooses not to renew. TheEmployment Agreement sets forth the compensation payable to the chief executiveofficer and the time that he is required to devote to the business of SenseIt. Iftermination occurs after SenseIt has made a commercial sale of a Lucentproduct, as described in the Lucent Agreement, or has acquired a businesshaving revenues of $10 million or more in any one year, termination withoutcause will result in SenseIt’s obligation to pay the chief executive officer atwo-year severance based on the respective annualized salary over the previousfive years. The Employment Agreement is between SenseIt and its chief executiveofficer; Isonics Corporation has no obligation under the contract.

The results of SenseIthave been included in our consolidated results as of the exercise date of thePurchase Agreement. The minority interest held in the net assets of SenseIt isincluded in the caption “minority interest in consolidated subsidiary” in ourconsolidated balance sheet. Additionally, the consolidated statements ofoperations include a noncash charge in the amount of $667,000 recognized bySenseIt related to the chief executive officer’s 10% ownership interest inSenseIt.

**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 be eitherunnecessary to support a more 

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

focusedproduct portfolio or incompatible with the future direction of the segment’soperations. Immediately prior to the decision to sell the assets, the equipmenthad a cumulative net book value of approximately $1,026,000. In the first andfourth quarters of the year ended April 30, 2006, certain assets werewritten down to their estimated fair value, less selling costs, yielding acumulative impairment loss on assets held for sale in the amount of $466,000. Duringthe year ended April 30, 2007, all of the assets held for sale were soldfor a net gain of $112,000.

**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 $1,207,000 and $70,000 at April 30, 2007, and April 30, 2006,respectively. Accumulated amortization of the leased equipment at April 30,2007, and April 30, 2006, was approximately $151,000 and $43,000,respectively. Amortization of assets under capital leases is included indepreciation expense. During the year ended April 30, 2007, in association with a capital lease transactionwe issued a lessor a common stock warrant (valued at $66,000 using theBlack-Scholes pricing model) to purchase 31,250 shares of common stock at $3.36per share. The common stock warrant vested immediately, expires on November 28,2009, and will be amortized to interest expense over the term of the leaseusing the effective interest method.

Thefollowing represents the future minimum lease payments remaining under capitalleases as of April 30, 2007 (in thousands):

| **Year ending April 30,**                  | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|------------|------------|
| 2008                                                      |       | $          | 486        |       |
| 2009                                                      |       | 486        |       |
| 2010                                                      |       | 330        |       |
| Total minimum  lease payments                             |       | 1,302      |       |
| Less: amount  representing interest                       |       | 252        |       |
| Present value of  minimum lease payments                  |       | 1,050      |       |
| Less: current  portion of obligation under capital leases |       | 340        |       |
| Long term obligation  under capital leases                |       | $          | 710        |       |

 

**NOTE 9—BORROWINGS**

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

We currently have oneactive lending facility with a financial institution. 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, 2007, the outstanding balance onthe loan is $134,000 and is classified as current liability. The note is notsecured by collateral and bears no significant financial covenants. 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. In June 2007, the remaining balance of the notewas paid in full.

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

**Note Issued inConnection with EMG Acquisition**

In connection with theacquisition of the business and assets of EMG in June 2004, we issued a$1,700,000 promissory note that was collateralized by the assets acquired by usand certain other assets owned by us relating to our pre-existing semiconductoroperations. In March 2007, the final payment was made on this note and asa result there is no outstanding balance as of April 30,2007.

**8% ConvertibleDebentures**

*Description andInitial 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 “8% Debenture Warrants”)granting the right to purchase a total of 385,000 common shares. As of April 30,2007, the 8% Debentures have been paid in full, as described in more detailsubsequently in this footnote. The warrants expire February 24, 2008 and wereoriginally exercisable at an exercise price of $25.00 per share. However, thewarrants contain a ratchet provision triggered by a subsequent equity sale. Underthis provision, the warrant exercise price would be reduced to the effectiveprice per share (or effective exercise price per share) of the subsequentequity sale.  Concurrently, the number ofwarrants would be adjusted such that the aggregate exercise price would beequal to the aggregate exercise price prior to adjustment. Due to the issuanceof convertible debentures in May 2006, the warrant provision was activatedto the effect of reducing the exercise price to $5.00 per share and increasingthe number of shares issuable under the warrants. Additional detail is providedsubsequently within this footnote.  Underspecified conditions, including the lack of an effective registration statementfor the underlying shares, and after a period of one year from issuance, theWarrants may be exercised by means of a cashless exercise. This provisionpermits the warrant holder to cancel a portion of the warrants at the thencurrent share price to receive the balance of the warrants in common stockwithout payment to us.

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 were required to pay 1/12 of the original principal balance on thefirst day of each calendar month on all 8% Debentures outstanding at the timeof each payment.  Both the principal andinterest were payable, at our option, in common stock or cash, subject tovarious requirements. If we chose to make a scheduled principal payment byissuing common stock, and all requirements to do so were met, the conversionprice was the lesser of the then Conversion Price or 88% of the average of theten final bid prices ending on the trading day immediately prior to the monthlyredemption date.  If we chose to make ascheduled interest payment by issuing common stock, and all requirements to doso were met, the conversion price was the lesser of the then Conversion Priceor the lesser of  (i) 90% of theaverage of the twenty final bid prices ending on the trading day immediatelyprior to the applicable interest payment date or (ii) 90% of the averageof the twenty final bid prices ending on the trading day immediately prior tothe date the applicable interest payment shares are issued and delivered ifafter the interest payment date.

As a result of a freestanding registration rightsagreement, we had an obligation to register the shares underlying the 8%Debentures and 8% Debenture Warrants (the registration statement became effectiveon July 26, 2005) and have a continuing obligation to keep theregistration statement continuously effective. Failure to meet this obligation,as defined, will result in our incurring liquidated damages in the 

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

amount of 1.0% of theprincipal amount of the purchase price per month for any shares derived fromthe 8% Debentures or 8% Debenture Warrants and then held by each of the holdersof the 8% Debentures at the time liquidated damages are payable.

We evaluated the embedded conversion feature in the 8%Debentures and concluded that the feature did 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 8% Debenture Warrants and concluded that the warrants also meetthe scope exception found in SFAS 133 and, therefore, were initially classifiedin equity. Lastly, we evaluated the freestanding registration rights agreement(discussed above) and concluded that it met the definition of a derivativeinstrument under SFAS 133. The fair value of the derivative liability wasdetermined to be immaterial based on a probability-weighted, discountedcashflow evaluation of its terms. No amendment of warrant terms has been donewhich would require the application of FSP EITF 00-19-2 to the freestandingregistration rights agreement.

We allocated the proceeds received between the 8%Debentures and the related warrants based on the relative fair value of eachinstrument. The $3,525,000 allocated to the 8% Debenture Warrants was recordedas additional paid-in capital and as a corresponding reduction to the carryingvalue of the 8% Debentures. In addition, in accordance with EITF 00-27, *Application of Issue No. 98-5 to CertainConvertible Instruments* (“EITF 00-27”) 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$25.00 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 was being amortized to interestexpense over the term of the 8% Debentures using the effective interest methodat an effective interest rate of 19%. During the years ended April 30,2007 and 2006, $285,000 and $4,270,000, respectively, of this discount wasamortized 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 warrant granting the right to purchase 13,475 shares of commonstock (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 were being amortized to amortization of debtissuance costs over the life of the convertible debenture using the effectiveinterest method. During years ended April 30, 2007 and 2006, $121,000 and$1,260,000, respectively, of the capitalized debt issuance costs was amortizedto expense. At April 30, 2007, there is no unamortized debt issuance cost.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 was being amortized to interest expense over the term ofthe convertible debenture using the effective interest method.

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

*Payment ofPrincipal and Interest in Shares of Common Stock*

In our third fiscal quarter of our year endedApril 30, 2006, we determined that it had become probable that we wouldrepay the principal portion of the 8% Debentures in common stock instead of cash.As such, 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 years endedApril 30, 2007 and 2006, we recorded additional interest expense of$429,000 and $1,392,000, respectively, representing the increased accretionresulting from the probable repayment of the 8% Debentures principal in commonstock.

Havingmet all requirements to allow us to do so, we elected to make certain quarterlyinterest payments and monthly amortization payments of principal and interestin shares of our common stock, as follows (in thousands, except share amounts):

| ** **                                               | ** ** | **Shares Issued  for Principal** | ** ** | **Principal  Book Value  Reduction** | ** ** | **Shares  Issued for  Interest** | ** ** | **Effective  Interest Paid** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|---------------------------------------|------------|-----------------------------------|------------|
| September 2005  interest payment                    |       |                                       | —     |                                      |       |                                  | $          | —                            |       |   |   | 50,150 |   |   |   | $ | 506 |   |   |
| March 2006  amortization payment                    |       |                                       | 292,017    |                                      |       |                                  | 2,156      |                              |       |   | 44,824 |   |   |   | 337 |   |   |
| April 2006  amortization payment                    |       |                                       | 386,149    |                                      |       |                                  | 2,157      |                              |       |   | 15,420 |   |   |   | 88 |   |   |
| Payments made during the year ended  April 30, 2006 |       |                                       | 678,166    |                                      |       |                                  | 4,313      |                              |       |   | 110,394 |   |   |   | 931 |   |   |
| May 2006 amortization payment                       |       |                                       | 390,464    |                                      |       |                                  | 2,071      |                              |       |   | 13,644 |   |   |   | 73 |   |   |
| June 2006  amortization payment                     |       |                                       | 493,452    |                                      |       |                                  | 1,873      |                              |       |   | 5,864 |   |   |   | 23 |   |   |
| September 2006  amortization payment                |       |                                       | 71,308     |                                      |       |                                  | 284        |                              |       |   | 2,906 |   |   |   | 11 |   |   |
| October 2006  amortization payment                  |       |                                       | 85,775     |                                      |       |                                  | 284        |                              |       |   | 2,705 |   |   |   | 9 |   |   |
| November 2006  amortization payment                 |       |                                       | 106,641    |                                      |       |                                  | 284        |                              |       |   | 2,688 |   |   |   | 8 |   |   |
| December 2006  amortization payment                 |       |                                       | 87,145     |                                      |       |                                  | 284        |                              |       |   | 1,940 |   |   |   | 6 |   |   |
| January 2007  amortization payment                  |       |                                       | 118,767    |                                      |       |                                  | 284        |                              |       |   | 1,495 |   |   |   | 4 |   |   |
| February 2007  amortization payment                 |       |                                       | 117,006    |                                      |       |                                  | 284        |                              |       |   | 726 |   |   |   | 2 |   |   |
| Payments made during the year ended  April 30, 2007 |       |                                       | 1,470,558  |                                      |       |                                  | 5,648      |                              |       |   | 31,968 |   |   |   | 136 |   |   |
|                                                     |       |                                       | 2,148,724  |                                      |       |                                  | $          | 9,961                             |       |   |   | 142,362 |   |   |   | $ | 1,067 |   |   |

 

*Induced Conversion*

On March 9, 2006,holders of our 8% Debenturesconverted outstanding principal in the amount of $9,000,000 into 1,551,724shares of our common stock. We gave the holders of all 8% Debentures the temporary right to convert a portion or theirentire principal amount into shares of our common stock at a temporaryconversion price of $5.80 per share (a reduction from the prior conversion priceof $25.00 per share). At the close of business on March 8, 2006, theclosing price for our common stock was $6.56 per share. Additionally, we issued2,507 shares of our common stock in payment of interest then due on theconverted principal amount. We have accounted for this transaction by applyingthe induced conversion principles set out in SFAS No. 84, *Induced Conversions ofConvertible Debt—An Amendment of*

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

*APB Opinion No. 26*(“SFAS 84”). This standard sets out the method of accounting forconversions of convertible debt to equity securities when the debtor inducesconversion of the debt by offering additional securities or other considerationto convertible debt holders. In accordance with SFAS 84, we calculated theexpense equal to the fair value of all securities transferred in thetransaction in excess of the fair value of securities issuable pursuant to theoriginal conversion terms. As a result, for the year ended April 30, 2006,we recognized debt conversion expense in the amount of $7,227,000.

