Securities
and Exchange Commission


Washington,
D.C. 20549




FORM
10-K




x
            Annual report
      under Section 13 or 15(d)
              of the
      Securities Exchange Act of
1934




For the
fiscal year ended December 31, 2009





o
            Transition
      report under Section 13 or 15(d)
              of the
      Securities Exchange Act of
1934




For the
transition period from __________ to __________





Commission
File Number: 000-31805





Power Efficiency
Corporation


(Exact
name of registrant as specified in its Charter)





Delaware
            
            22-3337365(State
      or Other Jurisdiction of Incorporation or Organization)
            
            (I.R.S.
      Employer Identification No.)3960
      Howard Hughes Pkwy, Ste 460Las
      Vegas, NV
            
            89169(Address
      of Principal Executive Offices)
            
            (Zip
      Code)




(702)
697-0377


(Issuer’s
Telephone Number, Including Area Code)





Securities
Registered under Section 12(g) of the Exchange Act:





Common Stock, $.001 Par
Value


(Title of
Class)




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




Check if there is no disclosure of
delinquent filers in response to Item 405 of Regulation S-K contained in this
form, and no disclosure will be contained, to the best of Company’s knowledge,
in definitive proxy or information statements incorporated by reference in Part
III of this Form 10-K or any amendment to this Form 10-K.   x




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 and Regulations S-T
(§ 232.405 of this chapter) during the preceding 12 months (or for
such shorter period that the registrant was required to submit and post such
files).  Yes o No o





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





Large
      accelerated filer o
            Accelerated
      filer o
            Non-accelerated
      filer o
            Smaller
      reporting company x





Indicate
by check mark whether the Company is a shell company (as defined in Rule 12b-2
of the Exchange Act).


Yes o No x




As of
June 30, 2009, the aggregate market value of the common stock held by
non-affiliates of the issuer was $4,952,150.  This amount is based on
the closing price of $0.15 per share for the Company’s common stock as of such
date.




On March
31, 2010 there were 44,825,883 shares of the Company’s common stock
outstanding.




DOCUMENTS
INCORPORATED BY REFERENCE


None.





In this
report, references to “we”, “us” or “our” collectively refer to Power Efficiency
Corporation.












SPECIAL
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS




This
report and the documents incorporated into this report contain forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995 (the “PSLRA”), including, but not limited to, statements relating to the
Company’s business objectives and strategy. Such forward-looking statements are
based on current expectations, management beliefs, certain assumptions made by
the Company’s management, and estimates and projections about the Company’s
industry. Words such as “anticipates,” “expects,” “intends,” “plans,”
“believes,” “seeks,” “estimates,” “forecasts,” “is likely,” “predicts,”
“projects,” “judgment,” variations of such words and similar expressions are
intended to identify such forward-looking statements. These statements are not
guarantees of future performance and are subject to certain risks, uncertainties
and assumptions that are difficult to predict with respect to timing, extent,
likelihood and degree of occurrence. Therefore, actual results and outcomes may
differ materially from those expressed, forecasted, or contemplated by any such
forward-looking statements.




Factors
that could cause actual events or results to differ materially include, but are
not limited to, the following: continued market acceptance of the Company’s
products; the Company’s ability to expand and/or modify its products on an
ongoing basis; general demand for the Company’s products, intense competition
from other developers, manufacturers and/or marketers of energy reduction and/or
power saving products; the Company’s negative net tangible book value; the
Company’s negative cash flow from operations; delays or errors in the Company’s
ability to meet customer demand and deliver products on a timely basis; the
Company’s lack of working capital; the Company’s need to upgrade its facilities;
changes in laws and regulations affecting the Company and/or its products; the
impact of technological advances and issues; the outcomes of pending and future
litigation and contingencies; trends in energy use and consumer behavior;
changes in the local and national economies; and other risks inherent in and
associated with doing business in an engineering and technology intensive
industry. See “Management’s Discussion and Analysis or Plan of Operation.” Given
these uncertainties, investors are cautioned not to place undue reliance on any
such forward-looking statements.




Unless
required by law, the Company undertakes no obligation to update publicly any
forward-looking statements, whether as a result of new information, future
events or otherwise. However, readers should carefully review the risk factors
set forth in other reports or documents that the Company files from time to time
with the Securities and Exchange Commission (the “SEC”), particularly Annual
Reports on Form 10-K, Quarterly Reports on Form 10-Q and any Current Reports on
Form 8-K.


2




GLOSSARY
OF TERMS




Set forth
below are technical terms used in the discussion in this document and
explanations of the meanings of those terms.




Alternating
      Current (AC)
            
            A
      type of electrical current, the direction of which is reversed at regular
      intervals or cycles; in the U.S. the standard is 120 reversals or 60
      cycles per second; typically abbreviated as AC.Ampere
      (amp)
            
            A
      unit of measure for an electrical current; the amount of current that
      flows in a circuit; abbreviated as amp.Current
      (Electrical)
            
            The
      flow of electrical energy (electricity) in a conductor, measured in
      amperes.Cycle
            
            In
      an alternating current, the current goes from zero potential (or voltage)
      to a maximum in one direction, back to zero, and then to a maximum
      potential (or voltage) in the other direction. The number of complete
      cycles per second determines the current frequency; in the U.S. the
      standard for alternating current is 60 cycles.Efficiency
            
            Efficiency
      is the ratio of work (or energy) output to work (or energy) input, and
      cannot exceed 100 percent.Energy
            
            The
      capability of doing work.Horsepower
      (HP)
            
            A
      unit for measuring the power of motors or the rate of doing work. One
      horsepower equals 33,000 foot-pounds of work per minute or 746
      watts.Induction
            
            The
      production of an electric current in a conductor by the variation of a
      magnetic field in its vicinity.Induction
      Motor
            
            The
      simplest and most rugged electric motor, it consists of a wound stator and
      a rotor assembly. The AC induction motor is so named because the electric
      current flowing in its secondary member (the rotor) is induced by the
      alternating current flowing in its primary member (stator). The power
      supply is connected only to the stator. The combined electromagnetic
      efforts of the two currents produce the force to create
      rotation.Inrush
      Current
            
            The
      current that flows at the instant of connection of a motor to the power
      source. Usually expressed as a multiple of motor full-load
      current.Kilowatt
      (kW)
            
            A
      standard unit of electrical power equal to one thousand
    watts.Load
            
            The
      demand on an energy producing system. The energy consumption or
      requirement of a piece or group of equipment.Motor
            
            A
      machine supplied with external energy that is converted into force and/or
      motion.Power
            
            The
      rate at which work is done, typically measured in watts or
      horsepower.Power
      Factor
            
            The
      ratio of watts to volt-amperes of an AC electric
  circuit.Soft-start
            
            Soft-start
      is the regulation of the supply voltage from an initial low value to full
      voltage during the starting process.Torque
      (Motor)
            
            The
      rotating force provided by a motor. The units of torque may be expressed
      as pound-foot, pound-inch (English system), or newton-meter (metric
      system).




3




Torque
      (Starting)
            
            This
      torque is what is available to initially get the load moving and begin its
      acceleration.Transformer
            
            An
      electromagnetic device that changes the voltage of alternating current
      electricity; it consists of an induction coil having a primary and
      secondary winding and a closed iron core.Voltage
            
            The
      amount of electromotive force, measured in volts that exists between two
      points.Watt
            
            The
      amount of power required maintaining a current of one ampere at a pressure
      of one volt when the two are in phase with each other. One horsepower is
      equal to 746 watts.




4




PART I




Item
1.  Description of Business.




(a)
Business
Development




Formation




Power
Efficiency Corporation (the “Company”) was incorporated in Delaware on October
19, 1994. From inception through 1997, the Company was a development stage
entity that was engaged in the design, development, marketing and sale of
proprietary solid state electrical components designed to reduce energy
consumption in alternating current induction motors. Alternating current
induction motors are commonly found in industrial and commercial facilities
throughout the world.




(b)
Business of the
Company




The
Company’s Principal Products and Technology




In the
late 1990s the Company commenced the sale of its initial product, which was
based on analog technology and reduces energy consumption in alternating current
induction motors in certain applications. This product has been known by several
names, including the Power
Commander® and Power
Genius.  In 2005 the Company began development of a digital
product that would overcome many of the commercial limitations of the analog
product.  In 2008, limited models of the first-generation of the
digital product were launched. In mid-2009 the Company launched a line of
products up to 300 horsepower that had certification from Underwriters
Laboratories (“UL”) and its second-generation digital circuitry was
launched.  Going forward, the Company has chosen to call its products
Motor Efficiency Controllers (“MEC”).





The
Company has developed patented and patent-pending technologies for effectively
controlling the energy usage of an electric motor. The Company’s first United
States Patent was granted in 1998. Over the past four years the Company has
undertaken extensive study and computer modeling of motors and their energy use,
and has developed digital technologies for its controllers. In the process, the
Company has discovered what it believes are significant innovations and has
completed numerous patent filings around these new inventions. The Company has
branded these collective patented and patent pending technologies as E-SAVE Technology® and has a
registered trademark on this name.





The
Company has developed technologies and products for use on three-phase and
single-phase motors. Three-phase power and motors are generally found in
industrial and commercial buildings for larger applications than single-phase
power and motors.




The
Company’s marketing efforts initially focused on the three-phase version but it
is also now marketing the single-phase product. The Company’s digital
Three-Phase MEC is designed to have the following functionality:




1.
            Start
      a motor




2.
            Provide
      a soft start for the motor, bringing it gradually from rest to full
      speed




3.
            Provide
      various motor protection capabilities, such as sensing current overload,
      phase loss, under- and over-voltage, and
more.




4.
            Save
      energy when the motor is at full speed but is less than fully
      loaded





The
Company’s digital Single-Phase MEC is designed to have the following
functionality:




1.
            Start
      a motor




2.
            Provide
      a soft start for the motor, bringing it gradually from rest to full
      speed




3.
            Save
      energy when the motor is at full speed but is less than fully
      loaded





Three-Phase
and Single-Phase MECs are unique particularly because of their energy savings
capabilities. The product reduces energy consumption by electric motors by
electronically sensing and controlling the amount of energy the motor consumes.
A motor with an MEC installed only uses the energy it needs to perform its work
task, thereby increasing its efficiency. The result is a reduction of energy
consumption typically ranging from 15% - 35% in applications that do not always
run at peak load levels.  The amount of energy savings depends on a
variety of factors, including the load on the motor and the motor’s
characteristics.




5




The
Company’s management believes its Motor Efficiency Controllers offer certain
advantages over competing products for the following reasons:




·
            Motor
      and Equipment Life: The MEC extends motor life by reducing the stress and
      strain on the motor and surrounding equipment, and reduces the amperage to
      the motor, which results in cooler
running.




·
            Successful
      Utility and Customer Tests: The MEC has been successfully tested by
      numerous electric utilities and customers. For example, Paragon Consulting
      Services, a contractor for Nevada Power Company, the electric utility for
      southern Nevada, performed 8 field tests on escalators and one on an
      elevator in major Las Vegas casinos.  The tests resulted in
      average energy savings of over 30% on the escalators and 20% on the
      elevator.




·
            Utility
      Incentive Financing: The three-phase product has qualified for rebate
      incentive financing, most frequently called “rebates”, from many electric
      utilities. This financing is generally paid to the end user of the MEC as
      an incentive to invest in energy saving products. As such, this financing
      effectively decreases the cost of the Company’s MEC for end users. The
      utilities that have approved the Company’s products for incentive
      financing include: NV Energy (formerly Nevada Power Company and Sierra
      Pacific Power Company), the Los Angeles Department of Water and Power,
      Southern California Edison, Sacramento Municipal Utility District, Anaheim
      Utilities, the New York Power Authority, Excel Energy and San Diego Gas
      and Electric.




·
            Acceptance
      by Original Equipment Manufacturers: The Company’s products have been
      approved and installed by numerous original equipment manufacturers
      (“OEMs”) in the escalator and granulator
  industries.




Three-Phase
MEC




The
Company initially focused its marketing efforts for the Three-Phase MEC in the
elevator and escalator industry, although the Company is also actively marketing
this product to industrial markets, such as recycling, mining, plastics, and
manufacturing.  Industries that operate equipment such as conveyor
systems, crushing equipment, stamping presses, granulators, grinders, shredders
and other motor driven equipment with varying loads, are believed to be viable
target markets for the Three-Phase MEC. The Company is seeking to target markets
with appropriate applications and market access, using direct sales, OEMs,
distributors and independent representatives to address these
markets.




Single-Phase
Product





Like the
Company’s three-phase product described above, the Company’s single-phase
productreduces
energy consumption in electric motors by sensing and controlling the amount of
energy the motor consumes. Many motors commonly used in home appliances and
other consumer goods are single-phase AC motors. Since the single-phase product
is much smaller, has a much lower price point, and can be incorporated directly
into a broad variety of applications, the Company believes it is a product most
suitable for installation at the OEM level.





Product
Development





The
Company has devoted significant time and resources in the past several years
toward developing “digital” versions of its three-phase and single-phase
products. Through this process, the Company has transformed its technology so
that its key technological breakthroughs are primarily incorporated in
algorithms and software on a microchip. The Company believes the digital
versions of its products have several distinct advantages over the older analog
versions, including:




·
            Motor
      starter and motor protection capabilities similar to standard solid state
      starters sold by large motor control companies. The analog product could
      not start a motor and provided no motor protection, so the customer had to
      purchase these items at additional costs for components and installation.
      The digital MEC instead incorporates all these functions and therefore
      replaces a standard solid state motor
control.




·
            Increased
      ease of installation and reduced technical support requirements. For
      example, instead of approximated and manual adjustments during
      installation, which can require technical support from the Company, the
      digitized unit will allow more simplified and precise adjustments by
      customers and third party
installers.




·
            Reduced
      product size, which is important for many
  installations.




·
            Input-output
      communications capabilities, so the device can communicate with external
      control systems.




·
            Increased
      functionality. The Company expects to be able to add new functionality to
      the products. These new functions may include such things
    as:




·
            Recording
      and reporting of actual energy
savings;




·
            Prediction
      of maintenance problems by reading and reporting on changes in the motor’s
      operating characteristics; and




·
            More
      secure intellectual property protection through the use of secured chips
      and software.





Marketing
and Sales




The
Company’s marketing efforts have historically been concentrated in the elevator
and escalator industry, primarily to OEMs of elevator and escalator equipment
and end users that own this equipment.  With UL approval in mid-2009,
the Company has targeted more heavily industrial markets, such as mining
aggregates and plastics. End users of the Company’s products include retail
chains, hotels, airports, transit systems, and mining, plastics and
manufacturing companies.




6




The
Company sells products into the elevator and escalator market primarily to and
through large OEM resellers. The elevator and escalator market is dominated by
four global companies, Otis Elevator, Schindler, ThyssenKrupp and KONE.
Collectively these companies are believed to have over 80% of the world market
for new equipment and service contracts. The Company has formal supply
agreements for North America with ThyssenKrupp and KONE. The Company also sells
to and completes projects with Otis Elevator and Schindler.





The
Company is focused on penetrating industrial markets through independent
representatives and distributors who will in turn sell to OEMs of industrial
equipment and end users. The Company significantly increased these industrial
market activities in late 2009 after receiving UL certification, since this
certification is required by many industrial concerns.





The
Company’s longer term goal is to be a high value supplier of technologies, with
numerous OEMs and other resellers engaged with high volume sales and/or
licensing agreements.





Manufacturing
and Distribution




The
Company’s products are manufactured internally and by a multi-billion dollar
global contract manufacturer, Sanmina SCI (“Sanmina”). The Company’s strategy is
to manufacture internally products that sell at lower volumes, such as MECs for
very large motors, and to outsource the manufacturing of higher volume products,
such as smaller units and circuit boards. The Company believes this strategy
allows for high quality production, cost efficiencies, and the capability to
rapidly increase production volumes. Management believes this strategy has the
ability to meet the Company’s production needs and the Company would be
successful in finding alternative manufacturers should Sanmina not be available
to manufacture our product.





Competition




Power
Efficiency believes the principal competitive factors in the Company’s markets
include innovative product development, return on investment from energy
savings, product quality, product performance, utility rebate acceptance,
established customer relationships, name recognition, distribution and
price.





Three-Phase
Competition. The
Company’s Three-Phase MEC’s principal capabilities include being a motor
starter, providing a soft start and protection for the motor, and reducing the
motor’s electricity consumption once the motor is at full speed. The Company
believes its products are unique primarily because of the last capability –
energy savings.





The first
capabilities - starting, soft starting and protecting a motor - are commonly
found in existing motor control products. There are billions of dollars of motor
starters and soft starts sold every year. These products are typically
manufactured and marketed by large motor control companies, many of which have
longer operating histories, established markets and far greater financial,
advertising, research and development, manufacturing, marketing, personnel and
other resources than the Company currently has or may reasonably be expected to
have in the foreseeable future. This competition may have an adverse effect on
the ability of the Company to commence and expand its operations or operate in a
profitable manner.





There are
also several small companies that reportedly make products that combine motor
starting, soft starting and energy savings. The Company is unaware of any large
company that makes a product of this nature. Although the Company has not
completed any formal market study, the Company believes its Three-Phase MEChas the following
competitive advantages over other products:




·
            It
      combines soft start features with energy savings features in a single
      integrated unit that is CSA, UL and CE certified and has achieved energy
      savings levels of up to 15% to 35% in independent, third party
      testing;




·
            Its
      circuitry is proprietary, protected by one patent.  Three
      additional patent filings on new innovations are pending approval of the
      U.S. Patent and Trademark Office;




·
            It
      has been tested extensively by utilities with documented energy savings
      and approval for incentive financing
rebates;




·
            It
      is accepted by OEMs in the escalator and granulator industries.





Single-Phase
Competition.  There have been
several companies that have, with different technologies, attempted to exploit
this market due to the enormous opportunity in single-phase motor applications.
These products include among others, “Green Plug” (voltage clamping), “Power
Planner” (digital microchip) and “Econelectric” (power factor control). The
Company has made numerous innovations in the past three years that it believes
overcome many of the problems with these and the Company’s earlier designs. The
Company has filed for a patent on these innovations and has reduced the product
in size and cost to the point it can be sold to OEMs of applicable appliances
and other equipment driven by single-phase AC motors.




7




Premium
Efficiency Motors.  Motors are rated by
their efficiency at full load. However, when motors, including “premium
efficiency motors” are lightly loaded, they become very inefficient. Management
believes that the energy savings gain attributable to premium efficiency motors
is materially lower than that of its MEC on underloaded motor applications.
Furthermore, the Company’s products are able to save energy on underloaded
premium efficiency motors, so that such motors and the Company’s technology are
not mutually exclusive.




Source
of Supply and Availability of Raw Materials




The MEC
has been designed to use standard, off-the-shelf, easily acquired components,
except for the custom made circuit boards. Such off-the-shelf components are
basic items readily available worldwide at competitive prices. They come in
standard and miniature versions and offer the Company latitude in product design
and production. Although the Company believes most of the key components
required for the production of its products are currently available in
sufficient production quantities from multiple sources, there can be no
assurance they will remain so readily available or at comparable
prices.




Customers




The
Company currently does business with approximately 20 customers. Of this number,
four customers presently account for approximately 71% of the Company’s gross
revenues.   These customers and their respective gross revenue
percentages are KONE – 49%; IXYS – 8%; Otis – 7%; and Global PET –
7%.  The Company is, and may continue to be, dependent upon a limited
number of customers. Accordingly, the loss of one or more of these customers may
have a material adverse effect upon the Company’s business.




Patents
and Proprietary Rights




The
Company currently relies on a combination of trade secrets, non-disclosure
agreements and patent protection to establish and protect its proprietary rights
in its products. There can be no assurance these mechanisms will provide the
Company with any competitive advantages. Furthermore, there can be no assurance
others will not independently develop similar technologies, duplicate or
“reverse engineer” the proprietary aspects of the Company’s
technology.




The
Company has one U.S. patent issued with respect to its products. The “Balanced
and Synchronized Phase Detector for an AC Induction Motor Controller,” No.
5,821,726, was issued on October 13, 1998 and expires in 2017. This patent
covers improvements to the technology under the NASA License Agreement
(described below), which were developed by the Company. Management believes this
patent protects the Company’s intellectual property position beyond the
expiration of the NASA License Agreement.





The
Company has filed three utility patents on new inventions associated with the
development of its digital products.  The Company is continually
making improvements to its products and technologies, and anticipates making
additional patent filings on new inventions when warranted.





The
Company has obtained U.S. Trademark registration of the E-Save Technology®
mark.





NASA
License Agreement




The
Company had been the exclusive United States licensee of certain power factor
controller technology owned by the United States of America, as represented by
NASA. This license agreement covered the United States and its territories and
possessions and did not require the Company to pay royalties to NASA in
connection with the Company’s sale of products employing technology utilizing
the licensed patents. The Company’s rights under the license agreement were
non-transferable and were not to be sublicensed without NASA’s
consent.  The license agreement terminated on December 16, 2002 upon
expiration of all of the licensed patents.




The
Company believes its products and other proprietary rights do not infringe any
proprietary rights possessed by third parties. There can be no assurance,
however, that third parties will not assert infringement claims in the future,
the defense costs of which could be substantial.




8





Government
Regulation




The
Company is not required to be certified by any government agencies. However,
most of the Company’s products are manufactured to comply with specific codes
that meet industry accepted safety standards. Presently, many of the Company’s
products are certified to comply with UL 508 Industrial Control Equipment and
the Company has also received certification meeting CSA (Canadian Standards
Association) B44.1/ASME-17.5 Elevator and Escalator Electrical Equipment for
many of the Company’s products. Many of the Company’s products are also CE
marked. The Department of Commerce does not require the Company’s technology to
be certified for export. The Company’s industrial code is 421610 and the SIC
code is 5063.





Deregulation
of Electrical Energy




Sales of
the Company’s product are not dependent on deregulation of the electrical energy
market as the Company’s product can be sold in regulated and deregulated
markets.




Research
and Development




The
Company intends to continue its research and development effort to introduce new
products based on its energy saving technology. Towards this end, the Company
spent $953,004 and $1,016,158 in fiscal years 2009 and 2008, respectively, on
research and development activities, virtually none of which was borne by
customers. A major focus of the Company’s foreseeable research and development
activities will be on completing additional features and refinements to the
three-phase and single phase products. The Company also anticipates the
possibility of working with OEMs that make or purchase motor control equipment,
in order to develop products with features or specifications they
require.




Effect
of Environmental Regulations




The
Company is not aware of any federal, state, or local provisions regulating the
discharge of materials into the environment or otherwise relating to the
protection of the environment with which compliance by the Company has had, or
is expected to have, a material effect upon the capital expenditures, earnings,
or competitive position of the Company.




Employees




At the
date of this document, the Company employs fourteen people.  Of this
number, two are engaged in accounting and finance, three in operations and
general management, three in sales and marketing, and six in product research
and development, engineering and manufacturing.  At such time as
business conditions dictate, the Company may hire additional personnel for,
among other things, increased engineering, marketing and sales. The Company has
no collective bargaining agreements and considers its relationship with its
employees to be good. The Company utilizes consultants in the areas of
marketing, product and technology development and finance on a regular
basis.




(c)
Reports to Security
Holders





The
Company is a smaller reporting company, and as such files Annual Reports on Form
10-K, Quarterly Reports on Form 10-Q under the scaled disclosure requirements
and Current Reports on Form 8-K on a regular basis with the SEC.





The
public may read and copy any materials the Company files with the SEC at the
SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C.
20549.  The public may obtain information on the operation of the
Public Reference Room by calling the SEC at 1-800-SEC-0330.  The SEC
maintains an internet site that contains reports, proxy and information
statements, and other information regarding issuers that file electronically
with the SEC at http://www.sec.gov.





Item
      1A.
            Risk
      Factors.




RISKS
RELATED TO OUR BUSINESS





Unless
We Achieve Profitability and Related Positive Cash Flow, We May Not Be Able To
Continue Operations, And Our Auditors Have Questioned Our Ability To Continue As
A "Going Concern".




The
Company has suffered recurring losses from operations, and experienced a
deficiency of cash of approximately $3,000,000 and $3,100,000 from operations
for the years ended December 31, 2009 and 2008, respectively.  For the
years ended December 31, 2009 and December 31, 2008, we had net losses of
$4,168,708 and $3,948,204, respectively.  In our Auditors’ Report
dated March 31, 2010 on our December 31, 2009 financial statements included
in this report, our auditors have stated that these factors raise substantial
doubt about our ability to continue as a “going concern”.  Our
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amount of
liabilities that might be necessary should we be unable to continue in
existence.




9




The
Company’s continuation as a “going concern” is dependent upon achieving
profitable operations and related positive cash flow and satisfying our
immediate cash needs by external financing until we are profitable.  Our
plans to achieve profitability include developing new products, obtaining new
customers and increasing sales to existing customers.  We are seeking to
raise additional capital through equity issuance, debt financing and other types
of financing, but we cannot guarantee that sufficient capital will be
raised.




We
Have A Limited Operating History, Have Experienced Recurring Losses And Have
Limited Revenue.




To date,
and due principally to a lack of working capital, our operations have been
limited in scale. Although we have an arrangement with an outsourced production
facility to manufacture our products, have established relationships with
suppliers, and have received contracts for our products, we may experience
difficulties in production scale-up, product distribution, and obtaining and
maintaining working capital until such time as our operations have been
scaled-up to acceptable commercial levels.  We have not had a
profitable quarter in the past three years and we cannot guarantee we will ever
operate profitably. In addition, we have limited revenue. For the year ended
December 31, 2009, our total revenues were $283,990, and for the year ended
December 31, 2008, our total revenues were $480,513.





We
Do Not Have A Bank Line Of Credit.




At the
present time, we do not have a bank line of credit, which further restricts our
financial flexibility.





We
Will Require Additional Funds To Meet Our Cash Operating Expenses And Achieve
Our Current Business Strategy.




The
Company continues to have limited working capital and will be dependent upon
additional financing to meet capital needs and repay outstanding debt. We cannot
guarantee additional financing will be available on acceptable terms, if at all.
We also need additional financing to raise the capital required to fully
implement our business plan. Our current operating expense level is
approximately $250,000 to $300,000 per month.  Management is seeking
to raise additional capital through equity issuance, debt financing or other
types of financing.  However, there are no assurances that sufficient
capital will be raised.





