UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549




———————


FORM
10-Q/A


(Amendment No. 1)


———————


(Mark
One)


þQUARTERLY REPORT PURSUANT TO SECTION
13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934




For the
quarterly period ended June 30,
2010




or




 ̈TRANSITION REPORT PURSUANT TO SECTION
13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934




For the
transition period from ____________ to ________________






Commission
file number 333-123092


———————


IMAGE
METRICS, INC.


(Exact
name of registrant as specified in its charter)


———————




Nevada
              
              20-1719023(State
      or other jurisdiction
                of
      incorporation or organization)
              
              (I
      R S Employer
                Identification
      No.)





1918
Main Street, Santa Monica, California  90405


(Address
of principal executive offices)     (Zip Code)




(310)
656-6551


(Registrant’s
telephone number, including area code)




———————




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




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation 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  ̈  No  ̈Not
applicable þ




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company.
(Check one):




Large
      accelerated filer
               ̈
              
              Accelerated
      filer
               ̈Non-accelerated
      filer
               ̈
              
              Smaller reporting company
              þ





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





As of
September
17, 2010, there were 15,869,277 shares of the issuer’s common stock, par
value $0.001 issued and outstanding.









Explanatory Note
  We are
filing this Amendment No. 1 to our quarterly report on Form 10-Q for the three
months ended on June 30, 2010, filed with the SEC on September 17, 2010 (the
“Original Report”), for the purposes of restating its financial
statements.  Specifically, we have amended the consolidated financial
statements and footnotes to the consolidated financial statements in the Form
10-Q/A to properly apply the provisions of FASB Accounting Standards
Codification No. 820, “Fair Value Measurements and Disclosures”.    In
addition, we have amended the statement of operations and earnings per share
calculations to reflect the deemed dividend was issued by Image Metrics
Limited to SHV and one other shareholder prior to the exchange
transaction.  We have amended the following items:
 
 the
unaudited condensed consolidated financial statements, and
 Notes
1, 4, 5, 6, 7, 8, 10, 11 and 12 to the unaudited condensed consolidated
financial statements.
 
 Except as
discussed above, we have not modified or updated disclosures presented in the
Original Report. Accordingly, this Amendment No. 1 does not reflect events
occurring after the filing of the Original Report, nor does it modify or update
those disclosures affected by subsequent events. It also does not affect
information contained in the Original Report which was not impacted by these
restatements. Events occurring after the filing of the Original Report or other
disclosures necessary to reflect subsequent events have been or will be
addressed in our reports filed subsequent to the Original Report. This Amendment
No. 1 should be read in conjunction with our filings made with the Securities
and Exchange Commission subsequent to the filing of the Original Report,
including any amendments to those filings.
 
 This Form
10-Q/A replaces the Original Report in its entirety.


IMAGE
METRICS, INC.


JUNE
30, 2010 QUARTERLY REPORT ON FORM 10-Q/A


TABLE
OF CONTENTS




PAGEPART
      I - FINANCIAL INFORMATIONItem
      1.
                    Financial
      Statements
                    1Balance
      Sheets as at June 30, 2010 (Restated) (Unaudited) and September 30, 2009
      (Unaudited)
                    1Statements
      of Operations for the three and nine months ended June 30, 2010 (Restated)
      and 2009 (Unaudited)
                    2Statements
      of Cash Flows for the nine months ended June 30, 2010 (Restated) and 2009
      (Unaudited)
                    3Notes
      to Condensed Consolidated Financial Statements (Unaudited)
                    4Item
      2.
                    Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                    16Item
      3.
                    Quantitative
      and Qualitative Disclosures About Market Risk
                    24Item
      4.
                    Controls
      and Procedures
                    24PART
      II - OTHER INFORMATIONItem
      1.
                    Legal
      Proceedings
                    24Item
      1A.
                    Risk
      Factors
                    24Item
      2.
                    Unregistered
      Sales of Equity Securities and Use of Proceeds
                    33Item
      3.
                    Defaults
      Upon Senior Securities
                    33Item
      4.
                    Submission
      of Matters to a Vote of Security Holders
                    33Item
      5.
                    Other
      Information
                    33Item
      6.
                    Exhibits
                    33









PART
1 – FINANCIAL INFORMATION




ITEM 1.
FINANCIAL STATEMENTS




Image
Metrics, Inc.


Condensed
Consolidated Balance Sheets


(Amounts
in thousands of US Dollars, except share data)




June
      30,
                                        2010
                                      
                                      
                                      September 30,
                                        2009(Unaudited)(restated)AssetsCurrent
      assetsCash
      and cash equivalents
                                      
                                      $
                                      262
                                      
                                      
                                      $
                                      803Restricted
      cash
                                      
                                      
                                      100
                                      
                                      
                                      
                                      100Accounts
      receivable
                                      
                                      
                                      350
                                      
                                      
                                      
                                      422Prepaid
      and other current assets
                                      
                                      
                                      259
                                      
                                      
                                      
                                      256Total
      current assets
                                      
                                      
                                      971
                                      
                                      
                                      
                                      1,581Property
      and equipment (net)
                                      
                                      
                                      192
                                      
                                      
                                      
                                      177Investment
      in Optasia
                                      
                                      
                                      -
                                      
                                      
                                      
                                      729192
                                      
                                      
                                      
                                      906Total
      assets
                                      
                                      $
                                      1,163
                                      
                                      
                                      $
                                      2,487Liabilities
      and shareholders’ deficitCurrent
      liabilitiesAccounts
      payable
                                      
                                      $
                                      1,296
                                      
                                      
                                      $
                                      539Accrued
      expenses and other current liabilities
                                      
                                      
                                      751
                                      
                                      
                                      
                                      1,219Deferred
      revenue
                                      
                                      
                                      6,083
                                      
                                      
                                      
                                      8,522Notes
      payable, net of discount
                                      
                                      
                                      1,075
                                      
                                      
                                      
                                      830Notes
      payable to related party, net of discount
                                      
                                      
                                      564
                                      
                                      
                                      
                                      -Warrant
      liability
                                      
                                      
                                      3,986
                                      
                                      
                                      
                                      -Total
      current liabilities
                                      
                                      
                                      13,755
                                      
                                      
                                      
                                      11,110Notes
      payable (noncurrent portion)
                                      
                                      
                                      -
                                      
                                      
                                      
                                      80Notes
      payable to related party (noncurrent portion)
                                      
                                      
                                      -
                                      
                                      
                                      
                                      2,078Total
      liabilities
                                      
                                      
                                      13,755
                                      
                                      
                                      
                                      13,268Shareholders’
      deficitCommon
      Stock, $0.001 par value. Authorized 75,000,000 shares; issued and
      outstanding 15,869,277 and 11,851,637 shares at June 30, 2010 and
      September 30, 2009, respectively
                                      
                                      
                                      16
                                      
                                      
                                      
                                      12Series
      A Convertible Preferred stock, $0.001 par value.  Authorized
      15,000,000 shares; issued and outstanding 9,371,098 and 0 shares at June
      30, 2010 and September 30, 2009, respectively
                                      
                                      
                                      6,753
                                      
                                      
                                      
                                      -Additional
      paid-in-capital
                                      
                                      
                                      17,464
                                      
                                      
                                      
                                      15,445Accumulated
      deficit
                                      
                                      
                                      (36,573
                                      )
                                      
                                      
                                      (25,983
                                      )Accumulated
      other comprehensive loss
                                      
                                      
                                      (252
                                      )
                                      
                                      
                                      (255
                                      )Total
      shareholders’ deficit
                                      
                                      
                                      (12,592
                                      )
                                      
                                      
                                      (10,781
                                      )Total
      liabilities and shareholders’ deficit
                                      
                                      $
                                      1,163
                                      
                                      
                                      $
                                      2,487




See notes
to the condensed consolidated financial statements.




1




Image
Metrics, Inc.


Condensed
Consolidated Statements of Operations


(Amounts
in thousands of US Dollars, except share data)


(unaudited)




Three Months ended
                                                          June
      30,
                                                        
                                                        
                                                        Nine Months ended
                                                          June
      30,2010
                                                        
                                                        
                                                        2009
                                                        
                                                        
                                                        2010
                                                        
                                                        
                                                        2009(restated)
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (restated)Revenue
                                                        
                                                        $
                                                        926
                                                        
                                                        
                                                        $
                                                        176
                                                        
                                                        
                                                        $
                                                        4,887
                                                        
                                                        
                                                        $
                                                        1,737Cost
      of revenue (exclusive of depreciation shown separately
    below)
                                                        
                                                        
                                                        (722
                                                        )
                                                        
                                                        
                                                        (874
                                                        )
                                                        
                                                        
                                                        (2,361
                                                        )
                                                        
                                                        
                                                        (1,506
                                                        )Gross
      profit (loss)
                                                        
                                                        
                                                        204
                                                        
                                                        
                                                        
                                                        (698
                                                        )
                                                        
                                                        
                                                        2,526
                                                        
                                                        
                                                        
                                                        231Operating
      expensesSelling
      and marketing
                                                        
                                                        
                                                        399
                                                        
                                                        
                                                        
                                                        667
                                                        
                                                        
                                                        
                                                        1,242
                                                        
                                                        
                                                        
                                                        2,199Research
      and development
                                                        
                                                        
                                                        323
                                                        
                                                        
                                                        
                                                        342
                                                        
                                                        
                                                        
                                                        934
                                                        
                                                        
                                                        
                                                        1,077Depreciation
      and amortization
                                                        
                                                        
                                                        51
                                                        
                                                        
                                                        
                                                        36
                                                        
                                                        
                                                        
                                                        143
                                                        
                                                        
                                                        
                                                        171General
      and administrative
                                                        
                                                        
                                                        1,598
                                                        
                                                        
                                                        
                                                        601
                                                        
                                                        
                                                        
                                                        5,433
                                                        
                                                        
                                                        
                                                        2,417Total
      operating expenses
                                                        
                                                        
                                                        2,371
                                                        
                                                        
                                                        
                                                        1,646
                                                        
                                                        
                                                        
                                                        7,752
                                                        
                                                        
                                                        
                                                        5,864Operating
      loss
                                                        
                                                        
                                                        (2,167
                                                        )
                                                        
                                                        
                                                        (2,344
                                                        )
                                                        
                                                        
                                                        (5,226
                                                        )
                                                        
                                                        
                                                        (5,633
                                                        )Interest
      income (expense)
                                                        
                                                        
                                                        329
                                                        
                                                        
                                                        
                                                        (95
                                                        )
                                                        
                                                        
                                                        (3,062
                                                        )
                                                        
                                                        
                                                        (344
                                                        )Optasia
      investment impairment
                                                        
                                                        
                                                        (729
                                                        )
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        (729
                                                        )
                                                        
                                                        
                                                        -Foreign
      exchange gain (loss)
                                                        
                                                        
                                                        (1
                                                        )
                                                        
                                                        
                                                        (124
                                                        )
                                                        
                                                        
                                                        (163
                                                        )
                                                        
                                                        158Total
      other expense
                                                        
                                                        
                                                        (401
                                                        )
                                                        
                                                        
                                                        (219
                                                        )
                                                        
                                                        
                                                        (3,954
                                                        )
                                                        
                                                        
                                                        (186
                                                        )Loss
      before provision for income taxes
                                                        
                                                        
                                                        (2,568
                                                        )
                                                        
                                                        
                                                        (2,563
                                                        )
                                                        
                                                        
                                                        (9,180
                                                        )
                                                        
                                                        
                                                        (5,819
                                                        )Provision
      for income taxes
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        -Net
      loss
                                                        
                                                        $
                                                        (2,568
                                                        )
                                                        
                                                        $
                                                        (2,563
                                                        )
                                                        
                                                        $
                                                        (9,180
                                                        )
                                                        
                                                        $
                                                        (5,819
                                                        )Deemed
      dividend
                                                        
                                                        
                                                        (30
                                                        )
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        (1,140
                                                        )
                                                        
                                                        
                                                        -Net
      loss attributable to common stock
                                                        
                                                        
                                                        (2,598
                                                        )
                                                        
                                                        
                                                        (2,563
                                                        )
                                                        
                                                        
                                                        (10,320
                                                        )
                                                        
                                                        
                                                        (5,819
                                                        )Basic
      and diluted net loss per share of common stock
                                                        
                                                        $
                                                        (0.16
                                                        )
                                                        
                                                        $
                                                        (0.22
                                                        )
                                                        
                                                        $
                                                        (0.76
                                                        )
                                                        
                                                        $
                                                        (0.49
                                                        )Weighted
      average shares used in computing net loss per share of common
      stock
                                                        
                                                        
                                                        15,869,277
                                                        
                                                        
                                                        
                                                        11,851,637
                                                        
                                                        
                                                        
                                                        13,516,842
                                                        
                                                        
                                                        
                                                        11,851,637




See notes
to the condensed consolidated financial statements.




2




Image
Metrics, Inc.


Condensed
Consolidated Statements of Cash Flows


(Amounts
in thousands of US Dollars, except share data)


(unaudited)




Nine months ended June 30,2010
                                      
                                      
                                      2009(restated)Operating
      activities:Net
      loss
                                      
                                      $
                                      (9,180
                                      )
                                      
                                      $
                                      (5,819
                                      )Adjustments
      to reconcile net loss to net cash used for operating
      activities:Depreciation
      and amortization
                                      
                                      
                                      143
                                      
                                      
                                      
                                      171Stock-based
      compensation
                                      
                                      
                                      214
                                      
                                      
                                      
                                      16Non-cash
      interest expense
                                      
                                      
                                      2,950
                                      
                                      
                                      
                                      264Foreign
      currency transaction loss (gain)
                                      
                                      
                                      163
                                      
                                      
                                      
                                      (158
                                      )Changes
      in assets and liabilities:Accounts
      receivable
                                      
                                      
                                      (64
                                      )
                                      
                                      
                                      (781
                                      )Prepaid
      expenses, other current and other non-current assets
                                      
                                      
                                      726
                                      
                                      
                                      
                                      2Deferred
      revenue
                                      
                                      
                                      (2,304
                                      )
                                      
                                      
                                      4,306Accounts
      payable
                                      
                                      
                                      758
                                      
                                      
                                      
                                      (99
                                      )Accrued
      expenses and other liabilities
                                      
                                      
                                      (468
                                      )
                                      
                                      
                                      (482
                                      )Total
      adjustments
                                      
                                      
                                      2,118
                                      
                                      
                                      
                                      3,240Net
      cash used for operating activities
                                      
                                      
                                      (7,062
                                      )
                                      
                                      
                                      (2,580
                                      )Investing
      activities:Purchase
      of fixed assets
                                      
                                      
                                      (158
                                      )
                                      
                                      
                                      (131
                                      )Net
      cash used for investing activities
                                      
                                      
                                      (158
                                      )
                                      
                                      
                                      (131
                                      )Financing
      activities:Proceeds
      from exercise of stock options
                                      
                                      
                                      2
                                      
                                      
                                      
                                      -Payments
      on nonconvertible notes
                                      
                                      
                                      (274
                                      )
                                      
                                      
                                      (754
                                      )Payments
      on convertible notes
                                      
                                      
                                      (400
                                      )
                                      
                                      
                                      -Proceeds
      from issuance of convertible notes
                                      
                                      
                                      4,575
                                      
                                      
                                      
                                      2,224Proceeds
      from sale of stock
                                      
                                      
                                      2,893
                                      
                                      
                                      
                                      1,553Payment
      of debt issuance costs
                                      
                                      
                                      (80
                                      )
                                      
                                      
                                      -Net
      cash provided by financing activities
                                      
                                      
                                      6,716
                                      
                                      
                                      
                                      3,023Effects
      of exchange rates on cash and cash equivalents
                                      
                                      
                                      (37
                                      )
                                      
                                      
                                      (67
                                      )Net
      increase (decrease) in cash and cash equivalents
                                      
                                      
                                      (541
                                      )
                                      
                                      
                                      246Cash
      and cash equivalents, beginning of period
                                      
                                      
                                      803
                                      
                                      
                                      
                                      108Cash
      and cash equivalents, end of period
                                      
                                      $
                                      262
                                      
                                      
                                      $
                                      354Supplemental
      disclosure of cash flow information:Cash
      paid during the period:Interest
                                      
                                      $
                                      112
                                      
                                      
                                      $
                                      80Income
      taxes
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Non-cash
      financing activities:Conversion
      of notes payable to Series A Preferred Shares
                                      
                                      $
                                      5,462
                                      
                                      
                                      $
                                      4,859Issuance
      of warrants in connection with convertible notes payable
                                      
                                      $
                                      333
                                      
                                      
                                      $
                                      -Beneficial
      conversion feature in connection with convertible notes
      payable
                                      
                                      $
                                      630
                                      
                                      
                                      $
                                      -Beneficial
      conversion feature in connection with Series A convertible preferred
      stock
                                      
                                      $
                                      670
                                      
                                      
                                      $
                                      -Beneficial
      conversion feature in connection with Series B convertible preferred
      stock
                                      
                                      $
                                      470
                                      
                                      
                                      $
                                      -




See notes
to condensed consolidated financial statements.