*May 2006 Offer*

On May 18, 2006, we made an offer to the holdersof our 8% Debentures to pay in cash the principal balance remaining immediatelysubsequent to making the monthly payment scheduled June 1, 2006, plus a 5%premium and accrued interest, both items to also be paid in cash. On May 19,2006, approximately $5.0 million out of the then-outstanding $8.2 million8% Debentures accepted our offer. The offer was made and accepted contingentupon the cash payment being made to the accepting holders on or before June 1,2006, from the proceeds of a financing that we were then working to completeand which is discussed below. In accepting our offer, the holders agreed tolimit the anti-dilution provision on their warrants originally issued withtheir debentures such that the warrants would fully ratchet based upon thefinancing completed on May 31, 2006, and then the ratchet would beconverted to a price-only ratchet whereby the exercise price would still bereduced to the effective price per share (or effective exercise price pershare) of the subsequent equity sale but where the number of shares purchasableunder the warrant 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 financing withvariable conversion terms (such contractual terms we do not believe to be inforce). In accordance with this offer and subsequent to closing the financingon May 31, 2006, we paid approximately $4.1 million from the proceeds ofthe financing to the holders accepting our offer (such payment was calculatedafter including the impact on their outstanding principal balance of the normalmonthly amortization payment made to them on June 1, 2006). This paymentresulted in a reduction in the principal balance of the 8% Debentures of$3,880,000.

In accounting for theoffer and subsequent payment, we allocated between three components the $4.1 millionpaid to certain holders of the 8% Debentures: the interest due at the time ofpayment, the amendment to the terms of certain outstanding warrants and theprincipal reduction of the 8% Debentures. We recorded an expense in the amountof $357,000 (included in selling, general and administrative expenses) relatedto the amendment to the terms of certain outstanding warrants originally issuedwith the 8% Debentures, such charge representing the decrease in the fair valueof the amended warrants as compared to the fair value of the warrantsimmediately prior to amendment. We recorded a gain in the amount of $227,000 onthe extinguishment of debt (included as a line item in other income (expense)),such amount calculated as the difference between the reacquisition price andthe net carrying amount of the extinguished debt, which bore a nominalprincipal amount of $3,880,000. Additionally, we wrote off capitalized debtissuance costs related to the extinguished debt in the amount of $44,000(included in amortization of debt issuance costs).

*Warrant contractualadjustment*

As a result of the issuance of the convertibledebentures in May 2006 (subsequently discussed within this footnote),which includes a fixed conversion price of $5.00, the warrants associated withthe 8% Debentures were amended per the warrant such that the warrant exerciseprice was reduced from 

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

$25.00 per share ofcommon stock to $5.00 per share of common stock. Simultaneously, the number ofshares purchasable under the warrants increased from 398,475 to 1,992,375. Dueto our offer made on May 18, 2006, to the holders of the 8% Debentures andthe acceptance of the offers by certain holders, of the currently outstandingwarrants associated with the 8% Debentures, warrants to purchase 1,139,250shares of common stock have a price ratchet only whereby no change to thenumber of shares purchasable will occur and warrants to purchase 853,125 sharesof commons stock continue to retain the original ratchet provisions.

Upon the issuance of theconvertible debentures in May 2006 and the resulting ratchet to the 8%Debenture Warrants, we reevaluated the classification of the aforementioned853,125 warrants originally issued with the 8% Debentures and which stillcontain a full ratchet provision. We evaluated the warrants in accordance withthe provisions of SFAS 133 and EITF Issue No. 00-19, *Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock* (“EITF00-19”) which provide guidance, among other topics, as to whether equityor derivative liability classification is appropriate for freestanding warrants.Because of the issuance of the variable rate financing, we no longer havecontrol over the ratchet of the fully ratcheting warrants. Therefore, there isa possibility (and per EITF 00-19 we are not allowed to consider in ourevaluation the likelihood of such an event occurring) that the number of sharesissuable related to the warrant could exceed our authorized but unissued sharesif the warrant were to ratchet to a sufficiently low exercise price. If we didnot have sufficient authorized but unissued shares to satisfy the number ofshares issuable under the warrant if exercised, we may have to net cash settlea portion or all of the warrant. Accordingly, we reclassified theaforementioned warrants from equity to derivative liabilities in the amount of$1,773,000, which represents the estimated fair value of the warrants at thedate of reclassification. Further, we are required to recognize in earnings ateach reporting date the gain or loss on our derivative instruments. We recordeda gain on derivative instruments for the year ended April 30, 2007,in the amount of $752,000, such amount representing the estimated change infair value of the warrants between the date the warrants were classified asliabilities and April 30, 2007.

*Other disclosure*

Two former holders of the8% Debentures have at various times asserted that the issuance of the 2006Debentures constituted a default (due to a potential variable conversionprovision contained within the 2006 Debentures) under the 8% Debentures. Wehave contested that allegation on several bases and will defend against anyfurther allegation of default as necessary. 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. If they prove a default,we could be liable for an amount of approximately $1,200,000, including accruedinterest.

**2006 ConvertibleDebentures**

*Description andInitial Accounting*

On May 31, 2006, we completed a private placementpursuant to which we issued to one accredited investor, Cornell CapitalPartners, L.P. (“Cornell”) a secured convertible debenture with a principalamount of $10,000,000, which was the first of three secured convertibledebentures (cumulatively, the “2006 Debentures”), for which the aggregateprincipal amount issued was $16,000,000, which remains 

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

outstanding in itsentirety as of April 30, 2007, but offset by a discount of $9,030,000 forfinancial statement presentation. On June 5, 2006 (two trading days priorto the filing of a registration statement contemplated in the transactiondocuments correlated with the 2006 Debentures), we issued the second of thethree 2006 Debentures. This 2006 Debenture has a principal amount of $3,000,000.The final 2006 Debenture with a principal amount of $3,000,000 was issued on November 16,2006, two trading days prior to a registration statement being declaredeffective by the SEC. The 2006 Debentures are convertible into shares of ourcommon stock at the lesser of $5.00 (the “Fixed Conversion Price”) or 80% ofthe average of the two lowest daily volume weighted average prices (“VWAP”) ofour stock during the five trading days immediately preceding the conversiondate (the “Market Conversion Price”). The 2006 Debentures mature on May 31,2009 (the “Maturity Date”). In addition to the 2006 Debentures, we issued threewarrants (the “2006 Debenture Warrants”) to purchase a total of 2,000,000shares of our common stock at exercise prices of $5.00 per share (500,000warrants), $7.00 per share (750,000 warrants) and $8.00 per share (750,000warrants). 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 2006 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 plans will not cause anadjustment under this provision.

Interest originally accrued on the outstandingprincipal balance at the annual rate of 6%. As disclosed in more detailsubsequently within this footnote, the interest rate was amended in April 2007to 13% initially with a periodically declining rate reducing to 7.75%immediately prior to maturity. Interest is payable on the Maturity Date in cashor shares of our common stock, at our option. At April 30, 2007, accruedinterest expense on the 2006 Debentures was $851,000 and is included in thecaption “other long-term liabilities” in the consolidated balance sheet. If wechoose to pay accrued interest in shares of our common stock, the number ofshares to be issued will be calculated as the amount of interest due divided by88% of the volume weighted average price of our common stock for the fivetrading days preceding the Maturity Date.

The investor and an unaffiliated party provided usservices in connection with completing the transaction. To compensate theseentities for those services, we issued them 165,000 shares of our common stock(the “Buyers Shares”). We also paid Cornell or its affiliates fees in thecumulative amount of $900,000.

We were contractually required to seek stockholderapproval of this transaction by no later than January 31, 2007, (exclusiveof any shares acquired in this transaction or related transactions), includingthe ability to issue a maximum of 16 million shares upon conversion of the 2006Debentures and to approve an increase in authorized shares of common stock toat least 175 million shares. On October 30, 2006, we held our annualmeeting of stockholders whereby the stockholders approved the total number ofshares issuable under the transaction documents. Although more stockholdersvoted in favor of amending our articles of incorporation to increase ourauthorized common stock, we did not receive the number of votes for theproposal required by California law to complete the amendment as required. Underthe terms of both the 2006 Debentures and the related warrants, if we hadinsufficient authorized capitalization after December 31, 2006, we had anobligation to call and hold a special meeting of its stockholders within 

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

60 days for the solepurpose of increasing our authorized capitalization. As aforementioned, anincrease in authorized capitalization from 75 million shares of common stock to175 million shares of common stock was approved at a special meeting ofstockholders on January 2, 2007. As part of a waiver agreement enteredinto with Cornell in February 2007 (discussed below), Cornell waived theoriginal compliance period.

The 2006Debentures, the 2006 Debenture Warrants and the Buyers Shares have certainlimitations on our ability to issue shares to the holders of the instrumentsand impose certain limitations on Cornell’s ability to sell shares.

·       Weare prohibited from issuing shares of our common stock to the holders of the 2006 Debentures (upon conversion orpayment of interest) and the 2006Debenture Warrants (upon exercise) if the issuance would result in Cornellbeneficially owning more than 4.99% of our outstanding common stock (althoughCornell can waive this provision upon more than 65 days notice to us).

·       Ifconverting using the Market Conversion Price, Cornell is limited to convertingno more than $400,000 of the principal or accrued interest on the 2006 Debentures into shares of ourcommon stock in any seven calendar day period.

·       Themaximum number of shares that may be issued upon conversion of the principalamount of the 2006 Debentures iscontractually limited to 16 million shares.

Initially, if at a conversion event, we hadinsufficient shares authorized but unissued and unreserved to convert principaland pay interest in common stock, our stock was not listed or quoted on amarket (as defined), we had not timely satisfied any conversion obligations orthe issuance of shares would have violated certain other defined sections ofthe agreement, the holder had a right to request net cash settlement of theconversion based upon a defined calculation. This contractual provision wasmodified in April 2007 as disclosed in more detail subsequently in thisfootnote.

If there is an effective underlying registrationstatement and if the volume weighted average price of our common stock is equalto or greater than $10.00 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 in cash a portion or all amounts outstandingunder the 2006 Debentures priorto the Maturity Date provided the closing bid price of our common stock is lessthan $10.00 at the time the redemption notice is provided. If we exercise thisredemption right, a redemption premium in the amount of 20% of the principalamount being redeemed will be due. During the ten day notification period,Cornell may elect to convert any portion or all of the outstanding 2006 Debenture amount.

Through May 31, 2007, we granted Cornell theright to participate in any allowed capital raise up to 50% of the raise. Untilsuch time no portion of the principal and interest due on the 2006 Debentures is outstanding, wehave granted Cornell the right to participate in any allowed capital raise upto 25% of the raise.

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

The 2006Debenture Warrants are exercisable for cash only unless there is no effectiveunderlying registration statement, at which point a holder can elect a cashlessexercise. As the shares underlying the $7.00 and $8.00 warrants, eachexercisable for 750,000 shares of our common stock, are not currentlyregistered, the holder of the warrants currently has a right of cashlessexercise for these two warrants. The then-effective warrant exercise price willbe adjusted upon the occurrence of any stock dividends, stock splits, pro ratadistributions, or fundamental transactions as described in the 2006 Debenture Warrant agreements. Additionally,the exercise price and number of shares upon issuance of common stock aresubject to adjustment in cases where we issue shares of common stock (otherthan Excluded Securities or issuances in connection with other components ofthe 2006 Debenture documents)for consideration per share less than the then-existing warrant exercise price.If an adjustment is triggered, the warrant exercise price for the warrant for500,000 shares at an exercise price of $5.00 per share and the warrant for750,000 shares at an exercise price of $7.00 per share will be adjusted to aprice determined by multiplying such exercise price by a fraction of which (a) thenumerator shall be the number of shares of common stock outstanding immediatelybefore such issuance plus the number of shares of common stock that theaggregate consideration received by us for such issuance would purchase at thewarrant exercise price then in effect and (b) the denominator shall be thenumber of shares of common stock outstanding immediately prior to such issuanceplus the number of new shares to be issued in the triggering event. Concurrently,the number of shares issuable upon exercise of the warrant will be adjustedsuch that the aggregate exercise price would be equal to the aggregate exerciseprice prior to adjustment. The warrant for 750,000 shares exercisable at $8.00per share has a different adjustment calculation whereby a subsequenttriggering equity issuance would lead to a reduction in the warrant exerciseprice per share equal to the price per share (or effective exercise price pershare) of the subsequent equity issuance. There would be no change to thenumber of shares issuable under the warrant. In February 2007, theconversion terms of certain warrants were adjusted as disclosed in more detailsubsequently within this footnote.