When our
operations require additional financing, if we are unable to obtain it on
reasonable terms, we would be forced to restructure, file for bankruptcy or
cease operations, any of which could cause you to lose all or part of your
investment in us.





Our
Management Group Owns Or Controls A Significant Number Of The Outstanding Shares
Of Our Common Stock And Will Continue To Have Significant Ownership Of Our
Voting Securities For The Foreseeable Future.




As of the
date of this report, management controls approximately twenty-two percent (22%)
of our issued and outstanding Common Stock and voting equivalents.
Additionally,Summit Energy Ventures,
LLC (“Summit”) owns twelve percent (12%) of our common stock and voting
equivalents, which is included in the above number. Summit is controlled by
Steven Strasser, our Chairman and CEO, and he has the right to vote all shares
owned by Summit. BJ Lackland, our CFO, owns a minority equity interest in
Summit.  As a result, these persons will have the ability, acting as a
group, to greatly influence our affairs and business, including the election of
directors and, subject to certain limitations, approval or preclusion of
fundamental corporate transactions. This concentration of ownership of our
common stock may:




·
            delay
      or prevent a change in the control;




·
            impede
      a merger, consolidation, takeover, or other transaction involving the
      Company; or




·
            discourage
      a potential acquirer from making a tender offer or otherwise attempting to
      obtain control of the Company.




The
relationships between Summit and our executive officers are discussed in more
detail under “Certain Relationships And Related Party Transactions”
herein.




10




Our
Business Depends Upon The Maintenance Of Our Proprietary Technology, And We
Rely, In Part, On Contractual Provisions To Protect Our Trade Secrets And
Proprietary Knowledge.





The
Company depends upon its proprietary technology, relying principally upon trade
secret and patent law to protect this technology.  The Company also
regularly enters into confidentiality agreements with key employees,
customers, potential customers, and vendors and limits access to and
distribution of trade secrets and other proprietary information. However, these
measures may not be adequate to prevent misappropriation of our
technology.  Additionally, our competitors may independently develop
technologies substantially equivalent or superior to our technology. In
addition, the laws of some foreign countries do not protect our proprietary
rights to the same extent as the laws of the United States. We also are subject
to the risk of adverse claims and litigation alleging infringement of
intellectual property rights of others.





Confidentiality
agreements to which we are party may be breached, and we may not have adequate
remedies for any breach. Our trade secrets may also be known without breach of
such agreements or may be independently developed by competitors. Our inability
to maintain the proprietary nature of our technology and processes could allow
our competitors to limit or eliminate any competitive advantages we may
have.





We
Are Dependent On Third-Party Suppliers.





Although
we believe most of the key components required for the production of our
products are currently available in sufficient production quantities from
multiple sources, they may not remain so readily available. It is possible that
other components required in the future may necessitate custom fabrication in
accordance with specifications developed or to be developed by us. Also, in the
event that we, or our contract manufacturer, as applicable, are unable to
develop or acquire components in a timely fashion, our ability to achieve
production yields, revenues and net income can be expected to be adversely
affected.  Additionally, we are dependent on Sanmina-Sci to
manufacture our higher volume products.  While we believe we would be
successful in finding alternative manufacturers should this manufacturer not be
available to manufacture our product, it could take substantial time and effort
to locate such alternatives and, depending on the timing of the loss of
Sanmina-Sci, could result in disruption in delivery schedules and harm to our
clients, our reputation and future prospects.





We
Are Developing And Commercializing New Energy Saving Technologies And
Products Which Will Involve Uncertainty And Risks Related To Product Development
And Market Acceptance.





Our
success is dependent, to a large degree, upon our ability to fully develop and
commercialize our technology and gain industry acceptance of our products based
upon our technology and its perceived competitive
advantages.  Accordingly, our prospects must be considered in light of
the risks, expenses and difficulties frequently encountered in connection with
the establishment of a new business in a highly competitive industry,
characterized by frequent new product introductions. We anticipate that we will
incur substantial expense in connection with the development and testing of our
proposed products and expect these expenses to result in continuing and
significant losses until such time, if ever, that we are able to achieve
adequate levels of sales or license revenues.





We
Have Limited Experience in Direct Sales.





Our
products have been distributed primarily through OEMs. We have recently begun
pursuing an expanded distribution strategy designed to reduce our reliance on
OEMs. Pursuant to this strategy, we are increasing our direct sales efforts into
new markets. Our future growth and profitability will depend upon the successful
development of business relationships with additional OEMs, growth in direct
sales, and sales through select resellers and reps to penetrate the market with
our products.





We
Currently Depend On A Small Number Of Customers And Expect To Continue To Do
So.





The
Company currently does business with approximately 20 customers. Of this number,
four customers accounted for approximately 71% of our gross revenues in
2009.  We are, and may continue to be, dependent upon a small number
of customers. Accordingly, the loss of one or more of these customers is likely
to have a material adverse effect on our business.




Most
Of Our Current And Potential Competitors Have Greater Name Recognition,
Financial, Technical And Marketing Resources, And More Extensive Customer Bases
And Industry Relationships Than We Do, All Of Which Could Be Leveraged To Gain
Market Share To Our Detriment, Particularly In An Environment Of Rapid
Technological Change.




We
compete against a number of companies in the electric motor energy savings
market, many of which have longer operating histories, established markets and
far greater financial, advertising, research and development, manufacturing,
marketing, personnel and other resources than we currently have or may
reasonably expect to have in the foreseeable future. This competition may have
an adverse effect on our ability to expand our operations or operate profitably.
The motor control industry is also highly competitive and characterized by rapid
technological change. Our future performance will depend in large part upon our
ability to become and remain competitive and to develop, manufacture and market
acceptable products in these markets. Competitive pressures may necessitate
price reductions, which can adversely affect revenues and profits. If we are not
competitive in our ongoing research and development efforts, our products may
become obsolete, or be priced above competitive levels. However, management
believes, based upon their performance and price, our products are attractive to
customers. We cannot guarantee that competitors will not introduce comparable or
technologically superior products, which are priced more favorably than our
products.




11





Changes
In Retail Energy Prices Could Affect Our Business.





We have
found that a customer’s decision to purchase an MEC (or similar product) is
primarily driven by the payback on the investment resulting from the increased
energy savings.  Although management believes that current retail
energy prices support an attractive return on investment for our products, the
future retail price of electrical energy may not remain at such levels, and
price fluctuations reducing energy expense could adversely affect product
demand.





Loss
Of Key Personnel Could Have Significant Adverse Consequences.





We
currently depend on the services of Steve Strasser, and BJ Lackland, our Chief
Executive Officer and Chief Financial Officer, respectively. The loss of the
services of either of these persons could have an adverse effect on our
business. As discussed under “Management”, we have entered into long-term
employment contracts with Messrs. Strasser and Lackland, but such contracts do
not guarantee they will remain with us.





We
Do Not Have “Key Man” Life Insurance.





The
Company presently does not have any key man life insurance policies. As soon as
practicable following the commencement of profitable operations (which may never
occur), we intend to purchase key man life insurance on the life of our
principal executive officer, Steven Strasser. Upon purchase of such insurance,
we intend to pay the premiums and be the sole beneficiary. The lack of such
insurance may have a material adverse effect upon our business.





Delaware
Law Limits The Liability Of Our Directors.





Pursuant
to our Certificate of Incorporation, the Company’s directors are not liable to
us or our stockholders for monetary damages for breach of fiduciary duty, except
for liability in connection with a breach of the duty of loyalty, for acts or
omissions not in good faith or which involved intentional misconduct or a
knowing violation of law for dividend payments or stock repurchases illegal
under Delaware law or any transaction in which a director has derived an
improper personal benefit.





Potential
Product Liability Claims May Not Be Fully Covered By Insurance.





The
Company may be subject to potential product liability claims that could, in the
absence of sufficient insurance coverage, have a material adverse impact on us.
Presently, we have general liability coverage that includes product liability up
to $2,000,000 and umbrella liability up to $4,000,000. Any large product
liability suits occurring early in our growth may significantly and adversely
affect our ability to expand the market for our products.




RISKS
RELATED TO OUR COMMON STOCK AND CAPITAL STRUCTURE





Trading
In Our Common Stock Over The Last 12 Months Has Been Limited, So Investors May
Not Be Able To Sell As Many Of Their Shares As They Want At Prevailing
Prices.




Prices of
our common stock are quoted on the OTC Bulletin Board. Approximately 26,000
shares were traded on an average daily trading basis for the 12 months ended
December 31, 2009.  If limited trading in our common stock continues,
it may be difficult for shareholders to sell their shares. Also, the sale of a
large block of our common stock could depress the market price to a greater
degree than a company that typically has a higher volume of trading of its
securities.





The
Limited Public Trading Market May Cause Volatility In Our Stock
Price.




The
Company’s common stock is currently quoted on a limited basis on the OTC
Bulletin Board under the symbol “PEFF”. The quotation of our common stock on the
OTC Bulletin Board does not assure that a meaningful, consistent and liquid
trading market exists at all times, and in recent years such market has
experienced extreme price and volume fluctuations that have particularly
affected the market prices of many smaller companies like us. Our common stock
is thus subject to this volatility. Sales of substantial amounts of our common
stock, or the perception that such sales might occur, could adversely affect
prevailing market prices of our common stock.




12





An
Active And Visible Trading Market For Our Common Stock May Not
Develop.





The
market for our common stock may become inactive in the future. In the absence of
an active trading market:




·
            Investors
      may have difficulty buying and selling or obtaining market
      quotations;




·
            Market
      visibility for our common stock may be limited;
  and




·
            A
      lack of visibility for our common stock may have a depressive effect on
      the market price for our common
stock.




The OTC
Bulletin Board is an inter-dealer, over-the-counter market that provides
significantly less liquidity than NASDAQ, and quotes for stocks included on the
OTC Bulletin Board are not listed in the financial sections of newspapers, as
are those for the NASDAQ Stock Market. The trading price of the common stock is
expected to be subject to significant fluctuations in response to variations in
quarterly operating results, changes in analysts’ earnings estimates,
announcements of innovations by the Company or its competitors, general
conditions in the industry in which we operate and other factors. These
fluctuations, as well as general economic and market conditions, may have a
material or adverse effect on the market price of our common stock.





Penny
Stock Regulations May Impose Certain Restrictions On Marketability Of Our
Securities.





The SEC
has adopted regulations which generally define a “penny stock” to be any equity
security that has amarket price of less
than $5.00 per share or anexercise price of less
than $5.00 per share, subject to certain exceptions. As a result, our common
stock is subject to rules that impose additional requirements on broker-dealers
who sell such securities to persons other than established customers and
accredited investors (generally those with net worth in excess of $1,000,000 or
annual income exceeding $200,000, or $300,000 together with their spouse). For
transactions covered by these rules, the broker-dealer must make a special
suitability determination for the purchase of such securities and have received
the purchaser’s written consent to the transaction prior to the purchase.
Additionally, for any transaction involving a penny stock, unless exempt, the
rules require the delivery, prior to the transaction, of a risk disclosure
document relating to the penny stock market. The broker-dealer must also
disclose the commission payable to both the broker-dealer and the registered
representative, current quotations for the securities and, if the broker-dealer
is the sole market maker, the broker-dealer must disclose this fact and the
broker-dealer’s presumed control over the market. Finally, monthly statements
must be sent disclosing recent price information for the penny stock held in the
account and information on the limited market in penny stocks. Consequently, the
“penny stock” rules may restrict the ability of broker-dealers to sell the
Company’s securities and may affect the ability of investors to sell the
Company’s securities in the secondary market and the price at which such
purchasers can sell any such securities.




Stockholders
should be aware that, according to the Commission, the market for penny stocks
has suffered in recent years from patterns of fraud and abuse. Such patterns
include:




·
            Control
      of the market for the security by one or a few broker-dealers that are
      often related to the promoter or
issuer;




·
            Manipulation
      of prices through prearranged matching of purchases and sales and false
      and misleading press releases;




·
            "Boiler
      room" practices involving high pressure sales tactics and unrealistic
      price projections by inexperienced sales
  persons;




·
            Excessive
      and undisclosed bid-ask differentials and markups by selling
      broker-dealers; and




·
            The
      wholesale dumping of the same securities by promoters and broker-dealers
      after prices have been manipulated to a desired level, along with the
      inevitable collapse of those prices with consequent investor
      losses.




The
Company’s management is aware of the abuses that have occurred historically in
the penny stock market.




13




We
May Never Pay Cash Dividends On Our Common Stock.





We have
not paid or declared any dividends on our common stock and do not anticipate
paying or declaring any cash dividends on our common stock in the foreseeable
future.





Sales
Of Common Stock Under Rule 144 May Adversely Affect The Market Price Of Our
Common Stock.





Possible Resales under Rule
144. Of the 44,825,883 shares of the Company’s common stock
outstanding on the date of this report, 33,295,056 shares are freely trading in
the market place (the “Free Trading Shares”). The Free Trading Shares are
comprised mostly of shares (1) originally issued in private offerings of common
stock from June through March 2007, that were later registered in the Company’s
S-1 Registration Statement (the “Registration Statement”), declared effective on
October 10, 2008 and (2) shares originally issued in transactions exempt from
registration under the Securities Act.





The
remaining 11,530,927 shares of our common stock outstanding are restricted
securities as defined in Rule 144 and under certain circumstances may be resold
without registration pursuant to Rule 144.  These shares include the
9,968,910 shares held by Summit and Steven Strasser in the aggregate, and
1,661,917 shares held by directors and insiders.





In
addition, the Company had approximately 31,387,469 common stock purchase
warrants outstanding and approximately 16,479,896 common stock options
outstanding as of the date of this report, including the warrants issued in
connection with the private offer and sale of preferred stock units in 2008 and
2009 (See Note 18 to the Financial Statements).  The shares issuable
on exercise of the options and warrants may, under certain circumstances, be
available for public sale in the open market under the Registration Statement or
pursuant to Rule 144, subject to certain limitations.





In
general, pursuant to Rule 144, after satisfying a six month holding period: (i)
affiliated stockholder (or stockholders whose shares are aggregated) may, under
certain circumstances, sell within any three month period a number of securities
which does not exceed the greater of 1% of the then outstanding shares of common
stock or the average weekly trading volume of the class during the four calendar
weeks prior to such sale and (ii) non-affiliated stockholders may sell without
such limitations, provided we are current in our public reporting
obligations.  Rule 144 also permits the sale of securities by
non-affiliates that have satisfied a one year holding period without any
limitation or restriction.  Any substantial sale of the common stock
pursuant to Rule 144 may have an adverse effect on the market price of the
Company’s shares.





Exercise
Of Outstanding Options And Warrants Will Dilute Ownership Of Outstanding
Shares.





As of the
date of this report, the Company has reserved 71,429 shares of common stock for
issuance upon exercise of stock options or similar awards which may be granted
pursuant to the 1994 Plan, of which no options are
outstanding.  Furthermore, we have reserved 25,000,000 shares of our
common stock for issuance upon exercise of stock options or similar awards which
may be granted pursuant to the 2000 Plan, of which options to purchase an
aggregate of 16,479,896 shares are outstanding. The outstanding options under
the 2000 Plan have a weighted average exercise price of $0.34. As of the date of
this report, we have issued warrants exercisable for 31,387,469 shares of common
stock to financial consultants, investors, former employees and other business
partners, having a weighted average exercise price of $0.43 and expiring on
various dates from February 2010 to December 2014. Exercise of these options and
warrants in the future will reduce the percentage of common stock held by the
public stockholders. Furthermore, the terms on which we could obtain additional
capital during the life of the options and warrants may be adversely affected,
and it should be expected that the holders of the options and warrants would
exercise them at a time when we would be able to obtain equity capital on terms
more favorable than those provided for by such options and
warrants.





Our
Issuance Of “Blank Check” Preferred Stock Could Adversely Affect Our Common
Stockholders.





The
Company’s Certificate of Incorporation authorizes the issuance of “blank check”
preferred stock with such designations, rights and preferences as may be
determined from time to time by the board of directors. Accordingly, our Board
of Directors is empowered, without stockholder approval, to issue preferred
stock with dividends, liquidation, conversion, voting or other rights that could
adversely affect the relative voting power or other rights of the holders of our
common stock. In the event of issuance, the preferred stock could be used as a
method of discouraging, delaying or preventing a change in control of the
Company, which could have the effect of discouraging bids for the Company and
thereby prevent stockholders from receiving the maximum value for their
shares.  From August 12, 2009, through January 20, 2010, the Company
sold 23,375 shares if its Series C preferred stock, and 32,750 shares of its
Series C-1 preferred stock in private offerings of units (See Note 18 to the
Financial Statements).








Item
      1B.
            Unresolved
      Staff Comments.





None




14




Item
      2.
            Description
      of Property.




The
Company’s corporate office space is located at 3960 Howard Hughes Pkwy, Suite
460, Las Vegas, Nevada 89169.  The office lease calls for rent of
$11,292 per month, plus annual increases equal to 3%, through the end of the
lease term in February 2011.





The
Company leased research and development space at 6380 South Valley View Blvd,
Suite 412, Las Vegas, Nevada 89118.  The lease calls for rent of
$1,995 plus common area maintenance charges, per month, through the end of the
lease term in August 2010.





The
Company leased manufacturing and warehouse space at 6380 South Valley View Blvd,
Suite 402, Las Vegas, Nevada 89118.  The lease calls for rent of
$1,605 plus common area maintenance charges, per month, through the end of the
lease term in August 2010.





Item
      3.
            Legal
      Proceedings.





The
Company is currently involved in a lawsuit against a former director and the
company at which he is currently CEO (collectively, the
“Defendants”).  The Company filed this action against the Defendants
for misappropriation of trade secrets, false advertising, defamation/libel and
other claims primarily arising from the Defendants’ use of the Company’s
confidential and proprietary information in the development and marketing of
motor control products.  The Company seeks a temporary restraining
order, preliminary injunction, permanent injunction, damages, exemplary damages,
attorneys’ fees and costs against the Defendants.  The Company’s
complaint was filed on August 6, 2009 in the U.S. District Court, District of
Nevada.





PART II




Item
      5.
            Market
      for Common Equity and Related Stockholder
  Matters.




Market
for Common Stock




The
Company’s common stock is thinly traded on the National Association of
Securities Dealers’ Over the Counter Bulletin Board (“OTCBB”) under the symbol
“PEFF”.




The
following table sets forth the high and low bid information for quarterly
periods in the two twelve month periods ended December 31, 2009 and December 31,
2008




Twelve
      months Ended December 31, 2009
            
            High
            
            
            LowOctober
      1, 2009 — December 31, 2009
            
            $
            0.45
            
            
            
            0.20July
      1, 2009 — September 30, 2009
            
            
            0.25
            
            
            
            0.11April
      1, 2009 — June 30, 2009
            
            
            0.30
            
            
            
            0.12January
      1, 2009 — March 31, 2009
            
            
            0.30
            
            
            
            0.08




Twelve
      months Ended December 31, 2008
            
            High
            
            
            LowOctober
      1, 2008 — December 31, 2008
            
            $
            0.25
            
            
            
            0.08July
      1, 2008 — September 30, 2008
            
            
            0.32
            
            
            
            0.19April
      1, 2008 — June 30, 2008
            
            
            0.39
            
            
            
            0.26January
      1, 2008 — March 31, 2008
            
            
            0.55
            
            
            
            0.26




As of
March 31, 2010, there were 168 shareholders of record of the Company’s common
stock.  Because many of our shares are held by brokers and other
institutions on behalf of stockholders, we are unable to estimate the total
number of stockholders represented by record holders.




15




The
Company has not paid dividends on its common stock since its incorporation. The
Company does not expect to pay cash dividends on its common stock in the
foreseeable future. The Company intends to invest funds otherwise available for
dividends, if any, on improving the Company’s capital assets.





EQUITY
COMPENSATION PLAN INFORMATION AS OF MARCH 31, 2010




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 2000 Stock
      Option and Restricted Stock Plan (excluding securities reflected in column
      (a))(c)2000
      Stock Option and Restricted Stock Plan approved by security
      holders
            
            
            16,479,896
            
            
            $
            0.34
            
            
            
            8,520,104Equity
      compensation plans not approved by security holders
            
            
            0
            
            
            
            0.00
            
            
            
            0Total
            
            
            16,479,896
            
            
            $
            0.34
            
            
            
            8,520,104





The
Company maintains a Stock Option Equity Compensation Plan.  (See Note
12 to the Financial Statements)





Recent
Sales of Unregistered Securities





During
the period covered by this report we did not issue any securities that were not
registered under the Securities Act of 1933, as amended, except previously
disclosed in a quarterly report on Form 10-Q or a current report on Form
8-K.





Item
      6.
            Selected
      Financial Data





We are a
“smaller reporting company” as defined by Regulation S-K and as such, are not
providing the information contained in this item pursuant to Regulation
S-K.





Item
      7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.




OVERVIEW




The
Company generates revenues from a single business segment: the design,
development, marketing and sale of proprietary energy efficiency technologies
and products for electric motors.  The Company’s products, called
Motor Efficiency Controllers (“MEC”), save up to 35 percent of the electricity
used by a motor in appropriate applications.  The Company’s patented
technology platform, called E-Save Technology®, saves energy when a constant
speed alternating current induction motor is operating in a lightly loaded
condition.  Target applications for the Company’s three-phase MECs
include escalators, MG set elevators, grinders, crushers, saws, stamping
presses, and many other types of industrial equipment.  The Company
has also developed a single-phase MEC targeted at smaller motors, such as those
found in clothes washers, dryers, and other appliances and light commercial
equipment.  The Company has one existing patent and three patents
pending on E-Save Technology®.





Analog
Three-phase MEC




The
Company began generating revenues from sales of its patented analog three-phase
MEC line of motor controllers in the late 1990’s.  The Company sold
this product through the second quarter of 2009.





Digital
Three-phase MEC




In 2005,
the Company began development of a digital version of its three-phase MEC so
that the product would be capable of high volume sales through existing
distribution channels for motor controls.  The digital version is much
smaller in size and easier to install than the analog product, is driven by a
powerful microprocessor and digital signal processor. The digital MEC is a
complete motor control device, meaning is can start, stop, soft start and
protect a motor, and is therefore capable of replacing standard motor starters
and soft starts that do not save energy. The product can be installed by OEMs at
their factories or it can be retrofitted on to existing equipment.




16




In 2008,
the Company launched limited sales of the digital three-phase MEC and initiated
testing if the digital product by several OEMs, primarily in the
elevator/escalator industry.  In the summer of 2009, the Company
announced its first OEM agreements and that it had received Underwriters’
Laboratories (“UL”) certification on a full line of the Company’s digital
three-phase products.  UL certification enables the Company to sell
its digital three-phase products to industrial markets.  The Company
is developing a network of independent sales representatives to penetrate the
industrial markets.





Digital
Single-phase MEC




In 2006,
the Company began development on its digital single-phase
product.  The digital single phase MEC is targeted at appliances, such
as clothes washers and dryers.  The Company has one patent pending on
its digital single-phase MEC.





Capitalization




As of
December 31, 2009, the Company had total stockholders’ equity of $801,642
primarily due to (i) the Company’s sale of 30,250 shares of Series C and Series
C-1 Convertible Preferred Stock in a private offering in December of 2009, (ii)
the Company’s sale of 140,000 shares of Series B Convertible Preferred Stock in
a private offering from October of 2007 through January of 2008, (iii) the
Company’s sale of 12,950,016 shares of common stock in a private stock offering
from November of 2006 through March of 2007, (iv) the Company’s sale of
14,500,000 shares of common stock in a private stock offering in July and August
of 2005, (v) the Company’s sale of 2,346,233 shares of Series A-1 Convertible
Preferred stock to Summit Energy Ventures, LLC in June of 2002 and (vi) the
conversion of notes payable of approximately $1,047,000 into 982,504 shares of
Series A-1 Convertible Preferred Stock in October of 2003.  All of the
Company’s Series A-1 Convertible Preferred Stock was converted into the
Company’s common stock in 2005.





Because
of the nature of our business, the Company makes significant investments in
research and development for new products and enhancements to existing
products.  Historically, the Company has funded its research and
development efforts through cash flow primarily generated from debt and equity
financings.  Management anticipates that future expenditures in
research and development will continue at current levels.





The
Company’s results of operations for the year ended December 31, 2009 were marked
by a significant decrease in revenues and an increase in losses from operations
that are more fully discussed in the following section “Results of Operations
for the Years Ended December 31, 2009 and 2008”.  Sales cycles for our
products are generally lengthy and can range from less than a month to well over
one year, depending on customer profile.  Larger OEM deals and sales
to larger end users generally take a longer period of time, whereas sales
through channel partners may be closed within a few weeks.  Because of
the complexity of this sales process, a number of factors that are beyond the
control of the Company can delay the closing of transactions.




RESULTS
OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008





The
following table sets forth certain line items in our condensed statement of
operations as a percentage of total revenues for the periods
indicated:





Year
      Ended December 31, 2009
            
            
            Year
      Ended December 31, 2008Revenues
            
            
            100.0
            %
            
            
            100.0
            %Cost
      of revenues
            
            
            78.8
            
            
            
            82.8Gross
      profit
            
            
            21.2
            
            
            
            17.2Costs
      and expenses:Selling,
      general and administrative
            
            
            933.0
            
            
            
            631.1Research
      and development
            
            
            335.6
            
            
            
            211.5Depreciation
      and amortization
            
            
            23.4
            
            
            
            15.5Total
      expenses
            
            
            1,292.1
            
            
            
            858.1Loss
      from operations
            
            
            (1,270.9
            )
            
            
            (840.9
            )Other
      income
            
            
            (175.6
            )
            
            
            21.8Provision
      for taxes
            
            
            (21.4
            )
            
            
            (2.6
            )Net
      loss
            
            
            (1,467.9
            )
            
            
            (821.7
            )Dividends
      paid or payable on Series B, Series C and Series C-1 Preferred
      Stock
            
            
            447.5
            
            
            
            113.6Net
      loss attributable to common shareholders
            
            
            (1,915.5
            )
            
            
            (935.3
            )




17




REVENUES




Revenues
for the year ended December 31, 2009, were approximately $284,000 compared to
approximately $481,000 for the year ended December 31, 2008, a decrease of
$197,000 or 41%.  This decrease is mainly attributable to a decrease
in sales in the elevator and escalator market during the year ended December 31,
2009. Specifically, escalator manufacturer and service provider sales fell to
approximately $183,000 for the year ended December 31, 2009, from $363,000 for
the year ended December 31, 2008.  Sales of the analog product to one
escalator manufacturer and service provider, which is one of the Company’s
largest customers, slowed very significantly during this period in anticipation
of release of their private label version of our digital product.  The
digital product has been tested and approved for use on a retrofit and OEM basis
by this customer, and a supply agreement was signed during the second quarter of
2009, and the customer’s private label version of our digital product was
launched at the end of the second quarter of 2009.  The digital
product offers greater features and functionality compared to the analog
product, making it more attractive as an OEM product.  Furthermore,
industrial sales fell to approximately $78,000 for the year ended December 31,
2009, from approximately $118,000 for the year ended December 31,
2008.  Sales of the Company’s single-phase product, which is for use
on small appliances, totaled approximately $23,000 for the year ended December
31, 2009.  There were no comparable sales of the single-phase product
in 2008.  For the year ended December 31, 2009, industrial and other
sales, of which all but one sale consisted of digital units, were approximately
27% of total revenues, escalator and elevator sales, which consisted of a mix of
digital units and analog units, were approximately 65% of total revenues, and
sales of our single-phase product were approximately 8% of total
revenues.  For the year ended December 31, 2008, industrial and other
sales, which consisted of a mix of digital units and analog units, were
approximately 21% of total revenues, and escalator and elevator sales, which
consisted mostly of analog units, were approximately 79% of total
revenues.