3




Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


As Restated in
Note 1


(unaudited)






1.
            Description
      of Business and Summary of Significant Accounting Policies
      (restated)




Restatement




On
January 25, 2011, the Company determined it had not properly applied the
provisions of FASB Accounting Standards Codification No. 820, “Fair Value
Measurements and Disclosures”.  As a result, the Company was required to
restate its financial statements and amend its Form 10-Q for the period ended
June 30, 2010 with an increase in fair value of warrant liability of $3.99
million, an increase in notes payable discount of $0.19 million, a decrease in
Series A convertible preferred stock of $1.11 million, a decrease in retained
earnings of $3.84 million, an increase in additional paid-in-capital of $1.15
million, an increase in net loss of $0.21 million and $2.74 million for the
three months and nine months ended June 30, 2010, respectively, and an increase
in net loss attributable to common stock of $0.24 million and $3.88 million for
the three months and nine months ended June 30, 2010, respectively. 
Additionally, we have adjusted our statement of operations and earnings per
share to reflect the deemed dividend that was issued by Image Metrics Limited to
SHV and one other shareholder prior to the exchange
transaction.


The table
below reflects the balances originally recorded, the adjustment to correct the
changes described above, and the restated balances, as presented in the
accompanying financial statements.
 Three
      Months ended June 30, 2010
                              
                              
                              Nine
      Months ended June 30, 2010As
      previously
                              
                              
                              
                              
                              
                              
                              
                              
                              As
      previouslyreported
                              
                              
                              Adjustment
                              
                              
                              As
      restated
                              
                              
                              Reported
                              
                              
                              Adjustment
                              
                              
                              As
      restatedConsolidated Balance
      Sheet impactNotes
      payable to related party, net of discount
                              
                              $
                              650
                              
                              
                              $
                              (86
                              )
                              
                              $
                              564
                              
                              
                              $
                              650
                              
                              
                              $
                              (86
                              )
                              
                              $
                              564Notes
      payable, net of discount
                              
                              $
                              1,179
                              
                              
                              $
                              (104
                              )
                              
                              $
                              1,075
                              
                              
                              $
                              1,179
                              
                              
                              $
                              (104
                              )
                              
                              $
                              1,075Warrant
      liability
                              
                              $
                              -
                              
                              
                              $
                              3,986
                              
                              
                              $
                              3,986
                              
                              
                              $
                              -
                              
                              
                              $
                              3,986
                              
                              
                              $
                              3,986Total
      current liabilities
                              
                              $
                              9,959
                              
                              
                              $
                              3,796
                              
                              
                              $
                              13,755
                              
                              
                              $
                              9,959
                              
                              
                              $
                              3,796
                              
                              
                              $
                              13,755Total
      liabilities
                              
                              $
                              9,959
                              
                              
                              $
                              3,796
                              
                              
                              $
                              13,755
                              
                              
                              $
                              9,959
                              
                              
                              $
                              3,796
                              
                              
                              $
                              13,755Additional
      paid-in-capital
                              
                              $
                              16,315
                              
                              
                              $
                              1,147
                              
                              
                              $
                              17,464
                              
                              
                              $
                              16,315
                              
                              
                              $
                              1,147
                              
                              
                              $
                              17,464Series
      A convertible preferred stock
                              
                              $
                              7,858
                              
                              
                              $
                              (1,105
                              )
                              
                              $
                              6,753
                              
                              
                              $
                              7,858
                              
                              
                              $
                              (1,105
                              )
                              
                              $
                              6,753Accumulated
      deficit
                              
                              $
                              (32,733
                              )
                              
                              $
                              (3,840
                              )
                              
                              $
                              (36,573
                              )
                              
                              $
                              (32,733
                              )
                              
                              $
                              (3,840
                              )
                              
                              $
                              (36,573
                              )Total
      shareholders’ deficit
                              
                              $
                              (8,796
                              )
                              
                              $
                              (3,796
                              )
                              
                              $
                              (12,592
                              )
                              
                              $
                              (8,796
                              )
                              
                              $
                              (3,796)
                              
                              
                              $
                              (12,592
                              )Consolidated
      Statements of Operations impactInterest
      income (expense)
                              
                              
                              540
                              
                              
                              
                              (211
                              )
                              
                              
                              329
                              
                              
                              
                              (323
                              )
                              
                              
                              (2,739
                              )
                              
                              
                              (3,062
                              )Total
      other expense
                              
                              
                              (190
                              )
                              
                              
                              (211
                              )
                              
                              
                              (401
                              )
                              
                              
                              (1,215
                              )
                              
                              
                              (2,739
                              )
                              
                              
                              (3,954
                              )Loss
      before provision for income taxes
                              
                              
                              (2,357
                              )
                              
                              
                              (211
                              )
                              
                              
                              (2,568
                              )
                              
                              
                              (6,441
                              )
                              
                              
                              (2,739
                              )
                              
                              
                              (9,180
                              )Net
      loss
                              
                              
                              (2,357
                              )
                              
                              
                              (211
                              )
                              
                              
                              (2,568
                              )
                              
                              
                              (6,441
                              )
                              
                              
                              (2,739
                              )
                              
                              
                              (9,180
                              )Deemed
      dividend
                              
                              
                              -
                              
                              
                              
                              (30
                              )
                              
                              
                              (30
                              )
                              
                              
                              -
                              
                              
                              
                              (1,140
                              )
                              
                              
                              (1,140
                              )Net
      loss attributable to common stock
                              
                              
                              (2,357
                              )
                              
                              
                              (241
                              )
                              
                              
                              (2,598
                              )
                              
                              
                              (6,441
                              )
                              
                              
                              (3,879
                              )
                              
                              
                              (10,320
                              )Basic
      and diluted loss per shares
                              
                              $
                              (0.15
                              )
                              
                              
                              (0.01
                              )
                              
                              $
                              (0.16
                              )
                              
                              $
                              (0.54
                              )
                              
                              
                              (0.22
                              )
                              
                              $
                              (0.76
                              )Weighted
      average shares used
                              
                              
                              15,869,277
                              
                              
                              
                              
                              
                              
                              
                              15,869,277
                              
                              
                              
                              11,917,141
                              
                              
                              
                              
                              
                              
                              
                              13,516,842Consolidated
      Statements of Cash Flows impactNet
      loss
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (6,441
                              )
                              
                              
                              (2,739
                              )
                              
                              
                              (9,180
                              )Noncash
      interest expense
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              211
                              
                              
                              
                              2,739
                              
                              
                              
                              2,950Total
      adjustments to reconcile net loss to net cash used for operating
      activities
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (621
                              )
                              
                              
                              2,739
                              
                              
                              
                              2,118


Nature
of Business




Image
Metrics, Inc. is a leading global provider of technology-based facial animation
services to the interactive entertainment and film industries.  Any
references to the “Company” or “Image Metrics” are to Image Metrics, Inc. and
its consolidated subsidiary.





Basis
of Presentation




The
Company’s consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America on
a going concern basis, which presumes that the Company will be able to realize
its assets and discharge its liabilities in the normal course of business for
the foreseeable future.





The
Company has incurred significant operating losses and has accumulated a $36.6
million deficit as of June 30, 2010. The Company's ability to continue as a
going concern is dependent upon it being able to successfully raise further
capital through equity or debt financing and continued improvement of its
results of operations.


These
conditions indicate a material uncertainty that casts significant doubt about
the Company’s ability to continue as a going concern.   The
accompanying financial statements do not reflect any adjustments to the carrying
values of the assets and liabilities as a result of this uncertainty.  The
Company believes it will secure the necessary debt or equity financing to
continue operations and meet its obligations.  Thus, we have continued to
adopt the going concern basis of accounting in preparing the financial
statements.





These
consolidated financial statements do not include any adjustments to the amounts
and classifications of assets and liabilities that might be necessary should the
Company be unable to continue as a going concern.





Unaudited
Interim Financial Information




The
accompanying Consolidated Balance Sheets as of June 30, 2010 and September 30,
2009, the Consolidated Statements of Operations for the three and nine months
ended June 30, 2010 and 2009, and the Condensed Consolidated Statements of Cash
Flows for the nine months ended June 30, 2010 and 2009 are unaudited. These
unaudited interim Consolidated Financial Statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America (GAAP). In our opinion, the unaudited interim Consolidated Financial
Statements include all adjustments of a normal recurring nature necessary for
the fair presentation of our financial position as of June 30, 2010, our results
of operations for the three and nine months ended June 30, 2010 and 2009, and
our cash flows for the nine months ended June 30, 2010 and 2009. The results of
operations for the three and nine months ended June 30, 2010 are not necessarily
indicative of the results to be expected for the year ending September 30,
2010.




These
unaudited interim Consolidated Financial Statements should be read in
conjunction with the Consolidated Financial Statements and related notes filed
as an Exhibit to our Form 8- K/A filed
on April 14, 2010.




4




Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


As Restated in
Note 1


(unaudited)







Principles
of Consolidation




The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiary.  Intercompany accounts and transactions have been
eliminated in consolidation.




Reverse
Merger




On March
10, 2010, we acquired through an exchange offer all of the outstanding ordinary
shares and preferred shares of Image Metrics Limited, a private company
incorporated in England and Wales (“Image Metrics LTD”), in exchange for
11,851,637 shares of our common stock, par value $.001 per share. In the merger,
we exchanged 11,851,637 shares of our common stock, par value $.001 per share
for all of the outstanding share capital of Image Metrics LTD comprised of
2,125,197 shares of ordinary stock, 300,607 A ordinary stock, 1,567,178
preferred ordinary stock and 2,725,633 series B preferred ordinary stock. 
As a result, Image Metrics LTD is now our wholly-owned subsidiary. The
transaction is referred to in this quarterly report on Form 10-Q as the exchange
transaction.





Prior to the exchange transaction, the
Company was named International Cellular Accessories (“ICLA”). ICLA did not have
any operations and had nominal assets.  Subsequent to the exchange
transaction, the former Image Metrics LTD shareholders held a majority of the
voting interest in the Company.  Therefore, the exchange transaction was
determined to be the merger of a private operating company, Image Metrics, LTD,
into a public non-operating shell, ICLA.  Accordingly, the Company
accounted for the exchange as a capital transaction in which Image Metrics LTD
issued stock for the net monetary assets of the Company accompanied by a
recapitalization.  The pre-acquisition financial statements of the
accounting acquirer, Image Metrics LTD, became the historical financial
statements of the combined companies.  These historical consolidated
financial statements of the Company do not include the operations of
International Cellular Accessories (“ICLA”) prior to March 10, 2010, but only
reflect the operations of Image Metrics LTD and its subsidiary. 
Additionally, the Company’s pre-exchange transaction equity has been restated to
reflect the equivalent number of common shares of the Company received by Image
Metrics LTD shareholders in the exchange transaction, with differences between
the par value of the Company and Image Metrics LTD’s stock recorded as an
adjustment to additional paid in capital. Upon the exchange transaction, the
Company adjusted its capitalization to reflect the legally issued and
outstanding shares existing pursuant to the exchange.





Concentration
of Credit Risk




The
Company’s largest single customer accounted for 65% and 79% of total
consolidated revenue for the nine months ended June 30, 2010 and 2009,
respectively.  Whereas this customer did not account for any significant
amount of revenue during the three months ended June 30, 2010 and 2009. 
 The Company’s relationship with the customer is governed by a contract
between the two parties which identifies games and game characters upon which
the Company will work, prices for the services to be rendered, and specified
payments to be made by the customer to the Company. As of June 30, 2010 and
September 30, 2009, the Company did not have any outstanding accounts receivable
from this customer.





5




Revenue
Recognition




The
Company derives its revenues from the sale of consulting services, model
building, character rigging and animation services. The majority of services are
sold in multiple-element arrangements.  The Company recognizes revenue
pursuant to the requirements of the Financial Accounting Standards Board
Accounting Standards Codification (“ASC”) 605, as amended by Accounting
Standards Update (“ASU”) 2009-13, “Revenue Recognition - Multiple-Deliverable
Revenue Arrangements”, when persuasive evidence of an arrangement exists,
delivery has occurred, the fee is fixed or determinable, and collectability is
probable. Revenue is presented net of sales, use and value-added taxes collected
on behalf of the Company’s customers.





For sales
that involve the delivery of multiple elements, the Company allocates revenue to
each undelivered element based on the element’s fair value as determined by
vendor-specific objective evidence (“VSOE”), which is the price charged when
that element is sold separately, or third party evidence (“TPE”).  When
VSOE and TPE are unavailable, fair value is based on management’s best estimate
of selling price.  When management’s estimate is used to determine fair
value, management makes its estimates using reasonable and objective evidence to
determine the price.  For elements not yet sold separately, the fair value
is equal to the price established by the Company’s management if it is probable
that the price will not change before the element is sold separately. The
Company reviews its VSOE and third party evidence at least annually. As the
Company has concluded it is unable to establish fair values for one or more
undelivered elements within a multiple-element arrangement using VSOE, the
Company uses TPE or the Company’s best estimate of the selling price for that
unit of accounting, being the price at which the vendor would transact if the
unit of accounting were sold by the vendor regularly on a standalone basis.
During
fiscal year 2009 and the nine months ended June 30, 2010, the majority of our
revenue is related to contracts that involve the delivery of multiple elements,
as such, all the revenue associated with these contracts were recognized based
on estimated selling price.


Estimated
selling price for each deliverable is determined based on a calculation of
internal direct costs plus our anticipated profit margin, which is the method we
would use to sell the same deliverable on a standalone basis, then compared for
reasonableness to available market information on prices charged by other
providers for similar services or products.  Significant deliverables in
the arrangement qualify as separate units of account and are recognized
throughout the service period as the elements are delivered.


Subsequent
Events




In
May 2009, the FASB issued ASC 855, “Subsequent Events”, which establishes
the general standards of accounting for and disclosures required for events
occurring after the balance sheet date but before financial statements are
issued or are available to be issued.  Under ASC 855 the effects of all
subsequent events that provide additional evidence about conditions that existed
at the date of the balance sheet, including the estimates inherent in the
process of preparing financial statements, are required to be recognized in the
financial statements.  Subsequent events that provide evidence about
conditions that did not exist at the date of the balance sheet but arose after
the balance sheet date but before financial statements are issued or are
available to be issued should not be recognized in the financial statements but
may need to be disclosed to prevent the financial statements from being
misleading.  In accordance with this standard, we evaluated subsequent
events through the filing date of this Form 10-Q.





Use
of Estimates




The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the amounts reported and disclosed in the financial
statements and accompanying notes. Actual results could differ from those
estimates.  On an ongoing basis, the Company evaluates its estimates,
including those related to revenue recognition, valuation of deferred tax assets
and tax contingency reserves and fair value of the Company’s options and
warrants to purchase common stock. Changes in estimates resulting from
continuing changes in the economic environment will be reflected in the
financial statements in future periods.




Impact
of Recently Issued Accounting Standards




There
were no accounting pronouncements adopted by the Company or issued during the
three months ended June 30, 2010 that had a material effect on the unaudited
condensed consolidated financial statements or that are reasonably certain to
have a material impact on the unaudited condensed consolidated financial
statements in future periods.





6




2.
            Cost
      Method Investments




As of
September 30, 2009, the Company maintained a long-term investment in its
previously wholly-owned subsidiary, Optasia Medical, Ltd. (“Optasia”).  In
October 2006, the Company sold the subsidiary to a group of investors which was
led by the Company’s largest investor, Saffron Hill Ventures.  Upon the
sale of Optasia, the Company retained 34% ownership in Optasia.  The
Company did not have the ability to exert “significant influence” as defined by
ASC 323 “Investments- Equity methods and Joint Ventures” and accounted for the
investment on the cost method.   The investment is reviewed
periodically for indicators of impairment and, if indentified as having such
indicator(s), would be subject to further analysis to determine if the
investment is other-than-temporarily impaired.


3.
              Optasia
      Investment Impairment


On July
31, 2010, Optasia was placed into Administrative Receivorship in the United
Kingdom.  Optasia was subsequently sold by the Administrator to Saffron
Hill Ventures for an undisclosed amount.  The sale eliminated any remaining
ownership the Company had in Optasia.  During the third quarter of 2010,
the Company wrote off its investment in Optasia resulting in the Company
recording a loss on investment of  $729,000.