As a result of a freestanding registration rightsagreement, we had several obligations to register the shares underlying the 2006 Debentures, Buyers Shares and 2006 Debenture Warrants. In February 2007,we entered into a waiver agreement with Cornell as disclosed in more detailsubsequently within this footnote. The waiver agreement included waiver ofcertain deficiencies and amended certain clauses of the original registrationrights agreement. A discussion of the registration rights follows:

Initial registration statement—We were required tofile an initial registration statement to register 2,183,947 shares of commonstock (related to the Buyers Shares, the 2006 Debenture Warrant exercisable for 500,000 shares at $5.00 pershare and 1,518,947 shares to be issued upon conversion of the 2006 Debentures) no later than August 7,2006 (a registration statement was filed on June 7, 2006) and to have theinitial registration statement declared effective by September 28, 2006 (theregistration statement was declared effective on November 20, 2006). Becausewe failed to meet our effectiveness deadline, we could have incurred liquidateddamages of one percent of the outstanding balance of the 2006 Debentures for each thirty-day period,prorated by day, subsequent to the date of the deadline missed until such timeas the registration statement was declared effective. However, in November 2006Cornell waived the penalty in respect to obtaining effectiveness of theoriginal registration statement. No concession was given by us in return forthe waiver.

Subsequent registration statement—As a result of our stockholders approving the Cornelltransaction on October 30, 2006, we were obligated to file an amendedregistration statement by November 30, 2006, to register the full numberof shares required under the 2006Debenture transaction documents (representing the Buyers Shares, sharesunderlying the 2006 DebentureWarrants and shares upon the 

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

conversion of the 2006 Debentures based on a definedformula but in an amount not to exceed 16 million shares) and obtaineffectiveness of the registration statement by January 15, 2007. We wereunable to file any additional registration statement until our stockholders approved the increase inauthorized shares of common stock on January 2, 2007. Additionally,current interpretation by the SEC of registration rules regardingfinancing structures with market-based conversion features precludes us fromregistering at one time the full number of shares required by the 2006 Debenture transaction documents. Consequently,we had a contractual obligation to pay Cornell liquidated damages equal to 1%of the liquidated value of the 2006Debentures outstanding ($160,000 assuming no conversions by Cornell) for each30 day period until such time, if ever, that we became in compliance with ourcontractual obligation to Cornell. In February 2007, we entered into awaiver agreement with Cornell as disclosed in more detail subsequently withinthis footnote.

Continued effectiveness—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 % per thirty-day liquidated damages penalty.

We are not obligated to pay liquidated damages formore than a total of 365 calendar days. We may elect to pay any liquidateddamages in cash or shares of our common stock if registered. Failure to complywith our registration obligations may, subsequent to any grace periods andopportunities to cure, be deemed an event of default.

Additionally, other events, as defined in the 2006Debenture agreement, may also allow the 2006Debenture holders to declare us in default. Remedies for an event of default,include the option to accelerate payment of the full principal amount of theDebentures, together with interest and other amounts due, to the date ofacceleration and Cornell will have the right to request such payment in cash orin shares of our common stock.

So long as principal amounts are outstanding under the2006 Debentures, we have agreedto not sell capital stock or grant security interests which meet certaindefined characteristics without the prior consent of Cornell. However, certaintransactions defined as Excluded Securities are exempted from this priorconsent provision. Excluded Securities include (1) securities issued inconnection 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 employeeswithin the first thirty days of employment, (4) securities issued pursuantto an approved stock plan, (5) up to 250,000 shares (priced not less thanmarket) which may be issued as long as no registration rights are included andas long as not pursuant to a Form S-8 and (6) any otherissuances to holders of other pre-existing securities if such issuances areprovided for in the terms of such instrument.

The 2006 Debentures are secured by individual securityagreements with Isonics Vancouver, Inc. (“IVI”), Isonics Homeland Security and DefenseCorporation (“HSDC”) and PPSC.

F-31

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

We allocated the net proceeds received between thefirst $13,000,000 2006Debentures and the related warrants based on the relative fair value of eachinstrument. The $2,718,000 allocated to the warrants was recorded as additionalpaid-in capital and as a corresponding reduction to the carrying value of the2006 Debentures. We evaluated the embedded conversion feature in the 2006Debentures in accordance with the provisions of SFAS 133 and EITF 00-19and concluded that, due to certain provisions which could result in net cashsettlement, the feature should be classified as a derivative instrument andshould be recorded as a liability in our consolidated financial statements. Accordingly,we recorded the aforementioned embedded conversion feature as a derivativeliability in the amount of $6,342,000 (which represents the estimated fairvalue of the feature at the date the financing was consummated) and as acorresponding reduction in the carrying value of the 2006 Debentures. We also recorded the embedded conversion featurerelated to the $3,000,000 debenture issued in November 2006 as aderivative liability in the amount of $949,000 and as a corresponding reductionto the carrying value of that debenture. Further, we are required to recognizein earnings at each reporting date the gain or loss on our derivativeinstruments. During the year ended April 30, 2007, we recorded a gain onderivative instruments in the amount of $4,411,000, such amount representingthe estimated change in fair value of the embedded conversion feature betweenthe date the financing transactions were consummated and the date thederivative liability was reclassed to equity in April 2007. See the moredetailed disclosure of the April 2007 agreement appearing subsequently inthis footnote.

The cumulative discount on the first $13,000,000 ofthe 2006 Debentures in theamount of $9,786,000 (arising from the allocation of a portion of the proceedsto the related warrants, the classification of the embedded conversion featureas a derivative liability and the cash fee paid to Cornell) and the discount onthe final $3,000,000 of the 2006Debentures in the amount of $1,114,000 (arising from the classification of theembedded conversion feature as a derivative liability and the cash fee paid toCornell) are being amortized to interest expense over the term of the 2006 Debentures using the effectiveinterest method at an effective interest rate of 49% and 19%, respectively. Duringthe year ended April 30, 2007, $1,874,000 of discount was amortized tointerest expense.

We capitalized as debt issuance costs the fair valueof the 165,000 Buyers shares (an amount of $601,000) and $28,000 of costsdirectly incurred in consummating the financing and these capitalized costs arebeing amortized to amortization of debt issuance costs over the life of the 2006 Debenture using the effectiveinterest method. During the year ended April 30, 2007, $110,000 of thecapitalized debt issuance costs was amortized to expense.

The 2006 Debenture Warrants with anexercise price of $7.00 per share (750,000 warrants) and $8.00 per share(750,000 warrants) were not exercisable until after our stockholders approved the issuance of these two warrants (as partof the total transaction shares, as defined) in a stockholders’ meeting. On October 30, 2006, our stockholders approved the transactionwith Cornell and accordingly these two warrants became exercisable. Uponbecoming exercisable, we re-evaluated the classification of the warrants inaccordance with the provisions of SFAS 133 and EITF 00-19 and concludedthat, due to having an insufficient number of authorized shares (including allother commitments which may require the issuance of stock) to potentiallysettle the warrants, the warrants should be classified as a derivative instrumentand should be recorded as a liability in our consolidated financial statements.Accordingly, we reclassified the aforementioned warrants out of equity and as aderivative liability in the amount of $1,611,000 (which represents theestimated fair value of the warrants at the date the warrants becameexercisable). At a stockholdermeeting on January 2, 2007, the stockholdersapproved the increase in authorized capital to 175 million shares and weamended our Articles of Incorporation accordingly. At that 

F-32

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

time, wethen had a sufficient number of authorized shares to potentially settle thewarrants and the warrants were reclassified back to equity at their fair valueon January 2, 2007, which is an amount of $869,000. We recorded a gain onderivative instruments during the year ended April 30, 2007, in the amountof $742,000, such amount representing the estimated change in fair value of thewarrants between the date the warrants were classified as derivativeliabilities and the date reclassified back to equity on January 2, 2007.

*February 2007Waiver Agreement*

On February 19, 2007, we entered into a waiveragreement (the “Waiver Agreement”) with Cornell that, among other terms, waivedcertain deficiencies in compliance with (including our aforementioned inabilityto achieve effectiveness of a registration statement by the required date andour inability to achieve an increase to our authorized shares by the requireddate) and amended certain clauses of the 2006 Debenture transaction documents. Inthe Waiver Agreement, Cornell also agreed to provide funds to us in the amountof up to $2,000,000 by April 12, 2007, if we were unable to raise thefunds from other sources. In return for the waivers granted, amendments to thetransaction documents and commitment to provide additional funding undercertain circumstances, we agreed to provide a one-time ratchet to the $7.00warrant and the $8.00 warrant, each exercisable for 750,000 shares. Theone-time ratchet will occur upon the first conversion by a holder of the 2006 Debentures and the exercise priceof the aforementioned warrants will be automatically adjusted to the average ofthe two lowest daily VWAPs of our common stock during the five trading daysprior to such conversion (to the extent that the new exercise price is lowerthan the then existing exercise price). Due to the waiver of certaindeficiencies, we believe we are now in compliance with all obligations underthe 2006 Debenture transactiondocuments and, accordingly, have classified the 2006 Debentures as a noncurrentliability.

Although the payment of contractually specified cashamounts was waived, the concession to allow a one-time ratchet granted toCornell in the Waiver Agreement has a charge associated with it and, as such,we incurred a cost to obtain the waiver and other commitments by Cornell. Accordingly,we recorded a selling, general and administrative expense in the amount of$949,000 during the year ended April 30, 2007, related to this damagesprovision. The charge represents the excess of the fair value of the amendedwarrant over the fair value of the original warrant immediately prior toamendment.

Further, the WaiverAgreement provides that we must file a registration statement within 60calendar days of receipt of written notification by the holder requesting thatthe registration statement be filed. This registration statement must includethe total transaction shares unregistered at that time (or the maximum sharesthat may be registered as advisable by the SEC if less than the totaltransaction shares unregistered). After filing, we must use our best efforts togain effectiveness of the registration statement within 45 days of filing. On February 21,2007, Cornell provided written notification of their request that we file anadditional registration statement within 60 days (by April 22, 2007). Subsequentlyand without the granting of any concessions by us, Cornell withdrew thatrequest to file a registration statement.

*April 2007Document Amendment Agreement*

On April 5,2007, we entered into a document amendment agreement (“The Document AmendmentAgreement”) with Cornell that resulted in four main changes to the 2006Debentures:

·       Interestrate—the interest rate was adjusted from 6% throughout the life of thedebenture to a tiered structure as follows: from April 9, 2007 thru April 8,2008 at an annual rate equal to 13%, 

F-33

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

from April 9, 2008thru October 8, 2008 at an annual rate equal to 11% and October 9,2008 until the outstanding principal balance is paid in full at an annual rateequal to 7.75%.

·       Conversionlimitation—the ability of Cornell to convert the 2006 Debentures is furtherlimited such that Cornell is not be entitled to convert any amount ofoutstanding principal and/or interest under the 2006 Debentures without ourwritten consent until after February 28, 2008, provided however that thislimitation will not apply if either the average VWAPs of the our common stockfor five consecutive trading days is $3.00 or greater or an Event of Defaulthas occurred.

·       NewEvent of Default—we may be declared in default if the number of shares ofcommon stock authorized, unissued and unreserved for all purposes isinsufficient to pay principal under the 2006 Debentures.

·       Removalof potential net cash settlement provision—the original provision which wouldhave allowed net cash settlement of a conversion of the 2006 Debentureconversion is stricken from the 2006 Debenture agreements in its entirety.

We first evaluated thistransaction to determine whether or not debt extinguishment accounting shouldbe applied. As a component of our evaluation, we reviewed EITF 96-19, *Debtor’s Accounting for a Modification or Exchange ofDebt Instruments*and EITF 06-06, *Debtor’s Accounting for a Modification (or Exchange) of ConvertibleDebt Instruments*. These standards focus on the change to the presentvalue of the cash flows under the existing debt structure and the new debtstructure and also on the change to the fair value of or a substantiveamendment to the embedded conversion feature within the convertible debenture. Weconcluded that the amended debenture agreement did not meet any of theaforementioned criteria which would require accounting for the transaction as adebt extinguishment. Next, we consulted EITF 06-07, *Issuer’sAccounting for a Previously Bifurcated Conversion Option in a Convertible DebtInstrument When the Conversion Option No Longer Meets the Bifurcation Criteriain FASB Statement No. 133, “Accounting for Derivative Instruments andHedging Activities”*(“EITF 06-07”). The abstract provides guidanceon the accounting required when an embedded conversion feature no longer meetsthe bifurcation criteria of SFAS 133. As noted above, the embedded conversionfeature associated with the 2006 Debentures was originally classified as aderivative liability. However, due to the approval by our stockholders inJanuary 2007 of an increase in our authorized shares to 175,000,000 and due tothe deletion of the net cash settlement provision in the 2006 Debentures whichoccurred in the Document Amendment Agreement, the embedded conversion featureno longer meets the bifurcation criteria in SFAS 133. As such, in accordancewith SFAS 06-07 we reclassified the embedded conversion feature from derivativeliabilities to equity in the amount of $2,881,000, the estimated fair value ofthe embedded conversion feature on April 5, 2007, the day upon which thebifurcation criteria in SFAS 133 was not longer met. Further, ETIF 06-07 notesthat the debt discount recognized when the embedded conversion feature was originallybifurcated from the convertible debt should continue to be amortized.