COST
OF REVENUES




Cost of
revenues for the year ended December 31, 2009 were approximately $224,000
compared to approximately $398,000 for the year ended December 31, 2008, a
decrease of $174,000, or 44%.  This decrease is mainly attributable to
a decrease in sales in both the elevator and escalator and the industrial
markets during the year ended December 31, 2009.  Also, the Company
recorded an inventory obsolescence charge of approximately $41,000 during the
year ended December 31, 2008 and no comparable charge was recorded during the
year ended December 31, 2009.  As a percentage of sales, total cost of
revenues decreased to approximately 79% for the year ended December 31, 2009,
compared to approximately 82% for the year ended December 31,
2008.  The decrease in the costs as a percentage of sales was
primarily due to the Company increasing its prices on certain units, which
resulted in higher margins during the year ended December 31, 2009, and an
increase in the sale of digital units, which have higher average margins than
analog units, as well as no inventory obsolescence charges during
2009.





GROSS
PROFIT





Gross
profit for the year ended December 31, 2009 was approximately $60,000 compared
to approximately $83,000 for the year ended December 31, 2008, resulting in a
decrease of $23,000 or 28%. This decrease is mainly attributable to a decrease
in sales in both the elevator and escalator and the industrial markets during
the year ended December 31, 2009, partially offset by the inventory obsolescence
charge recorded by the Company during the year ended December 31, 2008, as
described above. As a percentage of revenue, gross profit increased to
approximately 21% for the year ended December 31, 2009, compared to
approximately 17% for the year ended December 31, 2008.





OPERATING
EXPENSES




Selling,
General and Administrative Expenses




Selling,
general and administrative expenses were approximately $2,650,000 for the year
ended December 31, 2009, compared to approximately $3,033,000 for the year ended
December 31, 2008, a decrease of $383,000 or 13%. The decrease in selling,
general and administrative expenses compared to the prior year was primarily due
to a decrease in travel expenses, consulting fees, and a decrease in stock based
compensation costs related to FASB ASC 718 (SFAS 123(R)).  These
decreases were partially offset by increases in legal and professional fees,
related to the Company’s patent attorneys and litigation (see Item 3 – Legal
Proceedings), and a change in the Company’s independent registered accounting
firm.




18




Research
and Development Expenses




Research
and development expenses were $953,000 for the year ended December 31, 2009
compared to approximately $1,016,000 for the year ended December 31, 2008, a
decrease of $63,000 or 6%. This decrease is mainly attributable to a decrease in
the Company’s product development and certification costs related to the
Company’s digital controller for both its single-phase and three-phase products
during the year ended December 31, 2009.





Change
in Fair Value of Warrant Liability





Warrants
issued in connection with a private offering of the Company’s common stock
completed on July 8, 2005 and August 31, 2005 are being accounted for as
liabilities in accordance with FASB ASC 820-10, Fair Value Measurements and
Disclosures(Prior
authoritative literature:FASB EITF 07-5, Determining Whether
an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock (“EITF
07-5”),issued January 2009), based on an analysis of the terms and
conditions of the warrant agreements.





As a
result, the fair value of these warrants (five year warrants to purchase up to
5,696,591 shares of the Company’s common stock at an exercise price of $0.44 per
share), amounting to $381,856 as of January 1, 2009, was reclassified from
equity and reflected as a liability.  The fair value of these warrants
amounted to $828,827 as of December 31, 2009.  The $514,089 increase
in the fair value of these warrants during 2009 has been reflected as a
non-operating loss in the Statement of Operations for 2009.  The
warrants are being valued at each reporting period using the Black-Scholes
pricing model to determine the fair market value per share.  We will
continue to mark the warrants to market value each quarter-end until they
expire.





Financial
Condition, Liquidity, and Capital Resources: For the Year Ended December 31,
2009




The
Company has suffered recurring losses from operations, and experienced a
deficiency of cash of approximately $3,000,000 and $3,100,000 from operations
for the years ended December 31, 2009 and 2008, respectively.  For the
years ended December 31, 2009 and December 31, 2008, we had net losses of
$4,168,708 and $3,948,204, respectively.  In our Auditors’ Report
dated March 31, 2010 on our December 31, 2009 financial statements included
in this report, our auditors have stated that these factors raise substantial
doubt about our ability to continue as a “going concern”.  Our
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amount of
liabilities that might be necessary should we be unable to continue in
existence.





The
Company’s continuation as a “going concern” is dependent upon achieving
profitable operations and related positive cash flow and satisfying our
immediate cash needs by external financing until we are profitable.  Our
plans to achieve profitability include developing new products, obtaining new
customers and increasing sales to existing customers.  We are seeking to
raise additional capital through equity issuance, debt financing and other types
of financing, but we cannot guarantee that sufficient capital will be
raised.




On March
30, 2010, the Company issued unsecured notes payable to Steven Strasser, the
Company’s CEO, totaling $125,000.  The notes bear interest at 5%,
payable upon maturity. The notes mature two months after issuance.





Since
inception, the Company has financed its operations primarily through the sale of
its securities.  In 2009, the Company received a total of
approximately $1,210,000 in gross proceeds from a private placement of its
Series C and Series C-1 preferred stock and warrants to purchase common
stock.  In 2008 and 2007, the Company received a total of
approximately $8,025,000 in gross proceeds from a private placement of its
Series B preferred stock, common stock and warrants to purchase common stock, as
to which the Company was required to file a registration statement on Form SB-2
or other relevant registration statement.  Of this amount, $1,850,000
was converted from existing debt securities.  Also in 2007, the
Company grossed approximately $680,000 in cash from the exercise of
warrants.  As of December 31, 2009 the Company has received a total of
approximately $21,515,000 from public and private offerings of its equity
securities, received $300,000 from a bridge note with a shareholder (which was
converted into 3,000,000 shares of common stock and 1,500,000 warrants with an
additional investment of $300,000 on July 8, 2005), received approximately
$445,386 under a bank line of credit (which was repaid during 2002), and
received $1,000,000 under a line of credit with a shareholder (which was
converted to Series A-1 Preferred Convertible shares during 2003). In October
2004 and February 2005, the Company received $1,589,806 in debt financing
through a debt offering arranged by a placement agent, Pali Capital. Of this
total, $300,000 plus accrued interest was converted from borrowings with the
same shareholder as referenced above.  In April 2006, the Company
received $1,000,000 in debt financing from EMTUCK , LLC, in which the managing
member is a management company wholly owned and controlled by Steven Strasser,
the Company's CEO.  In May 2006, the Company received an additional
$500,000 in debt financing from EMTUCK.  In November 2006, the Company
received $2,000,000 in debt financing.  Of this amount, $1,450,000 was
converted from borrowings from prior investors.  This $2,000,000 note
was paid off in full in October of 2007.  As of December 31, 2009 the
Company had cash of $247,564 and has no outstanding debt
securities.




19




Net cash
used for operating activities for the year ended December 31, 2009 was
$3,002,386 which primarily consisted of: a net loss of $4,168,708; less bad debt
expense of $8,149, depreciation and amortization of $66,589, loss on the
disposal of fixed assets of $3,097, warrants and options issued in connection
services from vendors, and to employees and consultants of $405,143, change in
fair value of warrant liability of $514,089, deferred tax provision of $49,946,
decreases in prepaid expenses and other current assets of $10,728, and deposits
of $11,292, increases in accounts receivable of $30,133 and inventory of
$35,233.  In addition, these amounts were partially offset by
decreases in deferred rent of $3,750, and increases in accounts payable and
accrued expenses of $166,405.





Net cash
used for operating activities for the year ended December 31, 2008 was
$3,102,847 which primarily consisted of: a net loss of $3,948,204; less bad debt
expense of $7,770, inventory obsolescence expense of $40,758, depreciation and
amortization of $74,539, warrants and options issued in connection with services
from vendors, and to employees and consultants of $765,504, common stock issued
for consulting services of $7,960, decreases in accounts receivable of $57,323
and deposits of $84,057, increases in inventory of $155,016 and prepaid expenses
of $5,869.  In addition, these amounts were partially offset by
decreases in accounts payable and accrued expenses of $30,669 and customer
deposits of $1,605, and increases in deferred rent of $605.





Net cash
used in investing activities for fiscal year 2009 was $32,882, compared to
$132,364 in fiscal year 2008.  The amount for 2009 consisted of the
purchase of fixed assets of $9,601, costs related to patent applications of
$24,174, and proceeds from the sale of fixed assets of $893.  The
amount for 2008 consisted of the purchase of fixed assets of $104,857, and costs
related to patent applications of $27,507.




Net cash
provided by financing activities for fiscal year 2009 was
$1,182,819.  The entire amount consisted of the net proceeds from the
issuance of equity securities.





Net cash
provided by financing activities for fiscal year 2008 was
$248,846.  The entire amount consisted of the net proceeds from the
issuance of equity securities.





The
Company expects to increase its operating expenses, particularly in research and
development and selling, general and administrative expenses, for the
foreseeable future in order to execute its business strategy. As a result, the
Company anticipates that operating expenses will constitute a material use of
any cash resources.





Cash
Requirements and Need for Additional Funds




The
Company anticipates a substantial need for cash to fund its working capital
requirements.  It is the opinion of management that approximately $2.5
- 3 million will be required to cover operating expenses, including, but not
limited to, marketing, sales, research and operations during the next twelve
months.  If the Company is unable to obtain funding on reasonable
terms or finance its needs through current operations, the Company will be
forced to restructure, file for bankruptcy or cease operations.





Notable
changes to expenses are expected to include an increase in the Company’s sales
personnel and efforts, and developing more advanced versions of the Company’s
technology and products.





Critical
Accounting Policies and Estimates





Management’s
discussion and analysis of Power Efficiency Corporation’s financial condition
and results of operations are based upon the condensed financial statements
contained in this Annual Report on Form 10-K, which have been prepared in
accordance with accounting principles generally accepted in the United
States.  The preparation of these financial statements requires
management to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and disclosure of contingent assets
and liabilities.  On an on-going basis, management evaluates
estimates, including those related to the valuation of inventory and the
allowance for uncollectible accounts receivable.  We base our
estimates on historical experience and on various other assumptions that
management believes to be reasonable under the circumstances, the results of
which form the basis for making judgments about the carrying values of assets
and liabilities that are not readily apparent from other
sources.  Actual results may differ materially from these estimates
under different assumptions or conditions.  We believe the following
critical accounting policies affect our more significant judgments and estimates
used in the preparation of our condensed financial statements.




20




Inventories




Inventories
are valued at the lower of cost (first-in, first-out) or market.  The
Company reviews inventory for impairments to net realizable value whenever
circumstances arise.  Such circumstances may include, but are not
limited to, the discontinuation of a product line or re-engineering certain
components making certain parts obsolete.  Management has determined a
reserve for inventory obsolescence is not necessary at December 31, 2009 or
2008.





Accounts
Receivable




The
Company carries its accounts receivable at cost less an allowance for doubtful
accounts and returns.  On a periodic basis, the Company evaluates its
accounts receivable and establishes an allowance for doubtful accounts, based on
a history of past write-offs and collections and current credit
conditions.  Change in customer liquidity or financial condition could
affect the collectability of that account, resulting in the adjustment upward or
downward in the provision for bad debts, with a corresponding impact to our
results of operations.





Fair
Value Measurements:




FASB ASC
820-10 (SFAS No. 157) emphasizes that fair value is a market-based
measurement, not an entity-specific measurement. Therefore, a fair value
measurement should be determined based on the assumptions that market
participants would use in pricing the asset or liability. As a basis for
considering market participant assumptions in fair value measurements, FASB ASC
820-10 (SFAS No. 157) establishes a fair value hierarchy that distinguishes
between market participant assumptions based on market data obtained from
sources independent of the reporting entity (observable inputs that are
classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s
own assumptions about market participant assumptions (unobservable inputs
classified within Level 3 of the hierarchy). The Company has applied FASB ASC
820-10 (SFAS 157) to measure the amount of the liability related to its
derivative instruments at fair value and to determine fair value for purposes of
testing goodwill for impairment.





Level 1
inputs utilize quoted prices (unadjusted) in active markets for identical
assets or liabilities that the Company has the ability to access. Level 2 inputs
are inputs other than quoted prices included in Level 1 that are observable for
the asset or liability, either directly or indirectly. Level 2 inputs may
include quoted prices for similar assets and liabilities in active markets, as
well as inputs that are observable for the asset or liability (other than quoted
prices), such as interest rates and yield curves that are observable at commonly
quoted intervals. Level 3 inputs are unobservable inputs for the asset or
liability, which is typically based on an entity’s own assumptions, as there is
little, if any, related market activity. In instances where the determination of
the fair value measurement is based on inputs from different levels of the fair
value hierarchy, the level in the fair value hierarchy within which the entire
fair value measurement falls is based on the lowest level input that is
significant to the fair value measurement in its entirety. The Company’s
assessment of the significance of a particular input to the fair value
measurement in its entirety requires judgment, and considers factors specific to
the asset or liability.





Revenue
Recognition




Revenue
from product sales is recognized at the time of shipment, when all services are
complete.  Returns and other sales adjustments (warranty accruals,
discounts and shipping credits) are provided for in the same period the related
sales are recorded.





Accounting
for Stock Based Compensation




The
Company accounts for employee stock options as compensation expense, in
accordance with FASB ASC 718 (SFAS 123(R)).  FASB ASC 718 (SFAS
123(R)) requires companies to expense the value of employee stock options and
similar awards, and applies to all outstanding and vested stock-based
awards.





In
computing the impact, the fair value of each option is estimated on the date of
grant based on the Black-Scholes options-pricing model utilizing certain
assumptions for a risk free interest rate; volatility; and expected remaining
lives of the awards.  The assumptions used in calculating the fair
value of share-based payment awards represent management's best estimates, but
these estimates involve inherent uncertainties and the application of
management’s judgment.  As a result, if factors change and the Company
uses different assumptions, the Company’s stock-based compensation expense could
be materially different in the future. In addition, the Company is required to
estimate the expected forfeiture rate and only recognize expense for those
shares expected to vest.  In estimating the Company’s forfeiture rate,
the Company analyzed its historical forfeiture rate, the remaining lives of
unvested options, and the amount of vested options as a percentage of total
options outstanding.  If the Company’s actual forfeiture rate is
materially different from its estimate, or if the Company reevaluates the
forfeiture rate in the future, the stock-based compensation expense could be
significantly different from what we have recorded in the current
period.  The impact of applying FASB ASC 718 (SFAS 123(R))
approximated $405,000 and $766,000 in additional compensation expense during the
periods ended December 31, 2009 and 2008, respectively.  Such amounts
are included in research and development expenses and selling, general and
administrative expense on the statement of operations.




21




Product
Warranties




The
Company typically warrants its products for two years.  Estimated
product warranty expenses are accrued in cost of sales at the time the related
sale is recognized. Estimates of warranty expenses are based primarily on
historical warranty claim experience. Warranty expenses include accruals for
basic warranties for products sold.   While management believes
our estimates are reasonable, an increase or decrease in submitted warranty
claims could affect warranty expense and the related current and future
liability.





Provision
for Income Taxes




The
Company utilizes the asset and liability method of accounting for income taxes
pursuant to FASB ASC 740 Accounting for Income Taxes (Prior
authoritative literatureFASB SFAS No. 109, Accounting for Income Taxes (“SFAS
109”)),whichrequires the
recognition of deferred tax assets and liabilities for both the expected future
tax impact of differences between the financial statement and tax basis of
assets and liabilities, and for the expected future tax benefit to be derived
from tax loss and tax credit carryforwards.  FASB ASC 740 (SFAS 109)
additionally requires the establishment of a valuation allowance to reflect the
likelihood of realization of deferred tax assets.  We have reported
net operating losses for consecutive years, and do not have projected taxable
income in the near future.  This significant evidence causes our
management to believe a full valuation allowance should be recorded against the
deferred tax assets.





FASB ASC
740-10-25-10 Definition of
Settlement in FASB Interpretation No. 48 (Prior authoritative literatureFIN 48-1 Definition of
Settlement in FASB Interpretation No. 48 (“FIN 48-1”) issued May
2007)provides
guidance on how to determine whether a tax position is effectively settled for
the purpose of recognizing previously unrecognized tax benefits.  FASB
ASC 740-10-25-10 (FIN 48-1) is effective retroactively to January 1,
2007.  Under FASB ASC 740 (FIN 48), the impact of an uncertain tax
position taken or expected to be taken on an income tax return must be
recognized in the financial statements at the amount that is more likely than
not to be sustained upon audit by the relevant taxing authority. An uncertain
income tax position will not be recognized in the financial statements unless it
is more likely than not of being sustained. The implementation of FASB ASC 740
(FIN 48) and FASB ASC 740-10-25-10 (FIN 48-1) did not have a material impact on
the Company’s financial position, results of operations or cash
flows.





Goodwill




FASB ASC
350, Goodwill and Other
Intangible Assets (Prior authoritative literature:FASB SFAS No. 142, Goodwill and Other Intangible
Assets (“SFAS 142”)) requires that goodwill shall not be
amortized.  At a minimum, goodwill is tested for impairment, on an
annual basis by the Company, or when certain events indicate a possible
impairment, utilizing a two-step test, as described in FASB ASC 350 (SFAS
142).





The
Company’s most recent impairment analysis was performed on December 31, 2009, on
the Company’s single reporting unit.  Using the Company’s market
capitalization (based on Level 1 inputs), management determined that the
estimated fair market value substantially exceeded the company’s book value. As
of December 31, 2009, the Company’s market capitalization was $13,896,024, and
the Company’s book value was $801,642.  As of December 31, 2008, the
Company’s market capitalization was $8,651,088, and the Company’s book value was
$4,046,747.  Based on this, no impairment exists as of December 31,
2009 and 2008.  Circumstances may arise in which the Company will
perform an impairment test in addition to its annual tests.  A significant impairment could have a
material adverse affect on our financial condition and results of
operations.





New
Accounting Pronouncements:




In
October 2009, the Financial Accounting Standards Board issued Accounting
Standards Update 2009-13, “Revenue Recognition (Topic 605) Multiple-Deliverable
Revenue Arrangements, a consensus of the FASB Emerging Issues Task Force (“ASU
2009-13”).  ASU 2009-13 amends existing accounting guidance for
separating consideration in multiple-deliverable arrangements.  ASU
2009-13 establishes a selling price hierarchy for determining the selling price
of a deliverable.  The selling price used for each deliverable will be
based on vendor-specific objective evidence if available, third-party evidence
if vendor-specific evidence is not available, or estimated selling price if
neither vendor-specific evidence nor third-party evidence is
available.  ASU 2009-13 eliminates residual method of allocation and
requires that arrangement consideration be allocated at the inception of the
arrangement to all deliverables using the “relative selling price
method.”  The relative selling price method allocates any discount in
the arrangement proportionately to each deliverable on the basis of each
deliverable’s selling price.  ASU 2009-13 requires that a vendor
determine its best estimate of selling price in a manner that is consistent with
that used to determine the price to sell the deliverable on a stand-alone
basis.  ASU 2009-13 is effective prospectively for revenue
arrangements entered into or materially modified in fiscal years beginning on or
after June 15, 2010, with earlier adoption permitted.  We do not
believe the adoption of ASU 2009-13 will have any material impact on our
financial statements.




22




In
January 2010, the FASB issued accounting standards update (ASU) No. 2010-06,
Fair Value Measurements and Disclosures (Topic 820)—Improving Disclosures about
Fair Value Measurements (ASU No. 2010-06). ASU No. 2010-06 requires: (1) fair
value disclosures of assets and liabilities by class; (2) disclosures about
significant transfers in and out of Levels 1 and 2 on the fair value hierarchy,
in addition to Level 3; (3) purchases, sales, issuances and settlements be
disclosed on gross basis on the reconciliation of beginning and ending balances
of Level 3 assets and liabilities; and (4) disclosures about valuation methods
and inputs used to measure the fair value of Level 2 assets and liabilities. ASU
No. 2010-06 becomes effective for the first financial reporting period beginning
after December 15, 2009, except for disclosures about purchases, sales,
issuances and settlements of Level 3 assets and liabilities which will be
effective for fiscal years beginning after December 15, 2010. We are currently
assessing what impact, if any, ASU No. 2010-06 will have on our fair value
disclosures; however, we do not believe the adoption of the guidance provided in
this codification update to have a material impact on our financial
statements.





Item
      7A.
            Quantitative
      and Qualitative Disclosures About Market
Risk





We are a
“smaller reporting company” as defined by Regulation S-K and as such, are not
providing the information contained in this item pursuant to Regulation
S-K.




Item
      8.
            Financial
      Statements and Supplementary Data.





The
financial statements of the Company and the notes related to the financial
statements, together with the independent registered public accounting firms’
reports thereon, are set forth beginning on pages F-1 of this
report.




Item
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure.





None





Item
      9A.
            Controls
      and Procedures.




(a)
Evaluation of Disclosure Controls and Procedures.




Under the
supervision and with the participation of its Chief Executive Officer and Chief
Financial Officer, management has evaluated the effectiveness of the Company’s
disclosure controls and procedures as of the end of the period covered by this
report pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934 (the
Exchange Act).  Based on that evaluation, the Chief Executive Officer,
and Chief Financial Officer have concluded that, as of the end of the period
covered by this report, due to the material weakness in financial reporting, the
Company’s disclosure controls and procedures are not effective in ensuring that
information required to be disclosed in the Company’s Exchange Act reports is
(1) recorded, processed, summarized and reported in a timely manner, and (2)
accumulated and communicated to the Company’s management, including its Chief
Executive Officer, and Chief Financial Officer, as appropriate to allow timely
decisions regarding required disclosure.




(b)
Changes in Internal Control Over Financial Reporting.





During
the quarter ended December 31, 2009, there were no significant changes in the
Company’s internal controls or in other factors that could materially affect
these controls subsequent to the date of their evaluation; however management
determined that there were material weaknesses in the Company’s internal
controls as of December 31, 2009. Accordingly, corrective actions were
required.





(c)
Management’s Report on Internal Control Over Financial Reporting




Our Chief
Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), are responsible
for establishing and maintaining adequate internal control over financial
reporting, as such term is defined in Rule 13a-15(f) of the Securities Exchange
Act of 1934, as amended (the “Exchange Act”).




Internal
control over financial reporting is promulgated under the Exchange Act as a
process designed by, or under the supervision of, our CEO and CFO and effected
by our board of directors, management and other personnel, to provide reasonable
assurance regarding the reliability of financial reporting and the preparation
of financial statements for external purposes in accordance with generally
accepted accounting principles and includes those policies and procedures
that:




•
            Pertain
      to the maintenance of records that in reasonable detail accurately and
      fairly reflect the transactions and dispositions of our
      assets;




23




•
            Provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with generally accepted
      accounting principles, and that our receipts and expenditures are being
      made only in accordance with authorizations of our management and
      directors; and




•
            Provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition or disposition of our assets that could have a
      material effect on the financial
statements.




Readers
are cautioned that internal control over financial reporting, no matter how well
designed, has inherent limitations and may not prevent or detect
misstatements.  Therefore, even effective internal control over
financial reporting can only provide reasonable assurance with respect to the
financial statement preparation and presentation.




Our
management, under the supervision and with the participation of our CEO and CFO,
has evaluated the effectiveness of our internal controls over financial
reporting as defined in Exchange Act Rules 13a-15(f) and15d-15(f) as of the end
of the period covered by this Report based upon the framework in Internal
Control—Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission (COSO).  Based on such evaluation, our
management concluded that there were material weaknesses in internal controls
over financial reporting and has made an assessment that our internal control
over financial reporting is not effective as of December 31, 2009.




A
“material weakness” is defined as a significant deficiency or combination of
significant deficiencies that results in more than a remote likelihood that a
material misstatement of the annual or interim financial statements will not be
prevented or detected.  A “significant deficiency” is defined as a
control deficiency, or combination of control deficiencies, that adversely
affects the Company’s ability to initiate, authorize, record, process, or report
external financial information reliably in accordance with generally accepted
accounting principles such that there is more than a remote likelihood that a
misstatement of the Company’s annual or interim financial statements that is
more than inconsequential will not be prevented or detected.




Management
identified the following material weaknesses in the Company’s internal control
over financial reporting as of December 31, 2009:




•
            As
      of December 31, 2009, there was a material internal control weakness in
      the Company’s determination of the fair values of its warrant
      liability.  This was identified as a result of errors identified
      in the Company’s warrant valuation model.  The Company
      calculated its warrant values utilizing an estimated volatility
      rate.  During the audit for the year ended December 31, 2009,
      the Company’s independent registered accounting firm determined that the
      estimated volatility rate the Company used was
      incorrect.   The Company reviewed and revised its estimated
      volatility rate and warrant valuation model, which resulted in material
      differences in the Company’s warrant liability and related fair market
      value adjustments on warrant liability for the year ended December 31,
      2009.  The Company determined that the error was not material to
      prior quarters.  The Company has elected to provide corrected
      unaudited quarterly financial data presented in Note 18 to the Financial
      Statements, beginning on page F-31 of this
  report.