4.
            Fair
      Value Measurements
      (restated)








Level 1
  Level 2
  Level 3
    Assets
and liabilities measured at fair value on a recurring basis include the
following at June 30, 2010 (in thousands):
  Description
                                        
                                        
                                        June
      30, 2010
                                        
                                        
                                        Quoted
      Prices in Active Markets for Identical Assets
                                          (Level
      1)
                                        
                                        
                                        Significant
      Other Observable Inputs
                                          (Level
      2)
                                        
                                        
                                        Significant
      Unobservable Inputs
                                          (Level
      3)Warrant
      liability
                                        
                                        
                                        $
                                        3,986
                                        
                                        
                                        
                                        –
                                        
                                        
                                        
                                        –
                                        
                                        
                                        $
                                        3,986
  Description
                                          
                                          
                                          September
      30, 2009
                                          
                                          
                                          Quoted
      Prices in Active Markets for Identical Assets
                                            (Level
      1)
                                          
                                          
                                          Significant
      Other Observable Inputs
                                            (Level
      2)
                                          
                                          
                                          Significant
      Unobservable Inputs
                                            (Level
      3)Investment
      in Optasia
                                          
                                          
                                          $
                                          729
                                          
                                          
                                          
                                          –
                                          
                                          
                                          
                                          –
                                          
                                          
                                          $
                                          729
  Description
                                            
                                            
                                            Balance
      at
                                              September
      30, 2009
                                            
                                            
                                            Realized
      loss
                                            
                                            
                                            Balance
      at
                                              June
      30, 2010Investment
      in Optasia
                                            
                                            
                                            $
                                            729
                                            
                                            
                                            $
                                            729
                                            
                                            
                                            $
                                            0
  The
warrant liability which is included within current liabilities, represents the
fair value of the warrants outstanding.  The warrants contain anti-dilution
provisions that cause a downward adjustment in the exercise price if the Company
issues shares of its common stock at a price below the trigger price then in
effect.  As of June 30, 2010, the trigger price was $1.00.
 
 Currently,
there is not an observable market for this type of derivative and, as such, we
determined the value of the derivative using a Monte Carlo Simulation, which
takes into consideration the fair market value of the Company’s stock, the
warrant strike price, the life of the warrant, the volatility of our common
stock, the risk-free interest rate, and assumptions about events triggering down
round repricing of the warrants.  The underlying security of the warrants
are unregistered common stock, as such, the Company has determined the value of
an unregistered share of common stock has a lower value than a registered share
of common stock for lack of a market for these shares.  The discount for
lack of marketability was determined based on the put value of an option on the
common shares underlying the warrants using a Black-Scholes-Merton
model with a one year estimated life.  The one year estimated life was
determined to be the expected time before the underlying security would be
registered.
  The
following table presents a reconciliation for our assets and
liabilities measured and recorded at fair value on a recurring basis, using
significant unobservable inputs (Level 3) for the three months and nine months
ended June 30, 2009 (in thousands):
  Level
      3Balance
      at September 30, 2008
                              
                              $
                              -Issuance
      of warrants with derivativesTotal
      gains or losses (realized/unrealized):
                              
                              
                              -Included
      in earnings (or changes in net assets)
                              
                              
                              -Included
      in other comprehensive income
                              
                              
                              -Settlement
                              
                              
                              -Balance
      at June 30, 2009
                              
                              $
                              -
  The
following table presents a reconciliation for our assets and
liabilities measured and recorded at fair value on a recurring basis, using
significant unobservable inputs (Level 3) for the three months and nine months
ended June 30, 2010 (in thousands):
  Level
      3Balance
      at September 30, 2009
                                                                  
                                                                  $
                                                                  -Issuance
      of warrants with derivatives
                                                                  
                                                                  
                                                                  -Total
      gains or losses (realized/unrealized):
                                                                  
                                                                  
                                                                  -Included
      in earnings (or changes in net assets)
                                                                  
                                                                  
                                                                  -Included
      in other comprehensive income
                                                                  
                                                                  
                                                                  -Transfers
      in to Level 3
                                                                  
                                                                  
                                                                  263
 Balance
      at December 31, 2009
                                                        
                                                        $
                                                        263Issuance
      of warrants with derivatives
                                                        
                                                        
                                                        1,698Total
      gains or losses (realized/unrealized):
                                                        
                                                        
                                                        -Included
      in earnings (or changes in net assets)
                                                        
                                                        
                                                        2,448Included
      in other comprehensive income
                                                        
                                                        
                                                        -Settlement
                                                        
                                                        
                                                        (232
                                                        )
 Balance
      at March 31, 2010
                                                    
                                                    $
                                                    4,177Issuance
      of warrants with derivatives
                                                    
                                                    
                                                    217Total
      gains or losses (realized/unrealized):
                                                    
                                                    
                                                    -Included
      in earnings (or changes in net assets)
                                                    
                                                    
                                                    (408
                                                    )Included
      in other comprehensive income
                                                    
                                                    
                                                    -Transfers
      in to Level 3
                                                    
                                                    
                                                    -Balance
      at June 30, 2010
                                                    
                                                    $
                                                    3,986
 For
assets and liabilities recorded at other than fair value, the carrying value of
cash and cash equivalents, accounts receivable, accounts payable, other current
liabilities and short-term debt approximate their fair value because of the
short-term maturity of these instruments.  The fair-value of long-term debt
is estimated using a discounted cash flow method based on the Company’s current
borrowing rates for similar types of financing without a quoted market
price.  No fair value has been included for the cost method investment, as
the Company was unable to determine a reliable and practicable valuation to
adequately value the development stage investee because it has uncertainties
about its ultimate growth potential and viability.  During this quarter,
the cost basis was evaluated for impairment and was determined to be fully
impaired.  The fair value and carrying value, before applying discounts, of
the Company’s notes payable are summarized as follows (in thousands), see
note 5 for further details on the Company’s debt:


June
      30, 2010
                          
                          
                          September 30, 2009Carrying
                            value
                          
                          
                          Fair
                            value
                          
                          
                          Carrying
                            value
                          
                          
                          Fair
                            valueLiabilitiesCurrent
      portion of notes payable
                          
                          $
                          1,241
                          
                          
                          $
                          1,239
                          
                          
                          $
                          956
                          
                          
                          $
                          948Current
      portion of notes payable to related party
                          
                          
                          650
                          
                          
                          
                          650
                          
                          
                          
                          -
                          
                          
                          
                          -Noncurrent
      portion of notes payable
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          114
                          
                          
                          
                          112Noncurrent
      portion of notes payable to related party
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          2,077
                          
                          
                          
                          1,734$
                          1,891
                          
                          
                          $
                          1,889
                          
                          
                          $
                          3,147
                          
                          
                          $
                          2,794Discount
      on notes payable
                          
                          
                          (252
                          )
                          
                          
                          
                          
                          
                          
                          (159
                          )1,639
                          
                          
                          
                          1,889
                          
                          
                          
                          2,988
                          
                          
                          
                          2,794




7




5.
              Notes
      Payable (restated)
  Q3
2010 Bridge Loan
 During
the third quarter of 2010, the Company established a $1.5 million credit
facility (“Q3 2010 Bridge Loan”). As of June 30, 2010, the Company had issued
$1.4 million in promissory notes under this credit facility, including $0.6
million issued to Saffron Hill Ventures Guernsey LTD. The payment of the
promissory notes and the Company’s obligations thereunder are not secured by any
collateral. The promissory notes bear interest at 10% per annum and mature at
the earlier of February 24, 2011 or such date the Company completes a private
placement of units consisting of one share of the Company’s series A convertible
preferred stock and a detachable warrant to purchase one-half share of its
common stock (an “Offering”); provided that, at any closing of an Offering, not
more than 50% of the closing net proceeds will be repaid to any lender before a
minimum of $2,500,000 in aggregate net proceeds have been raised by the Company.
Upon the Company completing an Offering, the holders of these notes have the
option to convert the principal and accrued interest into the Offering at the
price of $1.00. In the event the Company fails to repay the promissory notes in
full on or before the maturity date, the promissory notes’ interest rate will be
increased to 18% per annum and the promissory notes will be convertible into
common stock of the Company at a conversion price of $0.50 per share. The
Company may, at its option, prepay all or any part of the principal of the
promissory notes without payment of any premium or penalty. The holders of the
notes also received warrants to purchase 420,000 shares of the Company’s common
stock at $1.50 per share and have expiration dates between May and July 2014.
The Company, though the use of a Monte Carlo Simulation valuation method,
assigned a fair value of $204,000 to these warrants and recorded a discount
against the Q3 2010 Bridge Loan for an equal amount that will be amortized as
interest expense over the period the notes remain outstanding. As of June 30,
2010, the Company had accrued interest related to these notes in the amount of
$10,000 and had recognized interest expense for the three months ended June 30,
2010 of $32,000. As of June 30, 2010, the unamortized balance of the discount
was $149,000.




ICLA
Notes




Between
May 10, 2006 and February 22, 2010, the Company issued an aggregate of $196,000
of convertible notes. The convertible notes accrue interest at 5% per annum,
compounded annually.  We are currently in default of these convertible
notes.  Upon completion of the share exchange transaction on March 10,
2010, these convertible notes entered a default status as a result of the
Company having a change of ownership.  The interest rate on the notes did
not change upon default.  As of June 30, 2010, the principal and accrued
interest owed on these loans was $222,000.





Saffron
Hill Ventures II 2009 Loan




On April
27, 2009, Image Metrics LTD signed a loan agreement with its largest
shareholder, Saffron Hill Ventures (“SHV”) in the amount of $1,200,000. The loan
bore interest at 6.0% plus the Bank of England base rate.  The effective
interest rate as of March 10, 2010 was 6.5%.  The loan’s principal and all
accrued interest were converted into equity as part of the Company’s private
offering that closed on March 10, 2010.  (See note 5 for further
discussion.)





Private
Individual Loan




On March
13, 2009, Image Metrics LTD signed a loan agreement with a private individual.
The loan facility is for a maximum of $500,000 and bore interest at 5.0% plus
LIBOR (London Interbank Offered Rate), the effective interest rate as of March
10, 2010 was 5.23%. All principal and accrued interest were converted into
equity as part of the Company’s private offering that closed on March 10,
2010.  (See note 5 for further discussion.)





Saffron
Hill Ventures Loans




Between
July 2005 and April 2008, Image Metrics LTD signed three loan agreements with
Saffron Hill Ventures Limited Partnership (“SHVLP”). The loan facilities’
available amounts were £450,000, £1,000,000 and £1,500,000 with the proceeds to
be used for general working capital.  The £450,000 loan bore interest at
LIBOR plus 2%, and the other loans bore interest at LIBOR plus 8%.





The loan
for £450,000 had beneficial contingent conversion rights, whereby the loan could
be converted into equity of Image Metrics LTD at a discount.  The
contingency was based upon the Company completing a successful equity offering
which raises at least £100,000.  The conversion price would have been equal
to 80% of the share price in the offering.  Upon receiving proceeds from
the loan, the Company recorded a discount on the note equal to the intrinsic
value of the beneficial conversion rights in the amount of $222,000. In
accordance with ASC 470-20 “Debt with Conversion and Other Options”, the Company
did not recognize this discount into earnings as the contingency had not been
removed.





8




On
October 27, 2008, Image Metrics LTD converted the loans from SHVLP into series B
preferred ordinary shares of Image Metrics LTD’s stock, which were converted to
ordinary shares and then exchanged for common stock as part of the exchange
transaction.  (See notes 1 and 5 for further discussion.)




ETV
Capital 2008 Loan




On March
3, 2008, Image Metrics LTD signed a loan agreement with ETV Capital, Inc.
(“ETV”). The loan facility was for a maximum of $1,000,000 with the proceeds to
be used for general working capital.  The loan is to be paid in equal
installments commencing July 2008 and continuing through December 31, 2010 at a
fixed interest rate of 11.43%.  The loans are secured by a first priority
security interest in all assets of Image Metrics LTD.





As part
of the loan agreement, ETV received warrants to purchase shares of stock of
Image Metrics LTD.  The warrants would have allowed ETV to purchase up to
£140,000 of Image Metrics LTD’s shares at an exercise price equal to the lower
of £1.65 or the price offered to investors in the next equity offering made by
Image Metrics LTD. These warrants are treated as derivatives and recorded as
warrant liability on the balance sheet.  Currently, there is not an
observable market for this type of derivative and, as such, the Company
determined the value of the derivative using a Monte Carlo Simulation, which
takes into consideration the fair market value of the Company’s stock, the
warrant strike price, the life of the warrant, the volatility of our common
stock, the risk-free interest rate, and assumptions about events triggering down
round repricing of the warrants.  Prior to March 15, 2010, the Company’s
common stock was not traded on any stock exchange, as such, the Company, through
the use of a third party valuation firm, determined the fair value of its common
stock as of October 1, 2009 and December 31, 2009.   These warrants
were exchanged on March 10, 2010 for new warrants to purchase shares of Common
Stock in the Company.  (See note 6 for further discussion.)
  Upon
receipt of the loan proceeds, the Company allocated the proceeds based on the
fair values of the warrants and the debt.  The Company though the use of a
Monte Carlo Simulation method, assigned a fair value of $102,000 to these
warrants and recorded a discount against the ETV Capital 2008 Loan for an equal
amount that will be amortized as interest expense over the period the notes
remain outstanding.  The fair value assigned to the warrants was equal to
$102,000 and was recorded as a discount to the loan.  The discount is being
amortized over the term of the loan.  As of June 30, 2010, the unamortized
balance of the discount was $1,000 and $18,000 as of September 30, 2009. 
The Company recognized $5,000 and $12,000 of interest expense for the three
months ended June 30, 2010 and 2009, respectively, from the amortization of this
discount. The Company recognized $3,000 and $13,000 of interest expense for
three months ended June 30, 2010 and 2009, respectively, for the contractual
interest obligation on the note.  The Company recognized$18,000 and
$40,000  of interest expense for the nine months ended June 30, 2010 and
2009, respectively, from the amortization of this discount. The Company
recognized $14,000 and $42,000 of interest expense for nine months ended June
30, 2010 and 2009, respectively, for the contractual interest obligation on the
note.
 
 ETV,
also, received options to purchase up to $200,000 of shares of equity of Image
Metrics LTD in the Company’s first offering after the loan was established.
These options had an initial exercise price of $1.72 but were subject to be
reduced based on future equity offerings. These options expired unexercised
in December 2008. The Company determined the value of these options through
the use of the Black-Scholes-Merton option pricing model. The value assigned to
these options was $214,000 and a corresponding notes payable discount in an
equal amount was recorded at the time of issuance. As of March 31, 2010,
the unamortized balance of the discount was $85,000. The Company recognized
an expense of $27,000 and $54,000 in the three and six months ended March
31, 2010 associated with this discount.


Royal
Bank of Scotland Loan




In
January 2002, Image Metrics LTD obtained a bank loan for £250,000. The loan bore
interest at 2.5% per annum.  The loan was guaranteed under the Small Firms
Loans Guarantee Scheme in the United Kingdom. The loan was paid off in February
2010.




6.
            Shareholders’
      Equity (restated)





Classes
of Shares




The
Company’s Board of Directors has authorized two classes of shares, common stock
and preferred stock.  The rights of the holders of the two classes of
shares are identical, except preferred stock receives priority if the Company
was to have a liquidation or reduction of capital, and preferred stock
shareholders are not entitled to receive dividends. The only currently
designated preferred stock is the Series A Convertible Preferred Stock. 
 Series A Convertible Preferred Stock may be converted at any time at the
option of the stockholder and automatically convert upon sale or transfer of
common stock at a ratio of 1:1.




9




Saffron
Hill Venture Loans Conversion




On
October 27, 2008, Image Metrics LTD converted the Saffron Hill Venture Loans
into Series B Preferred Ordinary shares of its stock, which were converted to
ordinary shares and then exchanged for common stock as part of the exchange
transaction, see note 1 for further discussion. The outstanding principal and
accrued interest on this date was £2,902,000 and was converted into 1,759,390
Series B Preferred stock at a conversion price of £1.65 per share.  The
exchange did not result in a gain or loss.  (See note 4 for further
discussion.)





December
2008 Private Equity Offering




In
December 2008, Image Metrics LTD completed a private equity fund raising round
by selling 599,393 shares of its Series B Preferred Ordinary shares at £1.65 per
share for a total raise of £989,000.  The round was fully subscribed by two
of Image Metrics LTD’s existing investors, one of which was a member of Image
Metrics LTD’s Board of Directors.  The Series B Preferred Ordinary shares
were converted to ordinary shares and then exchanged for common stock as part of
the exchange transaction. (See note 1 for further discussion.)