**April 2007Debenture**

*Description andInitial Accounting*

On April 10, 2007, we completed a privateplacement pursuant to which we issued to one accredited investor (Cornell) a13% secured convertible debenture with a principal amount of $2,000,000 (the “April 2007Debenture”), which remains outstanding in its entirety as of April 30, 2007,but offset by a discount of $336,000 for financial statement presentation. The April 2007Debenture is convertible into 

F-34

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

shares of our common stockat the lesser of $5.00 (the “Fixed Conversion Price”) or 80% of the average ofthe two lowest daily VWAPs of our stock during the five trading daysimmediately preceding the conversion date (the “Market Conversion Price”). Additionally,the Fixed Conversion Price has a contractual one-time ratchet. The one-timeratchet will occur upon the first conversion of any convertible debenture heldby Cornell (who currently holds both the 2006 Debentures as well as this April 2007Debenture) whereby the Fixed Conversion Price will be automatically adjusted tothe average of the two lowest daily VWAPs of our common stock during the fivetrading days prior to such conversion (to the extent that the new exerciseprice is lower than the then existing exercise price). The April 2007Debenture matures on May 30, 2009. In addition to the debenture, we issuedone warrant (the “April 2007 Debenture Warrant”) to purchase a total of250,000 shares of our common stock at exercise prices of $5.00 per share. Thewarrant expires April 10, 2010 and contains (1) a one-time priceratchet equivalent to the aforementioned ratchet on the April 2007Debenture and (2) a price ratchet whereby the warrant exercise price would be reduced to the effective price per share(or effective exercise price per share) of a subsequent equity sale, if lowerthan the then-existing exercise price. If a price ratchet occurred,there would be no change to the number of shares issuable under the warrant.

Additionally, the then-effective conversion price willbe adjusted upon the occurrence of any stock dividends, stock splits, pro ratadistributions, or fundamental transactions as described in the April 2007Debenture agreement. Additionally, the Fixed Conversion Price will be reducedif we issue shares of stock or other instruments that are exchangeable into orconvertible into common stock at an effective price less than the FixedConversion Price. The Fixed Conversion Price will be adjusted to mirror the conversion,exchange or purchase price at issue. Our issuance and exercise of options whichare compensatory and pursuant to our stock option plans will not cause anadjustment under this provision.

Interest accrues on the outstanding principal balanceat the annual rate of 13%. Interest is payable on May 30, 2009, in cash orshares of our common stock, at our option. At April 30, 2007, accruedinterest expense on the April 2007 Debenture was $14,000. If we choose topay accrued interest in shares of our common stock, the number of shares to beissued will be calculated as the amount of interest due divided by 88% of thevolume weighted average price of our common stock for the five trading dayspreceding the Maturity Date.

We paid Cornell or its affiliates fees in thecumulative amount of $175,000 at the closing of the April 2007 Debenturetransaction.

We are contractually required to seek stockholderapproval of this transaction by no later than November 30, 2007,(exclusive of any shares acquired in this transaction or related transactions),including the ability to issue a maximum of 10 million shares upon conversionof the April 2007 Debentures and 250,000 shares for issuance upon exerciseof the April 2007 Debenture Warrant.

The April 2007 Debenture and the April 2007 Debenture Warrant have certainlimitations on our ability to issue shares to the holders of the instrumentsand impose certain limitations on Cornell’s ability to sell shares.

·       Weare prohibited from issuing shares of our common stock to the holders of the April 2007Debentures (upon conversion or payment of interest) and the April 2007Debenture Warrants (upon exercise) if the issuance would result in Cornellbeneficially owning more than 4.99% of our outstanding common stock (althoughCornell can waive this provision upon more than 65 days notice to us).

F-35

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

·       Cornellis not entitled to convert any amount of outstanding principal and/or interestunder the April 2007 Debenture without our written consent until after February 28,2008, provided however that this limitation will not apply if either theaverage VWAPs of the our common stock for five consecutive trading days is$3.00 or greater or an Event of Default has occurred.

·       Themaximum number of shares that may be issued upon conversion of the principalamount of the April 2007 Debentures is contractually limited to 10 millionshares.

We have the right, after providing ten trading daysadvance written notice, to redeem in cash a portion or all amounts outstandingunder the April 2007 Debenture prior to the Maturity Date provided theclosing bid price of our common stock is less than $10.00 at the time theredemption notice is provided. If we exercise this redemption right, aredemption premium in the amount of 20% of the principal amount being redeemedwill be due. During the ten day notification period, Cornell may elect toconvert any portion or all of the outstanding 2006 Debenture amount.

The April 2007 Debenture Warrants are exercisablefor cash only unless, after October 9, 2007, there is no effectiveunderlying registration statement or if an Event of Default has occurred, atwhich point a holder can elect a cashless exercise. The then-effective warrantexercise price will be adjusted upon the occurrence of any stock dividends,stock splits, pro rata distributions, or fundamental transactions as describedin the April 2007 Debenture Warrant agreement.

There is a freestanding registration rights agreementwhich imposes certain obligations to register the shares underlying the April 2007Debenture and April 2007 Debenture Warrants. A discussion of theregistration rights follows:

Initial registration statement—Upon a written demandfrom the holder, we are obligated to file the Initial Registration Statement,which registers 19.99% of our common stock then outstanding if the registrationstatement is filed prior to obtaining stockholderapproval of the transaction or which registers 33% of the then outstandingshares of our common stock if the registration statement is filed subsequent toobtaining stockholder approvalof the transaction. The Effectiveness Deadline is 120 days from receiving awritten demand from the holder to commence registration.

Subsequent registration statement—We are obligated tofile a Subsequent Registration Statement within 30 days of when we first know,or reasonably should have known, that any underlying shares not registered inthe Initial Registration Statement can be registered without objection by theSEC. The Effectiveness Deadline is 60 days from when we first know, orreasonably should have known, we are obligated to file the registrationstatement.

Continued effectiveness—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, weare obligated to use our best efforts to keep the registration statementeffective.

If we do not meet our registration and effectivenessobligation, we may be required to pay liquidated damages equal to 1% of the aggregatepurchase price of the April 2007 Debenture each month we do not meet ourobligations. We are not obligated to pay cumulative liquidated damages for morethan a total of 12% of the aggregate purchase price of the April 2007Debenture. We may elect to pay any liquidated damages in cash or shares of ourcommon stock if registered. Failure to comply with our registration obligationsmay, subsequent to any grace periods and opportunities to cure, be deemed anevent of default.

F-36

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

Additionally, other events, as defined in the April 2007Debenture agreement, may also allow the holders to declare us in default. Remediesfor an event of default include the option to accelerate payment of the fullprincipal amount of the Debentures, together with interest and other amountsdue, to the date of acceleration and the holder will have the right to requestsuch payment in cash or in shares of our common stock.

So long as principal amounts are outstanding under theApril 2007 Debentures, we have agreed to not sell capital stock or grantsecurity interests which meet certain defined characteristics without the priorconsent of Cornell. However, certain transactions defined as ExcludedSecurities are exempted from this prior consent provision. Excluded Securitiesinclude (1) securities issued in connection with a strategic partnershipor joint venture, (2) securities issued as consideration for a merger orconsolidation or the acquisition of a business, product, license or other assetof another person or entity, (3) options (priced not less than at themarket) provided to employees within the first thirty days of employment, (4) securitiesissued pursuant to an approved stock plan, (5) up to 1,000,000 shares(priced not less than market) which may be issued as long as no registrationrights are included and as long as not pursuant to a Form S-8 and (6) anyother issuances to holders of other pre-existing securities if such issuancesare provided for in the terms of such instrument.

The April 2007Debenture is secured by individual security agreements with IVI, HSDC and PPSC as well as a pledgeand escrow agreement related to our shares of Class A Common Stock ofSenseIt.

We allocated the net proceeds received between the$2,000,000 April 2007 Debenture and the related warrants based on therelative fair value of each instrument. The $169,000 allocated to the warrantswas recorded as additional paid-in capital and as a corresponding reduction tothe carrying value of the April 2007 Debenture. We evaluated the embeddedconversion feature in the April 2007 Debentures in accordance with theprovisions of SFAS 133 and EITF 00-19 and concluded that the feature doesnot meet the bifurcation criteria in SFAS 133.

The cumulative discount on the $2,000,000 April 2007Debenture in the amount of $344,000 (arising from the allocation of a portionof the proceeds to the related warrants and the cash fee paid to Cornell) isbeing amortized to interest expense over the term of the April 2007Debentures using the effective interest method at an effective interest rate of9%. During the year ended April 30, 2007, $8,000 of discount was amortizedto interest expense. In addition, wereviewed the April 2007 Debenture in accordance with EITF 00-27for the existence of a beneficial conversion feature and determined that thereis no beneficial conversion feature present at inception. However, the one-timeprice ratchet to the Fixed Conversion Price falls under the guidance ofcontingent conversion options. As the nature of the one-time price ratchet doesnot allow us to compute the number of shares which may be issued uponconversion if the one-time ratchet is activated, we cannot compute the amountof the beneficial conversion feature. Instead, when and if the one-time ratchetis activated, we will compute the incremental intrinsic value that results fromthe activation of the one-time ratchet and recognize any beneficial conversionfeature at that time.

We capitalized $15,000 oflegal fees as capitalized issuance costs and are amortizing the balance toamortization of debt issuance costs over the life of the April 2007Debenture using the effective interest method.

F-37

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

*Disclosure*

Thefollowing represents the scheduled maturities of long-term debt, excludingcapital leases, for amounts on our balance sheet as of April 30, 2007 (inthousands):

| **Year ending April 30,** | ** ** | ** ** | ** ** | **Book  Value** | ** ** | **Face  Value** | ** ** |
|------------------------------------------|------------|------------|------------|-----------------|------------|-----------------|------------|
| 2008                                     |       | $          | 134        |            | $          | 134             |       |
| 2009                                     |       | —     |       | —          |       |
| 2010                                     |       | 8,634      |       | 18,000          |       |
| 2011                                     |       | —     |       | —          |       |
| 2012                                     |       | —     |       | —          |       |
| Total                                    |       | $          | 8,768      |            | $          | 18,134          |       |

 

**NOTE 10—COMMITMENTSAND CONTINGENCIES**

As of April 30, 2007we had commitments outstanding for capital expenditures of approximately$2,450,000, of which we cancelled subsequent to year end a $1,700,000commitment related to one piece of semiconductor equipment.

**Operating leasecommitments**

In April 2007, we renewed a month-to-month lease(at a rate of $3,077 per month) with the Colorado School of Mines ResearchInstitute to continue leasing office and storage space at our current location.

Werent additional office and production facilities under operating leasesexpiring through September 2013. Rent expense for operating leases was$545,000, $468,000 and $308,000 for the years ended April 30, 2007, 2006and 2005, respectively. Future minimum annual operating lease commitments as ofApril 30, 2007, are as follows (in thousands):

| **Year ending April 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|
| 2008                                     |       | $          | 368        |       |
| 2009                                     |       | 316        |       |
| 2010                                     |       | 229        |       |
| 2011                                     |       | 193        |       |
| 2012                                     |       | 199        |       |
| Thereafter                               |       | 293        |       |
| Total                                    |       | $          | 1,598      |       |

 

F-38

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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. The agreement originally required thepurchase of certain quantities at prices to be determined as a percentage ofthe then prevailing market price. In June 2006, we renegotiated thepricing terms with our supplier to a fixed price negotiated annually in advance.Additionally, we have moved from the long-term purchase obligations in the planto successive one-year purchase commitments set annually in advance, althoughdue to the degradation in the market for oxygen—18, no contractual purchaseamount was put in place for calendar year 2007. During the years ended April 30,2007, 2006 and 2005, we made purchases under this agreement of $771,000,$2,638,000 and $3,380,000, respectively. This supplier contract was assumed bythe buyer in the sale of the Life Sciences segment in June 2007. See Note 18.