•
            As
      of December 31, 2009, there was a material internal control weakness in
      the Company’s accounting for deferred income taxes.  This was
      identified as a result of errors identified during the audit in the
      Company’s tax provision.  Previously, the Company did not
      recognize a deferred tax liability related to its amortization of goodwill
      for tax purposes.  The Company reviewed and revised its tax
      provision to include this deferred tax liability as of January 1, 2009 and
      for the year ended December 31, 2009.  The Company determined
      that the error was not material to prior years.  The corrected
      unaudited quarterly financial data presented in Note 18 to the Financial
      Statements, beginning on page F-31 of this report has also been corrected
      for this matter.




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




Item
      9B.
            Other
      Information.





None.




24




PART III




Item
      10.
            Directors,
      Executive Officers, and Corporate
Governance.




INFORMATION
ABOUT THE COMPANY'S EXECUTIVE OFFICERS AND DIRECTORS





The
following table lists the current executive officers and directors and, in the
case of directors, their length of service on the board. Each director is
elected to hold office for a term expiring at the first annual meeting of
stockholders held following such director's election and until his successor has
been elected and qualified, or until his prior resignation or removal. All of
the Company's current directors were either appointed by the plurality of votes
cast by the holders of our common stock present, or represented, at the 2009
Annual Meeting of the Stockholders in July 2009, or elected by the board. On March
29, 2010, Gregory Curhan resignedfrom the Board of
Directors. Mr. Curhan’s resignation is not as a result of any
disagreement with the Company on any matter relating to the Company’s
operations, policies or practices.




Name
            
            Age
            
            Director
      Since
            
            PositionSteven
      Z. Strasser
            
            61
            
            2002
            
            Chairman,
      Chief Executive OfficerJohn
      (BJ) Lackland
            
            39
            
            2002
            
            Director,
      Chief Financial Officer, and SecretaryGeorge
      Boyadjieff
            
            71
            
            2006
            
            Director,
      Senior Technical AdvisorDouglas
      M. Dunn
            
            67
            
            2006
            
            DirectorRichard
      Morgan
            
            64
            
            2007
            
            DirectorGary
      Rado
            
            70
            
            2005
            
            DirectorKenneth
      Dickey
            
            68
            
            2009
            
            Director,
      Consultant




Director
Independence




Pursuant
to SEC rules, a majority of our Board of Directors is comprised of independent
directors, as defined under Section 121(A) of the New York Stock Exchange
Constitution and Rules.  Messrs. Boyadjieff, Dickey, Dunn, Morgan and
Rado are independent directors.  Our audit committee is comprised of
Messrs. Dunn, Morgan and Rado; and our compensation committee is comprised of
Messrs. Boyadjieff, Dickey and Rado, all of whom are independent
directors.




Steven Strasser – Chairman and
Chief Executive Officer. Prior to becoming the Company’s CEO in October 2004,
Mr. Strasser was the Managing Director, founder and majority owner of Summit
Energy Ventures LLC, currently the largest stockholder in Power Efficiency
Corporation. Summit is a private equity firm focused on investments in companies
with energy efficiency technologies. At Summit, Mr. Strasser spent four years,
from 2001 through 2005, evaluating and investing in energy technology companies
and serving on the boards of portfolio companies. Mr. Strasser has been a
director since August 2002.




From 1984
through 2000, Mr. Strasser was the founder and CEO of Northwest Power
Enterprises. Over its seventeen-year history, Northwest Power Enterprises and
its predecessor companies were involved in multiple aspects of the energy
development business.  Mr. Strasser received law degrees from McGill
University, Montreal, Canada and the University of Washington, Seattle,
Washington.




John (BJ) Lackland
–Director, Chief Financial Officer, and Secretary. Mr. Lackland
became the Company’s CFO in October 2004. Mr. Lackland has been the Vice
President and Director Summit Energy Ventures since 2001, a private equity firm
that is the largest stockholder in Power Efficiency Corporation. Summit focuses
on investments in companies with energy efficiency technologies. At Summit, Mr.
Lackland evaluated and invested in energy technology companies and served on the
boards of portfolio companies. Prior to joining Summit, Mr. Lackland was
the Director of Strategic Relations at Encompass Globalization, where he was in
charge of strategic alliances and mergers and acquisitions. Prior to Encompass,
he was the Director of Strategic Planning and Corporate Development at an
Internet business development consulting company, where he was in charge of
strategic planning and investor relations. Mr. Lackland has been an
independent consultant to Fortune 1,000 companies and startups.
Mr. Lackland also worked at The National Bureau of Asian Research, an
internationally acclaimed research company focusing on U.S. policy toward Asia,
where he led economic and political research projects for Microsoft, Dell,
Compaq and U.S. government agencies. Mr. Lackland has been a director since
August 2002.




25




Mr. Lackland
earned an M.B.A. from the University of Washington Business School, an M.A. in
International Studies (Asian Studies) from the University of Washington’s
Jackson School of International Studies, and a B.A. in Politics, Philosophy and
Economics from Claremont McKenna College.




George Boyadjieff— Director and Senior
Technical Advisor. Mr. Boyadjieff has been a director of the Company since May
2006, and Senior Technical Advisor of the Company since April 2005. Mr.
Boyadjieff is the retired CEO of the former Varco International, a New York
Stock Exchange traded oil service company with over $1.3 billion in annual
revenues at the time of Mr. Boyadjieff’s retirement. Varco has recently merged
with National Oil Well to become National Oil Well Varco (NOV). Mr. Boyadjieff
joined Varco in 1969 as Chief Engineer and was appointed CEO in 1991. Currently
Mr. Boyadjieff is a director of Southwall Technologies, a Silicon Valley hi-tech
firm. Mr. Boyadjieff joined Southwall in December 2004.




Mr.
Boyadjieff holds over 50 US patents related to oil and gas well drilling
equipment. Mr. Boyadjieff holds BS and MS degrees in Mechanical Engineering from
the University of California at Berkeley and is a graduate of the University of
California at Irvine executive program.




Dr. Douglas Dunn — Dr. Dunn
has had an extensive career in research, business and academic leadership. Dr.
Dunn served as dean of Carnegie Mellon University's Graduate School of
Industrial Administration (now the Tepper School of Business) from July 1996
through June 2002, after which he retired. He began his career at AT&T Bell
Laboratories, and his corporate experienced culminated in senior positions as a
corporate officer leading Federal Regulatory Matters, Regional Government
Affairs, and Visual Communications and Multimedia Strategy for AT&T. Dr.
Dunn is a board member of Universal Stainless & Alloy Products, Inc.
(NasdaqNM: USAP). He holds a Ph.D. in business from the University of Michigan,
an MS in industrial management and a BS in physics from the Georgia Institute of
Technology.




Richard Morgan – Mr.
Morgan is currently Of Counsel to the law firm of Lionel, Sawyer & Collins,
and is the Dean Emeritus and a former Professor of Law at the William S. Boyd
School of Law at the University of Nevada, Las Vegas, a position he held from
September 1, 1997 through June 30, 2007. Mr. Morgan is an experienced legal
educator, having served as dean at both the Arizona State University College of
Law and the University of Wyoming College of Law. Mr. Morgan earned his B.A. in
Political Science at the University of California, Berkeley in 1967. In 1971 he
received his J.D. from UCLA, where he was an editor of the UCLA Law Review. He
practiced with the Los Angeles law firm of Nossaman, Krueger & Marsh in the
corporate/securities areas from 1971 to 1980. He was a professor at the Arizona
State University College of Law from 1980 to 1987 and served as associate dean
from 1983 to 1987. He was dean at the University of Wyoming College of Law from
1987 to 1990 and returned to the Arizona State University College of Law in
1990, where he served as dean and professor of law until 1997.




Gary Rado– Mr. Rado retired
in 2002 after being the President of Casio Inc. USA for 3 years. He joined Casio
in 1996 as an EVP to spearhead the move into the digital camera
business.  Before joining Casio, Mr. Rado was with Texas Instruments
Inc. for 21 years.   He was the Division Manager of the Consumer
Products Division Worldwide and ran the division for 7 years, including two
years while based in Europe. This division was responsible for home computer,
calculator, and educational products.  Mr. Rado earned a Bachelors of
Science in Business Administration from Concord College in 1963.




Kenneth Dickey– Mr. Dickey is
the co-founder of The Institute of Strategic Mapping, and has spent his
extensive career learning how superior results can be achieved from very average
businesses and how to translate this winning process into an understandable,
reusable format.  Mr. Dickey has been retired since February
2002.  From October 1999 to February 2002, Mr. Dickey was Vice
President Sales-Marketing for Safetronics, where he developed sales and
marketing strategies, completed Safetronic’s acquisition of Fincor Electric, a
manufacturer of variable frequency drives, and ran that business
unit.  Prior to this, Mr. Dickey was the President/CEO of Cleveland
Motion Control, Dynact Inc., and Motion Science, Inc., from February 1997 to
October 1999.  Prior to this, Mr. Dickey served as Senior Vice-President
Sales for Reliance Electric/Rockwell Automation from 1994 thru 1996. His
responsibilities included Sales/Marketing with 76 sales offices (located in the
Americas), which generated more than $900 million in revenue. He also spent 9
years as the Operating General Manager of the Industrial Motor Division at
Reliance Electric from 1986 to 1994.  Mr. Dickey earned his Bachelor of
Science degree in Finance from the University of Akron and an Executive MBA from
Case-Western Reserve University.




f


Board
of Directors and Committees of the Board





Our
business affairs are conducted under the direction of our board of
directors.  The role of our board of directors is to effectively
govern our affairs for the benefit of our stockholders and, to the extent
appropriate under governing law, of other constituencies, which include our
employees, customers, suppliers and creditors.  Our board strives to
ensure the success and continuity of our business through the selection of a
qualified management team.  It is also responsible for ensuring that
our activities are conducted in a responsible ethical manner.  Our
board of directors has two standing committees – an audit committee and a
compensation committee.




26




Our board
of directors met eight times in 2009.




We do not
have a policy that requires directors to attend our annual meetings of
stockholders.  All but one of the directors attended the 2009 Meeting
of Stockholders on July 16, 2009.




Audit
Committee




Douglas
Dunn, Richard Morgan and Gary Rado currently serve on our audit
committee.  Messrs. Dunn, Morgan and Rado are each independent
directors as required by Section 301 of the Sarbanes-Oxley Act of 2002, Rule
10A(3)(b)(1) of the Securities Exchange Act of 1934 and Section 121(A) of the
New York Stock Exchange Constitution and Rules.  Raymond Skiptunis
served as the Chairman of our audit committee from January 1 through April 20,
2009.  Dr. Dunn, the current Chairman of our audit committee,
qualifies as a financial expert.  Our audit committee, among other
things:




•
            selects
      the independent auditors, considering independence and
      effectiveness;




•
            receives
      the written disclosures and the letter from the independent accountant
      required by applicable requirements of the Public Company Accounting
      Oversight Board regarding the independent accountant's communications with
      the audit committee concerning independence, and has discussed with the
      independent accountant the independent accountant's
      independence;




•
            discusses
      the scope and results of the audit with the independent auditors and
      reviews with management and the independent auditors our interim and
      year-end operating results;




•
            discusses
      with the independent accountant the matters required to be discussed by
      Statement on Auditing Standards No. 114 (Communications with Audit
      Committees);




•
            considers
      the adequacy of our internal accounting controls and audit
      procedures;




•
            reviews
      and approves all audit and non-audit services to be performed by the
      independent auditors; and




•
            administers
      the whistleblower policy.




The audit
committee has the sole and direct responsibility for appointing, evaluating and
retaining our independent auditors and for overseeing their work.




Compensation
Committee




Kenneth
Dickey, Gary Rado and George Boyadjieff currently serve on our compensation
committee.  Messrs. Dickey, Rado and Boyadjieff are independent
directors as required by SEC Rules and as defined in Section 121(A) of the
American Stock Exchange Constitution and Rules.  Mr. Dickey serves as
the Chairman of our compensation committee.  Our compensation
committee, among other things:




•
              recommends
      to the board of directors the compensation level of the executive
      officers;




•
            reviews
      and makes recommendations to our board of directors with respect to our
      equity incentive plans;




•
            establishes
      and reviews general policies relating to compensation and benefits of our
      employees.




Committee
Interlocks and Insider Participation





None of
our executive officers currently serve as a member of the board of directors or
compensation committee of any entity that has one or more executive officers
serving on our board of directors or compensation committee.




27




SECTION
16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE





Section
16 of the Securities Exchange Act of 1934, as amended, requires that all
executive officers and directors of the Company and all persons who beneficially
own more than ten percent of the Company's common stock file an initial report
of their ownership of the Company's securities on Form 3 and report changes in
their ownership of the Company's securities on Form 4 or Form 5. These filings
must be made with the Securities and Exchange Commission and the National
Association of Securities Dealers with a copy sent to the Company.  To
our knowledge, all executive officers, directors and all persons who
beneficially own more than ten percent of the Company’s common stock have timely
filed these filings.





CODE
OF CONDUCT





The
Company adopted a code of conduct on August 8, 2008.  In early 2006,
the Company developed and implemented an official Employee Manual that requires
ethical behavior from its employees, and defines the consequences of unethical
behavior by its employees.





Item
      11.
            Executive
      Compensation.




Summary Compensation Table




The
following table summarizes compensation information for the last two fiscal
years for (i) Mr. Steven Z. Strasser, our Principal Executive Officer and (ii)
John (BJ) Lackland, our Principal Financial Officer, who were serving as
executive officers at the end of the fiscal year and who we refer to
collectively, the Named Executive Officers.





SUMMARY
      COMPENSATION TABLEName
      and principal position
            
            Year
            
            Salary
      ($)
            
            
            Bonus
      ($)
            
            
            Stock
      Awards ($)
            
            
            Option
      Awards ($)
            
            
            Non-Equity
      Incentive Plan Compensation ($)
            
            
            Nonqualified
      Deferred Compensation Earnings ($)
            
            
            All
      Other Compensation ($)
            
            
            Total
      ($)Steven
      Z. Strasser(1)
            
            2009
            
            $
            304,730
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            304,730Chairman
      and Chief
            
            2008
            
            $
            311,208
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            311,208Executive
      OfficerJohn
      (BJ) Lackland (2)
            
            2009
            
            $
            177,037
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            177,037Director
      and Chief
            
            2008
            
            $
            198,042
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            198,042Financial
      Officer
            
            
            
            
            
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -




Narrative
Disclosure to Summary Compensation Table




During
2004, we hired the following officers: Steven Strasser, Chief Executive Officer,
and John (BJ) Lackland, Chief Financial Officer. Effective June 1, 2005, the
Company entered into employment agreements with the above
officers.  These two individuals comprise our current executive
officers.  The term of each agreement is five years.  In the
event of a defined change in control of the Company, each agreement will provide
for accelerated vesting of stock options and a cash severance payment equal to
2.99 times the executive's then current salary and previous year's
bonus.




The
following table sets forth the material financial terms of the agreements for
each of our executives as of December 31, 2009:




Name
            
            Salary
      (1)
            
            Bonus(4)
            
            Common
      Stock Options(5)Steven
      Strasser
            
            $
            275,000
            (2)
            
            
            
            3,000,000BJ
      Lackland
            
            $
            175,000
            (3)
            
            
            
            1,800,000





(1)
            To
      be increased annually by at least 5% of current year’s base
      salary.




28




(2)
            First
      year's salary to be paid $60,000 in cash and options to purchase 1,612,500
      shares of Common Stock at an exercise price equal to not less than market
      at date of grant in lieu of remaining cash vesting quarterly over one
      year.




(3)
            First
      year's salary to be paid $120,000 in cash and options to purchase 412,500
      shares of Common Stock at an exercise price equal to market at date of
      grant in lieu of remaining cash vesting quarterly over one
      year.




(4)
            At
      the discretion of the disinterested members of the
  Board.




(5)
            Vesting
      evenly and quarterly over five
years.




Outstanding
equity awards




OUTSTANDING
      EQUITY AWARDS AT FISCAL YEAR-ENDOPTION
      AWARDS
            
            STOCK
      AWARDSName
            
            Number
      of Securities Underlying Unexercised Options (#)
              Exercisable
            
            
            Number
      of Securities Underlying Unexercised Options
              (#)
              Unexercisable
            
            
            Equity
      Incentive Plan Awards: Number of Securities Underlying Unexercised
      Unearned Options
              (#)
            
            
            Option
      Exercise Price
              ($)
            
            Option
      Expiration Date
            
            Number
      of Shares or Units of Stock That Have Not Vested
              (#)
            
            
            Market
      Value of Shares or Units of Stock That Have Not Vested
              ($)
            
            
            Equity
      Incentive Plan Awards: Number of Unearned Shares, Units or Other Rights
      That Have Not Vested
              (#)
            
            
            Equity
      Incentive Plan Awards: Market or Payout Value of Unearned Shares, Units or
      Other Rights That Have Not Vested
              (#)Steven
      Strasser
            
            
            2,272,729
            
            
            
            300,000
            
            
            
            -
            
            
            $
            0.22
            
            5/31/2010
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -2,039,771
            
            
            
            -
            
            
            
            -
            
            
            $
            0.20
            
            5/31/2015
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -600,000
            
            
            
            -
            
            
            
            -
            
            
            $
            0.65
            
            11/28/2014
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -BJ
      Lackland
            
            
            2,032,500
            
            
            
            180,000
            
            
            
            -
            
            
            $
            0.20
            
            5/31/2015
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -375,000
            
            
            
            -
            
            
            
            -
            
            
            $
            0.65
            
            11/28/2014
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -





Stock
Option Plan Narrative Disclosure




As of
December 31, 2009, we had an aggregate of 17,474,896 shares of Common Stock
available for issuance under our stock plans. The following is a description of
our plans.




2000
Stock Option and Restricted Stock Plan, or the 2000 Plan




The 2000
Plan was adopted by our board of directors and our stockholders in
2000.  On July 16, 2009, the 2000 Plan was amended and restated. As of
December 31, 2009, no restricted shares of Common Stock have been issued, and
117,871 of the outstanding options to purchase shares of our Common Stock have
been exercised pursuant to the 2000 Plan.  There are 17,474,896
options outstanding under the 2000 Plan as of December 31, 2009.




Share
Reserve.  Under the 2000 Plan, we have initially reserved for
issuance an aggregate of 25,000,000 shares.




Administration.  The
2000 Plan is administered by the board of directors. The stock option awards
qualify as "performance-based-compensation" within the meaning of
Section 162(m) of the Internal Revenue Code of 1986, or the Code, with two
or more outside directors within the meaning of Section 162(m) of the Code. The
board of directors has the power to determine the terms of the awards, including
the exercise price, the number of shares subject to each award, the
exercisability of the awards and the form of consideration payable upon
exercise.




Eligibility.  Awards
under the 2000 Plan may be granted to any of our employees, directors or
consultants or those of our affiliates.




29




Options.  With
respect to non-statutory stock options intended to qualify as "performance-based
compensation" within the meaning of Section 162(m) of the Code and incentive
stock options, the exercise price must be at least equal to the fair market
value of our Common Stock on the date of grant.  In addition, the
exercise price for any incentive stock option granted to any employee owning
more than 10% of our Common Stock may not be less than 110% of the fair market
value of our Common Stock on the date of grant.  The term of any stock
option may not exceed ten years, except that with respect to any participant who
owns 10% or more of the voting power of all classes of our outstanding capital
stock, the term for incentive stock options must not exceed five
years.




Stock Awards.  The
administrator may determine the number of shares to be granted and impose
whatever conditions to vesting it determines to be appropriate, including
performance criteria.  The criteria may be based on financial
performance, personal performance evaluations and/or completion of service by
the participant.  The administrator will determine the level of
achievement of performance criteria.  Unless the administrator
determines otherwise, shares that do not vest typically will be subject to
forfeiture or to our right of repurchase, which we may exercise upon the
voluntary or involuntary termination of the participant's service with us for
any reason, including death or disability.




Adjustments upon Merger or Change in
Control.  The 2000 Plan provides that in the event of a merger
with or into another corporation or a "change in control," including the sale of
all or substantially all of our assets, and certain other events, our board of
directors (or a committee of the board of directors) may, in its discretion,
provide for some or all of:




·
            assumption
      or substitution of, or adjustment to, each outstanding
    award;




·
            acceleration
      of the vesting of options and stock appreciation
  rights;




·
            termination
      of any restrictions on stock awards or cash awards;
  or




·
            cancellation
      of awards in exchange for a cash payment to the
    participant.




Amendment and
Termination.  The board of directors has the authority to
amend, alter or discontinue the 2000 Plan, subject to the approval of the
stockholders, but no amendment will impair the rights of any award, unless
mutually agreed to between the participant and the administrator.




Compensation
of Directors Summary Table





DIRECTOR
      COMPENSATIONName
              (a)
            
            Fees
      Earned or Paid in Cash
              ($)
            
            
            Stock
      Awards ($)
            
            
            Option
      Awards ($)***
            
            
            Non-Equity
      Incentive
              Plan
      Compensation
              ($)
            
            
            Non-Qualified
      Deferred Compensation Earnings
              ($)
            
            
            All
              Other
      Compensation ($)
            
            
            Total
      ($)Raymond
      J. Skiptunis*
            
            $
            4,000
            
            
            
            -
            
            
            $
            8,250
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            12,250George
      Boyadjieff
            
            
            -
            
            
            
            -
            
            
            $
            11,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            11,000Douglas
      M. Dunn
            
            
            -
            
            
            
            -
            
            
            $
            13,750
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            13,750Richard
      Morgan
            
            
            -
            
            
            
            -
            
            
            $
            11,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            11,000Gary
      Rado
            
            
            -
            
            
            
            -
            
            
            $
            13,750
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            13,750Greg
      Curhan**
            
            
            -
            
            
            
            -
            
            
            $
            11,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            11,000Kenneth
      Dickey
            
            
            -
            
            
            
            -
            
            
            $
            17,250
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            17,250





*
            Mr.
      Skiptunis resigned from the Board of Directors on April 20,
      2009.




**
            Mr.
      Curhan resigned from the Board of Directors on March 29,
    2010.




**
            Aggregate
      fair value as of date of grant.





Narrative
to Director Compensation





In January 2009, non-employee directors
received options to purchase 100,000 shares of common stock per year for their
board service, pro-rated for the quarters in the year they
served.  Employee directors do not receive compensation for serving on
the board of directors.  The Chairman of the Audit Committee received
an additional 50,000 options per year, pro-rated for the quarters in the year he
served, and $1,000 per month for the months in the year he
served.  This cash payment ended when Mr. Skiptunis resigned as
Chairman.  The remaining members of the audit committee receive an
additional 25,000, prorated for the quarters in the year they
served.  Depending on the anticipated workload and organization, the
board of directors may elect to increase the compensation for committee members
and/or all non-executive board members.




30




Limitation
of Liability and Indemnification of Directors and Officers




Our
certificate of incorporation provides that the personal liability of our
directors shall be limited to the fullest extent permitted by the provisions of
Section 102(b)(7) of the General Corporation Law of the State of Delaware,
or the DGCL. Section 102(b)(7) of the DGCL generally provides that no
director shall be liable personally to us or our stockholders for monetary
damages for breach of fiduciary duty as a director, provided that our
certificate of incorporation does not eliminate the liability of a director for
(i) any breach of the director's duty of loyalty to us or our stockholders;
(ii) acts or omissions not in good faith or that involve intentional
misconduct or a knowing violation of law; (iii) acts or omissions in
respect of certain unlawful dividend payments or stock redemptions or
repurchases; or (iv) any transaction from which such director derives
improper personal benefit. The effect of this provision is to eliminate our
rights and the rights of our stockholders through stockholders' derivative suits
on our behalf, to recover monetary damages against a director for breach of her
or his fiduciary duty of care as a director including breaches resulting from
negligent or grossly negligent behavior except in the situations described in
clauses (i) through (iv) above. The limitations summarized above,
however, do not affect our or our stockholders' ability to seek non-monetary
remedies, such as an injunction or rescission, against a director for breach of
her or his fiduciary duty.




In
addition, our certificate of incorporation and bylaws provide that we shall, to
the fullest extent permitted by Section 145 of the DGCL, indemnify all
directors and officers who we may indemnify pursuant to Section 145 of the
DGCL. Section 145 of the DGCL permits a company to indemnify an officer or
director who was or is a party or is threatened to be made a party to any
proceeding because of his or her position, if the officer or director acted in
good faith and in a manner he or she reasonably believed to be in or not opposed
to the best interests of such company and, with respect to any criminal action
or proceeding, had no reasonable cause to believe his or her conduct was
unlawful. We have entered into indemnification agreements with our directors and
officers consistent with indemnification to the fullest extent permitted under
the DGCL.




We
maintain a directors' and officers' liability insurance policy covering certain
liabilities that may be incurred by our directors and officers in connection
with the performance of their duties. The entire premium for such insurance is
paid by us.




Insofar
as indemnification for liabilities arising under the Securities Act, our
directors and officers, and persons controlling us pursuant to the foregoing
provisions, we have been informed that in the opinion of the SEC, such
indemnification is against public policy as expressed in the Securities Act and
is therefore unenforceable.




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





STOCK
OWNERSHIP





The
following table sets forth information as to our shares of common stock
beneficially owned as of March 31, 2010by (i) each person known
by us to be the beneficial owner of more than five percent of our outstanding
common stock, (ii) each of our directors, (iii) each of our executive officers
named in the Summary Compensation Table and (iv) all of our directors and
executive officers as a group.




Name
      of
            
            
            
            
            Percent
      ofTitle
      of Class
            
            Beneficial
      Owner(1)
            
            Shares
      Owned
            
            
            Shares
      Owned(10)Common
      Stock
            
            Steven
      Strasser, CEO, Chairman of the Board
            
            
            23,974,575
            (2)
            
            
            40.75
            %Common
      Stock
            
            John
      (BJ) Lackland, CFO, Director
            
            
            2,886,026
            (3)
            
            
            6.07
            %Common
      Stock
            
            Gary
      Rado, Director
            
            
            867,303
            (4)
            
            
            1.90
            %Common
      Stock
            
            George
      Boyadjieff, Director
            
            
            3,472,105
            (5)
            
            
            7.36
            %Common
      Stock
            
            Douglas
      Dunn, Director
            
            
            743,026
            (6)
            
            
            1.63
            %Common
      Stock
            
            Richard
      Morgan, Director
            
            
            325,000
            (7)
            
            Less
      than 1
            %Common
      Stock
            
            Greg
      Curhan, Director
            
            
            125,000
            (8)
            
            Less
      than 1
            %Common
      Stock
            
            Kenneth
      Dickey, Director
            
            
            471,074
            (9)
            
            
            1.04
            %Common
      Stock
            
            Summit
      Energy Ventures, LLC
            
            
            8,803,901
            (2)
            
            
            18.80
            %Common
      Stock
            
            Sarkowsky
      Family L.P.
            