March
2010 Private Equity Offering




On March
10, 2010, the Company closed the first round of a private equity offering. 
The Company sold 8,394,098 units, each consisting of one share of the Company’s
Series A Convertible Preferred Stock and a detachable, transferable warrant to
purchase common stock at an exercise price of $1.50 per share, for $8.0 million
gross proceeds.  The $8.0 million included the conversion of $5.41 million
of its notes payable. The proceeds from the first close were reduced by $0.46
million for transaction costs, which primarily consist of legal fees and broker
commissions and $0.47 million for debt repayments, yielding net proceeds of
$1.66 million.  Each share of Series A Convertible Preferred Stock is
initially convertible into one share of common stock at any time.  Each
warrant entitles the holder to purchase one-half share of common stock at an
exercise price of $1.50 per share through March 26, 2014, subject to redemption
provisions based on the trading price and trading volume of our common
stock.  The value assigned to the warrants and the Series A Convertible
Preferred Stock was determined using a Monte Carlo simulation as described under
“Warrant Liability” in this footnote.





Simultaneously
with the close of the private equity offering, Image Metrics LTD exchanged all
of its outstanding equity for 11,851,637 shares of the Company.  As a
result, Image Metrics LTD became a wholly-owned subsidiary of the
Company.




In
connection with the exchange transaction, Saffron Hill Ventures and other
potential investors provided Image Metrics LTD with bridge financing.  The
bridge financing provided working capital while Image Metrics LTD worked to
complete the private equity offering.  On January 10, 2010, Image Metrics
LTD established a credit instrument in the amount of $2,000,000 in 10% Unsecured
Convertible Notes.





The
interest paid on the 10% Unsecured Convertible Notes was 4% of the total
principal of $2.0 million.  The note holders also received warrants to
purchase 663,000 shares of common stock of the Company.  210,600 warrants
of the total issued warrants were issued to Saffron Hill Ventures.  Each
warrant provides the holder the right to purchase one share of the Company’s
common stock at $1.50 per share.




The
warrants contain anti-dilution provisions which cause a downward adjustment in
the exercise price if the Company issues shares of its common stock at a price
below the trigger price then in effect.  As of June 30, 2010, the trigger
price was equal to $1.  The warrants were recorded as a warrant liability
on the balance sheet.
  Currently,
there is not an observable market for this type of derivative and, as such, we
determined the value of the derivative using a Monte Carlo Simulation, which
takes into consideration the fair market value of the Company’s stock, the
warrant strike price, the life of the warrant, the volatility of our common
stock, the risk-free interest rate, and the assumption about events triggering
down round pricing of the warrants.  The underlying security of the
warrants are unregistered common stock, as such, the Company has determined the
value of an unregistered share of common stock has a lower value than a
registered share of common stock for lack of a registered market for these
shares.  The discount for lack of market was determined based on the put
value of an option on the common stock underlying the warrants using
a Black-Scholes-Merton model with a one year estimated life.  The
one year estimated life was determined to be the expected time before the
underlying security would be registered.  The warrant liability fair value
was determined at time of each issuance and is revalued at the end of each
reporting period to fair value using a Monte Carlo Simulation with any
changes being recorded to the interest expense in the period the change
occurs.  The Company recorded interest expense of $0.32 million during the
three and nine months ended June 30, 2010 associated with these warrants. 
$1.6 million of the 10% Unsecured Convertible Notes were converted into equity
as part of the Company’s private equity offering that closed on March 10,
2010.  The remaining $0.4 million of the notes were repaid with the
proceeds from the private offering.
 
 On March
26, 2010, the Company closed the second round of its private equity
offering.  The Company sold 925,000 units, each consisting of one share of
the Company’s Series A Convertible Preferred Stock and a detachable,
transferable warrant to purchase common stock, for $0.93 million in gross
proceeds.  The proceeds from the second close were reduced by $0.07 million
for broker commission and expenses yielding net proceeds of $0.86 million. 
Each share of Series A Convertible Preferred Stock is initially convertible into
one share of common stock at any time.  Each warrant entitles the holder to
purchase one-half share of common stock at an exercise price of $1.50 per share
through March 26, 2014, subject to redemption provisions based on the trading
price and trading volume of our common stock.  The value assigned to the
warrants and the Series A Convertible Preferred Stock was determined using a
Monte Carlo Simulation.  The fair value of the common stock into which the
convertible preferred stock was convertible into on the date of issuance
exceeded the proceeds allocated to the redeemable convertible preferred stock by
$0.6 million, resulting in a beneficial conversion feature that was recognized
as an increase to additional paid-in capital and as a deemed dividend to the
convertible preferred stockholders.


10




Warrant
Liability




During
the second and the third quarters of fiscal 2010, in connection with the
issuance of the Company’s bridge loans and private placements, the Company
issued warrants to purchase 7,765,998 shares of common stock at an exercise
price of $1.50 per share and 370,700 shares of common stock at an exercise price
of $1.20 per share. The warrants are exercisable at the option of the holders at
any time through their expiration dates, which occur between March and June
2014.


The
warrants associated with the bridge loans and private placements contain
anti-dilution provisions that cause a downward adjustment in the exercise price
if the Company issues shares of its common stock at a price below the trigger
price then in effect.  As of June 30, 2010, the trigger price was equal to
$1.  The warrants were recorded as a warrant liability on the balance
sheet.
  Currently,
there is not an observable market for this type of derivative and, as such, we
determined the value of the derivative using a Monte Carlo Simulation, which
takes into consideration the fair market value of the Company’s stock, the
warrant strike price, the life of the warrant, the volatility of our common
stock, the risk-free interest rate, and the assumptions about events triggering
down round repricing of the warrants.  The underlying security of the
warrants are unregistered common stock, as such, the Company has determined the
value of an unregistered share of common stock has a lower value than a
registered share of common stock for lack of a market for these shares. 
The discount for lack of market was determined based on the put value of an
option on the common stock underlying the warrants using
a Black-Scholes-Merton model with a one year estimated life.  The
one year estimated life was determined to be the expected time before the
underlying security would be registered.  The warrant liability fair value
was determined at time of each issuance and is revalued at the end of each
reporting period to fair value using the Monte Carlo simulation with any changes
being recorded to the interest expense in the period the change
occurs.
  The
Company recorded interest income during the three months ended June 30, 2010 of
$0.58 million as a result of the decrease in the value of the warrant
liability.  The Company recorded net interest expense of $2.62 million
during the nine months ended June 30, 2010 associated with these
warrants.
 
 The fair
value of the warrants was estimated to be $3,986,000 as of June 30,
2010.  The following assumptions were used to estimate the fair value of
the warrants as of June 30, 2010:
  (1)
                          
                          June 30, 2010
                          (1)Common
      stock fair value
                          
                          
                          
                          
                          
                          $
                          1.34Volatility
                          
                          
                          
                          %
                          
                          
                          51.5
                          %Contractual
      term (years)
                          
                          
                          
                          
                          
                          
                          3.70Risk-free
      rate
                          
                          
                          
                          %
                          
                          
                          1.4
                          %Expected
      dividend yield
                          
                          
                          
                          %
                          
                          
                          0.0
                          %
  (1)
                        The
      common stock underlying the warrant is not registered with U.S. Securities
      and Exchange Commission; therefore, the underlying security is not
      tradeable on the OTC Bulletin Board.  The Company applied a discount
      for lack of market to the market value of its common stock to determine
      the fair value of the Company’s common stock. The discount for lack of
      market was determined based on an analysis completed by management based
      upon the value of a put option on
      the common stock using the Black-Scholes-Merton
    model.


SEC
Registration rights




As part
of the March 2010 private equity offering, the Company committed to meeting
certain SEC registration requirements, among them was to file a Form S-1 by June
9, 2010.  If the Company fails to meet any of these obligations, the
Company could be required to pay damages of $178,000 (2% of the aggregate
offering price) per month up to 12% until the default is cured.  These
damages can be waived if the Company's Board of Directors determines the
Company's management has exerted its best efforts to meet the
requirements.





In May
2010, the Company’s Board of Directors granted the Company an indefinite waiver
of its obligations to meet its requirement to file a Form S-1.  In
addition, in August 2010, the Board of Directors granted the Company a waiver of
its obligation to meets its requirement to file Form 8-Ks and a Form 10-Q for
the period ended June 30, 2010.  As a result of these waivers, the Company
is not subject to pay its investors any damages; therefore, the Company has not
recorded any liabilities for such damages.




11




ETV Equity Rights




As part
of the loan agreements with ETV, the Company granted ETV rights to purchase
shares of equity of Image Metrics LTD.  On March 10, 2010, ETV exchanged
these warrants and options to purchase equity shares of Image Metrics LTD for
warrants to purchase up to 224,583 preferred shares of the Company at an
exercise price of $1.50.  As of June 30, 2010, all the warrants were
outstanding. The Company compared the fair value of the ETV options and warrants
prior to exchange and subsequent to the exchange and concluded the value did not
increase; therefore, the Company did not record any additional interest expense
for this exchange.  The remaining discount associated with these warrants
will continue to amortize over the remaining period of the loan. (See note 4 for
additional discussion.)





7.
            Comprehensive
      Loss (restated)




The table
below reconciles the Company’s net loss with its comprehensive loss, (in
thousands):




Three Months Ended
                          June
      30,
                        
                        
                        Nine Months Ended
                          June
      30,2010
                        
                        
                        2009
                        
                        
                        2010
                        
                        
                        2009Net
      loss
                        
                        $
                        (2,568
                        )
                        
                        $
                        (2,563
                        )
                        
                        $
                        (9,180
                        )
                        
                        $
                        (5,819
                        )Foreign
      currency translation adjustments
                        
                        
                        9
                        
                        
                        
                        32
                        
                        
                        
                        4
                        
                        
                        
                        30Comprehensive loss
                        
                        $
                        (2,559
                        )
                        
                        $
                        (2,531
                        )
                        
                        $
                        (9,176
                        )
                        
                        $
                        (5,789
                        )




8.
            Net
      Loss per Common Stock (restated)




Basic net
loss per common stock excludes dilution for potentially dilutive securities and
is computed by dividing loss applicable to common stock shareholders by the
weighted average number of common shares outstanding during the period. Diluted
net loss per common stock reflects the potential dilution that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock. Potentially dilutive securities are excluded from the
computation of diluted net loss per share for all of the periods presented in
the accompanying statements of operations because the reported net loss in each
of these periods results in their inclusion being anti-dilutive. Common stock
equivalent shares consist of the shares issuable upon conversion of Series A
Convertible Preferred Stock and the exercise of stock options and warrants using
the treasury stock method. For the three and nine months ended June 30, 2010,
shares of potential common stock of approximately 9.4 million were not included
in the diluted calculation because the effect would be anti-dilutive. For the
three and nine months ended June 30, 2009, the Company did not have any
potential common stock that was considered anti-dilutive.




9.
            Commitments
      and Contingencies




Operating
Leases




The
Company has entered into non-cancellable operating leases for office
space.  Rent expense for operating leases was $167,000 and $478,000 for the
three and nine months ended June 30, 2010, respectively, and $171,000 and
$443,000 for the three and nine months ended June 30, 2009, respectively. The
Company is committed under operating leases with terminations through 2013 and
has the option to renew for five years. The Company received one year of free
rent under its UK office’s operating lease, upon inception of the lease. 
This rent free period is spread over the minimum lease period. All leases under
the Company are expensed on a straight-line basis. The total future minimum
lease rentals are scheduled to be paid as follows (in thousands):





Fiscal
      year ending2010
      (July to Sept. 2010)
                      
                      $
                      1232011
                      
                      
                      5022012
                      
                      
                      5192013
                      
                      
                      225Thereafter
                      
                      
                      -Total
      future minimum lease payments
                      
                      $
                      1,369




12




Letter
of Credit




In
connection with one of its office space leases, the Company has fulfilled its
security deposit requirement with an irrevocable standby letter of credit. 
At June 30, 2010 and 2009, the value of the letter of credit was $100,000. 
Under the terms of the lease, the security deposit requirement is reduced by
$20,000 on the anniversary date of each lease year through the lease end
date.  There is an annual fee of 0.25% payable on the available balance of
the letter of credit.  The letter of credit expires on March 31, 2011. The
letter of credit was undrawn at March 31, 2010 and 2009.  Under the terms
of this arrangement, the Company is required to maintain on deposit with the
bank a compensating balance in the form of a certificate of deposit equal to the
amount of the standby letter of credit.  At June 30, 2010 and September 30,
2009, the certificate of deposit is included in restricted cash.




10.
            Business
      Segment Information (restated)


The
Company primarily operates in two geographic business segments: the North
American region, which includes the United States and Canada, and Europe.
Revenue is assigned based on the region where the associated contracts were
originated. Expenses incurred are assigned to each respective region based on
which region incurred the expense. The following table summarizes revenue
recognized by region (in thousands):




Three Months Ended
                        June
      30,
                      
                      
                      Nine Months Ended
                        June
      30,2010
                      
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Europe
                      
                      $
                      253
                      
                      
                      $
                      156
                      
                      
                      $
                      3,709
                      
                      
                      $
                      1,632North
      America
                      
                      
                      673
                      
                      
                      
                      20
                      
                      
                      
                      1,178
                      
                      
                      
                      105Total
      revenue
                      
                      $
                      926
                      
                      
                      $
                      176
                      
                      
                      $
                      4,887
                      
                      
                      $
                      1,737




The
following table summarizes net loss by region (in thousands):




Three Months Ended
                          June
      30,
                        
                        
                        Nine Months Ended
                          June
      30,2010
                        
                        
                        2009
                        
                        
                        2010
                        
                        
                        2009Europe
                        
                        $
                        (1,191
                        )
                        
                        $
                        (858
                        )
                        
                        $
                        (2,905
                        )
                        
                        $
                        (772
                        )North
      America
                        
                        
                        (1,377
                        )
                        
                        
                        (1,705
                        )
                        
                        
                        (6,275
                        )
                        
                        
                        (5,047
                        )Total
      net loss
                        
                        $
                        (2,568
                        )
                        
                        $
                        (2,563
                        )
                        
                        $
                        (9,180
                        )
                        
                        $
                        (5,819
                        )




The
following table summarizes interest expense, depreciation and loss on investment
by region (in thousands):




Three Months Ended
                      June
      30,
                    
                    
                    Nine Months Ended
                      June
      30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009EuropeInterest
      income (expense)
                    
                    
                    (38
                    )
                    
                    
                    (95
                    )
                    
                    
                    (132
                    )
                    
                    
                    (344
                    )Depreciation
                    
                    
                    (10
                    )
                    
                    
                    (18
                    )
                    
                    
                    (30
                    )
                    
                    
                    (58
                    )Optasia
      investment impairment
                    
                    
                    (727
                    )
                    
                    
                    -
                    
                    
                    
                    (727
                    )
                    
                    
                    -North
      AmericaInterest
      Expense
                    
                    
                    367
                    
                    
                    
                    -
                    
                    
                    
                    (2,930
                    )
                    
                    
                    -Depreciation
                    
                    
                    (41
                    )
                    
                    
                    (18
                    )
                    
                    
                    (113
                    )
                    
                    
                    (113
                    )Optasia
      investment impairment
                    
                    
                    (2
                    )
                    
                    
                    -
                    
                    
                    
                    (2
                    )
                    
                    
                    -




13




11.
            Related
      Party Transactions (restated)




During
the three and nine months ended June 30, 2010 and 2009, the Company entered into
transactions, in the ordinary course of business, with Optasia Medical Ltd. The
value of services provided by Optasia was $6,000 and $13,000 during the three
and nine months ended June 30, 2010, respectively, and $6,000 and $13,000 during
the three and nine months ended June 30, 2009, respectively. The Company did not
have any amount due to Optasia as of June 30, 2010.





During
the three and nine months ended June 30, 2010, the Company incurred interest
expense of $7,000 and $114,000, respectively, related to notes payable to SHV,
its largest shareholder.  During the three and nine months ended June 30,
2009, the Company did not incur any interest expense, related to notes payable
to SHV, its largest shareholder.  The Company had accrued interest payable
to SHV of $7,000 and $27,000 as of June 30, 2010 and September 30, 2009,
respectively.





In
October 2008, Image Metrics LTD converted its Saffron Hill Ventures Loans into
Series B Preferred Ordinary shares, which were converted to ordinary shares and
then exchanged for common stock as part of the exchange transaction. (See notes
1, 4 and 5 for further discussion.)