**Other contingencies**

In October 2004, wereceived an inquiry from the Nasdaq Listing Investigation Unit (the “Nasdaqinquiry”), which included questions regarding our press releases, our publicrelations advisors and certain other disclosures that we have made publicly. InDecember 2004, we received an informal request for information from theSEC which asked questions similar to those posed in the Nasdaq inquiry, butwhich also asked about the termination of Grant Thornton LLP as our independentauditor. We have provided information, which we believe to be responsive to allof the questions posed in the Nasdaq inquiry and to the SEC. We have notreceived further requests for information from either entity since January 2005.We have no knowledge, however, whether either investigation will result in anyaction against us, which action may materially and adversely impact us, and ourability to carry on our business.

**NOTE 11—INCOMETAXES**

Deferredtax assets (liabilities) are comprised of the following (in thousands):

| ** **                                         | ** ** | **April 30,** | ** ** |
|----------------------------------------------------|------------|--------------------|------------|
| ** **                                         | ** ** | **2007**           | ** ** | **2006** | ** ** |
| Deferred tax assets                                |       |               |       |   |   |
| Accruals and expenses deductible in future periods |       | $                  | 2,323      |   | $ | 4,094 |   |
| Net operating loss and credit carryforwards        |       | 21,188             |       | 16,629 |   |
| Total deferred tax assets                          |       | 23,511             |       | 20,723 |   |
| Valuation allowance                                |       | (23,511            | )          | (20,723 | ) |
|                                               |       | —             |       | — |   |
| Deferred tax liabilities                           |       |               |       |   |   |
| Amortization and depreciation                      |       | —             |       | — |   |
|                                               |       | $                  | —     |   | $ | — |   |

 

F-39

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

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

| ** ** | ** ** | **Year Ended April 30,** | ** ** |
|------------|------------|------------------------------------|------------|
| ** ** | ** ** | **2007**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Current:   |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Federal    |       |                               | $          | — |   |   |   | $ | — |   |   |   | $ | — |   |   |
| State      |       |                               | —     |   |   |   | — |   |   |   | — |   |   |
| Foreign    |       |                               | —     |   |   |   | — |   |   |   | — |   |   |
|       |       |                               | —     |   |   |   | — |   |   |   | — |   |   |
| Deferred:  |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Federal    |       |                               | —     |   |   |   | — |   |   |   | — |   |   |
| State      |       |                               | —     |   |   |   | — |   |   |   | — |   |   |
| Foreign    |       |                               | —     |   |   |   | — |   |   |   | — |   |   |
| Total      |       |                               | $          | — |   |   |   | $ | — |   |   |   | $ | — |   |   |

 

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

| ** **                                                 | ** ** | **April 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                 | ** ** | **2007**           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected benefit  at federal statutory rate                |       | $                  | (4,476     | ) | $ | (10,996 | ) | $ | (5,160 | ) |
| State taxes net  of federal benefit                        |       | (408               | )          | (1,003 | ) | (470 | ) |
| Foreign income  taxed at different rates                   |       | (4                 | )          | 23 |   | 233 |   |
| Warrant exercise  tax deductions in excess of book expense |       | —             |       | (29 | ) | (1,277 | ) |
| Debt conversion  expense                                   |       | —             |       | 2,457 |   | — |   |
| Stock-based  compensation                                  |       | 609                |       | — |   | — |   |
| Gain on  derivatives                                       |       | (2,008             | )          | — |   | — |   |
| Debt discount  amortization                                |       | 2,984              |       | — |   | — |   |
| Other items                                                |       | 515                |       | 168 |   | 189 |   |
| Change in  valuation allowance                             |       | 2,788              |       | 9,380 |   | 6,485 |   |
|                                                       |       | $                  | —     |   | $ | — |   | $ | — |   |

 

The federal net operating loss (“NOL”) carryforward ofapproximately $54,508,000 as of April 30, 2007, expires on various datesthrough 2027. 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 cannot deductNOL carryforwards in excess of the Section 382 limitation. Due to these “changein ownership” provisions, utilization of NOL carryforwards may be subject to anannual limitation regarding their utilization against taxable income in futureperiods. We have not performed a Section 382 analysis. However, ifperformed, Section 382 may be found to limit potential future utilizationof our NOL carryforwards.

F-40

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

Chemotrade has a net operating loss carryforward ofapproximately $3,862,000. Under current German tax law, the carryforward islimited to 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 25,000 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. During the years ended April 30,2007 and 2006, we expensed $112,000 and $28,000, respectively, to selling,general and administrative expenses.

In September 2005, we entered into a financialadvisory services agreement with Clayton Dunning Capital Partners, Inc.,whereby we issued a common stock warrant (valued at $152,000 using theBlack-Scholes pricing model) to purchase 25,000 shares of common stock at$11.24 per share. The common stock warrant vested immediately, expires on September 8,2007, and was recorded as prepaid consulting expense, to be amortized ratablyover the expected service period of one year. During the years ended April 30,2007 and 2006, $51,000 and $101,000, respectively, was expensed to selling,general and administrative expenses. In May 2006, we granted ClaytonDunning Capital Partners, Inc. a common stock warrant (valued at $28,000based on the market price of our common stock on the date of grant) to purchasean additional 12,500 shares of common stock at $4.20 per share. The commonstock warrant vested immediately, expires on May 17, 2008 and the entire$28,000 was expensed to selling, general and administrative expenses during theyear ended April 30, 2007. In March 2007, we granted Clayton DunningCapital Partners, Inc. a common stock warrant (valued at $74,000 based onthe market price of our common stock on the date of grant) to purchase anadditional 100,000 shares of common stock at $1.65 per share. The common stockwarrant vested immediately, expires on March 4, 2009, and was recorded asprepaid consulting expense, to be amortized ratably over the expected serviceperiod of ten months. During the year ended April 30, 2007, $15,000 wasexpensed to selling, general and administrative expenses.

In September 2005, we entered into a consultingagreement with an individual to provide management services in our semiconductorproducts and services segment, whereby we issued a common stock warrant (valuedat $75,000 using the Black-Scholes pricing model) to purchase 12,500 shares ofcommon stock at $11.36 per share. The common stock warrant vested immediately,expires on August 16, 2007, and was recorded as prepaid consultingexpense, to be amortized ratably over the expected service period of eightmonths. As of April 30, 2006, the entire $75,000 has been expensed toselling, general and administrative expenses. In August 2006, we grantedthe same individual a common stock warrant (valued at $20,000 based on themarket price of our common stock on the date of grant) to purchase anadditional 12,500 shares of common stock at $2.68 per share. The common stockwarrant vested immediately, expires on July 31, 2008, and the entire$20,000 was expensed to selling, general and administrative expenses during theyear ended April 30, 2007.

F-41

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

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 provided 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 75,000 commonstock warrants (valued at $669,000 using the Black-Scholes pricing model) tothree newly hired advisory board members. The common stock warrants vestedimmediately, are exercisable at $16.00 per share, expire on November 1,2007 and were expensed to selling, general and administrative expenses duringthe year ended April 30, 2005. In May 2005 (see the discussion ofPPSC in Note 4) we acquired an entity owned in part by one of our advisoryboard 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 140,000 shares of our restrictedcommon stock at $5.00 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, 2005, 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 at $109,000 using the Black-Scholes pricingmodel) to purchase 30,000 shares of common stock at $9.60 per share. Theexpense associated with the common stock warrant was recorded as a selling,general and administrative expense during the year ended April 30, 2006,and the warrant expired unexercised on December 29, 2006.

**NOTE 13—STOCKHOLDERS’EQUITY**

**Expiration of Class Band C Warrants**

On December 29, 2006,the publicly traded Class B and Class C common stock warrantsexpired.

**Common SharesAuthorized**

On January 2, 2007,at a special meeting of stockholders,our stockholders approved anamendment to our Articles of Incorporation to increase our authorized capitalfrom 75,000,000 shares of common stock to 175,000,000 shares. On January 2,2007 we filed a Certificate of Amendment to our Articles of Incorporationincreasing our authorized capital with the California Secretary of State. Theamendment became effective on January 3, 2007.

**Reverse Stock Split**

On February 13, 2007,we effected a one-for-four reverse stock split of our common shares upon thefiling of a Certificate of Amendment to our Articles of Incorporation with theCalifornia Secretary of State. The reverse stock split was approved by our stockholders in the special meeting ofstockholders held on January 2,2007. As a result of the reverse stock split, effective February 13, 2007,every four shares of our issued and outstanding common stock was automaticallycombined into one issued and outstanding 

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

sharewithout any change in the par value of such shares. No fractional shares wereissued in connection with the reverse stock split. Stockholders who wereentitled to a fractional share received a whole share. The reverse splitaffected all of the holders of our common stock uniformly and did not affectany stockholder’s percentage of ownership interest, except to the extent thatthe reverse split resulted in any holder being granted a whole share for anyfractional share that resulted from the reverse split. Any shares of our commonstock or shares of common stock underlying options, warrants and convertibledebentures were proportionately reduced and the exercise prices of any warrantsor options and the conversion prices of any convertible debentures wereproportionately increased by the reverse stock split. All impacted amountsincluded in the consolidated financial statements and notes thereto have beenrestated for the stock split.

**Preferred StockAuthorized**

Originally 10,000,000shares of preferred stock were authorized for issuance, while as of April 30,2007, there were 7,650,000 shares remaining which may be issued, including2,500,000 shares designated as Series B Preferred Stock. As of April 30,2007, there are nooutstanding shares of any series of our preferred stock. The designation ofrights, preferences, privileges and restrictions of the Series C PreferredStock, Series D Preferred Stock, and Series E Preferred Stock werecancelled during the year ended April 30, 2007, by filing an amendment toour articles of incorporation with the California Secretary of State. Theshares were returned to undesignated “blank check” preferred stock.

**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 153,500 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 (76,750) of the common stock warrants had an exercise price of$4.96 per share while the remaining half (76,750) of the common stock warrantshad an exercise price of $5.40 per share. As of April 30, 2007, commonstock warrants exercisable for a total of 38,376 shares of common stock remain outstanding.During the year ended April 30, 2006, all 33,000 shares of Series EStock were converted into 665,322 shares of common stock.

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 00-27we 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 $4.96 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.

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

**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 150,000 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 toacquire 600,000 shares of our common stock. The common stock warrants, whichwere exercisable for one share of common stock for between $4.40 and $5.20 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 730,862 shares of common stock. During the year endedApril 30, 2006, the remaining 800 shares of Series D Stock wereconverted into 18,182 shares of common stock.

**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 50,000 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 56,926 shares of our common stock.Each common stock warrant (which were exercised in their entirety during theyear ended April 30, 2006) issued in this transaction was exercisable forone share of common stock at $5.00 per share. During the year ended April 30,2005, the remaining 9,000 shares of Series C Stock were converted (at$3.80 per share) into 236,842 shares of common stock.

**Series AConvertible Preferred Stock**

The Series A Stockoriginally consisted of 1,830,000 shares issued with a liquidation preferenceof $6.00 per share. During the year ended April 30, 2005, 957,000 sharesof Series A Convertible Preferred Stock (“Series A Stock”) wereconverted into 478,500 shares of common stock. On August 9, 2005, weredeemed the remaining 6,666 outstanding shares of the Series A Stock. Asa result, the holder no longer is able to convert the shares and the rights andpreferences associated with the Series A Stock have been terminated. Theholder is entitled to receive $1.50 for each share of the Series A Stock,an amount of approximately $10,000.