            
            9,118,455
            
            
            
            18.32
            %Common
      Stock
            
            Ron
      Boyer
            
            
            12,851,558
            
            
            
            23.36
            %Common
      Stock
            
            Michael
      J. Goldfarb Enterprises
            
            
            3,213,685
            
            
            
            6.84
            %Common
      Stock
            
            Byron
      LeBow Family Trust
            
            
            4,558,620
            
            
            
            9.47
            %Common
      Stock
            
            Marathon
      Hard Asset Fund L.P.
            
            
            5,289,370
            
            
            
            10.98
            %Common
      Stock
            
            Irwin
      Helford Family Trust
            
            
            3,341,424
            
            
            
            7.10
            %Common
      Stock
            
            All
      Executive Officers and Directors as a Group (8 persons)
            
            
            32,864,109
            
            
            
            49.56
            %







(1)
            Information
      in this table regarding directors and executive officers is based on
      information provided by them.  Unless otherwise indicated in the
      footnotes and subject to community property laws where applicable, each of
      the directors and executive officers has sole voting and/or investment
      power with respect to such shares.  The address for each of the
      persons reported in the table other than Commerce Energy Group is in care
      of Power Efficiency Corporation at 3960 Howard Hughes Pkwy, Ste 460, Las
      Vegas, Nevada 89169.




31




(2)
            Includes
      9,968,910 common shares and common shares subject to options and warrants
      exercisable within 60 days of the date hereof held by Summit, in which
      Steven Strasser is one of two members, 2,010,000 common shares subject to
      the conversion of 20,100 shares of Series B Preferred Stock, 1,083,334
      common shares subject to the conversion of 8,125 shares of Series C-1
      Preferred Stock, and 10,912,331 common shares subject to options and
      warrants which are presently exercisable or will become exercisable within
      60 days of the date hereof.  Mr. Strasser was also granted
      an additional 150,000 common shares subject to options which will become
      exercisable after 60 days of the date hereof.  Mr. Strasser’s
      options and warrants expire on various dates from May, 2010 through
      November, 2015.




(3)
            Includes
      188,526 common shares, 100,000 common shares subject to the conversion of
      1,000 shares of Series B Preferred Stock, and 2,597,500 common shares and
      common shares subject to options and warrants presently exercisable or
      will become exercisable within 60 days of the date hereof.  Mr.
      Lackland was also granted an additional 90,000 common shares subject to
      options which will become exercisable after 60 days of the date
      hereof.  Mr. Lackland’s options and warrants expire on various
      dates from May, 2010 through November,
2015.




(4)
            Includes
      61,053 common shares, 200,000 common shares subject to the conversion of
      2,000 shares of Series B Preferred Stock, and 606,250 common shares
      subject to options presently exercisable or will become exercisable within
      60 days of the date hereof.  Mr. Rado was also granted an
      additional 93,750 common shares subject to options which will become
      exercisable after 60 days of the date hereof.  Mr. Rado’s
      options expire on various dates from September, 2015 through February,
      2020.




(5)
            Includes
      1,122,105 common shares, 400,000 common shares subject to the conversion
      of 4,000 shares of Series B Preferred Stock, and 1,950,000 common shares
      subject to options and warrants presently exercisable or will become
      exercisable within 60 days of the date hereof.  Mr. Boyadjieff
      was also granted an additional 75,000 common shares subject to options
      which will become exercisable after 60 days of the date
      hereof.  Mr. Boyadjieff’s options and warrants expire on various
      dates from April, 2010 through February,
2020.




(6)
            Includes
      30,526 common shares, 100,000 common shares subject to the conversion of
      1,000 shares of Series B Preferred Stock, and 612,500 common shares
      subject to options presently exercisable or which will become exercisable
      within 60 days of the date hereof.  Dr. Dunn was also granted an
      additional 112,500 shares of common stock subject to options which will
      become exercisable after 60 days of the date hereof.  Dr. Dunn’s
      options expire on various dates from May 2016 through February,
      2020.




(7)
            Includes
      325,000 common shares subject to options presently exercisable or which
      will become exercisable within 60 days of the date hereof.  Mr.
      Morgan was also granted an additional 75,000 common shares subject to
      options exercisable after 60 days of the date hereof.  Mr.
      Morgan’s options expire on various dates from January, 2017 through
      February, 2020.




(8)
            Includes
      125,000 common shares subject to options presently exercisable or which
      will become exercisable within 60 days of the date hereof.  Mr.
      Curhan was also granted an additional 75,000 common shares subject to
      options exercisable after 60 days of the date hereof.  Mr.
      Curhan’s options expire on various dates from March, 2019 through
      February, 2020.




(9)
            Includes
      4,407 common shares, 166,667 common shares subject to the conversion of
      1,250 shares of Series C-1 Preferred Stock, 300,000 common shares subject
      to options and warrants presently exercisable or which will become
      exercisable within 60 days of the date hereof.  Mr. Dickey was
      also granted an additional 75,000 common shares subject to options
      exercisable after 60 days of the date hereof.  Mr. Dickey’s
      options expire on various dates from February, 2012 through February,
      2020.




(10)
            The
      percentage for common stock includes all common shares subject to options
      and warrants exercisable within 60 days of the date
  hereof.





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




Relationship
with Steven Strasser and Summit




Mr.
Strasser, our CEO, owns 99.5% of Summit.  As of March 31, 2009, Summit
owned 6,803,901 shares of our common stock and 2,000,000 warrants to purchase
common stock.  In addition, Mr. Strasser owns beneficially 23,974,575
shares of common stock (including those shares beneficially owned by Summit)
issued or issuable on the exercise of options and warrants, the conversion of
Series B Preferred Stock and the conversion of Series C-1 Preferred
Stock,  exercisable within 60 days of March 31, 2009.




On March
30, 2010, the Company issued unsecured notes payable to Steven Strasser, the
Company’s CEO, totaling $125,000. The notes bear interest at 5%, payable upon
maturity. The notes mature two months after issuance.




32




On
February 24, 2010, Mr. Strasser purchased 1,875 shares of Series C-1 Preferred
Stock and 93,750 warrants to purchase the Company’s common stock for $75,000 in
cash.




On
December 11, 2009, Mr. Strasser exchanged 6,250 shares of Series C Preferred
Stock into 6,250 shares of Series C-1 Preferred Stock and 312,500 warrants to
purchase the Company’s common stock.




On
September 29, 2009, Mr. Strasser purchased 350,000 shares of common stock, 2,500
shares of Series B Preferred Stock, and 203,062 warrants to purchase the
Company’s common stock for $90,000 in cash, from another
shareholder




On August
12, 2009, Mr. Strasser purchased 6,250 shares of Series C Preferred Stock and
312,500 warrants to purchase the Company’s common stock for $250,000 in
cash




On
January 21, 2008, Mr. Strasser purchased 1,600 units, resulting in the issuance
of 1,600 shares of Series B Preferred Stock and 80,000 warrants to purchase the
Company’s common stock, for $80,000 in cash.




Relationship
with John (BJ) Lackland




Mr.
Lackland, our CFO, owns 0.5% of Summit.  Mr. Lackland owns
beneficially 2,886,026 shares of common stock, issued or issuable on the
exercise of options and warrants, and the conversion of Series B Preferred
Stock, exercisable within 60 days of December 31, 2009.




On
September 29, 2009, Mr. Lackland purchased 1,000 shares of Series B Preferred
Stock and 50,000 warrants to purchase the Company’s common stock for $15,000 in
cash, from another shareholder.




Item
      14.
            Principal
      Accountant Fees and Services.




(1) Audit
Fees.





The
aggregate fees billed in fiscal years 2009 and 2008 for professional services
rendered by the principal registered accountant for the audit of the Company's
annual financial statements and review of financial statements included in the
Company’s Form 10-K or services that are normally provided by the accountant in
connection with statutory and regulatory filings or engagements for those fiscal
years were $90,064 and $68,125, respectively.





(2)
Audit-Related Fees.





The
aggregate fees billed in fiscal years 2009 and 2008 for assurance and related
services by the principal accountant that are reasonably related to the
performance of the audit or review of the Company's financial statements and are
not reported under Item 14(1) above were $0 and $0, respectively.





(3) Tax
Fees.





The
aggregate fees billed in fiscal years 2009 and 2008 for professional services
rendered by the principal accountant for tax compliance, tax advice, and tax
planning were $5,750 and $3,250, respectively.





(4) All
Other Fees





The
aggregate fees billed in fiscal years 2009 and 2008 for products and services
provided by the principal accountant, other than the services reported in Items
14(1) through 14(3) above were $0 and $0, respectively.





(5) Audit
Committee Approval




During
fiscal year 2009 and 2008, the Audit Committee pre-approved all engagements and
fees for services the principal registered accountant provided since it was
formally formed.




33




PART IV





Item
      15.
            Exhibits.




(a) Exhibits





EXHIBIT
INDEX




Description of
Document





Exhibit
              Number
            
            Description3.1
            
            Certificate
      of Incorporation of the Company, incorporated by reference to Exhibit 3.1
      to the Company's Annual Report on Form 10-SB filed on October 20,
      2000.3.2
            
            Amendment
      to the Certificate of Incorporation of the Company dated June 5, 2002,
      incorporated by reference to Exhibit 3.1 to Company's Current Report on
      Form 8-K filed on June 18, 2002.3.3
            
            Amendment
      to the Certificate of Incorporation of the Company dated July 6, 2005,
      incorporated by reference to Exhibit 3.3 to the Company’s Form SB-2
      Registration Statement filed October 25, 2005.3.4
            
            Amendment
      to the Certificate of Incorporation of the Company dated October 13, 2005,
      incorporated by reference to Exhibit 3.4 to the Company’s Form SB-2
      Registration Statement filed October 25, 2005.3.5
            
            Amended
      and Restated By-laws of the Company dated March 23, 2004, incorporated by
      reference to Exhibit 3.1 to Company’s Quarterly Report on Form 10-QSB
      filed on May 14, 2004.3.6
            
            Certificate
      of Amendment of Certificate of Designation of Series A Convertible
      Preferred Stock of Power Efficiency Corporation, incorporated by reference
      to Exhibit 4.2 to Company's Current Report on Form 8-K filed on May 25,
      2003.




34




3.7
            
            Certificate
      of Certificate Eliminating Reference To A Series Of Shares Of Stock From
      the Certificate of Incorporation of the Company, dated October 22, 2007,
      incorporated by reference to Exhibit 3.7 to the Company’s Amendment No. 2
      to Form S-1 filed on August 29, 2008.3.8
            
            Certificate
      of Designations of Preferences, Rights and Limitations of Series B
      Convertible Preferred Stock of Registrant dated October 23, 2007,
      incorporated by reference to Exhibit 3.8 to the Company’s Amendment No. 2
      to Form S-1 filed on August 29, 2008.3.9
            
            Certificate
      of Designation of the Company’s Series C Preferred Stock, incorporated by
      reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed
      August 21, 2009.4.1
            
            Form
      of Placement Agent Warrant issued pursuant to Exhibit 10.45, incorporated
      by reference to Exhibit 3.2 to Company’s Current Report on Form 8-K Filed
      on July 19, 20054.2
            
            Form
      of Investor Warrant, incorporated by reference to Exhibit 3.1 to Company’s
      Current Report on Form 8-K filed on July 19, 20054.3
            
            Specimen
      common stock certificate of the Company, incorporated by reference to
      Exhibit 4.5 to the Company’s Form SB-2/A Registration Statement filed
      December 8, 2005.4.4
            
            Agreement
      dated April 22, 2005, between the Company and Summit Energy Ventures, LLC,
      for the issuance of preferred stock and warrants, incorporated by
      reference to Exhibit 4.6 to the Company’s Form SB-2 Registration Statement
      filed October 25, 2005.4.5
            
            Agreement
      dated April 22, 2005, between the Company and Commerce Energy Group, Inc.,
      for the issuance of preferred stock and warrants, incorporated by
      reference to Exhibit 4.7 to the Company’s Form SB-2 Registration Statement
      filed October 25, 2005.4.6
            
            Form
      of Equity Warrant, incorporated by reference to Exhibit 4.1 to the
      Company’s Current Report on Form 8-K, filed January 24,
    20074.7
            
            Form
      of Equity Warrant, incorporated by reference to Exhibit 4.1 to the
      Company’s Current Report on Form 8-K, filed March 8,
  20074.8
            
            Form
      of Warrant, issued to certain investors in the Company’s private placement
      of units on January 21, 2008, incorporated by reference to Exhibit 4.8 to
      the Company’s Amendment No. 2 to Form S-1 filed on August 29,
      2008.4.9
            
            Form
      of Warrant, incorporated by reference to Exhibit 3.1 to the Company’s
      Current Report on Form 8-K filed August 21, 2009.10.1
            
            United
      States Patent #5,821,726, incorporated by reference to Exhibit 10(g) to
      Company's Annual Report on Form 10-SB filed on October 20,
      2000.10.2
            
            1994
      Stock Option Plan, incorporated by reference to Exhibit 10(i) to Company's
      Annual Report on Form 10-SB filed on October 20, 2000.10.3
            
            Patent
      License Agreement (DN-858) with NASA, incorporated by reference to Exhibit
      10.10 to Company's Amended Annual Report on Form 10-SB/A filed on October
      26 2001.10.4
            
            Patent
      License Agreement (DE-256) with NASA incorporated by reference to Exhibit
      10.11 to Company's Amended Annual Report on Form 10-SB/A filed on October
      26 2001.10.5
            
            Settlement
      and Release Agreement with NASA incorporated by reference to Exhibit 10.12
      to Company's Amended Annual Report on Form 10-SB/A filed on October 26
      2001.




35




10.6
            
            Modification
      No. 1 to Patent License Agreement (DE-256) with NASA, incorporated by
      reference to Exhibit 10.13 to Company's Amended Annual Report on Form
      10-SB/A filed on October 26 2001.10.7
            
            Product
      Warranty, incorporated by reference to Exhibit 10.16 to Company's Amended
      Annual Report on Form 10-SB/A filed on October 26 2001.10.8
            
            Test
      Report from Medsker Electric, Inc., incorporated by reference to Exhibit
      10.17 to Company's Amended Annual Report on Form 10-SB/A filed on October
      26 2001.10.9
            
            Test
      Report from Oak Ridge National Laboratory, incorporated by reference to
      Exhibit 10.18 to Company's Amended Annual Report on Form 10-SB/A filed on
      October 26 2001.10.10
            
            Test
      Report from Oregon State University - The Motor Systems Resource Facility,
      incorporated by reference to Exhibit 10.19 to Company's Amended Annual
      Report on Form 10-SB/A filed on October 26 2001.10.11
            
            Test
      Report from Otis Elevator Co., incorporated by reference to Exhibit 10.20
      to Company's Amended Annual Report on Form 10-SB/A filed on October 26
      2001.10.12
            
            Certificate
      of Amendment of Warrant, incorporated by reference to Exhibit 10.4 to
      Company's Current Report on Form 8-K filed May 25,
2003.10.13
            
            Settlement
      Agreement and Mutual General Release with Stephen L. Shulman and Summit
      Energy Ventures, LLC dated October 3, 2003, incorporated by reference to
      Exhibit 10.5 to Company's Quarterly Report on Form 10-QSB filed November
      14, 2003.10.14
            
            Amendment
      to the Amended and Restated Stockholders' Agreement among Anthony Caputo,
      Nicholas Anderson, Philip Elkus, Stephen Shulamn, Performance Control,
      LLC, Summit Energy Ventures, LLC and Power Efficiency Corporation dated
      September 22, 2003, incorporated by reference to Exhibit 10.7 to Company's
      Quarterly Report on Form 10-QSB filed November 14,
2003.10.15
            
            Business
      Property Lease with Arens Investment Company dated November 1, 2003,
      incorporated by reference to Exhibit 10.36 to Company's Annual Report on
      Form 10-KSB filed March 10, 2004.10.16
            
            Letter
      agreement with Pali Capital, Inc. dated February 25, 2004, incorporated by
      reference to Exhibit 10.40 to Company's Annual Report on Form 10-KSB filed
      March 10, 2004.10.17
            
            Amended
      and Restated 2000 Stock Option and Restricted Stock Plan dated February
      23, 2004, incorporated by reference to Exhibit 10.41 to Company's Annual
      Report on Form 10-KSB filed March 10, 2004.10.18
            
            Amended
      and Restated 1994 Stock Option Plan, incorporated by reference to Exhibit
      10.42 to Company's Annual Report on Form 10-KSB filed March 10,
      2004.10.19
            
            Single
      Phase Licensing Agreement with Commerce Energy Group, incorporated by
      reference to Exhibit 10.1 to Company's Quarterly Report on Form 10-QSB
      filed November 15, 2004.10.20
            
            Business
      Property Lease Amendment involving Glenborough LLC and Northwest Power
      Management, Inc. dated February 7, 2005, incorporated by reference to
      Exhibit 10.48 to the Company's Annual Report on Form 10-KSB filed on March
      31, 2005.10.21
            
            Settlement
      and Consulting Agreement with Keith Collin dated September 27, 2004,
      incorporated by reference to Exhibit 10.49 to the Company's Annual Report
      on Form 10-KSB filed on March 31, 2005.10.22
            
            Placement
      Agency Agreement dated as of June 1, 2005, between the Company and Joseph
      Stevens & Co., Inc., incorporated by reference to Exhibit 10.51 to the
      Company’s Form SB-2 Registration Statement filed October 25,
      2005.




36




10.24
            
            Consulting
      Agreement with George Boyadjieff, dated June 9, 2005, incorporated by
      reference to Exhibit 10.54 to the Company’s Form 10-KSB filed on March 31,
      200610.25
            
            Consulting
      Agreement with Steven Blum dated February 21, 2006, incorporated by
      reference to Exhibit 10.55 to the Company’s Form 10-KSB filed on March 31,
      200610.26
            
            Consulting
      Agreement with CEO Cast, Inc, dated January 2, 2006, incorporated by
      reference to Exhibit 10.56 to the Company’s Form 10-KSB filed on March 31,
      200610.27
            
            Letter
      Agreement with USBX Advisory Services, LLC, dated January 6, 2006,
      incorporated by reference to Exhibit 10.57 to the Company’s Form 10-KSB
      filed on March 31, 200610.28
            
            Employment
      Agreement with Steven Strasser dated June 1, 2005, incorporated by
      reference to Exhibit 8.1 to the Company’s Current Report of Form 8-K filed
      July 13, 2005.10.29
            
            Employment
      Agreement with John Lackland dated June 1, 2005, incorporated by reference
      to Exhibit 8.2 to the Company’s Current Report on Form 8-K filed on July
      13, 2005.10.30
            
            Interim
      Financing Agreement with EMTUCK, LLC dated April 18, 2006, incorporated by
      reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed on April 24, 2006.10.31
            
            Promissory
      Note granted to EMTUCK, LLC dated April 19, 2006, incorporated by
      reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K
      filed on April 24, 2006.10.32
            
            Security
      Agreement with EMTUCK, LLC dated April 19, 2006, incorporated by reference
      to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on April
      24, 2006.10.33
            
            Form
      of EMTUCK Warrant, incorporated by reference to Exhibit 10.4 to the
      Company’s Current Report on Form 8-K filed on April 24,
    2006.10.34
            
            Promissory
      Note granted to EMTUCK, LLC dated May 19, 2006, incorporated by reference
      to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on May
      26, 2006.10.35
            
            Form
      of Pali Note Extension Consent Letter dated October 23, 2006, incorporated
      by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed on October 27, 2006.10.36
            
            Form
      of Securities Purchase Agreement, dated November 30, 2006, incorporated by
      reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed on December 5, 2006.10.37
            
            Form
      of Note, dated November 30, 2006, incorporated by reference to Exhibit 4.1
      to the Company’s Current Report on Form 8-K filed on December 5,
      2006.10.38
            
            Form
      of Debt Warrant, incorporated by reference to Exhibit 4.2 to the Company’s
      Current Report on Form 8-K filed on December 5, 2006.10.39
            
            Form
      of Equity Warrant, incorporated by reference to Exhibit 4.3 to the
      Company’s Current Report on Form 8-K filed on December 5,
      2006.10.40
            
            Form
      of Securities Purchase Agreement, incorporated by reference to Exhibit
      10.1 to the Company’s Current Report on Form 8-K filed on January 24,
      2007.




37




10.41
            
            Consulting
      Agreement amendment with George Boyadjieff, dated June 9, 2007,
      incorporated by reference to the Quarterly Report on Form 10-QSB filed on
      August 13, 2007.10.42
            
            Manufacturing
      Services Agreement, dated September 6, 2007 by and among the Company
      and Sanima-Sci Corporation, incorporated by reference to Exhibit 10.1 to
      the Company’s Current Report on Form 8-K filed on September 13,
      2007.10.43
            
            Consulting
      Agreement amendment with George Boyadjieff, dated June 9, 2007,
      incorporated by reference to Exhibit 10.1 to the Company’s Quarterly
      Report on Form 10-QSB filed on August 13, 2007.10.44
            
            Manufacturing
      Services Agreement, dated September 6, 2007 by and among the Company and
      Sanima-Sci Corporation, incorporated by reference to Exhibit 10.1 to the
      Company’s Current Report on Form 8-K filed on September 12,
      2007.10.45
            
            Securities
      Purchase Agreement, dated as of October 27, 2007 by and between the
      Company and certain Investors, incorporated by reference to Exhibit 10.45
      to the Company’s Amendment No. 2 to Form S-1 filed on August 29,
      2008.10.46
            
            Securities
      Purchase Agreement, incorporated by reference to Exhibit 3.1 to the
      Company’s Current Report on Form 8-K filed August 21,
  2009.31.1
            
            Certification
      of Steven Strasser pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002; filed herewith31.2
            
            Certification
      of John Lackland pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002; filed herewith32.1
            
            Certification
      of Steven Strasser pursuant to Section 906 of the Sarbanes Oxley Act of
      2002; filed herewith32.2
            
            Certification
      of John Lackland pursuant to Section 906 of the Sarbanes Oxley Act of
      2002; filed herewith




38


SIGNATURES




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




POWER
      EFFICIENCY CORPORATIONDated: 
      March 31, 2010
              By:
              /s/STEVEN
      STRASSERSteven
      Strasser, President and ChiefExecutive
      Officer and Chairman of the BoardDated: 
      March 31, 2010
              By:
              /s/JOHN
      LACKLANDJohn
      Lackland, Chief Financial Officer and Director




In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the Company and in the capacities and on the
dates indicated.




Dated: 
      March 31, 2010
            By:
            /s/Gary
      RadoGary
      Rado, DirectorDated: 
      March 31, 2010
            By:
            /s/George boyadjieffGeorge
      Boyadjieff, DirectorDated: 
      March 31, 2010
            By:
            /s/Douglas  DunnDr.
      Douglas Dunn, DirectorDated: 
      March 31, 2010
            By:
            /s/Richard
      MorganRichard
      Morgan, DirectorDated: 
      March 31, 2010
            By:
            /s/Kenneth
      DickeyKenneth
      Dickey, Director




39


POWER EFFICIENCY
CORPORATION





FINANCIAL
STATEMENTS





DECEMBER 31, 2009 AND
2008







POWER EFFICIENCY
CORPORATION





DECEMBER 31, 2009 AND
2008




INDEX





PageReports
      of Independent Registered Public Accounting Firms
            
            F-1
      – F-2Financial
      Statements:Balance
      Sheets
            
            F-3Statements
      of Operations
            
            F-4Statements
      of Changes in Stockholders' Equity
            
            F-5Statements
      of Cash Flows
            
            F-6Notes
      to Financial Statements
            
            F-7
      - F-33








REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM





Board of
Directors


Power
Efficiency Corporation


Las
Vegas, Nevada




We have
audited the accompanying balance sheet of Power Efficiency Corporation as of
December 31, 2009 and the related statement of operations, changes in
stockholders’ equity and cash flows for the year then ended. These financial
statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial statements based on
our audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
Company is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting.  Our audit included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial reporting. Accordingly, we express no such
opinion.  An audit also includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation.  We
believe that our audit provides a reasonable basis for our opinion.





In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Power Efficiency Corporation at
December 31, 2009 and the results of its operations and its cash flows for the
year then ended in conformity with accounting principles generally accepted in
the United States of America.





The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. As discussed in Note 2 to the financial
statements, the Company has suffered recurring losses from operations and has a
working capital deficiency that raise substantial doubt about its ability to
continue as a going concern. Management’s plans in regard to these matters are
also described in Note 2. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.






/s/BDO
Seidman LLP





Las
Vegas, Nevada


March
30,
2010




F-1




REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM




Board of
Directors


Power
Efficiency Corporation


Las
Vegas, Nevada




We have
audited the accompanying balance sheet of Power Efficiency Corporation, (a
Delaware corporation) (the "Company") as of December 31, 2008, and the related
statements of operations, changes in stockholders' equity, and cash flows for
each of the year ended December 31, 2008.  These financial statements
are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these financial statements based on
our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
Company is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting.  Our audit included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial reporting.  Accordingly, we express no
such opinion.  An audit also includes examining, on a test basis,
evidence supporting the amounts and estimates made by management, as well as
evaluating the overall financial statement presentation.  We believe
that our audits provide a reasonable basis for our opinion.





In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Power Efficiency Corporation at
December 31, 2008 and the results of its operations and its cash flows for the
years ended December 31, 2008 in conformity with accounting principles generally
accepted in the United States of America.





The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern.  As discussed in Note 2 to the
financial statements, the Company has suffered recurring losses from operations,
and the Company has experienced a deficiency of cash from
operations.  These matters raise substantial doubt as to the Company's
ability to continue as a going concern.  Management's plans in regard
to these matters are also discussed in Note 2.  The financial
statements do not include any adjustments that might result from the outcome of
these uncertainties.