In
December 2008, Image Metrics LTD sold an aggregate of 599,393 shares of its
Series B Preferred Ordinary shares at £1.65 per share for a total of £989,000 to
two of the its  existing investors, one of which an affiliate of one is
also a member of the Company’s Board of Directors.  These shares were
converted to ordinary shares and then exchanged for common stock as part of the
exchange transaction.  (See note 1 for further discussion.)




As a
result of the Company initiating the March 10, 2010 private equity offering,
Series B Preferred Ordinary shareholders were entitled to purchase a defined
amount of additional shares of Series B Preferred Ordinary shares at par value
of $0.08. In February 2010, the Company sold to SHV 145,933 shares of its Series
B Preferred Ordinary shares at $0.08 per share.  This sale of Series B
Preferred Ordinary shares was accounted for as a deemed dividend in the amount
of $470,000 and recorded as a reduction to retained
earnings.





During
the three months ended June 30, 2010, the Company received loan proceeds in the
amount of $0.65 million from its largest shareholder, SHV.





In
connection with the March 10, 2010 private equity offering, SHV converted all of
its outstanding notes payable into Series A Convertible Preferred Stock and
purchased an additional $500,000 of Series A Convertible Preferred Stock and
warrants.  (See notes 5 and 6 for further
discussion.)




12.
              Subsequent events
      (restated)




Q3
2010 Private Equity Offering





On July
27 and August 31, 2010, the Company closed two rounds of a private equity
offering.  The Company sold 859,438 units, each consisting of one share of
the Company’s Series A Convertible Preferred Stock and a detachable,
transferable warrant to purchase common stock at an exercise price of $1.50 per
share, for $0.85 million in gross proceeds.  The $0.85 million in gross
proceeds included the conversion of $0.45 million of its notes payable.
 The proceeds from this offering were reduced by $142,000 for transaction
costs, which primarily consisted of legal fees and broker commissions, yielding
net proceeds of $258,000.





Each
share of Series A Convertible Preferred Stock is initially convertible into one
share of common stock at any time.  Each warrant entitles the holder to
purchase one-half share of common stock at an exercise price of $1.50 per share
through March 26, 2014, subject to redemption provisions based on the trading
price and trading volume of our common stock.   The value assigned to the
warrants and the Series A Convertible Preferred Stock was calculated using the
Monte Carlo Simulation.




Private
Individual Secured Convertible Loan





On
September 9, 2010, the Company entered into a secured convertible loan with a
private individual.  The facility is for a maximum of $2.6 million, of
which $1.1 million was drawn down by the Company subsequent to June 30,
2010.  The debt bears interest at 13.5% per year and matures on January 31,
2011 or, in the event that a subsequent financing is consummated, then the
maturity date will be the earliest maturity date of any indebtedness incurred in
the subsequent financing.




14




The loans
are secured by a first priority security interest in all assets of Image
Metrics. The debt is convertible at the option of the holder into common stock
of the Company at a conversion price equal to $1.00 per share.





In the
event the Company fails to repay the promissory notes in full on or before the
maturity date, the promissory notes’ interest rate will be increased to 18% per
annum. The Company may, at its option, prepay all or any part of the
principal of the promissory notes without payment of any premium or
penalty.




Resignation
of Michael Starkenburg as Chief Executive Officer and Director





On
September 7, 2010, Michael Starkenburg, CEO and a director of Image Metrics
notified the Company of his resignation from the Company effective September 10,
2010. Mr. Starkenburg’s resignation did not arise from any disagreement
with the Company or any matter relating to the Company’s operations, policies or
practices. Mr. Starkenburg does not serve on any committees of the Company’s
board of directors.




Appointment
of Robert Gehorsam as Chief Executive Officer





The
Company’s board of directors have appointed Robert Gehorsam, age 55, as the new
CEO and director of the Company effective September 10, 2010.  See the
Company’s Form 8-K filed September 13, 2010 for additional
information.




15




ITEM
2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS




Forward
Looking Statements





In
addition to historical information, this Quarterly Report on Form 10-Q contains
forward-looking statements that involve risks and uncertainties, many of which
are beyond our control. Our actual results could differ materially and adversely
from those anticipated in such forward-looking statements as a result of certain
factors, including those set forth in this report. Important factors that may
cause actual results to differ from these forward-looking statements include,
but are not limited to, for example:





·
            our
      inability to raise sufficient additional capital to operate our
      business;





·
            adverse
      economic conditions;





·
            unexpected
      costs, lower than expected sales and revenues, and operating
      deficits,





·
            the
      ability of our products and services to achieve market
      acceptance;





·
            our
      reliance on four customers for a significant percentage of our
      revenue;





·
            the
      volatility of our operating results and financial
    condition;





·
            our
      ability to develop and maintain relationships with entertainment
      companies;





·
            our
      ability to protect our intellectual
property;





·
            our
      ability to attract or retain qualified senior management personnel,
      including software and computer graphics engineers,
  and





·
            the
      factors set forth under the caption “Risk Factors” in Part II, Item 1A and
      other factors discussed from time to time in our news releases, public
      statements and/or filings with the Securities and Exchange Commission (the
      “SEC”).




16




All
statements, other than statements of historical facts, included in this report
regarding our strategy, future operations, financial position, estimated revenue
or losses, projected costs, prospects and plans and objectives of management
are forward-looking statements. When used in this report, the words “will,”
“may,” “believe,” “anticipate,” “intend,” “estimate,” “expect,” “project,”
“plan” and similar expressions are intended to identify forward-looking
statements, although not all forward-looking statements contain such identifying
words. All forward-looking statements speak only as of the date of this report.
We undertake no obligation to update any forward-looking statements or other
information contained herein. Although we believe that our plans, intentions and
expectations reflected in or suggested by the forward-looking statements in this
report are reasonable, we cannot assure stockholders and potential investors
that these plans, intentions or expectations will be achieved. We disclose
important factors that could cause our actual results to differ materially from
expectations under Part II, Item 1A entitled “Risk Factors”. These cautionary
statements qualify all forward-looking statements attributable to us or persons
acting on our behalf.




Introduction





The
following discussion should be read in conjunction with the information included
within our Audited Financial Statements for the years ended on September 30,
2009 and 2008 included as an exhibit in our Form 8-K/A filed with the SEC on
April 14, 2010, and the Condensed Consolidated Financial Statements and notes
thereto included in Part I, Item 1 of this Quarterly Report on Form
10-Q.





Description
of Our Company and Predecessor





We were
incorporated in the State of Nevada on October 6, 2004.  We were formed to
import and distribute a range of cellular accessories to wholesalers and
retailers throughout Canada and the United States.  In March 2005, we filed
a registration statement with the SEC, which became effective in May 2005, and
we became a publicly-reporting and trading company.  Our cellular
accessories business was discontinued in 2006 and we were inactive through March
10, 2010, though we continued to timely file our periodic reports with the
SEC.





On March
10, 2010, we acquired through an exchange offer all of the outstanding ordinary
shares and preferred shares of Image Metrics Limited, a private company
incorporated in England and Wales (“Image Metrics LTD”).  As a result of
the exchange offer, the Company is engaged in the business of providing
technology-based facial animation solutions to the interactive entertainment
industry.  Effective March 10, 2010, we changed our corporate name to Image
Metrics, Inc.  The term “Image Metrics” refers to Image Metrics LTD prior
to March 10, 2010, and Image Metrics, Inc. as of and after such
date.





Executive
Overview





Image
Metrics Inc., a Nevada corporation, is a leading global provider of
technology-based facial animation services to the interactive entertainment and
film industries.  Using proprietary software and mathematical algorithms
that “read” human facial expressions, our technology converts video footage of
real-life actors into 3D computer generated animated characters.   We
believe we are the leader in the field of facial animation in terms of quality,
cost and completion time.  In many contexts, we believe that we are able to
accomplish what other providers simply cannot.  Examples of our notable and
innovative facial animation projects include the 2010 “Red Dead Redemption”
video game, which sold more than 5 million copies in its first two weeks, 2009
“Grand Theft Auto IV” video game, which generated over $500 million in sales in
its first week, the 2009 computer generated aging of Brad Pitt in the feature
film “The Curious Case of Benjamin Button,” which won three Oscars including one
for achievement in visual effects, and the 2009 Black Eyed Peas’ Boom Boom Pow
music video, which earlier this year won the Grammy Award for best short form
music video.




17




Image
Metrics was founded in 2000 and has more than 60 man-years -  and $14.0
million -  invested in our computer vision based software.  We derive
our revenues from the sale of consulting services, model building, character
rigging and animation services. Our key intellectual property consists of one
patent registered in the United States, four additional patents in process, the
identification of 16 potential new patents, and significant well-documented
trade secrets.  We are continually updating our software and are
prosecuting a roadmap of technology innovations.  Prior to 2009, our
corporate emphasis was on developing technology rather than sales.  In
2009, our current management assumed their positions and, in 2009, a growth plan
was implemented that included our recently installed sales force and becoming a
public company.




The
facial animation market is not specifically followed by independent market
research firms, but independent research is available around animation in
general and on the video game and film businesses.  Using independent
market research from companies such as Acacia Research Group, SCRI
International, Inc. and NPD Group, we have developed estimates for the facial
animation market.  These estimates indicate that the facial animation
market generated $807 million of revenue in 2006, $1.4 billion in 2009, and is
forecast to grow to $1.9 billion by 2011.




Total
revenue during the third quarter of fiscal 2010 was $0.9 million up from
$0.2 million in the same period of fiscal 2009. Total revenue during the first
nine months of fiscal 2010 was$4.9 million up from $1.7 million in the same
period of fiscal 2009. The increases in revenue are the result of increased
demand for our services and expansion of our customer base.





Gross
margin was 22% for the third quarter of fiscal 2010, compared to -396% for the
same prior year quarter.  The marked improvement is a result of increased
number of projects completed in the third quarter of 2010.  During the
three months ended June 30, 2009, we had a minimal amount of work and as a
result experienced significant under utilization of our labor that comprises our
cost of revenue.  The gross margin was 52% for the first nine months of
fiscal year 2010 compared to 13% for the first nine months of fiscal year
2009.  The improvement during the nine months ended June 30, 2010 is the
result of the implementation of better pipeline process management and higher
number of projects that increased our labor utilization.





Cash
flows used for operations were $7.1 million for the first nine months of
fiscal 2010, compared to $2.6 million in the same period of fiscal 2009.
The decrease in cash flows from operations was primarily the result of a
decrease in deferred revenue, partially offset by increased accounts payable.
Cash flows from financing activities was $6.7 million for the first nine months
of fiscal 2010, compared to $3.0  million for the same period in
2009.  Increased cash flows were from additional debt and equity
financings.





Impact
of Recently Issued Accounting Standards




There
were no accounting pronouncements adopted by the Company or issued during the
three months ended June 30, 2010 that had a material effect on the unaudited
condensed consolidated financial statements or that are reasonably certain to
have a material impact on the unaudited condensed consolidated financial
statements in future periods.





Critical Accounting
Policies





A summary
of our significant accounting policies are disclosed in Note 1 of our Condensed
Consolidated Financial Statements included in Part I, Item 1 of this Quarterly
Report on Form 10-Q.  The following discussion addresses our most
critical accounting policies, which are those that are both important to the
portrayal of our financial condition and results of operations and that require
significant judgment or use of complex estimates.





18




We
consider certain accounting policies related to revenue recognition, notes
payable, and deferred tax assets and liabilities to be critical policies due to
the significance of these items to our operating results and the estimation
processes and management judgment involved in each.





Revenue
Recognition




We derive
our revenue from the sale of consulting services, model building, character
rigging and animation services. The majority of services are sold in
multiple-element arrangements.  We  recognize revenue pursuant to the
requirements of the Financial Accounting Standards Board Accounting Standards
Codification (“ASC”) 605, as amended by Accounting Standards Update (“ASU”)
2009-13, “Revenue Recognition - Multiple-Deliverable Revenue Arrangements”, when
persuasive evidence of an arrangement exists, delivery has occurred, the fee is
fixed or determinable, and collectability is probable. A majority of our
animation revenue is recognized in this manner. Revenue is presented net of
sales, use and value-added taxes collected on behalf of our
customers.





For sales
that involve the delivery of multiple elements, we  allocate revenue to
each undelivered element based on the element’s fair value as determined by
vendor-specific objective evidence (“VSOE”), which is the price charged when
that element is sold separately, or third party evidence (“TPE”).  When
VSOE and TPE are unavailable, fair value is based on management’s best estimate
of selling price.  When management’s estimate is used to determine fair
value, management makes its estimates using reasonable and objective evidence to
determine the price.  For elements not yet sold separately, the fair value
is equal to the price established by our management if it is probable that the
price will not change before the element is sold separately. We review our VSOE
and third party evidence at least annually. If we conclude we are unable to
establish fair values for one or more undelivered elements within a
multiple-element arrangement using VSOE, we use TPE, being the price at which
the vendor would transact if the unit of accounting were sold by the vendor
regularly on a stand-alone basis or our best estimate of the selling price for
that unit of accounting. During
fiscal year 2009 and the nine months ended June 30, 2010, the majority of our
revenue is related to contracts that involve the delivery of multiple elements,
as such, all the revenue associated with these contracts were recognized based
on estimated selling price.




Estimated
selling price for each deliverable is determined based on a calculation of
internal direct costs plus our anticipated profit margin, which is the method we
would use to sell the same deliverable on a standalone basis, then compared for
reasonableness to available market information on prices charged by other
providers for similar services or products.  Significant deliverables in
the arrangement qualify as separate units of account and are recognized
throughout the service period as the elements are delivered.


Notes
Payable





In
connection with the sale of debt or equity instruments, we may sell options or
warrants to purchase our common stock. In certain circumstances, these options
or warrants may be classified as derivative liabilities, rather than as equity.
Additionally, the debt or equity instruments may contain embedded derivative
instruments, such as embedded derivative features which in certain circumstances
may be required to be bifurcated from the associated host instrument and
accounted for separately as a derivative instrument liability.




For
options, warrants and bifurcated derivative features that are accounted for as
derivative instrument liabilities, we estimate fair value using either Monte
Carlo Simulation, quoted market prices of financial instruments with similar
characteristics or other valuation techniques. The valuation techniques require
assumptions related to the remaining term of the instruments and risk-free rates
of return, our current common stock price and expected dividend yield, and the
expected volatility of our common stock price over the life of the option.
Because of the limited trading history for our common stock, we estimate the
future volatility of our common stock price based the experience of other
entities considered comparable to our company.




Deferred
Tax Assets and Liabilities





Significant
judgment is required in determining our provision for income taxes. We assess
the likelihood that our deferred tax asset will be recovered from future taxable
income, and to the extent we believe that recovery is not likely, we establish a
valuation allowance. We consider future taxable income projections, historical
results and ongoing tax planning strategies in assessing the recoverability of
deferred tax assets. However, adjustments could be required in the future if we
determine that the amount to be realized is less or greater than the amount that
we recorded. Such adjustments, if any, could have a material impact on our
results of our operations.




19




We record
a valuation allowance to reduce our deferred income tax assets to the amount
that is more likely than not to be realized. In evaluating our ability to
recover our deferred income tax assets, we consider all available positive and
negative evidence, including our operating results, ongoing tax planning and
forecasts of future taxable income on a jurisdiction by jurisdiction basis. Our
cumulative pre-tax loss in recent years represents sufficient negative evidence
for us to determine that the establishment of a full valuation allowance against
the deferred tax asset is appropriate. This valuation allowance offsets net
deferred tax assets associated with future tax deductions as well as
carryforward items. In the event we were to determine that we would be able to
realize our deferred income tax assets in the future in excess of their net
recorded amount, we would make an adjustment to the valuation allowance which
would reduce the provision for income taxes.




Results
of Operations




On
January 25, 2011, we determined we had not properly applied the provisions of
FASB Accounting Standards Codification No. 820, “Fair Value Measurements and
Disclosures”.  As a result, we were required to restate our financial
statements and amend our 10-Q for the period ended June 30, 2010 with an
increase in fair value of derivative liabilities of 3.99 million, an increase in
notes payable discount of $0.19 million, a decrease in Series A convertible
preferred stock of $1.11 million, a decrease in retained earnings of $3.84
million, an increase in additional paid-in-capital of $1.15 million, an increase
in net loss of $0.21 million and $2.74 million for the three months and nine
months ended June 30, 2010, respectively, and an increase in net loss
attributable to common stock of $0.24 million and $3.88 million for the three
months and nine months ended June 30, 2010,
respectively.





The
following table sets forth key components of our results of operations during
the three months and nine months ended June 30, 2010 and 2009, both in dollars
and as a percentage of our net sales.