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

**Warrants**

Wehave issued warrants in connection with debt offerings, private placements ofboth common and convertible preferred stock, our IPO, services, legalsettlements and as consideration for concessions from lenders and vendors. Asummary of the activity in our warrants follows:

| ** **                                                                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|
| Outstanding,  April 30, 2004                                                  |       | 2,206,328                  |       |                                   | $          | 5.40 |   |   |
| Warrants issued for services                                                       |       | 75,000                     |       |                                   | 16.00      |   |   |
| Warrants issued in connection with financings                                      |       | 551,975                    |       |                                   | 19.48      |   |   |
| Exercised                                                                          |       | (1,464,675                 | )          |                                   | 5.00       |   |   |
| Expired                                                                            |       | (17,500                    | )          |                                   | 12.00      |   |   |
| Outstanding, April 30, 2005                                                   |       | 1,351,128                  |       |                                   | $          | 12.12 |   |   |
| Warrants issued for services                                                       |       | 37,750                     |       |                                   | 11.28      |   |   |
| Warrants issued for legal settlement                                               |       | 30,000                     |       |                                   | 9.60       |   |   |
| Class C warrants issued in connection with  exercise of Class B warrants |       | 90,503                     |       |                                   | 10.00      |   |   |
| Exercised                                                                          |       | (258,128                   | )          |                                   | 5.36       |   |   |
| Expired                                                                            |       | —                     |       |                                   | —     |   |   |
| Outstanding, April 30, 2006                                                   |       | 1,251,253                  |       |                                   | $          | 13.28 |   |   |
| Warrants issued for services                                                       |       | 125,000                    |       |                                   | 2.01       |   |   |
| Warrants issued due to ratchet of pre-existing  warrants                           |       | 1,593,900                  |       |                                   | 5.00       |   |   |
| Warrants issued in connection with financings or  capital lease                    |       | 2,281,250                  |       |                                   | 6.62       |   |   |
| Exercised                                                                          |       | —                     |       |                                   | —     |   |   |
| Expired                                                                            |       | (696,903                   | )          |                                   | 6.81       |   |   |
| Outstanding,  April 30, 2007                                                  |       | 4,554,500                  |       |                                   | $          | 5.97 |   |   |

 

Theoutstanding warrants as of April 30, 2007, are summarized as follows:

| ** **                                       | ** ** | **Number of  Shares  Outstanding** | ** ** | **Weighted  Average  Exercise  Price(1)** | ** ** | **Expiration  Date** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------|------------|-------------------------------------------|------------|----------------------|------------|
| Warrants issued  with 8% Debentures              |       |                                    | 1,992,375  |                                      |       |                 | $          | 5.00 |   |   | 02-24-2008 |   |
| Warrants issued  with 2006 Debentures            |       |                                    | 2,000,000  |                                      |       |                 | 6.88       |   |   | 05-30-2009 |   |
| Warrants issued  with April 2007 Debentures |       |                                    | 250,000    |                                      |       |                 | 5.00       |   |   | 04-09-2009 |   |
| Other Warrants                                   |       |                                    | 312,125    |                                      |       |                 | 7.20       |   |   |   | (2) |
|                                             |       |                                    | 4,554,500  |                                      |       |                 | $          | 5.97 |   |   |   |   |

----

(1)          Certain warrants issuedin financing transactions have provisions by which the exercise price may beadjusted. See Note 9 for further detail.

(2)          Theother warrants expire at various dates between July 2007 and November 2009.

F-45

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

**Extension ofWarrant Expiration Dates**

In June 2005, we extended the expiration dates ofour Class B Warrants and Class C Warrants from December 31,2005, to December 29, 2006, via an amendment to the Warrant Agreement.There were no other changes made to the terms and conditions of the WarrantAgreement. Accordingly, in the first quarter of our year ended April 30,2006, we recorded a non-cash charge in the statement of operations in theamount of approximately $300,000, such charge representing the excess of thefair value of the amended warrant over the fair value of the original warrantimmediately prior to amendment.

On December 29, 2005,we extended the expiration date of certain warrants to purchase 58,125 sharesof common stock at an exercise price of $5.00. The expiration date of thewarrants was extended from December 31, 2005, to December 29, 2006.There were no other changes made to the terms and conditions of the warrantagreements. During the year ended April 30, 2006, we recorded a non-cashoperating expense in the statement of operations in the amount of approximately$213,000, such charge representing the excess of the fair value of the amendedwarrant over the fair value of the original warrant immediately prior toamendment.

**NOTE 14—STOCK-BASEDCOMPENSATION, STOCK OPTION AND STOCK PURCHASE PLANS**

**Stock-basedCompensation**

On May 1, 2006, we adopted the provisions of SFAS123(R), requiring us to recognize expense related to the fair value of ourstock-based compensation awards. We elected to use the modified prospectivetransition method as permitted by SFAS 123(R) and therefore have notrestated our financial results for prior periods. Under this transition method,stock-based compensation expense for the year ended April 30, 2007,includes compensation expense for all stock-based compensation awards grantedprior to, but not yet vested as of May 1, 2006, based on the grant-datefair value estimated in accordance with the original provisions of SFAS No. 123,*Accounting for Stock-Based Compensation* (“SFAS123”). Stock-based compensation expense for all stock-based compensation awardsgranted subsequent to May 1, 2006, was based on the grant-date fair valueestimated in accordance with the provisions of SFAS 123(R). We recognizecompensation expense for stock option awards on a straight-line basis over therequisite service period of the award.

Options currently granted to employees generallyexpire five or ten years from the grant date and vest over a three year period,with 25% of the stock option vesting immediately and 25% vesting on theanniversary date of the grant date for each of the subsequent three years. Optionscurrently granted to external members of our Board of Directors generallyexpire five years from the grant date and vest immediately. As of April 30,2007, we have 251,000 shares issuable under the 2005 Stock Option Plan and250,000 shares issuable under the 2007 Restructuring Equity Plan (see furtherdiscussion regarding this plan in a subsequent section of this footnote). TheDirectors’ Stock Option Plan does not have an explicit cap as to the number ofshares issuable under the plan. It is our current policy to issue new sharesout of our authorized but unissued shares upon exercise of a stock option by aholder.

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

Thefollowing table sets forth the total stock-based compensation expense resultingfrom stock options included in our consolidated statements of operations (inthousands):

| ** **                                                 | ** ** | **Year ended   April 30,  2007** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Cost of revenues                                           |       |                                            | $          | 73 |   |   |
| Selling, general  and administrative                       |       |                                            | 3,249      |   |   |
| Research and  development                                  |       |                                            | 8          |   |   |
| Stock-based  compensation expense before income taxes      |       |                                            | 3,330      |   |   |
| Income tax  benefit                                        |       |                                            | —     |   |   |
| Total stock-based  compensation expense after income taxes |       |                                            | $          | 3,330 |   |   |

 

Net cash proceeds from the exercise of stock options were$0, $354,000 and $111,000 for the years ended April 30, 2007, 2006 and2005, respectively. In accordance with SFAS 123(R), we present excess taxbenefits from the exercise of stock options, if any, as financing cash flowsrather than operating cash flows. We have not realized excess tax benefits inany period presented. There was no share-based compensation cost capitalized aspart of an asset as of April 30, 2007.

Wepreviously accounted for awards granted under our equity incentive plans underthe intrinsic value method prescribed by Accounting Principles Board Opinion No. 25,*Accounting for Stock Issued to Employees andrelated interpretations*, as permitted by SFAS 123, as amended bySFAS No. 148, *Accounting forStock-based Compensation—Transition and Disclosure*, and provided proforma disclosure required by those statements, as if the fair value basedmethod defined in SFAS 123 had been applied. The respective exercise prices ofstock options granted were equal to the market price of our common stock on therespective dates of grant. Accordingly, no share-based compensation, other thanfor instruments issued to outside parties for services, was recognized in ourconsolidated financial statements in prior periods. The following tableillustrates the effect on net loss attributable to common stockholders and netloss per share attributable to common stockholders if we had applied the fairvalue recognition provisions of SFAS No. 123 to stock-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                                                                  |       |                                    | $          | (4.00 | ) |   |   | $ | (2.95 | ) |   |
| Adjusted                                                                     |       |                                    | $          | (4.14 | ) |   |   | $ | (3.14 | ) |   |

 

F-47

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

Share-basedcompensation recognized for the year ended April 30, 2007, as a result ofthe adoption of SFAS 123(R) as well as pro forma disclosures according tothe original provisions of SFAS 123 for periods prior to the adoption of SFAS123(R) use the Black-Scholes option pricing model for estimating fairvalue of options granted under our equity incentive plans. The following tablesets out the weighted-average assumptions used for calculating the fair valueof options granted during the years ended April 30, 2007, 2006 and 2005,respectively:

| ** **                | ** ** | **Year ended April 30,** | ** ** |
|---------------------------|------------|-----------------------------------------|------------|
| ** **                | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected life (in  years) |       |                                    | 5.7        |   |   |   | 4.7 |   |   |   | 4.7 |   |   |
| Interest rate             |       |                                    | 5.0        | % |   |   | 4.0 | % |   |   | 4.0 | % |   |
| Volatility                |       |                                    | 85         | % |   |   | 100 | % |   |   | 100 | % |   |
| Dividend yield            |       |                                    | —     |   |   |   | — |   |   |   | — |   |   |

 

Expected volatility is based on historical volatilityfor a period at least equal to the expected life of the option under evaluation.The expected life of an option is calculated using the simplified calculationof expected life, described in the SAB No. 107. The interest rate is basedon the U.S. Treasury yield curve in effect at the time of grant.

Stockoption activity for the year ended April 30, 2007, is as follows:

| ** **                             | ** ** | **Number of   Shares** | ** ** | **Weighted   Average   Exercise Price** | ** ** | **Weighted   Average   Remaining   Contractual   Term (years)** | ** ** | **Aggregate   Intrinsic Value** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| Outstanding,  April 30, 2004      |       |                             | 436,412    |                                                   |       |                                                                                     | $          | 5.56                                      |       |   |   |   |   |   |   |   |   |   |
| Granted                                |       |                             | 352,500    |                                                   |       |                                                                                     | 10.80      |                                      |       |   |   |   |   |   |   |   |   |
| Exercised                              |       |                             | (23,250    | )                                                      |       |                                                                                     | 4.76       |                                      |       |   |   |   |   |   |   |   |   |
| Canceled                               |       |                             | (54,000    | )                                                      |       |                                                                                     | 11.44      |                                      |       |   |   |   |   |   |   |   |   |
| Outstanding, April 30, 2005       |       |                             | 711,662    |                                                   |       |                                                                                     | $          | 7.72                                      |       |   |   | 6.2 |   |   |   | $ | 1,264,000 |   |   |
| Granted                                |       |                             | 131,250    |                                                   |       |                                                                                     | 8.52       |                                      |       |   |   |   |   |   |   |   |   |
| Exercised                              |       |                             | (104,779   | )                                                      |       |                                                                                     | 3.36       |                                      |       |   |   |   |   |   |   |   |   |
| Canceled                               |       |                             | (4,650     | )                                                      |       |                                                                                     | 8.76       |                                      |       |   |   |   |   |   |   |   |   |
| Outstanding, April 30, 2006       |       |                             | 733,483    |                                                   |       |                                                                                     | $          | 8.48                                      |       |   |   | 6.2 |   |   |   | $ | 193,000 |   |   |
| Granted                                |       |                             | 255,750    |                                                   |       |                                                                                     | 4.25       |                                      |       |   |   |   |   |   |   |   |   |
| Exercised                              |       |                             | —     |                                                   |       |                                                                                     | —     |                                      |       |   |   |   |   |   |   |   |   |
| Canceled                               |       |                             | (588,233   | )                                                      |       |                                                                                     | 8.42       |                                      |       |   |   |   |   |   |   |   |   |
| Outstanding, April 30, 2007       |       |                             | 401,000    |                                                   |       |                                                                                     | $          | 5.90                                      |       |   |   | 6.6 |   |   |   | $ | — |   |   |
| Exercisable, April 30, 2007       |       |                             | 261,875    |                                                   |       |                                                                                     | $          | 6.35                                      |       |   |   | 5.5 |   |   |   | $ | — |   |   |
| Expected to vest,  April 30, 2007 |       |                             | 54,151     |                                                   |       |                                                                                     | $          | 5.17                                      |       |   |   | 8.6 |   |   |   | $ | — |   |   |

 

The aggregate intrinsic value in the table aboverepresents the total pretax intrinsic value (i.e. the difference between ourclosing stock price on the last day of the respective fiscal year and theexercise price, multiplied by the number of respective shares) that would havebeen received by the option holders had all option holders exercised theiroptions on April 30, 2007, 2006 and 2005, respectively. This amount 

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

changes based on the fairmarket value of our common stock. Total intrinsic value of options exercisedwas $0, $534,000 and $406,000 for the year ended April 30, 2007, 2006 and2005, respectively.