/s/Sobel
& Co., LLC


Certified
Public Accountants





March
30,
2009


Livingston,
New Jersey




F-2




POWER
EFFICIENCY CORPORATION


BALANCE
SHEETS




Year
      Ended December 31,2009
            
            
            2008ASSETSCURRENT
      ASSETS:Cash
            
            $
            247,564
            
            
            $
            2,100,013Accounts
      receivable, net of allowance of $28,861 in 2009 and $26,082 in
      2008
            
            
            66,143
            
            
            
            44,159Inventories
            
            
            281,253
            
            
            
            246,020Prepaid
      expenses
            
            
            36,437
            
            
            
            47,165Total
      Current Assets
            
            
            631,397
            
            
            
            2,437,357PROPERTY
      AND EQUIPMENT, Net
            
            
            86,533
            
            
            
            144,967OTHER
      ASSETS:Deposits
            
            
            26,914
            
            
            
            38,206Patents,
      net
            
            
            86,342
            
            
            
            64,711Goodwill
            
            
            1,929,963
            
            
            
            1,929,963Total
      Other Assets
            
            
            2,043,219
            
            
            
            2,032,880$
            2,761,149
            
            
            $
            4,615,204LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIES:Accounts
      payable and accrued expenses
            
            $
            722,195
            
            
            $
            555,789Warrant
      liability
            
            
            828,827
            
            
            
            -Total
      Current Liabilities
            
            
            1,551,022
            
            
            
            555,789LONG-TERM
      LIABILITIES:Deferred
      rent
            
            
            8,918
            
            
            
            12,668Deferred
      tax liability
            
            
            399,567
            
            
            
            -Total
      Long-Term Liabilities
            
            
            408,485
            
            
            
            12,668Total
      Liabilities
            
            
            1,959,507
            
            
            
            568,457COMMITMENTS
      AND CONTINGENCIESSTOCKHOLDERS'
      EQUITY:Series
      B and Series C-1 Convertible Preferred Stock, $0.001 par value 10,000,000
      shares authorized, 170,250 issued and outstanding in 2009 and
      140,000 issued and outstanding in 2008
            
            
            170
            
            
            
            140Common
      stock, $0.001 par value, 140,000,000 shares authorized,
      44,825,883 shares issued and oustanding in 2009 and 43,255,441
      shares issued and oustanding in 2008
            
            
            44,826
            
            
            
            43,256Additional
      paid-in capital
            
            
            36,797,628
            
            
            
            35,307,119Accumulated
      deficit
            
            
            (36,040,982
            )
            
            
            (31,303,768
            )Total
      Stockholders' Equity
            
            
            801,642
            
            
            
            4,046,747$
            2,761,149
            
            
            $
            4,615,204




See
notes to financial statements.






F-3




POWER
EFFICIENCY CORPORATION STATEMENTS
OF OPERATIONS




Year
      Ended December 31,2009
            
            
            2008REVENUES
            
            $
            283,990
            
            
            $
            480,513COMPONENTS
      OF COST OF SALES:Material,
      labor and overhead
            
            
            223,762
            
            
            
            356,942Inventory
      obsolesence expense
            
            
            -
            
            
            
            40,758Total
      Cost of Sales
            
            
            223,762
            
            
            
            397,700GROSS
      PROFIT
            
            
            60,228
            
            
            
            82,813COSTS
      AND EXPENSES:Selling,
      general and administrative
            
            
            2,649,733
            
            
            
            3,032,733Research
      and development
            
            
            953,004
            
            
            
            1,016,158Depreciation
      and amortization
            
            
            66,589
            
            
            
            74,539Total
      Costs and Expenses
            
            
            3,669,326
            
            
            
            4,123,430LOSS
      FROM OPERATIONS
            
            
            (3,609,098
            )
            
            
            (4,040,617
            )OTHER
      INCOME (EXPENSE):Interest
      income
            
            
            15,294
            
            
            
            104,684Change
      in fair value of warrant liability
            
            
            (514,089
            )
            
            
            -Total
      Other Income (Expenses), Net
            
            
            (498,795
            )
            
            
            104,684LOSS
      BEFORE PROVISION FOR TAXES
            
            
            (4,107,893
            )
            
            
            (3,935,933
            )PROVISION
      FOR TAXES
            
            
            (60,815
            )
            
            
            (12,271
            )NET
      LOSS
            
            
            (4,168,708
            )
            
            
            (3,948,204
            )DIVIDENDS
      PAID OR PAYABLE ON SERIES B. SERIES C ANDSERIES
      C-1 CONVERTIBLE PREFERRED STOCK
            
            
            1,270,984
            
            
            
            545,800NET
      LOSS ATTRIBUTABLE TO COMMONSHAREHOLDERS
            
            $
            (5,439,692
            )
            
            $
            (4,494,004
            )BASIC
      AND FULLY DILUTED LOSS PER COMMON SHARE
            
            $
            (0.13
            )
            
            $
            (0.11
            )WEIGHTED
      AVERAGE COMMON SHARES OUTSTANDINGBASIC
            
            
            43,390,464
            
            
            
            40,909,504






See
notes to financial statements.




F-4




POWER
EFFICIENCY CORPORATION


STATEMENTS
OF CHANGES IN STOCKHOLDERS' EQUITY


YEAR
ENDED DECEMBER 31, 2009 AND 2008


Additional
            
            
            
            
            
            TotalCommon
      Stock
            
            
            Preferred
      Stock
            
            
            Paid-in
            
            
            Accumulated
            
            
            Stockholders'Shares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Capital
            
            
            Deficit
            
            
            EquityBalance,
      January 1, 2008
            
            
            40,367,523
            
            
            $
            40,368
            
            
            
            134,400
            
            
            $
            134
            
            
            $
            33,741,902
            
            
            $
            (26,809,764
            )
            
            $
            6,972,640Issuance
      of common stock
            
            
            40,000
            
            
            
            40
            
            
            
            -
            
            
            
            -
            
            
            
            7,960
            
            
            
            -
            
            
            
            8,000Issuance
      of preferred stock
            
            
            -
            
            
            
            -
            
            
            
            5,600
            
            
            
            6
            
            
            
            279,994
            
            
            
            -
            
            
            
            280,000Common
      stock dividends paid
            
            
            2,729,000
            
            
            
            2,729
            
            
            
            -
            
            
            
            -
            
            
            
            543,071
            
            
            
            (545,800
            )
            
            
            -Common
      stock issued upon exercise ofoptions
      and warrants
            
            
            118,918
            
            
            
            119
            
            
            
            -
            
            
            
            -
            
            
            
            (119
            )
            
            
            -
            
            
            
            -Warrants
      and options issued with commonstock
      and debt and to employees andconsultants,
      including debt discount
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            765,504
            
            
            
            -
            
            
            
            765,504Expenses
      related to issuance ofpreferred
      and common stock
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (31,193
            )
            
            
            -
            
            
            
            (31,193
            )Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (3,948,204
            )
            
            
            (3,948,204
            )Balance,
      December 31, 2008
            
            
            43,255,441
            
            
            
            43,256
            
            
            
            140,000
            
            
            
            140
            
            
            
            35,307,119
            
            
            
            (31,303,768
            )
            
            
            4,046,747Cumulative
      effect of change in accounting for warrant liability
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,433,954
            )
            
            
            1,052,099
            
            
            
            (381,855
            )Cumulative
      effect of deferred tax provision
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (349,621
            )
            
            
            (349,621
            )Adjusted
      opening balance, January 1, 2009
            
            
            43,255,441
            
            
            
            43,256
            
            
            
            140,000
            
            
            
            140
            
            
            
            33,873,165
            
            
            
            (30,601,290
            )
            
            
            3,315,271Issuance
      of preferred stock
            
            
            -
            
            
            
            -
            
            
            
            30,250
            
            
            
            30
            
            
            
            620,063
            
            
            
            -
            
            
            
            620,093Warrants
      issued with preferred stock
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            657,024
            
            
            
            -
            
            
            
            657,024Preferred
      stock dividends recognized on beneficial conversionfeatures
      of preferred stock issuances
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            589,907
            
            
            
            (589,907
            )
            
            
            -Expenses
      related to issuances of preferred stock
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (27,181
            )
            
            
            -
            
            
            
            (27,181
            )Common
      stock issued upon cashless exerciseof optionsand warrants
            
            
            18,781
            
            
            
            19
            
            
            
            -
            
            
            
            -
            
            
            
            (19
            )
            
            
            -
            
            
            
            -Warrants
      and options issued to employees and consultants
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            405,143
            
            
            
            -
            
            
            
            405,143Preferred
      stock dividends paid or payable in comon stock
            
            
            1,551,661
            
            
            
            1,551
            
            
            
            -
            
            
            
            -
            
            
            
            679,526
            
            
            
            (681,077
            )
            
            
            -Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (4,168,708
            )
            
            
            (4,168,708
            )Balance,
      December 31, 2009
            
            
            44,825,883
            
            
            $
            44,826
            
            
            
            170,250
            
            
            $
            170
            
            
            $
            36,797,628
            
            
            $
            (36,040,982
            )
            
            $
            801,642




See
notes to financial statements.




F-5




POWER EFFICIENCY CORPORATION
 STATEMENTS
OF CASH FLOWS




Year
      Ended December 31,2009
            
            
            2008CASH
      FLOWS PROVIDED BY (USED FOR):OPERATING ACTIVITIES:Net
      loss
            
            $
            (4,168,708
            )
            
            $
            (3,948,204
            )Adjustments
      to reconcile net loss to net cashused
      for operating activities:Bad
      debt expense
            
            
            8,149
            
            
            
            7,770Inventory
      obsolescense expense
            
            
            -
            
            
            
            40,758Depreciation
      and amortization
            
            
            66,589
            
            
            
            74,539Loss
      on disposition of fixed assets
            
            
            3,097
            
            
            
            -Warrants
      and options issued in connection with services from
vendorsand
      to employees and consultants
            
            
            405,143
            
            
            
            765,504Change
      in fair value of warrant liability
            
            
            514,089
            
            
            
            -Common
      Stock issued for consulting services
            
            
            -
            
            
            
            7,960Deferred
      tax provision
            
            
            49,946
            
            
            
            -Changes
      in certain assets and liabilities:Accounts
      receivable
            
            
            (30,133
            )
            
            
            57,323Inventory
            
            
            (35,233
            )
            
            
            (155,016
            )Prepaid
      expenses
            
            
            10,728
            
            
            
            (5,869
            )Deposits
            
            
            11,292
            
            
            
            84,057Accounts
      payable and accrued expenses
            
            
            166,405
            
            
            
            (30,669
            )Customer
      deposits
            
            
            -
            
            
            
            (1,605
            )Deferred
      rent
            
            
            (3,750
            )
            
            
            605Net
      Cash Used for Operating Activities
            
            
            (3,002,386
            )
            
            
            (3,102,847
            )INVESTING ACTIVITIES:Costs
      related to patent applications
            
            
            (24,174
            )
            
            
            (27,507
            )Purchase
      of property, equipment and other assets
            
            
            (9,601
            )
            
            
            (104,857
            )Sale
      of property, equipment and other assets
            
            
            893
            
            
            
            -Net
      Cash Used for Investing Activities
            
            
            (32,882
            )
            
            
            (132,364
            )FINANCING ACTIVITIES:Proceeds
      from issuance of equity securities, net of costs
            
            
            1,182,819
            
            
            
            248,846Net
      Cash Provided by Financing Activities
            
            
            1,182,819
            
            
            
            248,846DECREASE
      IN CASH
            
            
            (1,852,449
            )
            
            
            (2,986,365
            )CASHBeginning
      of year
            
            
            2,100,013
            
            
            
            5,086,378End
      of year
            
            $
            247,564
            
            
            $
            2,100,013




See
notes to financial statements.




F-6


POWER
EFFICIENCY CORPORATION
 NOTES TO
FINANCIAL STATEMENTS
 DECEMBER
31, 2009 AND 2008





NOTE
1  -  NATURE OF BUSINESS:





Power
Efficiency Corporation ("Power Efficiency" and/or the "Company"), is
incorporated in Delaware.  Power Efficiency designs, develops, markets
and sells proprietary solid state electrical devices designed to reduce energy
consumption in alternating current induction motors.  Alternating
current induction motors are commonly found in industrial and commercial
facilities throughout the world.  The Company currently has one
principal and proprietary product: the three phase Motor Efficiency Controller,
which is used in industrial and commercial applications, such as rock crushers,
granulators, and escalators.  Additionally, the Company has developed
a digital single phase controller in preparation for working with Original
Equipment Manufacturers (“OEMs”) to incorporate the technology into their
equipment.





The
Company's primary customers have been OEMs and commercial accounts located
throughout the United States of America and various countries.





Power
Efficiency formed Design Efficient Energy Services, LLC, a Delaware limited
liability company.  This entity was formed to obtain energy grants and
rebates for customers of the Company from state governmental
bodies.  Design Efficient Energy Services, LLC has been inactive since
inception.





NOTE
2  -  GOING CONCERN:





The
accompanying financial statements have been prepared assuming the Company is a
going concern, which assumption contemplates the realization of assets and
satisfaction of liabilities in the normal course of business.  The
Company has suffered recurring losses from operations, and the Company
experienced a $3,002,386 deficiency of cash from operations in 2009and lacks sufficient
liquidity to continue its operations.





These
factors raise substantial doubt about the Company's ability to continue as a
going concern.  The financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or the amount of liabilities that might be necessary should the Company
be unable to continue in existence.  Continuation of the Company as a
going concern is dependent upon achieving profitable
operations.  Management's plans to achieve profitability include
developing new products, obtaining new customers and increasing sales to
existing customers.  Management is seeking to raise additional capital
through equity issuance, debt financing or other types of
financing.  However, there are no assurances that sufficient capital
will be raised.  If we are unable to obtain it on reasonable terms, we
would be forced to restructure, file for bankruptcy or cease
operations.





NOTE
3  -  SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES:





Use
of Estimates:




The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period.  Actual results may differ from those
estimates.




F-7


POWER
EFFICIENCY CORPORATION
 NOTES TO
FINANCIAL STATEMENTS
 DECEMBER
31, 2009 AND 2008




Inventories:




Inventories
are valued at the lower of cost or market using the first-in, first-out cost
flow assumption.  The Company reviews inventory for impairments to net
realizable value whenever circumstances arise.  Such circumstances may
include, but are not limited to, the discontinuation of a product line or
re-engineering certain components making certain parts
obsolete.  Management has determined a reserve for inventory
obsolescence was not necessary at December 31, 2009 or 2008.





As of
December 31, inventories are comprised as follows:





2009
            
            
            2008Raw
      materials
            
            $
            175,806
            
            
            $
            178,698Finished
      Goods
            
            
            105,447
            
            
            
            67,322Inventories
            
            $
            281,253
            
            
            $
            246,020





Accounts
Receivable:




The
Company carries its accounts receivable at cost less an allowance for doubtful
accounts and returns.  On a periodic basis, the Company evaluates its
accounts receivable and establishes an allowance for doubtful accounts, based on
a history of past write-offs and collections and current credit
conditions.  The Company recorded an allowance for doubtful accounts
of $28,861 and $26,082 as of December 31, 2009 and 2008,
respectively.





Research
and Development:




Research
and development expenditures are charged to expense as incurred.





Property,
Equipment and Depreciation:




Property
and equipment are stated at cost.  Maintenance and repairs are
expensed as incurred, while betterments are capitalized.  Depreciation
is computed using the straight-line method over the estimated useful lives of
the assets, which range from 3 to 7 years.  Property and equipment are
reviewed for impairment whenever events or circumstances indicate that the
carrying amount of assets is not recoverable.





Website:




Website
development, maintenance and hosting costs are charged to expense as
incurred.





Shipping
and Handling Costs:




The
Company bills customers for freight.  Actual costs for shipping and
handling are included as a component of cost of sales.





Patents:




Costs
associated with applying for U.S. patents based upon technology developed by the
Company are capitalized.  At the time the patented technologies are
used in the business, the asset will be amortized on a straight line basis, over
the remaining term of the patent.  If no patent is issued, these costs
will be expensed in the period when it is determined that no patent will be
issued.





Deferred
Rent:




The
Company accounts for rent expense on a straight-line basis for financial
reporting purposes.  The difference between cash payments and rent
expense is included in deferred rent.




F-8




POWER
EFFICIENCY CORPORATION
 NOTES TO
FINANCIAL STATEMENTS
 DECEMBER
31, 2009 AND 2008


Fair
Value Measurements:




We
measure fair value in accordance with FASB ASC 820-10, Fair Value Measurements and
Disclosures(prior
authoritative literature:FASB SFAS No. 157, Fair Value Measurements,issued September 2006) (“FASB ASC 820-10
(SFAS 157)”).  FASB ASC 820-10 (SFAS No. 157)
emphasizes that fair value is a market-based measurement, not an entity-specific
measurement. Therefore, a fair value measurement should be determined based on
the assumptions that market participants would use in pricing the asset or
liability. As a basis for considering market participant assumptions in fair
value measurements, FASB ASC 820-10 (SFAS No. 157) establishes a fair value
hierarchy that distinguishes between market participant assumptions based on
market data obtained from sources independent of the reporting entity
(observable inputs that are classified within Levels 1 and 2 of the hierarchy)
and the reporting entity’s own assumptions about market participant assumptions
(unobservable inputs classified within Level 3 of the hierarchy). The Company
has applied FASB ASC 820-10 (SFAS 157) to recognize the liability related to its
derivative instruments at fair value and to determine fair value for purposes of
testing goodwill for impairment.





Level 1
inputs utilize quoted prices (unadjusted) in active markets for identical
assets or liabilities. Level 2 inputs are inputs other than quoted prices
included in Level 1 that are observable for the asset or liability, either
directly or indirectly. Level 2 inputs may include quoted prices for similar
assets and liabilities in active markets, as well as inputs that are observable
for the asset or liability (other than quoted prices), such as interest rates
and yield curves that are observable at commonly quoted intervals. Level 3
inputs are unobservable inputs for the asset or liability, which is typically
based on an entity’s own assumptions about market participants’ assumptions, as
there is little, if any, related market activity. In instances where the
determination of the fair value measurement is based on inputs from different
levels of the fair value hierarchy, the level in the fair value hierarchy within
which the entire fair value measurement falls is based on the lowest level input
that is significant to the fair value measurement in its entirety. The Company’s
assessment of the significance of a particular input to the fair value
measurement in its entirety requires judgment, and considers factors specific to
the asset or liability.





Liabilities
measured at fair value on a recurring basis include warrant liabilities
resulting from an equity financing in 2005 (see Note 10).  In
accordance with FASB ASC 820-10 (SFAS 157), the warrant liabilities are being
remeasured to fair value each quarter until they all expire.  The
warrants are valued using the Black-Scholes option pricing model, using
observable and unobservable assumptions (Level 3) consistent with our
application of FASB ASC 718 (SFAS 123(R)).




F-9




POWER
EFFICIENCY CORPORATION
 NOTES TO
FINANCIAL STATEMENTS
 DECEMBER
31, 2009 AND 2008


Revenue
Recognition:




Revenue
from product sales is recognized when pervasive evidence of an arrangement
exists, delivery has occurred, the price to the buyer is fixed or determinable,
and collectability is reasonably assured.  Returns and other sales
adjustments (warranty accruals, discounts and shipping credits) are provided for
in the same period the related sales are recorded.





Loss
Per Common Share:




Loss per
common share is determined by dividing net loss available to common stockholders
by the weighted average number of common shares outstanding during the
year.  Diluted loss per common share is equivalent to basic loss per
common share and is presented on the statement of operations.





Accounting
for Stock Based Compensation:




The
Company accounts for employee stock options as compensation expense, in
accordance with FASB ASC 718, Share-Based Payments(Prior authoritative
literature: FASB SFAS No. 123(R), Share-Based Payments(“SFAS 123(R)”)).  FASB ASC 718
(SFAS 123(R)) requires companies to expense the value of all employee stock
options and similar awards. In computing the impact, the fair value of each
option is estimated on the date of grant based on the Black-Scholes options
pricing model utilizing certain assumptions for a risk free interest rate;
volatility; and expected remaining lives of the awards.  The
assumptions used in calculating the fair value of share-based payment awards
represent management's best estimates, but these estimates involve inherent
uncertainties and the application of management judgment.  As a
result, if factors change and the Company uses different assumptions, the
Company’s stock-based compensation expense could be materially different in the
future. In addition, the Company is required to estimate the expected forfeiture
rate and only recognize expense for those shares expected to vest.  In
estimating the Company’s forfeiture rate, the Company analyzed its historical
forfeiture rate, the remaining lives of unvested options, and the amount of
vested options as a percentage of total options outstanding.  If the
Company’s actual forfeiture rate is materially different from its estimate, or
if the Company reevaluates the forfeiture rate in the future, the stock-based
compensation expense could be materially different from what we have recorded in
the current period.  The impact of applying FASB ASC 718 (SFAS
123(R)) approximated $405,000 and $766,000 in compensation expense during
the years ended December 31, 2009 and 2008, respectively.  Such
amounts are included in research and development expenses and selling,
general and administrative expense on the statement of
operations.  The Company issues new authorized, unissued shares upon
exercise of stock options.





Product
Warranties:




The
Company warranties its products for two years.  Estimated product
warranty expenses are accrued in cost of sales at the time the related sale is
recognized. Estimates of warranty expenses are based primarily on historical
warranty claim experience. Warranty expenses include accruals for basic
warranties for products sold.  While management believes our estimates
are reasonable, an increase or decrease in submitted warranty claims could
affect warranty expense and the related current and future
liability.




F-10




POWER
EFFICIENCY CORPORATION
 NOTES TO
FINANCIAL STATEMENTS
 DECEMBER
31, 2009 AND 2008




Provision
for Income Taxes:




The
Company utilizes the asset and liability method of accounting for income taxes
pursuant to FASB ASC 740 Accounting for Income Taxes (Prior
authoritative literatureFASB SFAS No. 109, Accounting for Income Taxes (“SFAS
109”)),whichrequires the
recognition of deferred tax assets and liabilities for both the expected future
tax impact of differences between the financial statement and tax basis of
assets and liabilities, and for the expected future tax benefit to be derived
from tax loss and tax credit carryforwards.  FASB ASC 740 (SFAS 109)
additionally requires the establishment of a valuation allowance to reflect the
likelihood of realization of deferred tax assets.  We have reported
net operating losses for consecutive years, and do not have projected taxable
income in the near future.  This significant evidence causes our
management to believe a full valuation allowance should be recorded against the
deferred tax assets.





Goodwill:




FASB ASC
350, Goodwill and Other
Intangible Assets (Prior authoritative literature:FASB SFAS No. 142, Goodwill and Other Intangible
Assets (“SFAS 142”), requires that goodwill shall not be
amortized.  At a minimum, goodwill is tested for impairment, on an
annual basis by the Company, or when certain events indicate a possible
impairment, utilizing a two-step test, as described in FASB ASC 350 (SFAS
142).  A significant impairment could have a material adverse effect
on our financial condition and results of operations.  No impairment
charges were recorded in 2009 or 2008.





The first
part of the test is to compare the Company’s fair market value to the book value
of the Company as of the date of the test.  If the fair market value
of the Company is greater than the book value, no impairment exists as of the
date of the test.  However, if book value exceeds fair market value,
the Company must perform part two of the test, which involves recalculating the
implied fair value of goodwill by repeating the acquisition analysis that was
originally used to calculate goodwill, using purchase accounting as if the
acquisition happened on the date of the test, to calculate the implied fair
value of goodwill as of the date of the test.





Advertising:




Advertising
costs are expensed as incurred.  Advertising expenses were $4,553 and
$48,987 for the years ended December 31, 2009 and 2008,
respectively.




F-11




POWER
EFFICIENCY CORPORATION
 NOTES TO
FINANCIAL STATEMENTS
 DECEMBER
31, 2009 AND 2008




New
Accounting Pronouncements:




In
October 2009, the Financial Accounting Standards Board issued Accounting
Standards Update 2009-13, “Revenue Recognition (Topic 605) Multiple-Deliverable
Revenue Arrangements, a consensus of the FASB Emerging Issues Task Force (“ASU
2009-13”).  ASU 2009-13 amends existing accounting guidance for
separating consideration in multiple-deliverable arrangements.  ASU
2009-13 establishes a selling price hierarchy for determining the selling price
of a deliverable.  The selling price used for each deliverable will be
based on vendor-specific objective evidence if available, third-party evidence
if vendor-specific evidence is not available, or estimated selling price if
neither vendor-specific evidence nor third-party evidence is
available.  ASU 2009-13 eliminates residual method of allocation and
requires that arrangement consideration be allocated at the inception of the
arrangement to all deliverables using the “relative selling price
method.”  The relative selling price method allocates any discount in
the arrangement proportionately to each deliverable on the basis of each
deliverable’s selling price.  ASU 2009-13 requires that a vendor
determine its best estimate of selling price in a manner that is consistent with
that used to determine the price to sell the deliverable on a stand-alone
basis.  ASU 2009-13 is effective prospectively for revenue
arrangements entered into or materially modified in fiscal years beginning on or
after June 15, 2010, with earlier adoption permitted.  We have not yet
determined the impact of the adoption of ASU 2009-13 on our consolidated
financial statements.




In
January 2010, the FASB issued accounting standards update (ASU) No. 2010-06,
Fair Value Measurements and Disclosures (Topic 820)—Improving Disclosures about
Fair Value Measurements (ASU No. 2010-06). ASU No. 2010-06 requires: (1) fair
value disclosures of assets and liabilities by class; (2) disclosures about
significant transfers in and out of Levels 1 and 2 on the fair value hierarchy,
in addition to Level 3; (3) purchases, sales, issuances and settlements be
disclosed on gross basis on the reconciliation of beginning and ending balances
of Level 3 assets and liabilities; and (4) disclosures about valuation methods
and inputs used to measure the fair value of Level 2 assets and liabilities. ASU
No. 2010-06 becomes effective for the first financial reporting period beginning
after December 15, 2009, except for disclosures about purchases, sales,
issuances and settlements of Level 3 assets and liabilities which will be
effective for fiscal years beginning after December 15, 2010. We are currently
assessing what impact, if any, ASU No. 2010-06 will have on our fair value
disclosures; however, we do not expect the adoption of the guidance provided in
this codification update to have any material impact on our consolidated
financial statements.





Financial
Statement Reclassifications:




Certain
reclassifications have been made to the 2008 financial statements in order for
them to conform to the 2009 financial statement presentation.