3
      months ended June 30,
                                                                                              
                                                                                              
                                                                                              9
      months ended June 30,2010
                                                                                              
                                                                                              
                                                                                              2009
                                                                                              
                                                                                              
                                                                                              2010
                                                                                              
                                                                                              
                                                                                              2009Amount
                                                                                              
                                                                                              
                                                                                              %
      of
                                                                                                Revenue
                                                                                              
                                                                                              
                                                                                              Amount
                                                                                              
                                                                                              
                                                                                              %
      of
                                                                                                Revenue
                                                                                              
                                                                                              
                                                                                              Amount
                                                                                              
                                                                                              %
      of
                                                                                                Revenue
                                                                                              
                                                                                              
                                                                                              Amount
                                                                                              
                                                                                              
                                                                                              %
      of
                                                                                                RevenueRevenue
                                                                                              
                                                                                              $
                                                                                              926
                                                                                              
                                                                                              
                                                                                              
                                                                                              100
                                                                                              %
                                                                                              
                                                                                              $
                                                                                              176
                                                                                              
                                                                                              
                                                                                              
                                                                                              100
                                                                                              %
                                                                                              
                                                                                              $
                                                                                              4,887
                                                                                              
                                                                                              100
                                                                                              %
                                                                                              
                                                                                              $
                                                                                              1,737
                                                                                              
                                                                                              
                                                                                              
                                                                                              100
                                                                                              %Cost
      of revenue (exclusive of depreciation shown separately
    below)
                                                                                              
                                                                                              
                                                                                              (722
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (78
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (874
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (497
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (2,361
                                                                                              )
                                                                                              (48
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (1,506
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (87
                                                                                              %)Gross
      Profit
                                                                                              
                                                                                              
                                                                                              204
                                                                                              
                                                                                              
                                                                                              
                                                                                              22
                                                                                              %
                                                                                              
                                                                                              
                                                                                              (698
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (397
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              2,526
                                                                                              
                                                                                              52
                                                                                              %
                                                                                              
                                                                                              
                                                                                              231
                                                                                              
                                                                                              
                                                                                              
                                                                                              13
                                                                                              %Operating
      ExpensesSelling
      & Marketing
                                                                                              
                                                                                              
                                                                                              399
                                                                                              
                                                                                              
                                                                                              
                                                                                              43
                                                                                              %
                                                                                              
                                                                                              
                                                                                              667
                                                                                              
                                                                                              
                                                                                              
                                                                                              379
                                                                                              %
                                                                                              
                                                                                              
                                                                                              1,242
                                                                                              
                                                                                              25
                                                                                              %
                                                                                              
                                                                                              
                                                                                              2,199
                                                                                              
                                                                                              
                                                                                              
                                                                                              127
                                                                                              %Research
      & Development
                                                                                              
                                                                                              
                                                                                              323
                                                                                              
                                                                                              
                                                                                              
                                                                                              35
                                                                                              %
                                                                                              
                                                                                              
                                                                                              342
                                                                                              
                                                                                              
                                                                                              
                                                                                              194
                                                                                              %
                                                                                              
                                                                                              
                                                                                              934
                                                                                              
                                                                                              19
                                                                                              %
                                                                                              
                                                                                              
                                                                                              1,077
                                                                                              
                                                                                              
                                                                                              
                                                                                              62
                                                                                              %Depreciation
                                                                                              
                                                                                              
                                                                                              51
                                                                                              
                                                                                              
                                                                                              
                                                                                              6
                                                                                              %
                                                                                              
                                                                                              
                                                                                              36
                                                                                              
                                                                                              
                                                                                              
                                                                                              20
                                                                                              %
                                                                                              
                                                                                              
                                                                                              143
                                                                                              
                                                                                              3
                                                                                              %
                                                                                              
                                                                                              
                                                                                              171
                                                                                              
                                                                                              
                                                                                              
                                                                                              10
                                                                                              %General
      & Administrative
                                                                                              
                                                                                              
                                                                                              1,598
                                                                                              
                                                                                              
                                                                                              
                                                                                              173
                                                                                              %
                                                                                              
                                                                                              
                                                                                              601
                                                                                              
                                                                                              
                                                                                              
                                                                                              341
                                                                                              %
                                                                                              
                                                                                              
                                                                                              5,433
                                                                                              
                                                                                              111
                                                                                              %
                                                                                              
                                                                                              
                                                                                              2,417
                                                                                              
                                                                                              
                                                                                              
                                                                                              139
                                                                                              %Total
      Operating Expenses
                                                                                              
                                                                                              
                                                                                              2,371
                                                                                              
                                                                                              
                                                                                              
                                                                                              256
                                                                                              %
                                                                                              
                                                                                              
                                                                                              1,646
                                                                                              
                                                                                              
                                                                                              
                                                                                              935
                                                                                              %
                                                                                              
                                                                                              
                                                                                              7,752
                                                                                              
                                                                                              159
                                                                                              %
                                                                                              
                                                                                              
                                                                                              5,864
                                                                                              
                                                                                              
                                                                                              
                                                                                              338
                                                                                              %Operating
      loss
                                                                                              
                                                                                              
                                                                                              (2,167
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (234
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (2,344
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (1,332
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (5,226
                                                                                              )
                                                                                              (107
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (5,633
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (324
                                                                                              %)Interest
      income (expense)
                                                                                              
                                                                                              
                                                                                              329
                                                                                              
                                                                                              
                                                                                              
                                                                                              36
                                                                                              %
                                                                                              
                                                                                              
                                                                                              (95
                                                                                              )
                                                                                              
                                                                                              
                                                                                              54
                                                                                              %
                                                                                              
                                                                                              
                                                                                              (3,06
                                                                                              )
                                                                                              (63
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (344
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (20
                                                                                              %)Optasia
      investment impairment
                                                                                              
                                                                                              
                                                                                              (729
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (79
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              0
                                                                                              %
                                                                                              
                                                                                              
                                                                                              (729
                                                                                              )
                                                                                              (15
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              0
                                                                                              %Foreign
      exchange gain (loss)
                                                                                              
                                                                                              
                                                                                              (1
                                                                                              )
                                                                                              
                                                                                              
                                                                                              0
                                                                                              %
                                                                                              
                                                                                              
                                                                                              (124
                                                                                              )
                                                                                              
                                                                                              
                                                                                              70
                                                                                              %
                                                                                              
                                                                                              
                                                                                              (163
                                                                                              )
                                                                                              (3
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              158
                                                                                              
                                                                                              
                                                                                              
                                                                                              9
                                                                                              %Total
      other expense
                                                                                              
                                                                                              
                                                                                              (401
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (43
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (219
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (124
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (3,954
                                                                                              )
                                                                                              (81
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (186
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (11
                                                                                              %)Income
      before taxes
                                                                                              
                                                                                              
                                                                                              (2,568
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (277
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (2,563
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (1,456
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (9,180
                                                                                              )
                                                                                              (188
                                                                                              %)
                                                                                              
                                                                                              
                                                                                              (5,819
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (335
                                                                                              %)Income
      Taxes
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              0
                                                                                              %
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              0
                                                                                              %
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              0
                                                                                              %
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              0
                                                                                              %Net
      Loss
                                                                                              
                                                                                              $
                                                                                              (2,568
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (277
                                                                                              %)
                                                                                              
                                                                                              $
                                                                                              (2,563
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (1,456
                                                                                              %)
                                                                                              
                                                                                              $
                                                                                              (9,180
                                                                                              )
                                                                                              (188
                                                                                              %)
                                                                                              
                                                                                              $
                                                                                              (5,819
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (335
                                                                                              %)




Total
revenue for the three months ended June 30, 2010 increased by 426 % at $0.93
million, compared to $0.18 million in the three months ended June 30, 2009.
Total revenue for the nine months ended June 30, 2010 increased by 181% at
$4.89 million, compared to $1.74 million in the nine months ended June 30,
2009.  The increase was primarily the result of the Company’s expansion of
its customer base and increased customer demand.




20




Cost
of Revenue, Excluding Depreciation and Amortization




Costs of
revenue primarily consist of direct personnel costs incurred to deliver
animation services.  Costs of revenue, excluding depreciation and
amortization, decreased by 17%, or $0.15 million, to $0.72 million for the three
months ended June 30, 2010, from $0.87 million for the three months ended June
30, 2009.  This decrease was the result of better management of animation
service focused labor, including more inefficient scheduling of resources in
alignment with customer needs.





Costs of
revenue, excluding depreciation and amortization, increased by 57%, or $0.85
million, to $2.36 million for the nine months ended June 30, 2010, from $1.51
million for the nine months ended June 30, 2009.  Cost of revenue increase
was the result of an increase in number of projects and service deliverables.
Our profit margin increased significantly for the nine months ended June 30,
2010 to 52% from 13% for the nine months ended June 30, 2009.  This
improvement is attributable to improved processes on managing our process
pipeline and project scheduling as well as gaining efficiencies when removing
the excess capacity from our pipeline.





Sales
and Marketing




Sales and
marketing expenses primarily consist of compensation costs, including incentive
compensation, travel expenses, advertising, and other sales and marketing
related costs.  Sales and marketing expenses decreased 40%, or $0.27
million, to $0.40 million for the three months ended June 30, 2010 from $0.67
million for the three months ended June 30, 2009.   The lower expenses
were directly attributable to fewer sales personnel.





Sales and
marketing expenses decreased 44%, or $0.96 million, to $1.24 million for the
nine months ended June 30, 2010 from $2.20 million for the nine months ended
June 30, 2009.  The decreases are the result of our expenditures during the
periods ending June 30, 2009 for market analysis, market research and market
development.  We put a high emphasis during the fiscal year 2009 in
developing our market presence to expand our customer base.





As a
percentage of revenue, sales and marketing expenses for the three months ended
June 30, 2010 decreased by 336% compared to the three months ended June 30, 2009
and decreased by 101% for the nine months ended June 30, 2010 compared to the
nine months ended June 30, 2009.  The decrease compared to revenue is a
direct result of more projects from an expanded customer base being completed
during the three months ended June 30, 2010 compared to the three months ended
March 3, 2009.




Research
and Development




Research
and development expenses consist primarily of employee-related costs for product
research and development.  Research and development expenses stayed
consistent at $0.32 million for the three months ended June 30, 2010 compared to
$0.34 million for the three months ended June 30, 2009.  Research and
development expenses decreased 13%, or $0.15 million, to $0.93 million for the
nine months ended June 30, 2010 from $1.08 million for the nine months ended
June 30, 2009. The decreases were attributable to fewer employees and a
reduction in incentive compensation for the remaining personnel. As a percentage
of revenue, research and development expenses decreased by 159% for the three
months ended June 30, 2010 from June 30, 2009.  This decrease compared to
revenue is a direct result of our continued service revenue growth.




Depreciation




Depreciation
expense consists of depreciation of long-lived property and equipment. 
Depreciation expenses remained consistent at approximately $0.05 million for the
three months ended June 30, 2010 and 2009 and $0.20 million for the nine months
ended June 30, 2010 and 2009.




As
a percentage of revenue, depreciation expense decreased to 6% for the three
months ended June 30, 2010 from 20% for the three months ended June 30, 2009 and
decreased to 3% for the nine months ended June 30, 2010 from 10% for the nine
months ended June 30, 2009.  This decrease compared to revenue is a direct
result of our continued service revenue growth and minimal capital expenditures
during the nine months ended June 30, 2010.





21




General
and Administrative




General
and administrative expenses consist principally of employee-related costs,
professional fees and occupancy costs.  General and administrative expenses
increased 166%, or $1.00 million, for the three months ended June 30, 2010 from
$0.60 million for the three months ended June 30, 2009.   The majority
of the increased expenses were from increased number of personnel resulting in
higher payroll by $0.50 million, increased stock compensation of $0.02 million,
professional fees that increased by $0.30 million and were primarily incurred
for debt and equity financing and preparation and review of SEC filings. 
Other increases include rent, travel and information technology services that,
combined, accounted for $0.15 million.





General
and administrative expenses for the nine months ended June 30, 2010 increased
125%, or $3.02 million, from $2.42 million for the nine months ended June 30,
2009.  The increased expenses were from increased number of personnel
resulting in higher base payroll and incentive compensation by $0.97 million,
increased stock compensation of $0.19 million, professional fees that increased
by $1.5 million and were primarily incurred for the exchange transaction, debt
and equity financing and audits. Other increases include rent, travel and
information technology services that, combined, accounted for $0.19
million.  Increased expenses were partially offset by lower office supply
and general expenses.




Interest
Income (Expense)
  Interest
income and expense is from warrants issued with our convertible notes payable
and private placement offerings along with the interest incurred on our
convertible notes payable. As a result of a decrease of $0.58 million in the
value of our warrant liability as of June 30, 2010, we recorded net interest
income for the three months ended June 30, 2010 of $0.32 million compared to
interest expense of $0.09 million in the three months ended June 30, 2009. Net
interest expense for the nine months ended June 30, 2010 increased 799% to $3.06
million compared to $0.34 million in the nine months ended June 30, 2009. The
majority of the interest expense is for the warrant liability incurred from the
issuance of warrants related to our notes payable and private placement
offerings.


As a
result of the Company defaulting on certain notes payable issued between October
2006 and February 2010, all outstanding amounts related to these notes payable
became immediately payable.  As such, we have classified all these notes
payable as current on our Balance Sheet.  These notes continue to accrue
interest at 5% per year until paid in full.




Gain
(Loss) on Foreign Exchange Transactions




Foreign
currency translation expense decreased 99% to $0.01 million during the three
months ended June 30, 2010 compared to $0.12 million during the three months
ended June 30, 2009.  The decrease is primarily attributable to fewer
expenses and sales transactions based in British pounds. We had a foreign
currency translation loss of $0.16 million for the nine months ended June 30,
2010 which was an increased expense of $0.32 million compared to the foreign
exchange gain of $0.16 million we had for the nine months ended June 30,
2009.  The variance was the result of fluctuations in exchange
rates.




22




Liquidity
and Capital Resources




We have
continued to finance operations through cash flows from operations, as well as
debt and equity transactions.  At June 30, 2010, we had $0.4 million in
cash.




Net cash
used in operating activities for the nine months ended June 30, 2010 and 2009
was $7.06 million and $2.58 million, respectively.  Our net loss of $9.18
million in the nine months ended June 30, 2010, was partially adjusted for
noncash interest of $2.95 million, stock compensation expense of $0.21 million,
and foreign currency transaction loss of $0.16 million.  Operating cash
flows were negatively impacted by a $2.30 million decrease in deferred revenue,
which was the result of substantial work completed for our largest
customer.  Operating cash outflows were offset by increased accounts
payable of $0.76 million.


Net cash
used for investing activities for the nine months ended June 30, 2010 and 2009
was $0.2 million, and $0.1 million, respectively.  The primary purchases
for June 30, 2010 and 2009 consisted of computer equipment and
software.





Net cash
provided by financing activities was $6.7 million and $3.0 million for the nine
months ended June 30, 2010 and 2009, respectively.  The net cash provided
from financing activities during the nine months of 2010, was from the issuance
of convertible notes, in the amount of $4.6 million, and $2.9 million received
from the sale of stock.  These cash receipts were partially offset from
payments on convertible and nonconvertible notes totaling $0.8 million, and
restriction of cash and the issuance of debt costs totaling $0.2 million. 
The net cash provided from financing activities in June 30, 2009, included
proceeds from the sale of stock and issuance of debt totaling $3.8 million,
which was partially offset by payments on nonconvertible notes for $0.8
million.





We have
certain notes payable that are in default, these notes payable have not had an
adverse impact on our ability to secure additional debt or equity financing and
we do not anticipate the defaults on these notes payable to restrict our ability
to secure additional financing in the future.





Off Balance Sheet
Arrangements





We do not
have any off balance sheet arrangements that have or are reasonably likely to
have a current or future effect on our financial condition, changes in financial
condition, revenues or expenses, results of operations, liquidity or capital
expenditures or capital resources that is material to an investor in our
securities.




Cash
Requirements




We
believe that our cash on hand and cash flow from operations will meet part of
our present cash needs and we will require additional cash resources, including
selling equity and seeking additional loans, to meet our expected capital
expenditure and working capital needs for the next 12 months. The sale of
additional equity securities could result in dilution to our stockholders. The
incurrence of indebtedness would result in increased debt service obligations
and could require us to agree to operating and financial covenants that would
restrict our operations. Financing may not be available in amounts or on terms
acceptable to us, if at all. Any failure by us to raise additional funds on
terms favorable to us, or at all, could limit our ability to expand or continue
our business operations and could harm our overall business
prospects.




These
conditions indicate a material uncertainty that casts significant doubt about
our ability to continue as a going concern.   We require additional
debt or equity financing to have the necessary funding to continue operations
and meet our obligations, and we believe that we will be able to obtain
financing.  Thus, we have continued to adopt the going concern basis of
accounting in preparing the financial statements.