The weighted averagegrant-date fair value of options granted during years ended April 30,2007, 2006 and 2005, were $3.01, $6.28 and $8.16, respectively. As of April 30,2007, $231,000 of total unrecognized compensation cost related to stock optionsis expected to be recognized over a weighted-average period of 0.8 years.

**Management Changesand Related Stock-Based Compensation**

In February 2007, we entered into a SettlementAgreement and Mutual Release with both (a) the former chief executiveofficer, president and chairman of the Board of Directors and (b) theformer senior vice president and vice chairman of the Board of Directorswhereby the individuals resigned those positions, terminated their employmentcontract with us, and accepted specified cash-based and stock-basedremuneration (consisting of an aggregate 450,000 shares of common stock fromthe 2005 Stock Option Plan) for continuing employment as non-officer,non-director, consulting employees.  Concurrently, the individuals forfeited theirexisting 217,188 outstanding stock options. The common stock received wasvalued at $859,000 and resulted in an accounting charge of $726,000, whichrepresents the excess of the fair value of the common stock granted over thefair value of the stock options surrendered. Additionally, the unamortizedexpense associated with the stock options surrendered was $857,000 and thisamount has been also recognized as an expense. Both expense amounts wereexpensed to selling, general and administrative expense in our consolidatedstatement of operations for the year ended April 30, 2007.  Additionally, as of April 30, 2007, thereis an accrued liability in the amount of $338,000 related to non-stock-basedcompensation for the aforementioned individuals.

Subsequent to theresignation of the aforementioned executives, the Board of Directors appointedthe chief executive officer of our 90% owned SenseIt subsidiary as the newChairman of the Board and entered into an employment agreement with theindividual. The individual was granted stock options to purchase 2.25 millionshares of our common stock (from the 2007 Restructuring Equity Plan—seesubsequent discussion in this footnote), vesting between the date theemployment agreement was signed and April 30, 2009. Additionally, changesin position were made with certain individuals of the remaining management team. These individuals forfeited theirexisting 185,207 outstanding stock options, which resulted in an accountingcharge in the amount of $283,000 which is included in the heading “selling,general and administrative” in our consolidated statement of operations for theyear ended April 30, 2007. Concurrently, these individuals were grantedcumulative stock options to purchase 1.0 million shares of our common stock(from the 2007 Restructuring Equity Plan), such shares vesting upon grant.

**Stock Option andPurchase Plans**

*2005 Stock OptionPlan*

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 as of April 30, 2007, was 875,000shares, of which 174,000 common stock options and 450,000 shares of commonstock were then issued (with 251,000 shares remaining available for issuance). Theexercise period shall not exceed ten years from the date of grant or threemonths following the date of termination of employment, whichever occursearlier. The option price shall not be less than the fair market value of 

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

thecommon stock on the date of grant. In May 2007, the Board approved aresolution increasing the shares available for issuance to 2,875,000, anincrease of 2,000,000 shares. Any options granted from this increased allotmentwill not be exercisable until approved by our stockholders and we expect toinclude the proposal to approve this plan as an item to be considered at ournext annual meeting of stockholders expected to be held in November 2007.

*2007 RestructuringEquity Plan*

In February 2007, theBoard of Directors approved a new stock option plan, the 2007 RestructuringEquity Plan (the “2007 Plan”), which authorizes the grant to our key employees,officers, consultants or advisors of incentive and nonqualified stock optionsto purchase shares of our authorized but unissued common stock. The maximumnumber of shares of our common stock available for issuance under this plan is3.5 million shares, of which 3.25 million have been issued under stock optionagreements with employees, as disclosed previously in this footnote. The 2007Plan will not be effective until approved by our stockholders and we expect toinclude the proposal to approve this plan as an item to be considered at ournext annual meeting of stockholders expected to be held in November 2007. UnderSFAS 123(R), a stock option is not considered granted for accounting purposesuntil stockholder approval is obtained (unless such approval is deemed aformality, which is not the case for the 2007 Plan). As such, no expense hasbeen recognized in the consolidated financial statements for the year ended April 30,2007. When and if the 2007 Plan is approved by the stockholders, we expect asignificant stock-based compensation charge to be incurred based on the fairvalue of the stock options on the date of stockholder approval. As of April 30,2007, the 3.25 million shares issued under stock option agreements include 1.5million which have vested, have a weighted average exercise price of $1.82, aweighted average remaining useful life of 4.8 years and an aggregate intrinsicvalue of $0.

*1996 Stock OptionPlan*

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, 2007, there remain20,000 options outstanding and zero shares are available for grant under the1996 Stock Option Plan. The outstanding shares expire on July 31, 2007.

*Directors’ StockOption Plan*

The 1998 Directors’ Plan provides that each personserving as a member of the Board, who is not an employee of ours, receiveoptions to purchase 5,000 shares of common stock when such person accepts aposition as a director and to receive an additional option to purchase 5,000shares when such person is re-elected as a director provided such person is notan employee of ours at the time of election. The exercise price for the optionsis the quoted market price on the date of grant and the options are exercisablefor five years from such date. The options granted under the directors’ planvest immediately. In the event a director resigns or is not re-elected to theBoard, failure to exercise the options within three months results in theoptions’ termination. As of April 30, 2007, options to purchase a total of57,500 shares were outstanding under the directors’ plan.

In July 2007, theBoard of Directors approved a new stock option plan, the 2007 Non-EmployeeDirectors Stock Option Plan (the “2007 Directors Plan”), which will replace the 1998 Directors’ Plancommencing immediately upon approval by the stockholders for directors electedor appointed at or after 

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

the meeting at which this 2007 Directors Plan isapproved by the shareholders. We expect to include the proposal toapprove this plan as an item to be considered at our next annual meeting ofstockholders expected to be held in November 2007. In order to attract andretain qualified Board members, the shares issuable to Board members will bechanged upon approval to the following: each non-employee person serving as a member of the Board will receiveoptions to purchase 50,000 shares of common stock when such person accepts hisposition as a director and to receive an additional option to purchase 50,000shares when such person is re-elected as a director. Further, (1) eachnon-employee director who serves as chair of the compensation committee or theaudit committee of the Board shall automatically be granted an option topurchase 10,000 shares of common stock on the date on which the person becomeschair of such committee and expresses his or her intention to serve in thatcapacity for at least one year following such appointment and (2) eachnon-employee director who serves as chair of the Board shall automatically begranted an option to purchase 50,000 shares of common stock on the date onwhich the person becomes chair of the Board and expresses his or her intentionto serve in that capacity for at least one year following such appointment. Theexercise price for the options is the quoted market price on the date of grantand the options are exercisable for five years from such date. The optionsgranted under the directors’ plan vest immediately. In the event a directorresigns or is not re-elected to the Board, failure to exercise the optionswithin three months results in the options’ termination. The maximum number ofshares of our common stock available for issuance under this plan, if and whenapproved, is 1.5 million shares.

*Executive andIncentive Stock Option Plans*

In November 1996 (andmodified subsequently), the Board of Directors adopted the Executives’ Incentiveand Incentive Stock Option Plans authorizing the granting of up to 250,000 and125,000 incentive and nonqualified stock options, respectively, to our keyemployees, directors or consultants. Effective November 13, 2001, ourstockholders approved an increase in the authorized shares for the Executiveand Incentive Stock Option Plans to 500,000 and 250,000, respectively. Incentivestock options are granted at a price not less than fair market value, andnonqualified stock options are granted at a price not less than 85% of the fairmarket value. Options are exercisable when vested, typically over four to fiveyears and expire five to ten years after the date of grant. In April 2005,the Board of Directors terminated the Executives’ Incentive and Incentive StockOption Plans. As of April 30, 2006, options to purchase a total of 150,000shares remain outstanding and zero shares are available for grant under theExecutive’s Incentive and Incentive Stock Option Plans. The outstanding sharesexpire at various dates through October 2014.

*Employee StockPurchase Plan*

The employee stockpurchase plan 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 werepurchased 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 30,2007, 22,860 shares have been issued under the plan. As of May 1, 2006,the Employee Stock Purchase Plan was terminated.

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

**NOTE 15—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 $88,000, $104,000 and $82,000 for the years endedApril 30, 2007, 2006 and 2005, respectively.

**NOTE 16—BUSINESSSEGMENT, GEOGRAPHIC, CUSTOMER AND PRODUCT INFORMATION**

**Segment information**

We currently have three reportable segments: homelandsecurity products, security services and semiconductor products and services. Ourhomeland security products segment includes both the marketing and developmentof our Ion MobilitySpectroscopy (“IMS”) technology and, through our 90%-owned subsidiary (SenseIt, see Note 6), the development of next-generationinfrared imaging and night vision technology through our Development &Licensing Agreement with Lucent Technologies, Inc. Our security servicessegment provides security and investigative services and is substantiallycomprised of the operations of Protection Plus Security Corporation, which wasacquired in May 2005. Our semiconductor products and services segmentprovides 300-millimeter (and smaller diameter) silicon wafer reclaim andtest products, wafer thinning and custom wafer products for the semiconductorindustry. Our segments are strategic business units, each of which consists ofsimilar products or services. They are managed separately because each segmentrequires different technology and marketing strategy and because each segmentsells to different customers. Reconciling items consist primarily of corporateassets or expenses that have not been allocated to a specific reportablesegment and the assets of our former life sciences operation which is nowcategorized as discontinued operations. Prior period amounts have beenreclassified to conform to current period presentation.

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

Information by segment isset forth below (in thousands):

| ** **                               | ** ** | **As of and for the Year Ended** | ** ** |
|------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                               | ** ** | **April 30,**                                             | ** ** |
| ** **                               | ** ** | **2007**                                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Segment revenues  from external sources: |       |                                                           |       |   |   |   |   |
| Homeland security products               |       | $                                                              | 28         |   | $ | 35 |   | $ | — |   |
| Security services                        |       | 14,682                                                         |       | 12,814 |   | — |   |
| Semiconductor products and services      |       | 13,021                                                         |       | 5,731 |   | 2,692 |   |
| Total                                    |       | $                                                              | 27,731     |   | $ | 18,580 |   | $ | 2,692 |   |
| Segment operating  (loss) income         |       |                                                           |       |   |   |   |   |
| Homeland security products               |       | $                                                              | (6,664     | ) | $ | (5,989 | ) | $ | (1,728 | ) |
| Security services                        |       | (425                                                           | )          | (24 | ) | — |   |
| Semiconductor products and services      |       | 326                                                            |       | (5,151 | ) | (6,484 | ) |
| Reconciling amounts(1)                   |       | (8,785                                                         | )          | (4,499 | ) | (3,744 | ) |
| Total                                    |       | $                                                              | (15,548    | ) | $ | (15,663 | ) | $ | (11,956 | ) |
| Total assets:                            |       |                                                           |       |   |   |   |   |
| Homeland security products               |       | $                                                              | 1,943      |   | $ | 1,300 |   |   |   |
| Security services                        |       | 6,127                                                          |       | 5,992 |   |   |   |
| Semiconductor products and services      |       | 9,068                                                          |       | 7,027 |   |   |   |
| Reconciling amounts(2)                   |       | 1,822                                                          |       | 3,544 |   |   |   |
| Total                                    |       | $                                                              | 18,960     |   | $ | 17,863 |   |   |   |

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(1)          Reconciling amounts forthe operating (loss) income information includes corporate expenses consistingprimarily of corporate salaries and benefits, professional and consulting fees,investor relations costs, warrant amendment expense, insurance and directors’compensation.

(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 as well as the assets of ourformer life sciences business which is now categorized as discontinuedoperations.

**Geographicinformation**

Wecurrently have no significant operations outside the United States. A summaryof our net assets by geographic area is presented below (in thousands):

| ** **    | ** ** | **As of April 30,** | ** ** |
|---------------|------------|------------------------------------|------------|
| ** **    | ** ** | **2007**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net assets:   |       |                               |       |   |   |   |   |
| United States |       | $                                  | 3,445      |   | $ | 2,077 |   | $ | 8,861 |   |
| Germany       |       | 110                                |       | 566 |   | 727 |   |
| Total         |       | $                                  | 3,555      |   | $ | 2,643 |   | $ | 9,588 |   |

 

Due to thereclassification of our life sciences business as discontinued operations, bothreported revenues attributed to foreign countries and long-lived assets locatedin foreign countries is not material. See Note 18 for more information.