F-12




POWER
EFFICIENCY CORPORATION
 NOTES TO
FINANCIAL STATEMENTS
 DECEMBER
31, 2009 AND 2008




NOTE
4  -  PREPAID EXPENSES:





As of
December 31, prepaid expenses assets are comprised as follows:





2009
            
            
            2008Prepaid
      insurance
            
            $
            5,634
            
            
            $
            10,192Other
      prepaid expenses
            
            
            30,803
            
            
            
            36,973Prepaid
      expenses
            
            $
            36,437
            
            
            $
            47,165





NOTE
5  -  PROPERTY AND EQUIPMENT:





At
December 31, property and equipment is comprised as follows:





2009
            
            
            2008Machinery
      and equipment
            
            $
            205,797
            
            
            $
            253,976Office
      furniture and equipment
            
            
            20,113
            
            
            
            20,113225,910
            
            
            
            274,089Less:  Accumulated
      depreciation
            
            
            139,377
            
            
            
            129,122Property
      and equipment, net
            
            $
            86,533
            
            
            $
            144,967





Depreciation
for the years ended December 31, 2009 and 2008 amounted to $64,045 and $71,996,
respectively.





NOTE
6  -  GOODWILL:





In
accordance with FASB ASC 350, Goodwill and Other Intangible
Assets (Prior
authoritative literature:FASB SFAS No. 142, Goodwill and Other Intangible
Assets (“SFAS 142”), previously recognized goodwill was tested by
management for impairment during 2009 and 2008 utilizing a two-step
test.  At a minimum, an annual goodwill impairment test is required,
or when certain events indicate a possible impairment.





The first
part of the test is to compare the Company’s fair market value to the book value
of the Company).  If the fair market value of the Company is greater
than the book value, no impairment exists as of the date of the
test.  However, if book value exceeds fair market value, the Company
must perform part two of the test, which involves recalculating the implied fair
value of goodwill by repeating the acquisition analysis that was originally used
to calculate goodwill, using purchase accounting as if the acquisition happened
on the date of the test, to calculate the implied fair value of goodwill as of
the date of the test.





F-13




POWER
EFFICIENCY CORPORATION
 NOTES TO
FINANCIAL STATEMENTS
 DECEMBER
31, 2009 AND 2008




The
Company has no accumulated impairment losses on goodwill.  The
Company’s impairment analysis is performed on December 31 each year, on the
Company’s single reporting unit.  Using the Company’s market
capitalization (based on Level 1 inputs), management determined that the
estimated  fair market value substantially exceeded the company’s book
value as of December 31, 2009 and 2008.  Based on this, no impairment
exists as of December 31, 2009 and 2008.





NOTE
7  -  INTANGIBLE ASSETS:





Intangible
assets subject to amortization consist of the following at December
31:





2009
            
            
            2008Patents
            
            $
            101,283
            
            
            $
            77,109Less:
      Accumulated amortization
            
            
            14,941
            
            
            
            12,398Intangible
      Assets, Net
            
            $
            86,342
            
            
            $
            64,711





Amortization
expense in 2009 and 2008 amounted to $2,542 for each year.





During
2009 and 2008, the Company capitalized approximately $24,000 and $28,000 in
expenses related to patent filings, respectively.  The Company will
begin amortizing these costs over the life of the patent, once the patented
technologies are used in the business.





Amortization
expense expected in the succeeding five years for the Company’s existing patents
is as follows:





2010
            
            $
            2,5422011
            
            
            2,5422012
            
            
            2,5422013
            
            
            2,5422014
            
            
            2,542Thereafter
            
            
            73,632$
            86,342





NOTE
8  -  CONCENTRATIONS OF CREDIT RISKS:





Financial
instruments which potentially subject the Company to concentrations of credit
risk consist primarily of cash and temporary cash investments and accounts
receivable.





The
Company maintains cash balances with commercial banks which at times may be in
excess of the insured limits.





Sales and
accounts receivable currently are from a relatively small number of customers of
the Company's products.  The Company closely monitors extensions of
credit.




F-14




POWER
EFFICIENCY CORPORATION
 NOTES TO
FINANCIAL STATEMENTS
 DECEMBER
31, 2009 AND 2008




Four
customers accounted for approximately 71% of 2009 sales and 79% of accounts
receivable at December 31, 2009.  One of these customers accounted for
49% of 2009 sales and 42% of accounts receivable at December 31, 2009. Four
customers accounted for approximately 82% of 2008 sales and 21% of accounts
receivable at December 31, 2008.  One of these customers accounted for
60% of 2008 sales and 10% of accounts receivable at December 31,
2008.





International
sales as a percentage of total revenues were 1% and 1% for each of the years
ended December 31 2009 and 2008.





NOTE
9  -  PROVISION FOR TAXES:





The
income tax provision is summarized as follows:





Year
      Ended
              December
      31, 2009
            
            
            Year
      Ended
              December
      31, 2008CurrentFederal
            
            $
            -
            
            
            $
            -State
            
            
            10,869
            
            
            
            12,271Total
      current
            
            
            10,869
            
            
            
            12,271DeferredFederal
            
            
            48,308
            
            
            
            -State
            
            
            1,638
            
            
            
            -Total
      deferred
            
            
            49,946
            
            
            
            -Total
      tax expense
            
            $
            60,815
            
            
            $
            12,271





Deferred
income taxes reflect the net tax effects of (a) temporary differences between
the carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for income tax purposes, and (b) operating losses and tax
credit carryforwards.




F-15


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





The tax
effects of significant items comprising the Company’s deferred taxes are as
follows:





December
      31, 2009
            
            
            December
      31, 2008Deferred
      tax assets:Accrued
      expenses
            
            $
            10,145
            
            
            $
            9,169Net
      operating losses
            
            
            10,351,295
            
            
            
            9,998,009Stock
      based compensation
            
            
            503,494
            
            
            
            -Tax
      credits
            
            
            48,390
            
            
            
            48,390Total
      deferred tax assets
            
            
            10,913,324
            
            
            
            10,055,568Deferred
      tax liabilities:Goodwill
            
            
            (399,567
            )
            
            
            (349,621
            )Fixed
      asset basis differences
            
            
            (16,062
            )
            
            
            (22,337
            )Total
      deferred tax liabilities
            
            
            (415,629
            )
            
            
            (371,958
            )Preliminary
      net deferred tax asset
            
            
            10,497,695
            
            
            
            9,683,610Less:  valuation
      allowance for deferred tax asset
            
            
            (10,897,262
            )
            
            
            (9,683,610
            )Net
      deferred tax liability
            
            $
            (399,567
            )
            
            $
            -





The
valuation allowance increased by $1.2 million during 2009 and $1.4 million
during 2008 primarily due to losses from current
operations.  Approximately $349,000 of the change during 2009 was
related to the prior year tax provision error discussed in Note 18.





As of
December 31, 2009 and 2008, the Company has available, on a federal tax basis,
net operating loss carryforwards of approximately $29.5 million and $26.1
million, respectively.  These net operating losses expire beginning
2020 through 2029.





FASB ASC
740-10 (SFAS 109) requires that the tax benefit of net operating losses,
temporary differences and credit carryforwards be recorded as an asset and that
management assesses whether realization is “more likely than
not.”  Realization of the future tax benefits is dependent of the
Company’s ability to generate sufficient taxable income within the carryforward
period.  Because of the Company’s history of operating losses,
management believes that the recognition of the deferred tax assets arising from
the above mentioned future tax benefits is currently not likely to be realized
and, accordingly, has provided a valuation allowance.


F-16





POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





A
reconciliation of the statutory tax rates for the years ended December 31 is as
follows:





2009
            
            
            2008Statutory
      rate
            
            
            (34
            )%
            
            
            (34
            )%State
      income taxes – all states
            
            
            (1
            )%
            
            
            (1
            )%Non-deductible
      stock based compensation
            
            
            2
            %
            
            
            -
            %Change
      in fair value of warrant liability
            
            
            4
            %
            
            
            -
            %True
      up of deferred tax balances
            
            
            9
            %
            
            
            -
            %Change
      in valuation allowance
            
            
            21
            %
            
            
            35
            %Effective
      tax rate
            
            
            1
            %
            
            
            -
            %





The
Company accounts for uncertain tax positions under the provisions of FASB ASC
740-10 (FIN 48).  The Company has not identified any uncertain tax
positions, nor does it believe it will have any material changes over the next
12 months.  Any interest or penalties resulting from examinations will
be recognized as a component of the income tax provision.  However,
since there are no unrecognized tax benefits as a result of the tax positions
taken, there are no accrued interest and penalties.





In
previous years, the Company did not recognize a deferred tax liability related
to its amortization of goodwill for tax purposes.  The Company
reviewed and revised its tax provision to include this deferred tax liability as
of January 1, 2009 and for the year ended December 31, 2009.  The
Company determined that the error was not material to prior years (see Note
18).





NOTE
10  -  WARRANTS:





Warrant
activity during the years ended December 31, 2008 and 2009 follows:





Warrants
            
            
            Average
              Exercise
      PriceWarrants
      outstanding at January 1, 2008
            
            
            29,013,968
            
            
            $
            0.45Issued
      during 2008
            
            
            1,280,000
            
            
            
            0.44Exercised
      during 2008
            
            
            (299,188
            )
            
            
            0.20Warrants
      outstanding at December 31, 2008
            
            
            29,994,780
            
            
            
            0.45Issued
      during 2009
            
            
            3,916,250
            
            
            
            0.33Canceled
      or Expired in 2009
            
            
            (2,523,561
            )
            
            
            0.55Warrants
      outstanding at December 31, 2009
            
            
            31,387,469
            
            
            $
            0.43





During
2009, the Company issued the following warrants: 1,235,000 warrants as
consulting fees to various consultants, which were valued at approximately
$175,000, and expensed in accordance with each warrant’s vesting schedule, as
selling, general and administrative expenses; 2,681,250 warrants to investors,
in connection with the Company’s private offerings of convertible preferred
stock (see Note 15), which were valued at approximately $590,000, of which
1,512,500 warrants valued at approximately $408,000 were classified in equity
and 1,168,750 warrants valued at approximately $182,000 were initially
classified as liabilities.  Subsequent to the grant date and upon
modification, the 1,168,750 warrants were reclassified into paid-in capital at
their fair value totaling $248,680 on the dates of
reclassification.


F-17


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





During
2008, the Company issued the following warrants: 1,000,000 warrants as
consulting fees to sales consultants, which were valued at approximately
$290,000.  Because these warrants vest at the discretion of the CEO,
the Company did not recognize an expense for these warrants in 2009 or 2008;
280,000 warrants to investors, in connection with the Company’s private offering
of convertible preferred stock (see Note 15), which were valued at approximately
$90,160, and recorded as additional paid-in capital.  During 2008, the
Company also expensed and included in selling general and administrative
expenses, $5,153 related to warrants, which vested during 2008.  These
warrants were issued in 2007 as consulting fees to a sales
consultant.





The fair
value of each warrant is estimated on the date of grant based on the
Black-Scholes option pricing model utilizing certain assumptions for a risk free
interest rate; volatility; and expected remaining lives of the
awards.  The assumptions used in calculating the fair value of
share-based payment awards represent management's best estimates, but these
estimates involve inherent uncertainties and the application of management
judgment.  In addition, the Company is required to estimate the
expected forfeiture rate and only recognize expense for those shares expected to
vest.  In estimating the Company’s forfeiture rate, the Company
analyzed its historical forfeiture rate, the remaining lives of unvested stock
warrants, and the amount of vested stock warrants as a percentage of total stock
warrants outstanding.





The fair
value of warrants granted is estimated on the date of grant based on the
weighted-average assumptions in the table below.  The assumption for
the expected life is based on evaluations of historical and expected exercise
behavior.  The risk-free interest rate is based on the U.S. Treasury
rates at the date of grant with maturity dates approximately equal to the
expected life at the grant date.  The historical daily stock
volatility of the Company’s common stock (the Company’s only class of publically
traded stock) over the estimated life of the stock warrant is used as the basis
for the volatility assumption.





Years
      endedDecember
      31,2009
            
            
            2008Weighted
      average risk-free rate
            
            
            0.18%
      - 2.70
            %
            
            
            4.06
            %Average
      expected life in years*
            
            
            3
            
            
            
            3.5Expected
      dividends
            
            None
            
            
            NoneVolatility
            
            
            121%
      - 209
            %
            
            
            275
            %Forfeiture
      rate
            
            
            46
            %
            
            
            43
            %


*
              The
      remaining useful life of 0.52 years was used to calculate the value of
      warrant liability as of December 31,
2009


F-18


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Warrant
Liability:




On
January 1, 2009, the Company adopted FASB ASC 815, Determining Whether an Instrument
(or Embedded Feature) Is Indexed to an Entity’s Own Stock (Prior authoritative
literature: FASB EITF 07-5, Determining Whether an Instrument
(or Embedded Feature) Is Indexed to an Entity’s Own Stock (“EITF
07-5”).The Company issued 5,696,591 warrants in connection
with a private offering of its common stock on July 8, 2005 and August 31,
2005.  The proceeds attributable to the warrants, based on the fair
value of the warrants at the date of issuance, amounted to $1,433,954 and were
accounted for as a liability and valued in accordance with FASB ASC 815 (EITF
07-5) based on an evaluation of the terms and conditions related to the warrant
agreements, which provide that the exercise price of these warrants shall be
reduced, if through a subsequent financing, the Company issues common stock
below the lowest per share purchase price of the offering.  The
warrant liability was valued at $828,827 and $381,856 as of December 31, 2009
and January 1, 2009, respectively, resulting in non-cash losses in our statement
of operations of $514,089 (including the fair value adjustment of $67,118
relating to warrants reclassified to equity) for the year ended December 31,
2009.  In adopting ASC 815 (EITF 07-5), the Company recorded a
$1,052,099 cumulative adjustment to opening accumulated deficit and a reduction
to paid-in capital of $1,433,954 on January 1, 2009.  In each
subsequent period, the Company adjusted the warrant liability to equal the fair
value of the warrants at the balance sheet date.  Changes in the fair
value of warrants classified as liability are recognized in
earnings.





Also, on
August 12, 2009 and October 5, 2009, the Company issued 1,168,750 warrants to
purchase the Company’s common stock, in conjunction with its sale of Series C
Convertible Preferred Stock.  The warrant agreements drafted for these
warrants inadvertently contained an anti-dilution provision, which required the
warrants to be classified as a liability.  As a result, the Company
initially classified $181,562 as a warrant liability.  The Company
reclassified these warrants to paid-in capital upon receiving consent from each
of the holders of these warrants to correct the warrant agreements to remove the
anti-dilution provision.  The fair value of the warrants on the dates
of reclassification totaled $248,680, resulting in an additional non-cash loss
of $67,118 in our statement of operations for the year ended December 31,
2009.  On December 11, 2009, the $248,680 was reclassified to paid-in
capital.





The
Company has estimated the fair value of its warrant liability using the
Black-Scholes option pricing model (Level 3 inputs) containing the following
assumptions:  volatility 121%, risk-free rate 1.78%, term equivalent
to the remaining life of the warrants.  The Company recorded a
non-cash expense related to these warrants of $514,089 for the year ended
December 31, 2009, which was recorded in other income (expense).





The
following reconciles the warrant liability for the nine months ended December
31, 2009:





Beginning
      balance, January 1, 2009
            
            $
            381,856Warrants
      classified as liabilities in 2009
            
            
            181,562Warrants
      reclassified to paid-in capital in 2009
            
            
            (248,680
            )Changes
      in fair value
            
            
            514,089Ending
      balance, December 31, 2009
            
            $
            828,827




F-19


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE
11  -  STOCK OPTION PLAN:





Stock
Option Plan activity during the years ended December 31, 2008 and 2009
follows:





Shares
            
            
            Average
              Exercise
      Price
            
            
            Aggregate
      Intrinsic Value*Options
      outstanding and exercisable at January 1, 2008
            
            
            14,309,896
            
            
            $
            0.36
            
            
            $
            2,718,880Granted
      during 2008
            
            
            1,095,000
            
            
            
            0.50Cancelled
      during 2008
            
            
            (1,825,000
            )
            
            
            0.37Options
      outstanding and exercisable at December 31, 2008
            
            
            13,579,896
            
            
            $
            0.37
            
            
            $
            -Granted
      during 2009
            
            
            4,450,000
            
            
            
            0.27Cancelled
      during 2009
            
            
            (485,000
            )
            
            
            0.42Exercised
      during 2009**
            
            
            (70,000
            )
            
            
            0.30
            
            
            
            7,700Options
      outstanding and exercisable at December 31, 2009
            
            
            17,474,896
            
            
            $
            0.34
            
            
            $
            -







*
            The
      aggregate intrinsic value represents the amount by which the market price
      of the Company’s common stock exceeds the average exercise price of
      outstanding options on a specific date, multiplied by the amount of
      outstanding options on that date.  If the average exercise price
      on the specific date exceeds the market price of the Company’s common
      stock, the intrinsic value is $0.




**
            All
      options were exercised under an approved cashless
  exercise





Weighted
average remaining contractual life at December 31, 2009, for all options is 7.69
years.





In 2000,
the Company adopted the 2000 Stock Option and Restricted Stock Plan (the "2000
Plan").  On July 16, 2009, the 2000 Plan was amended and
restated.  The 2000 Plan, as restated and amended, provides for the
granting of options to purchase up to 25,000,000 shares of common
stock.  170,000 options have been exercised cashlessly, resulting in
the issuance of 78,781 common shares, to date.  There are 17,474,896
options outstanding under the 2000 Plan as of December 31, 2009.





During
2009, the Company granted 4,450,000 stock options to directors and employees at
exercise prices approximating fair market value of the stock on the date of each
grant.  Such issuances to directors and employees were valued at
$640,170, utilizing similar factors as described below.  Stock options
issued to directors vest evenly per quarter during 2009.  Stock
options issued to employees vest evenly over five years from the date of
issuance.  Total stock options expensed during 2009, including stock
options granted in prior years which vested during the current year, totaled
$229,844, of which $26,172 was expensed and included in research and development
expenses, and $203,672 was expensed and included in selling, general and
administrative expenses.  The fair market value of stock options
issued in 2009 that has not been expensed is $591,071, and will be expensed
evenly over the next four years, unless cancelled.


F-20


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





During
2008, the Company granted 1,095,000 stock options to directors and employees at
exercise prices approximating fair market value of the stock on the date of each
grant.  Such issuances to directors and employees were valued at
$237,110, utilizing similar factors as described below.  Stock options
issued to directors vest evenly per quarter during 2009.  Stock
options issued to employees vest evenly over five years from the date of
issuance.  Total stock options expensed during 2009, including stock
options granted in prior years which vested during 2008, totaled $760,350, of
which a net reduction of $9,283 was recorded and included in research and
development expenses for options that were cancelled during the year, and
$769,633 was expensed and included in selling, general and administrative
expenses.  The fair market value of stock options issued in 2008 that
has not been expensed is $136,282, and will be expensed evenly over the next
three years, unless cancelled.





In 1994,
the Company adopted a Stock Option Plan (the "1994 Plan").  The 1994
Plan provides for the granting of options to purchase up to 71,429 shares of
common stock.  No options have been exercised to
date.  There are no options outstanding under the 1994 Plan, and the
Company does not plan to issue any more options under this plan.





Share
Based Compensation Payments:




During
the year ended December 31, 2009, the Board of Directors authorized the net
issuance of 4,450,000 stock options to directors and
employees.  During the year ended December 31, 2008, the Board of
Directors authorized the net issuance of 1,095,000 stock options to directors
and employees.  The fair value of each option grant was estimated on
the date of grant using the Black-Scholes option pricing model with the
following weighted-average assumptions used for grants: average expected
volatility of 161% and 275% for the years ended December 31, 2009 and 2008,
respectively; average risk-free interest rate of 2.9% and 4.06% for the years
ended December 31, 2009 and 2008, respectively;  expected remaining
lives of 10 years; no expected dividends for the years ended December 31, 2009
and 2008; and forfeiture rates of 46% and 43% for the years ended December 31,
2009 and 2008, respectively.





The
Company accounts for employee stock options as compensation expense, in
accordance with FASB ASC 718 (SFAS 123(R)).  FASB ASC 718 (SFAS
123(R)) requires companies to expense the value of employee stock options and
similar awards over the requisite service period.





In
computing the impact, the fair value of each option is estimated on the date of
grant based on the Black-Scholes options pricing model utilizing certain
assumptions for a risk free interest rate; volatility; and expected remaining
lives of the awards.  The assumptions used in calculating the fair
value of share-based payment awards represent management's best estimates, but
these estimates involve inherent uncertainties and the application of management
judgment.  As a result, if factors change and the Company uses
different assumptions, the Company’s stock-based compensation expense could be
materially different in the future. In addition, the Company is required to
estimate the expected forfeiture rate and only recognize expense for those
shares expected to vest.  In estimating the Company’s forfeiture rate,
the Company analyzed its historical forfeiture rate, the remaining lives of
unvested options, and the amount of vested options as a percentage of total
options outstanding.  If the Company’s actual forfeiture rate is
materially different from its estimate, or if the Company reevaluates the
forfeiture rate in the future, the stock-based compensation expense could be
materially different from what we have recorded in the current
period.




F-21




POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE 12 -
COMMITMENTS AND CONTINGENCIES:





Leases:




The
Company leases office space, a manufacturing and warehousing facility, and a
research and development facility in Las Vegas, Nevada.  The office
space lease includes a payment of $11,292 per month, plus annual increases of 3%
per year, which includes all cleaning and utilities, except phone and internet
service.  The term of the lease is five years.





The
Company also leases a manufacturing and warehouse facility and a research and
development facility.  The lease includes a payment of $3,600, plus
common area maintenance charges, per month.  The term of the lease is
three years and one month.





Minimum
future rentals are as follows:





Year2010
            
            
            177,0912011
            
            
            12,688$
            189,779





Rent
expense, including base rent and additional charges, for the year ended December
31, 2009 and 2008 was $205,160 and $212,742, respectively.





Patent
License Agreements:




The
Company was an exclusive licensee pursuant to a patent license agreement of
certain power factor controller technology owned by the United States, as
represented by the National Aeronautics and Space Administration
(NASA).  This license agreement covered the United States of America
and its territories and possessions on an exclusive basis and foreign sales on a
non-exclusive basis.  Such license agreement did not require the
Company to pay royalties to NASA in connection with the Company's sale of
products employing technology utilizing the licensed patents.  The
agreement terminated on December 16, 2002 upon the expiration of all of the
licensed patents.





The
Company filed and received its own patent (No. 5.821.726) on the Company’s
analog technology, that expires in 2017 that management believes will protect
the Company's intellectual property position. The Company has also
filed three utility patents in new inventions associated with the development of
its digital products, which are all pending approval with the U.S. Patent and
Trademark Office.  The costs associated with these patents are
capitalized and presented in the balance sheet.





Software
User License Agreements:




In 2009,
the Company entered into an agreement to purchase software licenses for
accounting, manufacturing and CRM software.  The commitment of the
software license agreement is approximately $28,000 in 2010 and $27,000 in
2009.  These amounts will be/are included net of amortization in
prepaid expenses on the face of the balance sheet.


F-22


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Litigation:




The
Company is currently involved in a lawsuit against one of its former directors,
who was also an employee of the Company, as well as the company the former
director formed (collectively, the “Defendants”).  The Company filed
this action against the Defendants for misappropriation of trade secrets, false
advertising, defamation/libel and other claims primarily arising from the
Defendant’s use of the Company’s confidential and proprietary information in the
development and marketing of motor control products.  The Company
seeks a temporary retraining order, preliminary injunction, permanent
injunction, damages, exemplary damages, attorneys’ fees and costs against the
Defendants.  The Company’s original complaint was filed on November
25, 2008, and its amended complaint was filed on August 6, 2009, in the U.S.
District Court, District of Nevada.





Subcontractors:




On
September 6, 2007, the Company entered into a manufacturing service agreement
with Sanima-Sci Corporation (“Sanmina-Sci”) for the production of digital units
and digital circuit boards.  Pursuant to this agreement, the Company
will purchase an amount of digital units, subject to certain minimum quantities,
from Sanmina-Sci equal to an initial firm order agreed upon by the Company and
Sanmina-Sci and subsequent nine-month requirements forecasts.  The
initial term of the contract is one year, and upon expiration of the initial
term, the contract will continue on a year to year basis until one party gives
notice to terminate.At the present time the
Company is not able to determine if the actual purchases will be in excess of
these minimum commitments, or if any potential liability will be
incurred.  The Company had approximately $170,000 and $340,000 in open
purchase orders with this subcontractor as of December 31, 2009 and 2008,
respectively.





Investment
Advisory Agreements:




On March
11, 2009, the Company entered into a consulting agreement with one of the
Company’s directors.  The agreement is for a term of 12 months and
calls for the director to provide investment and marketing related services for
the Company.  The director will receive $3,000 per month and 360,000
warrants to purchase the Company’s common stock, at an exercise price of $0.11
per share, under the terms of this agreement (see Note 10).  The
warrants vest equally over the term of the agreement.





On August
17, 2009, the Company entered into a consulting agreement with an investor
relations consulting firm.  This agreement calls for the consultant to
perform investor relations and public relations services for the
Company.  For its services, the Company has agreed to pay the
consultant a monthly retainer of $10,000, plus 450,000 warrants to purchase the
Company’s common stock, at an exercise price of $0.19 per share (see Note
10).  The term of the consulting agreement is initially for 12 months,
can be extended at the end of the term, and can be terminated immediately upon
written notice by either party.  The warrants vest equally over the
term of the agreement.


F-23


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Employment
Agreements:




On June
1, 2005, the Company entered into an employment and compensation agreement with
Steven Strasser, the Company’s Chief Executive Officer.  The agreement
is for a term of five years, with a base salary for the first year of the
agreement of $275,000 with annual increases of at least 5% of the current year’s
base salary and bonuses at the discretion of the compensation committee of the
board of directors.   During the first year of the Agreement, an
amount equal to $215,000 of the base salary shall be paid by grant of stock
options under the Company’s 2000 Stock Option and Restricted Stock Plan to
purchase 1,612,500 shares of the Company’s common stock, vesting in equal
quarterly installments over the year ending June 1, 2006, and the remaining
$60,000 of the base salary is to be paid-in cash.  The agreement with
this Chief Executive Officer also provides, among other things, for
reimbursement of certain business expenses and for certain payments to be made
to this Chief Executive Officer  in the event of a change in
control.  This Chief Executive Officer also received 1,818,180
incentive stock options in June 2005, which will vest over a five year period
and have an exercise price of $0.22, and 1,181,820 non-qualified stock options
which will vest over a five year period and have an exercise price of $0.20 (see
Note 11). The agreement also provides for certain non-competition and
nondisclosure covenants.  As of December 31, 2009, a total of
4,462,500 of the stock options are vested, and 150,000 stock options are
unvested, and all remain outstanding.  Of these stock options,
2,572,729 expire on May 31, 2010, and 2,039,771 expire on May 31,
2015.