23




ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Foreign
Exchange





Approximately
23% of our expenses were denominated in currencies other than the U.S. dollar
for the nine months ended June 30, 2010 and 2009.   We are
maintaining a market presence in the UK and throughout Europe.  As a
result, fluctuations in the values of the currencies in which we generate
revenue and incur expenses could adversely impact our results.




Fluctuations
in currencies relative to the U.S. dollar have affected and will continue to
affect period-to-period comparisons of our reported results of operations. For
the nine month ended June 30, 2010, we had foreign currency transaction losses
of $0.16 million while we had foreign currency transaction gains of $0.16
million during the nine months ended June 30, 2009.  The variance was a
result of significant fluctuations in the exchange rate between the British
pound and the US dollar.  As a result of the constantly changing currency
exposures and the volatility of currency exchange rates, we may experience
foreign currency losses in the future. We cannot predict the effect of exchange
rate fluctuations upon future operating results. Although we do not currently
undertake hedging transactions, we may choose to hedge a portion of our currency
exposure in the future.




Interest
Rate Risk




Fluctuation in interest
rates could impact our ability to obtain additional debt financing.Historically, we have
used external financing to fund operations and fluctuations could have a
significant impact on our operating results.




ITEM
4T. CONTROLS AND PROCEDURES




Restatement
of Our Financial Statements
  On
January 25, 2011, the Audit Committee of our Board of Directors, after
discussion with our independent registered public accounting firm, concluded
that our previously issued financial statements in the following reports should
no longer be relied upon because of errors in such financial
statements:
 
 o
              the
      interim period unaudited statements for the three and six month periods
      ended March 31, 2010, included in our Quarterly Report on Form 10-Q, filed
      with the Commission on May 24, 2010;
and
 o
              the
      interim period unaudited statements for the three and nine month periods
      ended June 30, 2010, included in our Quarterly Report on Form 10-Q, filed
      with the Commission on September 17,
2010.
  Our
previously issued financial statements, as defined above, should no longer be
relied upon as a result of us not properly applying the provisions of FASB
Accounting Standards Codification No. 820, “Fair Value Measurements and
Disclosures”.
 Management’s
Report on Internal Control Over Financial Reporting
  Management
of the Company is responsible for establishing and maintaining adequate internal
controls over financial reporting, as such term is defined in the Securities
Exchange Act of 1934 Rule 13a – 15 (f).  Under the supervision and with the
participation of our management, including our principal executive officer and
principal financial officer, we conducted an evaluation of the effectiveness of
the Company’s internal control over financial reporting as of December 31,
2009. In making this assessment we used the criteria set forth in the
framework in Internal Control – Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission.  Based on our
evaluation under the framework in Internal Control – Integrated Framework,
management had concluded that our internal control over financial reporting was
not effective as of December 31, 2009 due to material weaknesses in the
controls.
  The
Company’s chief executive officer and chief financial officer concluded that
material weaknesses existed in properly applying the provisions of FASB
Accounting Standards Codification No. 820, “Fair Value Measurements and
Disclosures” and application of an appropriate transfer pricing
policy.
 The
Company’s chief executive officer and chief financial officer in discussion with
the Company’s audit committee authorized the restatement of the previously
issued financial statements and concluded, as a result of the restatement, that
material weaknesses in internal control over financial reporting existed as of
June 30, 2010. The Company has restated its financial statements for the three
and six months ended March 31, 2010 to correct the errors. Based on the
restatement of the previously issued financial statements, the chief executive
officer and chief financial officer believe the financial statements have been
properly reflected as of June 30, 2010.  Management has made significant
changes subsequent to the June 30, 2010 balance sheet date and is engaged in an
ongoing effort to correct the material weaknesses in internal control over
financial reporting.
 
 The
restatement of our financial statements involved previously issued financial
statements for the periods ended March 31 and June 30, 2010, and, in
management’s evaluation of the effectiveness of our disclosure controls and
procedures as of the end of the quarterly period covered by this report, our
chief executive officer and chief financial officer concluded, as a result of
the restatement, that material weaknesses in our disclosure controls and
procedures continued to exist as at June 30, 2010, and that our disclosure
controls and procedures were not effective as of June 30, 2010. Given these
reportable conditions and material weaknesses, management has devoted additional
resources to resolving questions that arose during the period covered by this
report. As a result, we are confident our financial statements as of June 30,
2010 fairly present in all material respects our financial condition and results
of operations.
  Changes
in Internal Control Over Financial Reporting
 We have
taken actions and implemented new policies to mitigate certain weaknesses in our
disclosure controls and procedures that resulted in errors we identified with
regard to our financial statements at June 30, 2010, and for the three and six
months then ended, which required restatement of such financial statements, as
discussed above. Our accounting department staff have obtained additional
education on accounting for derivatives and measuring fair values of assets and
liabilities.  All disclosures and new financial accounting pronouncements
are reviewed internally and discussed with the Company’s independent registered
accounting firm, valuation experts and other accounting experts.  We are
dedicated to maintaining the high standards of financial accounting and
reporting that we have now established, and are committed to providing financial
information that is transparent, timely, complete and
accurate.


PART
II – OTHER INFORMATION





ITEM
1. LEGAL PROCEEDINGS





We are
not party to any material legal proceedings.





ITEM
1A. RISK FACTORS





If
we are unable to secure additional debt or equity financing, we may not be able
to meet our obligations and continue operations.





Our cash
on hand and cash flow from operations will only meet part of our present cash
needs and we will require additional cash resources, including selling equity
and seeking additional loans, to meet our expected capital expenditure and
working capital for the next 12 months.  Therefore, we require additional
debt or equity financing secure the necessary funding to continue operations and
meet our obligations.  Financing may not be available in amounts or on
terms acceptable to us, if at all.  Any failure by us to raise additional
funds on terms favorable to us, or at all, could limit our ability to expand or
continue our business operations and could harm our overall business
prospects.  We believe that if we are unsuccessful in securing additional
financing or improve our operational cash flows, our auditors will issue a
disclaimer about our ability to continue as a going concern in our upcoming year
end financial audit.




24




We
have a limited operating history, which limits the information available to you
to evaluate our business, and have a history of operating losses and uncertain
future profitability.




We have
incurred significant operating losses and have an accumulated deficit of $36.6
million as of June 30, 2010.  We incurred a loss from operations of $5.2
million during the nine months ended June 30, 2010, and expect to continue
operating at a loss for some period of time.  Our independent registered
public accounting firm has expressed substantial doubt about our ability to
continue as a going concern.  We face the risks and difficulties of an
early-stage company including the uncertainties of market acceptance,
competition, cost increases and delays in achieving business objectives. 
There can be no assurance that we will succeed in addressing any or all of these
risks, that we will achieve future profitability, or that we will achieve
profitability at any particular time.  The failure to do so would have a
material adverse effect on our business, financial condition and operating
results.




Because
the games and film industries are always evolving, their future growth and
ultimate size are difficult to predict.  Our business will not grow if the
use of our facial animation services does not continue to grow.




We are a
provider of technology-based facial animation services to the entertainment
industry.  Our industry is in the early stages of market acceptance of
products and related services and is subject to rapid and significant
technological change.  Because of the new and evolving nature of facial
animation technology, it is difficult to predict the size of this specialized
market, the rate at which the market for our facial animation services will grow
or be accepted, if at all, or whether emerging computer-generated animation
technologies will render our services less competitive or obsolete.  If the
market for our facial animation services fails to develop or grows slower than
anticipated, we would be significantly and materially adversely
affected.




If
our products and services do not achieve market acceptance, we may not achieve
our revenue and earnings goals in the time projected, or at all.




If we are
unable to operate our business as contemplated by our business model or if the
assumptions underlying our business model prove to be unfounded, we could fail
to achieve our revenue and earnings goals within the time we have projected, or
at all, which would have a detrimental effect on our business.  As a
result, the value of your investment could be significantly reduced or
completely lost.




Our
ability to generate revenue is highly dependent on building and maintaining
relationships with film and visual effects (VFX) studios, commercial producers
and game developers.  No assurance can be given that a sufficient number of
such companies will demand our facial animation services or other
computer-generated animation services, thereby expanding the overall market for
digital characters in films, games and other forms of entertainment and enabling
us to increase our revenue to the extent expected.  In addition, the rate
of the market’s acceptance of other computer-generated animation technologies
cannot be predicted.  Failure to attract and maintain a significant
customer base would have a detrimental effect on our business, operating results
and financial condition.




25




Our
future growth will be harmed if we are unsuccessful in developing and
maintaining good relationships with entertainment companies.




Our
business strategy may in the future be dependent on our ability to develop
relationships with entertainment companies to increase our customer base. 
These companies recommend our services to their customers, provide us with
referrals and help us build presence in the market.  These relationships
require a significant amount of time to develop.  Currently, we have
established a limited number of these relationships.  We must expand
current relationships and establish new relationships to grow our business in
accordance with our business plan.  We may not be able to identify,
establish, expand and maintain good relationships with quality entertainment
companies.  Additionally, it is uncertain that such relationships will
fully support and recommend our facial animation services.  Our failure to
identify, establish, expand and maintain good relationships with quality
entertainment companies would have a material and adverse effect on our
business.




The
majority of the contracts we have with customers are cancelable for any reason
by giving 30 days advance notice.




Our
customers have historically engaged us to perform services for them on a
project-by-project basis and are required by us to enter into a written
contractual agreement for the work, labor and services to be performed. 
Generally, our project contracts are terminable by the customer for any or no
reason on 30 days advance notice to us.  If a number of our customers were
to exercise cancellation rights, our business and operating results would be
materially and adversely affected.





26




We
have a large concentration of business from a small number of accounts.  A
decision by a key customer to discontinue or limit its relationship with us
could have a material adverse effect on our business.




We have
been highly dependent on sales of our facial animation products to a small
number of accounts.  Approximately 75% of our revenue for nine months ended
June 30, 2010 resulted from sales to two customers (Take-Two Interactive
Software, Inc. and Activision), and 89% of our revenue for the nine months ended
June 30, 2009 resulted from sales to three customers (including Take-Two
Interactive and Sony Entertainment).  Therefore, at present, a significant
portion of our business depends largely on the success of specific customers in
the commercial marketplace.  Our business could be adversely affected if
any of our key customers’ share of the commercial market declined or if their
customer base, in turn, eroded in that market.  A decision by one or more
of our key customers to discontinue or limit its relationship with us could
result in a significant loss of revenue to us and have a material adverse impact
on our business.




Our
operating results will be harmed if we are unable to manage and sustain our
growth.




Our
business is unproven on a large scale and actual revenue and operating margins,
or revenue and margin growth, may be less than expected.  If we are unable
to scale our production capabilities efficiently, we may fail to achieve
expected operating margins, which would have a material and adverse effect on
our operating results.




Our
facial animation services may become obsolete if we do not effectively respond
to rapid technological change on a timely basis.




Our
facial animation services are new and our business model is evolving.  Our
services depend on the needs of our customers and their desire to create
believable facial performances in computer-generated characters.  Since the
games and film industries are characterized by evolving technologies, uncertain
technology and limited availability of standards, we must respond to new
research and development and technological changes affecting our customers and
collaborators.  We may not be successful in developing and marketing, on a
timely and cost-effective basis, new or modified services, which respond to
technological changes, evolving customer needs, and competition.




If
we fail to recruit and retain qualified senior management and other key
personnel, we will not be able to execute our business plan.




Our
business plan requires us to hire a number of qualified personnel, as well as
retain our current key management.  The industry is characterized by heavy
reliance on software and computer graphics engineers.  We must, therefore,
attract leading technology talent both as full-time employees and as
collaborators, to be able to execute our business strategy.  Presently, our
key senior management and key personnel are Robert Gehorsam, Chief Executive
Officer, Ron Ryder, Chief Financial Officer, Brian Waddle, Executive Vice
President, and Kevin Walker, Ph.D., Chief Technology Officer.




The loss
of the services of one or more of our senior managers could impair our ability
to execute our business plan, which could hinder the development of products and
services.  We have entered into employment agreements with members of our
key senior management team, along with agreements with some of these members
regarding confidentiality, non-competition and invention assignment.  Under
California law, the non-competition provisions in the employment agreements will
likely be unenforceable, which could result in one or more members of our senior
management or key personnel leaving us and then, despite our efforts to prevent
them from doing so, competing directly against us for customers, projects and
personnel.




27




If
we fail to protect our intellectual property our current competitive strengths
could be eroded and we could lose customers, market share and
revenue.




Our
viability will depend on our ability to develop and maintain the proprietary
aspects of our technology to distinguish our service from our competitors’
products and services.  To protect our proprietary technology, we rely
primarily on a combination of confidentiality procedures, copyright, trademark
and patent laws.




We hold a
United States patent which expires in December 2025.  We have a number of
additional filings pending, or issued, which cover the technology that is
related to the subject of our United States patent.  In addition, we are
developing a number of new innovations for which we intend to file patent
applications.  No assurance can be given that any of these patents will
afford meaningful protection against a competitor or that any patent application
will be issued.  Patent applications filed in foreign countries are subject
to laws, rules, regulations and procedures that differ from those of the United
States, and thus there can be no assurance that foreign patent applications
related to United States patents will issue.  If these foreign patent
applications issue, some foreign countries provide significantly less patent
protection than the United States.  In addition, our contractual
relationships give rights, including ownership rights, in proprietary technology
to parties other than us.  The status of patents involves complex legal and
factual questions and the breadth of claims issued is uncertain. 
Accordingly, there can be no assurance that our patents, and any patents that
may be issued to us in the future, will afford protection against competitors
with similar technology.  No assurance can be given that patents issued to
us will not be infringed upon or designed around by others or that others will
not obtain patents that we would need to license or design around.  If
other companies’ existing or future patents containing broad claims are upheld
by the courts, the holders of such patents could require companies, including
us, to obtain licenses or else to design around those patents.  If we are
found to be infringing third-party patents, there can be no assurance that any
necessary licenses would be available on reasonable terms, if at
all.




Despite
our efforts to protect our proprietary rights, unauthorized parties may attempt
to copy aspects of our services or obtain and use information that we regard as
proprietary.  Unauthorized use of our proprietary technology could harm our
business.  Litigation to protect our intellectual property rights can be
costly and time-consuming to prosecute, and there can be no assurance that we
will be able to enforce our rights or prevent other parties from developing
similar technology or designing around our intellectual property.





Although
we believe that our products and services do not and will not infringe upon the
patents or violate the proprietary rights of others, it is possible such
infringement or violation has occurred or may occur which could have a material
adverse effect on our business.




Our
business is heavily reliant upon patented and patentable systems and methods
used in our  facial animation technology and related intellectual
property.  In the event that products and services we sell are deemed to
infringe upon the patents or proprietary rights of others, we could be required
to modify our products and services or obtain a license for the manufacture
and/or sale of such products and services.  In such event, there can be no
assurance that we would be able to do so in a timely manner, upon acceptable
terms and conditions, or at all, and the failure to do any of the foregoing
could have a material adverse effect upon our business.  Moreover, there
can be no assurance that we will have the financial or other resources necessary
to enforce or defend a patent infringement or proprietary rights violation
action.  Any litigation would also require our management to devote their
time and effort to fight it, which would detract from their ability to implement
our business plan, and would have a negative impact on our operations.  In
addition, if our products and services or proposed products and services are
deemed to infringe or likely to infringe upon the patents or proprietary rights
of others, we could be subject to injunctive relief and, under certain
circumstances, become liable for damages, which could also have a material
adverse effect on our business.




Our
customers are subject to numerous entertainment industry regulations, which
could adversely affect the nature and extent of the services we offer as a
result of changes in the regulatory or political climate.




Many
aspects of the games and film industries are subject to legislation at the
federal level concerning graphic violence and sexually explicit material. 
From time to time, the regulatory entities that have jurisdiction over the
industries adopt new or modified regulations or take other actions as a result
of their own regulatory processes or as directed by other governmental bodies,
including legislative and other authorities.  This changing regulatory and
political environment could adversely affect the nature and extent of the
services we are able to offer.




28




We
may in the future experience competition from film studios and game
developers.





Competition
in the development of facial animation technology is expected to become more
intense.  Competitors range from university-based research and development
graphics labs to development-stage companies and major domestic and
international film studios and game developers.  Many of these entities
have financial, technical, marketing, sales, distribution and other resources
significantly greater than those of ours.  There can be no assurance that
we can continue to develop our facial animation technology or that present or
future competitors will not develop computer-generated animation technologies
that render our facial animation technology obsolete or less marketable or that
we will be able to introduce new products and product enhancements that are
competitive with other products marketed by industry participants.