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

**CustomerInformation**

Three customers (Qimonda Richmond,LLC (formerly Infineon Technologies Richmond), Foot Locker Retail, Inc.and Citicorp North America, Inc.) accounted for approximately 21%, 14% and11% of revenues, respectively, for the year ended April 30, 2007. Threecustomers (Foot Locker Retail, Inc., Qimonda Richmond, LLC andConsolidated Edison Company) accounted for approximately 22%, 13% and 12% ofrevenues, respectively, for the year ended April 30, 2006. Two customers(Infineon Technologies Richmond and SEH America, Inc.) accounted for approximately24% and 11% of revenues, respectively, for the year ended April 30, 2005. Asof April 30, 2007, three customers (Qimonda Richmond, LLC, MicronTechnology, Inc. and Silicon Wafer Enterprises, LLC) accounted forapproximately 28%, 13% and 10%, respectively, of total net accounts receivable.As of April 30, 2006, two customers (Qimonda Richmond, LLC and CiticorpNorth America, Inc.) accounted for approximately 14% and 11%,respectively, of total net accounts receivable. A decision by a significant customerto substantially decrease or delay purchases from us or an inability to collectsignificant amounts owed to us could have a material adverse effect on ourconsolidated financial condition and results of operations.

**Product Information**

Ourproduct classes comprise revenues from: (1) homeland security productswhich consist of IMS-based products and (2) semiconductor products whichconsist of test wafers and custom wafer products to the semiconductor industry.Our services classes comprise revenue from: (1) homeland security serviceswhich consist predominately of security guard services and (2) semiconductorservices which consist of silicon wafer reclaim, wafer thinning and customwafer services for the semiconductor industry. A summary of revenues for thesesimilar classes or products and services is presented below (in thousands):

| ** **                  | ** ** | **For the Year Ended** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|
| ** **                  | ** ** | **April 30,**                    | ** ** |
| ** **                  | ** ** | **2007**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Homeland security  products |       | $                                     | 28         |   | $ | 35 |   | $ | — |   |
| Semiconductor  products     |       | 6,485                                 |       | 2,850 |   | 1,448 |   |
| Total products revenues     |       | $                                     | 6,513      |   | $ | 2,885 |   | $ | 1,448 |   |
| Homeland security services  |       | $                                     | 14,682     |   | $ | 12,814 |   | $ | — |   |
| Semiconductor  services     |       | 6,536                                 |       | 2,881 |   | 1,244 |   |
| Total services  revenues    |       | $                                     | 21,218     |   | $ | 15,695 |   | $ | 1,244 |   |

 

**NOTE 17—RELATEDPARTY TRANSACTIONS**

PPSC leased premises partially owned by a former ownerwho is a current employee of PPSC. The lease term was originally for thefour-year period ended May 15, 2009, however the lease was amended from afixed term to a month-to-month term and increased the monthly base rent to$4,500 per month. Additionally, we reimbursed the landlord 80% of the costsincurred by the landlord for taxes, maintenance of common areas and fire andhazard insurance as well as the entire amount of the premium incurred forrental loss insurance. This lease was terminated effective August 31, 2006.We paid $16,000 and $48,000 under this lease during the years ended April 30,2007 and 2006, respectively.

On January 1, 2002,we entered into a one-year consulting agreement with HS-Consult GmbH (“HSC”)primarily to assist Chemotrade in buying and selling isotope products. HSCprimarily consists of the former managing director of Chemotrade and anadditional former key employee of Chemotrade. The 

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

initialconsulting agreement expired on December 31, 2002 and required a monthlypayment of 5,500 Euros (approximately $7,000) for the services to be provided. Theconsulting agreement was renewed for terms of one year on January 1, 2005,and 2004 and required monthly payments of 5,500 Euros. The consulting agreementwas not subsequently renewed upon its expiration on December 31, 2005.

**NOTE 18—DISCONTINUEDOPERATIONS**

Duringthe three months ended January 31, 2007, we elected to discontinue theoperation of our life sciences business and to put the assets and business upfor sale. We decided to sell this business as it no longer fits our long-termstrategy and because of deteriorating business conditions in the historicalrevenue producing products in the segment. Revenue and pretax loss from thelife sciences business, reported as discontinued operations, are as follows (inthousands):

| ** **  | ** ** | **For the Year Ended** | ** ** |
|-------------|------------|---------------------------------------|------------|
| ** **  | ** ** | **April 30,**                    | ** ** |
| ** **  | ** ** | **2007**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues    |       | $                                     | 1,803      |   | $ | 5,136 |   | $ | 7,413 |   |
| Pretax loss |       | $                                     | (224       | ) | $ | (960 | ) | $ | (2,153 | ) |

 

Inaccordance with SFAS 144, the life sciences operation has been classified as adisposal group held for sale and has been presented as a discontinued operationin the consolidated financial statements and footnotes thereto. Prior yearfinancial statements have been restated to present the operations of the lifesciences disposal group as a discontinued operation. We evaluated the carryingamount of the life sciences disposal group and determined that the recording ofa loss for impairment was not warranted. The assets and liabilities of thediscontinued operation are presented separately under the captions “assets ofdiscontinued operations” and “liabilities of discontinued operations,”respectively, in the consolidated balance sheets, and consist of the following(in thousands):

| ** **                               | ** ** | **As of April 30,** | ** ** |
|------------------------------------------|------------|------------------------------------|------------|
| ** **                               | ** ** | **2007**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Assets of discontinued  operations:      |       |                               |       |   |   |   |   |
| Cash                                     |       | $                                  | 110        |   | $ | 531 |   | $ | 608 |   |
| Accounts receivable                      |       | 25                                 |       | 344 |   | 518 |   |
| Inventory                                |       | 66                                 |       | 447 |   | 1,073 |   |
| Property and equipment, net              |       | 228                                |       | 292 |   | 187 |   |
| Other assets                             |       | 62                                 |       | 99 |   | 46 |   |
| Total                                    |       | $                                  | 491        |   | $ | 1,713 |   | $ | 2,432 |   |
| Liabilities of  discontinued operations: |       |                               |       |   |   |   |   |
| Accounts payable and accrued liabilities |       | $                                  | 33         |   | $ | 14 |   | $ | 212 |   |
| Note payable                             |       | 39                                 |       | 47 |   | — |   |
| Total                                    |       | $                                  | 72         |   | $ | 61 |   | $ | 212 |   |

 

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 

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

$1,807,000 of goodwillassociated with this business segment had been impaired and the entire goodwillamount was written off to impairment of goodwill and intangible assets. Thefair value of the reporting unit was estimated using the expected present valueof future cash flows.

In June 2007, wecompleted the sale of the assets (excluding cash, accounts receivable andinventory) of the life sciences business for consideration of $850,000 in cash(net proceeds of approximately $700,000 after retirement of debt and expensesof the sale). We have not yet completed the accounting for the sale of thebusiness.

**NOTE 19—QUARTERLYDATA (UNAUDITED)**

The following tablescontain selected unaudited consolidated statement of operations data for eachquarter in the fiscal years ended April 30, 2007, and 2006 (in thousands,except per share amounts). Amounts presented below for all periods prior to thethree months ended January 31, 2007, will diverge from amounts reported inthe respective Form 10-Q or Form 10-QSB for eachrespective period due to (1) the classification of the former life sciencesbusiness as held for sale during the three months ended January 31, 2007and (2) the one-for-four reverse stock split effected on February 13,2007. See Notes 18 and 13, respectively, for additional information.

***Year endedApril 30, 2007***

| ** **                                                          | ** ** | **Three months ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                          | ** ** | **July 31,  2006**          | ** ** | **October 31,  2006** | ** ** | **January 31,  2007** | ** ** | **April 30,  2007** | ** ** |
| Revenues                                                            |       | $                                | 6,786      |   |   | $ | 7,255 |   |   |   | $ | 6,535 |   |   | $ | 7,155 |   |
| Gross margin                                                        |       | $                                | 1,219      |   |   | $ | 1,797 |   |   |   | $ | 1,396 |   |   | $ | 1,509 |   |
| Loss from  continuing operations                                    |       | $                                | (2,408     | ) |   | $ | (3,553 | ) |   |   | $ | (2,290 | ) |   | $ | (4,690 | ) |
| Income (loss)  from discontinued operations, net of income tax |       | $                                | 36         |   |   | $ | (48 | ) |   |   | $ | (87 | ) |   | $ | (125 | ) |
| Net loss                                                            |       | $                                | (2,372     | ) |   | $ | (3,601 | ) |   |   | $ | (2,377 | ) |   | $ | (4,815 | ) |
| Net loss  attributable to common stockholders                       |       | $                                | (2,372     | ) |   | $ | (3,601 | ) |   |   | $ | (2,377 | ) |   | $ | (4,815 | ) |
| Net loss per share—basic  and diluted(1):                      |       |                             |       |   | $ |   |   |   |   | $ |   |   |   | $ |   |   |
| Continuing operations                                               |       | $                                | (0.21      | ) |   | $ | (0.30 | ) |   |   | $ | (0.19 | ) |   | $ | (0.37 | ) |
| Discontinued operations                                             |       | $                                | 0.00       |   |   | $ | (0.00 | ) |   |   | $ | (0.01 | ) |   | $ | (0.01 | ) |
| Attributable to common stockholders                                 |       | $                                | (0.21      | ) |   | $ | (0.31 | ) |   |   | $ | (0.20 | ) |   | $ | (0.38 | ) |
| Weighted average common  shares outstanding                         |       | 11,367                           |       |   | 11,669 |   |   |   | 11,962 |   |   | 12,592 |   |

 

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

***Year endedApril 30, 2006***

| ** **                                                 | ** ** | **Three months ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                 | ** ** | **July 31,  2006**          | ** ** | **October 31,  2006** | ** ** | **January 31,  2007** | ** ** | **April 30,  2007** | ** ** |
| Revenues                                                   |       | $                                | 3,477      |   |   | $ | 4,213 |   |   |   | $ | 5,260 |   |   | $ | 5,630 |   |
| Gross margin                                               |       | $                                | (387       | ) |   | $ | (179 | ) |   |   | $ | 334 |   |   | $ | 803 |   |
| Loss from  continuing operations                           |       | $                                | (5,028     | ) |   | $ | (5,192 | ) |   |   | $ | (7,371 | ) |   | $ | (13,790 | ) |
| Loss from  discontinued operations, net of income tax |       | $                                | (144       | ) |   | $ | (60 | ) |   |   | $ | (290 | ) |   | $ | (466 | ) |
| Net loss                                                   |       | $                                | (5,172     | ) |   | $ | (5,252 | ) |   |   | $ | (7,661 | ) |   | $ | (14,256 | ) |
| Net loss  attributable to common stockholders              |       | $                                | (5,238     | ) |   | $ | (5,287 | ) |   |   | $ | (7,661 | ) |   | $ | (14,256 | ) |
| Net loss per share—basic  and diluted(1):             |       |                             |       |   | $ |   |   |   |   | $ |   |   |   | $ |   |   |
| Continuing operations                                      |       | $                                | (0.71      | ) |   | $ | (0.67 | ) |   |   | $ | (0.91 | ) |   | $ | (1.46 | ) |
| Discontinued operations                                    |       | $                                | (0.02      | ) |   | $ | (0.01 | ) |   |   | $ | (0.04 | ) |   | $ | (0.05 | ) |
| Attributable to common stockholders                        |       | $                                | (0.74      | ) |   | $ | (0.69 | ) |   |   | $ | (0.95 | ) |   | $ | (1.51 | ) |
| Weighted average common  shares outstanding                |       | 7,117                            |       |   | 7,717 |   |   |   | 8,105 |   |   | 9,472 |   |

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(1)          Netloss per share are computed independently for each of the quarters presented. Therefore,the sum of the quarterly per share information may not equal the annual pershare information.

**NOTE 20—SUBSEQUENTEVENTS**

Certain events occurringsubsequent to April 30, 2007, are discussed within other notes to theconsolidated financial statements.

**Capital Lease**

In May 2007, we entered into a capital lease tofinance two pieces of equipment to be used in production by our semiconductorproducts and services segment. The lease is in the amount of approximately$630,000, bears a nominal interest rate of 16%, has a term of 36 months andincludes a bargain purchase option whereby we have the right subsequent to theexpiration of the lease term to purchase the asset under lease for no more than5% of the original equipment cost. Additionally, we issued the lessor a commonstock warrant to purchase 40,000 shares of common stock at $1.50 per share. Thecommon stock warrant vested immediately, expires on May 28, 2010, and willbe amortized to interest expense over the term of the lease.

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