On June
1, 2005, the Company entered into an employment and compensation agreement with
John Lackland, the Company’s Chief Financial Officer.  The agreement
is for a term of five years, with a base salary for the first year of the
agreement of $175,000 with annual increases of at least 5% of the current year’s
base salary and bonuses at the discretion of the compensation committee of the
board of directors.   During the first year of the Agreement, an
amount equal to $55,000 of the base salary shall be paid by grant of stock
options under the Company’s 2000 Stock Option and Restricted Stock Plan to
purchase 412,500 shares of the Company’s common stock, vesting in equal
quarterly installments over the year ending June 1, 2006, and the remaining
$120,000 of the base salary is to be paid-in cash.  The agreement with
this Chief Financial Officer also provides, among other things, for
reimbursement of certain business expenses and for certain payments to be made
to this Chief Financial Officer in the event of a change in
control.  This Chief Financial Officer also received 1,733,750
incentive stock options in June 2005, which will vest over a five year period
and have an exercise price of $0.20, and 66,250 non-qualified stock options
which vested on June 1, 2006 and have an exercise price of $0.20 (see Note 11).
The agreement also provides for certain non-competition and nondisclosure
covenants.  As of December 31, 2009, a total of 2,122,500 of the stock
options are vested, and 90,000 stock options are unvested, and all remain
outstanding.  All of these stock options expire on May 31,
2015.


F-24


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Consulting
Agreements:





On June
9, 2005, the Company entered into a consulting agreement with an advisor to
serve as the Company’s Senior Technical Advisor.  The term of this
agreement is for 24 months and calls for the advisor to assist the Company in
digitizing the Company’s technology.  For his services, the Company
agreed to issue the advisor 400,000 options, vesting quarterly from the date of
the agreement (see Note 11).  In addition, the Company will reimburse
all reasonable and necessary expenses incurred by the advisor.  In the
event that the Company’s annual sales from digital products reaches $5,000,000,
the Company will pay the advisor a $100,000 one time bonus.  The
agreement contains confidentiality and non-competition
provisions.  This agreement can be terminated in 90 days by either
party by written notices.  On June 6, 2007, the Company renewed the
agreement with the advisor.  In connection with the renewal, the
Company granted the advisor 1,000,000 warrants (see Note 10), which vest upon
the approval of certain patents created by the advisor, by the US Patent Office,
or the buy-out of the Company, whichever occurs first.  All of the
1,000,000 warrants remain unvested as of December 31, 2009 and
2008.





On
January 7, 2008, the Company entered into a consulting agreement with a European
sales and marketing consultant.  This agreement was terminated on
September 1, 2008 and all obligations have been satisfied in full and all stock
options issued to the consultant were cancelled.





On
October 8, 2008 and October 27, 2008, the Company entered into two business
advisory agreements with two advisors.  The agreements call for each
of the advisors to perform introductory and business development services for
the Company.  For their services, the Company has agreed to grant each
advisor 250,000 common stock warrants (see Note 10), 50,000 of which will vest
upon the commencement of  testing of the Company’s technology as a
direct result of the advisors efforts, and the remaining 200,000 will vest upon
the purchase of the Company’s products or an agreement to license the Company’s
technology as a direct result of the advisors’ efforts.  As of
December 31, 2009, these agreements have been terminated and 50,000 of the
granted warrants have been vested.  The remaining warrants were
cancelled.





Other agreements:





On
January 23, 2008, the Company signed an efficiency aggregation contract with San
Diego Gas & Electric Company (“SDG&E”).  Under the terms of
this contract, SDG&E will pay the Company $0.14 per kWh of energy saved in
the first year of operation of the MEC, for new installations of the MEC in
SDG&E’s service area.   Payment to the Company is subject to
certain inspections, approvals and time restrictions.  The term of
this contract is for 5 years, and either party may terminate this contract upon
written notice.   As of the date of this report, Company has not
received any payments under this contract.





NOTE 13 -
RELATED PARTY TRANSACTIONS:





On
December 11, 2009, the Company entered into a financing transaction in which it
issued 8,750 units, each unit consisting of one share of the Company’s Series
C-1 Preferred Stock and a warrant to purchase up to 50 shares of the Company’s
common stock, in exchange for 8,750 shares of its Series C Preferred Stock in
accordance with the terms of the Series C Preferred Stock.  In this
transaction, Steven Strasser, the Company’s CEO, exchanged 6,250 shares, Kenneth
Dickey, a Director of the Company, exchanged 1,250 shares, and Scott Johnson,
the Company’s COO, exchanged 1,250 units shares (See Note 15).


F-25


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





On August
12, 2009, the Company entered into a financing transaction in which it issued
8,750 units, each unit consisting of one share of the Company’s Series C
Preferred Stock and a warrant to purchase up to 50 shares of the Company’s
common stock for $350,000 in cash.  In this transaction, Steven
Strasser, the Company’s CEO, purchased 6,250 units for $250,000 in cash, Kenneth
Dickey, a Director of the Company, purchased 1,250 for $50,000 in cash, and
Scott Johnson, the Company’s COO, purchased 1,250 units for $50,000 in cash (See
Note 15).





On
January 21, 2008, the Company entered into a financing transaction in which it
issued 5,600 units, each unit consisting of one share of the Company’s Series B
Preferred Stock and a warrant to purchase up to 50 shares of the Company’s
common stock to Steven Strasser, the Company’s Chief Executive Officer, for
$80,000 in cash (See Note 15).





NOTE
14  -  SUPPLEMENTAL DISCLOSURE OF CASH FLOWS
INFORMATION:





Cash paid
during the year ended December 31, for:





2009
            
            
            2008Income/franchise
      taxes
            
            $
            10,869
            
            
            $
            12,271





Non-cash
investing and financing activities during the year ended December 31,
for:





2009
            
            
            2008Warrants
      and options issued with common stock issued to employees and
      consultants
            
            $
            405,143
            
            
            $
            765,504Common
      stock issued upon cashless exercise of options and
warrants
            
            $
            19
            
            
            $
            -Warrants
      reclassified from liability to paid-in capital
            
            $
            248,680
            
            
            $
            -Exchange
      of Series C Preferred Stock to Series C-1 Preferred Stock
            
            $
            753,438
            
            
            $
            -Preferred
      stock dividend recognized for beneficial conversion features of preferred
      stock issuances
            
            $
            589,907
            
            
            $
            -Preferred
      stock dividends paid or payable in common stock
            
            $
            681,077
            
            
            $
            545,800




F-26


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE
15  -  CONVERTIBLE PREFERRED STOCK:





On
December 11, 2009 and December 29, 2009, the Company issued and sold 30,250
units, each unit consisting of one share of the Company’s Series C-1 Preferred
Stock, par value $.001 per share, and 50 warrants to purchase shares of the
Company’s common stock at an exercise price of $0.40 per share, resulting in the
sale and issuance of an aggregate of 30,250 shares of Series C-1 Preferred Stock
and warrants to purchase, initially, up to 1,512,500 shares of the Company’s
common stock, with exercise prices equal to $0.40 per share, in a private
offering for an aggregate of $1,210,000, of which $275,000 was in cash, and
$935,000 was from the conversion of 23,375 shares of the Company’s Series C
Preferred Stock, and is recorded as a component of Stockholders’
Equity.  The former Series C Preferred Stockholders retained their
original Series C warrants to purchase, initially, up to 1,168,750 shares of the
Company’s common stock, with exercise prices equal to $0.40 per share, that were
originally valued at approximately $182,000.  The securities were
issued pursuant to Regulation D of the Securities Act of 1933. All of the
purchasers of Units were either officers, directors or pre-existing stockholders
of the Company.  Each of these purchasers represented that they were
an “accredited investor” as such term is defined in Regulation D of the
Securities Act (See Note 13).  Of the aggregate $1,210,000 invested, a
value of approximately $408,000 was allocated to the 1,512,500 Series C-1
warrants, and a value of approximately $249,000 was allocated to the 1,168,750
Series C warrants, and recorded as a component of paid-in
capital.   The latter amount includes approximately $67,000 which
is attributable to the change in value of certain warrants classified as
liabilities.





Each
share of Series C-1 Preferred Stock is initially convertible into 133.33 shares
of the Company’s common stock, subject to adjustment under certain
circumstances.  The Series C-1 Preferred Stock is convertible at the
option of the holder at any time.  The Series C-1 Preferred Stock is
also subject to mandatory conversion in the event the average closing price of
the Company’s common stock for any ten day period equals or exceeds $1.00 per
share, such conversion to be effective on the trading day immediately following
such ten day period.  In addition, the Series C-1 Preferred
stockholders had the option to exchange their Series C-1 Preferred Stock for
units of a subsequent financing of the Company through December 30, 2009, at no
additional cost.  The Series C-1 Preferred Stock has a dividend equal
to 8% of the aggregate $1,210,000 stated value of the Series C-1 Preferred
Stock, payable annually in cash or stock, at the discretion of the Company’s
board of directors.  Upon any liquidation, dissolution, or winding up
of the Company, whether voluntary or involuntary, before any distribution or
payment is made to the holders of any stock of the Company, the holders of
Series C-1 Stock are entitled to be paid out of the assets of the Company,
proportionallywith
any other series of preferred stock, an amount per share of Series C-1 Stock
equal to the stated value (as adjusted for any stock dividends, combinations,
splits, recapitalizations and the like with respect to such shares), plus all
accrued but unpaid dividends (whether declared or not) on such shares of Series
C-1 Stock for each share of  Series C-1 Stock held by
them.  The conversion of the Series C Preferred Stock into units sold
in the offering of Series C-1 Preferred Stock and the conversion feature of the
Series C-1 Preferred Stock at the time of issuance were determined to be
beneficial conversion features on December 11, 2009, the date of the
transaction.  The Company recorded additional preferred stock
dividends of approximately $590,000 related to the beneficial conversion
feature.


F-27


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





On August
12, 2009 and October 5, 2009, the Company issued and sold 23,375 units, each
unit consisting of one share of the Company’s Series C Preferred Stock, par
value $.001 per share, and 50 warrants to purchase shares of the Company’s
common stock at an exercise price of $0.40 per share, resulting in the sale and
issuance of an aggregate of 23,375 shares of Series C Preferred Stock and
warrants to purchase, initially, up to 1,168,750 shares of the Company’s common
stock, with exercise prices of $0.40 per share, in a private offering for
$935,000 in cash, and is recorded as a component of Stockholders’
Equity.  The securities were issued pursuant to Regulation D of the
Securities Act of 1933. All of the purchasers of Units were either officers,
directors or pre-existing stockholders of the Company.  Each of these
purchasers represented that they were an “accredited investor” as such term is
defined in Regulation D of the Securities Act (See Note 13).  Of the
aggregate $935,000 invested, a value of approximately $182,000 was allocated to
the 1,168,750 warrants, and initially recorded as warrant
liabilities.  Subsequent to the grant date and upon qualification,
these warrants were reclassified into paid-in capital at their fair value
totaling $248,680 on the dates of reclassification.  All outstanding
shares of the Company’s Series C Preferred Stock were exchanged for the
Company’s Series C-1 Preferred Stock on December 11, 2009.  No shares
of the Company’s Series C Preferred Stock were outstanding at December 31,
2009.





Each
share of Series C Preferred Stock was initially convertible into 100 shares of
the Company’s common stock, subject to adjustment under certain
circumstances.  The Series C Preferred Stock was convertible at the
option of the holder at any time.  The Series C Preferred Stock was
also subject to mandatory conversion in the event the average closing price of
the Company’s common stock for any ten day period equals or exceeds $1.00 per
share, such conversion to be effective on the trading day immediately following
such ten day period.  In addition, the Series C Preferred stockholders
had the option to exchange their Series C Preferred Stock for units of a
subsequent financing of the Company through December 30, 2009, at no additional
cost.  The Series C Preferred Stock had a dividend equal to 8% of the
stated value of the Series C Preferred Stock, payable annually in cash or stock,
at the discretion of the Company’s board of directors.  Upon any
liquidation, dissolution, or winding up of the Company, whether voluntary or
involuntary, before any distribution or payment is made to the holders of any
stock of the Company, the holders of Series C Stock were entitled to be paid out
of the assets of the Company, proportionally with any other series of preferred
stock, an amount per share of Series C Stock equal to the stated value (as
adjusted for any stock dividends, combinations, splits, recapitalizations and
the like with respect to such shares), plus all accrued but unpaid dividends
(whether declared or not) on such shares of Series C Stock for each share
of  Series C Stock held by them.





On
various dates from October 29, 2007 through January 21, 2008, the Company issued
and sold 140,000 units, each unit consisting of one share of the Company’s
Series B Preferred Stock, par value $.001 per share, and a warrant to purchase
50 shares of the Company’s common stock, resulting in the sale and issuance of
an aggregate of 140,000 shares of Series B Preferred Stock and warrants to
purchase, initially, up to 7,000,000 shares of the Company’s common stock, with
exercise prices of $0.60 per share, in a private offering (the “Preferred
Offering”) for $7,000,000 in cash and cancellation of
indebtedness.  Many of the purchasers of Units were either officers,
directors or pre-existing stockholders or noteholders of the Company (See Note
13).


F-28


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Each
share of Series B Preferred Stock is initially convertible into 100 shares of
the Company’s common stock, subject to adjustment under certain
circumstances.  The Series B Preferred Stock is convertible at the
option of the holder at any time.  The Series B Preferred Stock is
also subject to mandatory conversion in the event the average closing price of
the Company’s common stock for any ten day period equals or exceeds $1.00 per
share, such conversion to be effective on the trading day immediately following
such ten day period.  The Series B Preferred Stock has a dividend
equal to 8% of the aggregate $7,000,000 stated value of the Series B Preferred
Stock, payable annually in cash or stock, at the discretion of the Company’s
board of directors.  Upon any liquidation, dissolution, or winding up
of the Company, whether voluntary or involuntary, before any distribution or
payment is made to the holders of any stock of the Company, the holders of
Series B Stock are entitled to be paid out of the assets of the Company,
proportionallywith
any other series of preferred stock, an amount per share of Series B Stock equal
to the stated value (as adjusted for any stock dividends, combinations, splits,
recapitalizations and the like with respect to such shares), plus all accrued
but unpaid dividends (whether declared or not) on such shares of Series B Stock
for each share of  Series B Stock held by them.





The
Preferred Offering was conducted pursuant to an exemption from the registration
requirements of the Securities Act of 1933, as amended, pursuant to Regulation
D, Section 4(2) and Rule 506 thereunder.  No placement agent or
underwriter was used in connection with the Offering and there is no commission,
finder’s fee or other compensation due or owing to any party.





On
December 11, 2009 the Company declared and paid a stock dividend of 77,977
shares of common stock, valued at $23,392, payable to all of the holders of its
Series C Preferred Stock.  As of December 31, 2009, the Company has $0
in dividends payable accrued for its Series C Preferred Stock, and $4,352 in
dividends payable accrued for its Series C-1 Preferred Stock, which is
classified as additional paid-in capital.





On
November 1, 2009, the Company declared a stock dividend of 1,473,684 shares of
common stock, valued at $560,000, payable to all of the holders of its Series B
Preferred Stock.  The dividend was paid on December 1,
2009.  As of December 31, 2009, the Company has $93,333 in dividends
payable accrued for its Series B Preferred Stock, which is classified as
additional paid-in capital.





On
November 1, 2008, the Company declared a stock dividend of 2,729,000 shares of
common stock, valued at $545,800, payable to all of the holders of its Series B
Preferred Stock.  The dividend was paid on November 24,
2008.  As of December 31, 2008, the Company had $0 in dividends
payable for its Series B Preferred Stock.





Series B
Preferred Stock Activity during the years ended December 31, 2008 and 2009 are
as follows:





Shares
            
            
            Par
      ValueSeries
      B Preferred Stock issued and outstanding at January 1,
2008
            
            
            134,400
            
            
            $
            134Issued
      during 2008
            
            
            5,600
            
            
            
            6Series
      B Preferred Stock issued and outstanding at December 31,
    2008
            
            
            140,000
            
            
            
            140Issued
      during 2009
            
            
            -
            
            
            
            -Series
      B Preferred Stock issued and outstanding at December 31,
    2009
            
            
            140,000
            
            
            $
            140




F-29


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Series C
Preferred Stock Activity during the years ended December 31, 2008 and 2009 are
as follows:





Shares
            
            
            Par
      ValueSeries
      C Preferred Stock issued and outstanding at January 1,
2008
            
            
            -
            
            
            $
            -Issued
      during 2008
            
            
            -
            
            
            
            -Series
      C Preferred Stock issued and outstanding at December 31,
    2008
            
            
            -
            
            
            
            -Issued
      during 2009
            
            
            23,375
            
            
            
            23Converted
      to Series C-1 Preferred Stock during 2009
            
            
            (23,375
            )
            
            
            (23
            )Series
      C Preferred Stock issued and outstanding at December 31,
    2009
            
            
            -
            
            
            $
            -





Series
C-1 Preferred Stock Activity during the years ended December 31, 2008 and 2009
are as follows:





Shares
            
            
            Par
      ValueSeries
      C-1 Preferred Stock issued and outstanding at January 1,
    2008
            
            
            -
            
            
            $
            -Issued
      during 2008
            
            
            -
            
            
            
            -Series
      C-1 Preferred Stock issued and outstanding at December 31,
      2008
            
            
            -
            
            
            
            -Issued
      during 2009
            
            
            30,250
            
            
            
            30Series
      C-1 Preferred Stock issued and outstanding at December 31,
      2009
            
            
            30,250
            
            
            $
            30


NOTE
16  -  COMMON STOCK


On
various dates from November 30, 2006 through March 31, 2007, the Company issued
and sold an aggregate of 14,116,680 shares of its common stock and 7,058,340
warrants to purchase its common stock (the “Equity Warrants”), in a private
offering (the “Offering”) for $4,235,000 in cash, cancellation of indebtedness
and in lieu of compensation owed to certain employees, officers and directors of
the Company.  The per share purchase price of the common stock was
$0.30.  The Equity Warrants have a per share exercise price of $0.40,
are exercisable immediately and expire on various dates from November 29, 2011
through March 30, 2012.





The
$4,235,000 investment included $250,000 from Steven Strasser, the Company’s
Chief Executive Officer, $30,000 from John (BJ) Lackland, the Company’s Chief
Financial Officer, $30,000 from Robert Murray, the Company’s former Chief
Operating Officer, and $300,000 from George Boyadjieff, a Director of the
Company.





The
Offering was conducted pursuant to an exemption from the registration
requirements of the Securities Act of 1933, as amended, pursuant to Regulation
D, Section 4(2) and Rule 506 thereunder.  No placement agent or
underwriter is entitled to compensation in connection with either the Offering
or the sale of the Notes and there is no commission, finder’s fee or other
compensation due or owing to any party.





NOTE 17 -
401(K) RETIREMENT PLANS:


The
Company maintains a 401(k) retirement plan (the 401(k) Plan).  The
401(k) Plan is voluntary, and available to all employees who have been with the
Company for at least six months.  The Company may make discretionary
contributions.  The Company did not make any contributions in 2009 or
2008.


F-30


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE 18 –
UNAUDITED SELECTED QUARTERLY FINANCIAL DATA:





During
the year ended December 31, 2009, the Company corrected errors in its warrant
liability valuation, related to its estimated volatility, as well as its
deferred tax liability calculation.





During
the year ended December 31, 2009, the Company discovered errors in its warrant
valuation model.  The Company calculated its warrant liability values
utilizing an estimated volatility rate.  During the audit for the year
ended December 31, 2009, the Company determined that the estimated volatility
rate used was incorrect.   The Company reviewed and revised its
estimated volatility rate and warrant valuation model, which resulted in
material differences in the Company’s warrant liability and related fair market
value adjustments on warrant liability for the year ended December 31,
2009.  The Company determined that the error was not material to prior
quarters due to the warrant liability’s non-cash nature and because the errors
were qualitatively insignificant to operations.





During
the year ended December 31, 2009, the Company identified errors in the Company’s
tax provision.  Previously, the Company did not recognize a deferred
tax liability related to its amortization of goodwill for tax
purposes.  The Company reviewed and revised its tax provision to
include this deferred tax liability as of January 1, 2009 and for the year ended
December 31, 2009.  The Company determined that the error was not
material to prior years due to the deferred tax provision’s non-cash nature and
because the errors were qualitatively insignificant to operations.





The
following tables set forth the corrected quarterly financial data.





For the
three months ended March 31, 2009:





As
      Previously Reported
            
            
            Adjustments
            
            
            As
      AdjustedRevenues
            
            $
            47,147
            
            
            $
            -
            
            
            $
            47,147Cost
      of revenues
            
            
            28,808
            
            
            
            -
            
            
            
            28,808Gross
      profit
            
            
            18,339
            
            
            
            -
            
            
            
            18,339Total
      costs and expenses
            
            
            837,846
            
            
            
            -
            
            
            
            837,846Loss
      from operations
            
            
            (819,507
            )
            
            
            -
            
            
            
            (819,507
            )Other
      income and (expense)
            
            
            (476,834
            )
            
            
            165,421
            
            
            
            (311,413
            )Loss
      before provision for taxes
            
            
            (1,296,341
            )
            
            
            165,421
            
            
            
            (1,130,920
            )Provision
      for taxes
            
            
            -
            
            
            
            12,486
            
            
            
            12,486Net
      loss
            
            
            (1,296,341
            )
            
            
            152,935
            
            
            
            (1,143,406
            )Dividends
      paid or payable on Series B and Series C Convertible Preferred
      Stock
            
            
            233,333
            
            
            
            -
            
            
            
            233,333Net
      loss attributable to common shareholders
            
            $
            (1,529,674
            )
            
            $
            152,935
            
            
            $
            (1,376,739
            )Basic
      and fully diluted loss per common share
            
            $
            (0.04
            )
            
            $
            0.01
            
            
            $
            (0.03
            )Weighted
      average common shares outstanding basic
            
            
            43,255,441
            
            
            
            43,255,441
            
            
            
            43,255,441




F-31


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





For the
three months ended June 30, 2009:





As
      Previously Reported
            
            
            Adjustments
            
            
            As
      AdjustedRevenues
            
            $
            75,393
            
            
            $
            -
            
            
            $
            75,393Cost
      of revenues
            
            
            49,556
            
            
            
            -
            
            
            
            49,556Gross
      profit
            
            
            25,837
            
            
            
            -
            
            
            
            25,837Total
      costs and expenses
            
            
            916,310
            
            
            
            -
            
            
            
            916,310Loss
      from operations
            
            
            (890,473
            )
            
            
            -
            
            
            
            (890,473
            )Other
      income and (expense)
            
            
            852,108
            
            
            
            (308,743
            )
            
            
            543,365Loss
      before provision for taxes
            
            
            (38,365
            )
            
            
            (308,743
            )
            
            
            (347,108
            )Provision
      for taxes
            
            
            -
            
            
            
            12,486
            
            
            
            12,486Net
      loss
            
            
            (38,365
            )
            
            
            (321,229
            )
            
            
            (359,594
            )Dividends
      paid or payable on Series B and Series C Convertible Preferred
      Stock
            
            
            140,000
            
            
            
            -
            
            
            
            140,000Net
      loss attributable to common shareholders
            
            $
            (178,365
            )
            
            $
            (321,229
            )
            
            $
            (499,594
            )Basic
      and fully diluted loss per common share
            
            $
            (0.00
            )
            
            $
            (0.01
            )
            
            $
            (0.01
            )Weighted
      average common shares outstanding basic
            
            
            43,255,441
            
            
            
            43,255,441
            
            
            
            43,255,441





For the
three months ended September 30, 2009:




As
      Previously Reported
            
            
            Adjustments
            
            
            As
      AdjustedRevenues
            
            $
            63,130
            
            
            $
            -
            
            
            $
            63,130Cost
      of revenues
            
            
            49,703
            
            
            
            -
            
            
            
            49,703Gross
      profit
            
            
            13,427
            
            
            
            -
            
            
            
            13,427Total
      costs and expenses
            
            
            940,412
            
            
            
            -
            
            
            
            940,412Loss
      from operations
            
            
            (926,985
            )
            
            
            -
            
            
            
            (926,985
            )Other
      income and (expense)
            
            
            (332,452
            )
            
            
            299,510
            
            
            
            (32,942
            )Loss
      before provision for taxes
            
            
            (1,259,437
            )
            
            
            299,510
            
            
            
            (959,927
            )Provision
      for taxes
            
            
            -
            
            
            
            12,486
            
            
            
            12,486Net
      loss
            
            
            (1,259,437
            )
            
            
            287,024
            
            
            
            (972,413
            )Dividends
      paid or payable on Series B and Series C Convertible Preferred
      Stock
            
            
            145,281
            
            
            
            -
            
            
            
            145,281Net
      loss attributable to common shareholders
            
            $
            (1,404,718
            )
            
            $
            287,024
            
            
            $
            (1,117,694
            )Basic
      and fully diluted loss per common share
            
            $
            (0.03
            )
            
            $
            0.00
            
            
            $
            (0.03
            )Weighted
      average common shares outstanding basic
            
            
            43,255,441
            
            
            
            43,255,441
            
            
            
            43,255,441




F-32


POWER
EFFICIENCY CORPORATION


NOTES TO
FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE 19 -
SUBSEQUENT EVENTS:





On
January 20, 2010, the Company issued and sold an additional 2,500 units,
resulting in the sale and issuance of an aggregate of 2,500 shares of Series C-1
Preferred Stock and warrants to purchase up to 125,000 shares of the Company’s
common stock for $100,000 in cash under the above referenced financing
transaction.





On March
30, 2010, the Company issued unsecured notes to Steven Strasser, the Company’s
CEO, totaling $125,000.  The notes bear interest at 5%, payable upon
maturity. The notes mature two months after issuance.


F-33