If
we fail to properly identify, negotiate and execute potential business
combinations, any merger and acquisition activity may adversely affect the value
of your investment.




We may
engage in mergers and acquisitions activity to accelerate our growth and market
presence, and our growth strategy includes such acquisitions.  These
transactions may cause you to experience dilution in your equity ownership
percentage, and there can be no assurance that we will be able to successfully
execute upon these potential acquisitions.  These transactions may have a
significant impact upon our overall business, management focus and ongoing cash
requirements.  If we fail to properly identify appropriate strategic
targets, to negotiate advantageous financial terms, to retain key personnel from
acquired companies, or to properly complete and integrate these operations, our
business may be adversely affected.




Our
customers are on various payment schedules and liquidity may be negatively
impacted if payment schedules change or customers are slow to pay.




We have
negotiated a variety of payment schedules with customers, and there is no
standard for payment cycles in our business.  These payment schedules are
likely to change, and we may not be able to negotiate equally favorable payment
schedules in the future. Further, we are vulnerable to delays in payments by
customers for services rendered or the uncollectibility of accounts
receivable.  Either of these factors could have a material adverse effect
on our liquidity and working capital position.  We are subject to credit
risks from time to time, particularly in the event that any of our receivables
represent sales to a limited number of customers.  Failure to properly
assess and manage such risks could require us to make accounting adjustments to
our revenue recognition policies and our allowance for doubtful
accounts.




The
value of your investment may be significantly reduced if we cannot fully fund
our growth strategy from the net proceeds of the private placement and from
projected revenue.




We need
to be able to fund the development and growth of our business from existing and
projected revenue, along with the net proceeds from our private placements, to
operate for the next 12 months as a going concern.  To execute our growth
strategy, we expect to need significant further development of both our
technology and our marketing infrastructure in existing and new markets. 
We have not completely identified all of the development and marketing
requirements to successfully execute this strategy.  If funds raised from
our private placements and generated on our own are insufficient to fund our
operations and to fully implement the actual required development, marketing and
expansion activities, we will be required to seek additional capital to fund
these activities, and may not be able to continue as a going concern, if we are
unable to secure such additional capital.  In addition, our plans or
assumptions with respect to our business, operations and cash flow may
materially change or prove to be inaccurate.  In this case, we may be
required to use part or all of the net proceeds of our private placements to
fund such expenses and/or seek additional capital.  This will depend on a
number of factors, including, but not limited to:




·
            the
      growth, condition and size of the games and film
    industries;





·
            the
      rate of growth of customer interest in believable facial animation in
      their games and films;





·
            the
      rate of market acceptance and new customer acquisition of our
      products;





·
            the
      rate of new product introduction and uptake by
  customers;




·
            our
      ability to negotiate favorable pricing and participation terms with
      customers;





·
            our
      ability to negotiate favorable payment arrangements with customers;
      and





·
            our
      ability to execute against our growth strategy and manage cash
      effectively.




29




If we
attempt to raise additional capital, it may not be available on acceptable
terms, or at all.  The failure to obtain required capital would have a
material adverse effect on our business.  If we issue additional equity
securities in the future, you could experience dilution or a reduction in
priority of your stock.




Our
ability to use net operating loss carryforwards to reduce future years' taxes
could be substantially limited if we experience an ownership change as defined
in the Internal Revenue Code.




Section 382
of the Internal Revenue Code contains rules that limit the ability of a company
to use its net operating loss carryforwards in years after an ownership change,
which is generally defined as any change in ownership of more than 50% of its
stock over a three-year testing period. These rules generally operate by
focusing on ownership changes among stockholders owning directly or indirectly
5% or more of the stock of a company and/or any change in ownership arising from
a new issuance of stock by the company. If, as a result of future transactions
involving our common stock, including purchases or sales of stock by 5%
stockholders, we undergo cumulative ownership changes which exceed 50% over the
testing period, our ability to use our net operating loss carryforwards would be
subject to additional limitations under Section 382.




Generally,
if an ownership change occurs, the annual taxable income limitation on the use
of net operating loss carryforwards is equal to the product of the applicable
long-term tax exempt rate and the value of the company's stock immediately
before the ownership change. Depending on the resulting limitation, a portion of
our net operating loss carryforwards could expire before we would be able to use
them.




As a
result of the exchange transaction on March 10, 2010, we are completing a review
of our net operating losses incurred by Image Metrics LTD and Image Metrics CA,
prior to the exchange transaction.





Our
inability to fully utilize our net operating losses to offset taxable income
generated in the future could have a material and negative impact on our future
financial position and results of operations.




Risks
Related to Our Common Stock




If
we do not timely file and have declared effective the initial registration
statement required pursuant to our private placement, we will be required to pay
liquidated damages.




As part
of our private placement, we entered into a registration rights agreement. Under
this agreement, we are obligated to file an initial registration statement
providing for the resale of the shares of common stock underlying the Series A
Convertible Preferred Stock and the warrants. Pursuant to the agreement, we
agreed to file and have declared effective the registration statement by a
certain date. If we do not meet this timeline, we must pay liquidated damages in
the amount equal to 2% of the aggregate investment amount per month, subject to
a maximum limit of 12% of the aggregate investment amount.




If
and when our registration statement becomes effective, a significant number of
shares of common stock will be eligible for sale, which could depress the market
price of our common stock.




Following
the effective date of the registration statement, a significant number of our
shares of common stock will become eligible for sale in the public market, which
could harm the market price of the stock. Further, shares may be offered from
time to time in the open market pursuant to Rule 144, and these sales may have a
depressive effect as well. In general, a person who has held restricted shares
for a period of nine months may, upon filing a notification with the SEC on Form
144, sell our common stock into the market, subject to certain
limitations.





30




There
has been no active public trading market for our common stock.




There is
currently no active public market for our common stock. An active trading market
may not develop or, if developed, may not be sustained. The lack of an active
market may impair your ability to sell your shares of common stock at the time
you wish to sell them or at a price that you consider reasonable. The lack of an
active market may also reduce the market value and increase the volatility of
your shares of common stock. An inactive market may also impair our ability to
raise capital by selling shares of common stock and may impair our ability to
acquire other companies or assets by using shares of our common stock as
consideration.




The
market price of our common stock may be volatile and may decline in
value.




The
market price of our common stock has been and will likely continue to be highly
volatile, as is the stock market in general, and the market for OTC Bulletin
Board quoted stocks, in particular. Some of the factors that may materially
affect the market price of our common stock are beyond our control, such as
changes in financial estimates by industry and securities analysts, conditions
or trends in the industry in which we operate or sales of our common stock.
These factors may materially adversely affect the market price of our common
stock, regardless of our performance. In addition, the public stock markets have
experienced extreme price and trading volume volatility. This volatility has
significantly affected the market prices of securities of many companies for
reasons frequently unrelated to the operating performance of the specific
companies. These broad market fluctuations may adversely affect the market price
of our common stock.




Our
stockholders may experience significant dilution if future equity offerings are
used to fund operations or acquire complementary businesses.




If our
future operations or acquisitions are financed through the issuance of equity
securities, our stockholders could experience significant dilution. In addition,
securities issued in connection with future financing activities or potential
acquisitions may have rights and preferences senior to the rights and
preferences of our common stock. We also established an incentive compensation
plan for our management and employees. We expect to grant options to purchase
shares of our common stock to our directors, employees and consultants and we
will grant additional options in the future. The issuance of shares of our
common stock upon the exercise of these options may result in dilution to our
stockholders.




Our
current management can exert significant influence over us and make decisions
that are not in the best interests of all stockholders.




Our
executive officers and directors beneficially own as a group approximately 52.0%
of our outstanding shares of common stock, inclusive of shares of common stock
issuable upon conversion of our Series A Convertible Preferred Stock. As a
result, these stockholders will be able to assert significant influence over all
matters requiring stockholder approval, including the election and removal of
directors and any change in control. In particular, this concentration of
ownership of our outstanding shares of common stock could have the effect of
delaying or preventing a change in control, or otherwise discouraging or
preventing a potential acquirer from attempting to obtain control. This, in
turn, could have a negative effect on the market price of our common stock. It
could also prevent our stockholders from realizing a premium over the market
prices for their shares of common stock. Moreover, the interests of the owners
of this concentration of ownership may not always coincide with our interests or
the interests of other stockholders and, accordingly, could cause us to enter
into transactions or agreements that we would not otherwise
consider.




31




Our
common stock is considered “penny stock” and may be difficult to
sell.




The SEC
has adopted regulations which generally define “penny stock” to be an equity
security that has a market or exercise price of less than $5.00 per share,
subject to specific exemptions. The market price of our common stock may be
below $5.00 per share and therefore may be designated as a “penny stock”
according to SEC rules. This designation requires any broker or dealer selling
these securities to disclose certain information concerning the transaction,
obtain a written agreement from the purchaser and determine that the purchaser
is reasonably suitable to purchase the securities. These rules may restrict the
ability of brokers or dealers to sell our common stock and may affect the
ability of our stockholders to sell their shares. In addition, since our common
stock is quoted on the OTC Bulletin Board, our stockholders may find it
difficult to obtain accurate quotations of our common stock and may find few
buyers to purchase the stock or a lack of market makers to support the stock
price.




We
do not anticipate paying dividends in the foreseeable future; you should not buy
our stock if you expect dividends.




We
currently intend to retain our future earnings to support operations and to
finance expansion and, therefore, we do not anticipate paying any cash dividends
on our common stock in the foreseeable future.





We
intend to apply for trading our common stock on Nasdaq, although we may not
satisfy its eligibility criteria for listing or will ever be listed on
Nasdaq.





We intend
to apply to list our common stock for trading on the Nasdaq Capital
Market.  No assurance can be given that we will satisfy the eligibility
criteria or other initial listing requirements, or that our shares of common
stock will ever be listed on Nasdaq or another national securities
exchange.




We
could issue “blank check” preferred stock without stockholder approval with the
effect of diluting then current stockholder interests and impairing their voting
rights, and provisions in our charter documents and under Nevada law could
discourage a takeover that stockholders may consider favorable.




Our
certificate of incorporation provides for the authorization to issue up to
20,000,000 shares of “blank check” preferred stock with designations, rights and
preferences as may be determined from time to time by our board of directors.
Our board of directors is empowered, without stockholder approval, to issue a
series of preferred stock with dividend, liquidation, conversion, voting or
other rights which could dilute the interest of, or impair the voting power of,
our common stockholders. The issuance of a series of preferred stock could be
used as a method of discouraging, delaying or preventing a change in control.
For example, it would be possible for our board of directors to issue preferred
stock with voting or other rights or preferences that could impede the success
of any attempt to change control of our company. In addition, advanced notice is
required prior to stockholder proposals.







If
we raise additional funds through the issuance of equity securities, or
determine in the future to register additional common or preferred stock, your
percentage ownership will be reduced, you will experience dilution which could
substantially diminish the value of your stock and such issuance may convey
rights, preferences or privileges senior to your rights which could
substantially diminish your rights and the value of your stock.




We may
issue additional shares of common stock for various reasons and may grant stock
options to employees, officers, directors and third parties. If we determine to
register for sale to the public additional shares of common stock or other debt
or equity securities in any future financing or business combination, a material
amount of dilution can be expected to cause the market price of the common stock
to decline. One of the factors which generally effects the market price of
publicly traded equity securities is the number of shares outstanding in
relationship to assets, net worth, earnings or anticipated earnings.
Furthermore, the public perception of future dilution can have the same effect
even if actual dilution does not occur.




32




ITEM
2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS




We issued
52,000 shares of series A Convertible Preferred stock during the three months
ended June 30, 2010 that were not previously reported in a Current Report on
Form 8-K.  We did not repurchase any securities during that
period.




ITEM
3. DEFAULT UPON SENIOR SECURITIES




We are
currently in default of the $196,000 notes issued between May 2006 and
February 2010 by the Company when it operated as International Cellular
Accessories.  Upon completion of the share exchange transaction on March
10, 2010, these notes payables entered a default status as a result of the
Company having a change of ownership.  As of June 30, 2010, the principal
and accrued interest owed on these loans was $222,000.  There were no other
defaults upon senior securities during the period ended June 30,
2010.




ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS




None




ITEM
5. OTHER INFORMATION




None




ITEM
6. EXHIBITS




Exhibit
      Number
              
              Desciption2.1
              
              Share
      Exchange Agreement, dated as of March 10, 2010, between International
      Cellular Accessories and Image Metrics Limited (Exhibit 2.1 to the
      Company’s Current Report on Form 8-K filed with the Securities and
      Exchange Commission on March 11, 2010 is incorporated herein by
      reference).3.1
              
              Charter
      of the Company (Exhibit 3.1 to the Company’s Quarterly Report for the
      periods ended March 31, 2010 on Form 10-Q filed with the Securities and
      Exchange Commission on May 24, 2010 is incorporated herein by
      reference).3.2
              
              Bylaws
      of the Company (Exhibit 3.2 to the Company’s Registration Statement on
      Form SB-2/A filed with the Securities and Exchange Commission on April 8,
      2005 is incorporated herein by reference).10.1
              
              Form
      of Private Placement Subscription Agreement to purchase units in Image
      Metrics, Inc. (Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on March 11, 2010 is
      incorporated herein by reference).10.2
              
              2009
      Stock Incentive Plan (Exhibit 10.2 to the Company’s Current Report on Form
      8-K filed with the Securities and Exchange Commission on March 16, 2010 is
      incorporated herein by reference).*10.3
              
              2010
      Stock Incentive Plan (Exhibit 10.4 to the Company’s Current Report on Form
      8-K filed with the Securities and Exchange Commission on May 7, 2010 is
      incorporated herein by reference).*10.4
              
              Form
      of Nonstatutory Stock Option Agreement Granted Under the 2010 Stock
      Incentive Plan (Exhibit 10.3 to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on May 7, 2010 is
      incorporated herein by reference).*31.1
              
              Certification
      by the Chief Executive Officer pursuant to Rule 13a-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302
      of the Sarbanes-Oxley Act of 200231.2
              
              Certification
      by the Chief Financial Officer pursuant to Rule 13a-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302
      of the Sarbanes-Oxley Act of 200232.1
              
              Certification
      by the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      200232.2
              
              Certification
      by the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002




33




SIGNATURE





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.




Date:
February 14, 2011




IMAGE
      METRICS, INC.By:
                  /s/ Ron
      RyderRon
      RyderChief
      Financial Officer(Principal
      Financial Officer andDuly
      Authorized
Officer)




34




EXHIBIT
INDEX




Exhibit
                    Number
                  
                  Description2.1
                  
                  Share
      Exchange Agreement, dated as of March 10, 2010, between International
      Cellular Accessories and Image Metrics Limited (Exhibit 2.1 to the
      Company’s Current Report on Form 8-K filed with the Securities and
      Exchange Commission on March 11, 2010 is incorporated herein by
      reference).3.1
                  
                  Charter
      of the Company (Exhibit 3.1 to the Company’s Quarterly Report for the
      periods ended March 31, 2010 on Form 10-Q filed with the Securities and
      Exchange Commission on May 24, 2010 is incorporated herein by
      reference).*3.2
                  
                  Bylaws
      of the Company (Exhibit 3.2 to the Company’s Registration Statement on
      Form SB-2/A filed with the Securities and Exchange Commission on April 8,
      2005 is incorporated herein by reference).10.1
                  
                  Form
      of Private Placement Subscription Agreement to purchase units in Image
      Metrics, Inc. (Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on March 11, 2010 is
      incorporated herein by reference).10.2
                  
                  2009
      Stock Incentive Plan (Exhibit 10.2 to the Company’s Current Report on Form
      8-K filed with the Securities and Exchange Commission on March 16, 2010 is
      incorporated herein by reference).*10.3
                  
                  2010
      Stock Incentive Plan (Exhibit 10.4 to the Company’s Current Report on Form
      8-K filed with the Securities and Exchange Commission on May 7, 2010 is
      incorporated herein by reference).*10.4
                  
                  Form
      of Nonstatutory Stock Option Agreement Granted Under the 2010 Stock
      Incentive Plan Plan (Exhibit 10.3 to the Company’s Current Report on Form
      8-K filed with the Securities and Exchange Commission on May 7, 2010 is
      incorporated herein by reference).*31.1**
                  
                  Certification
      by the Chief Executive Officer pursuant to Rule 15d-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302
      of the Sarbanes-Oxley Act of 200231.2**
                  
                  Certification
      by the Chief Financial Officer pursuant to Rule 15d-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302
      of the Sarbanes-Oxley Act of 200232.1**
                  
                  Certification
      by the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      200232.2**
                  
                  Certification
      by the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002





* 
Management contract or compensatory plan or arrangement.


** Filed
herewith.




35