**OMB****APPROVAL**OMB
                      Number:3235-0063Expires:January
                      31, 2008Estimated
                      average burdenhours
                      per
                      response2,196.00
 **UNITED
            STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-K/A**


**(Amendment
      No. 2)**




x ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE
      ACT OF 1934 FOR THE FISCAL YEAR ENDED  **** **** **DECEMBER
      31, 2005** **** **.**




o **** **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:  0-23336


**AROTECH
        CORPORATION**


(Exact
        name of registrant as specified in its charter)
  **Delaware**
                  (State
                    or other jurisdiction of incorporation or
                    organization)
              **95-4302784**
                (I.R.S.
                    Employer Identification
                    No.)


**1229
                Oak Valley Drive, Ann Arbor, Michigan**
                (Address
                  of principal executive offices)
            **48108**
                (Zip
                    Code)




**(800)
                281-0356**
              (Registrant’s
                telephone number, including area
                code)




Securities
      registered pursuant to Section 12(b) of the Act:




**Title
                of each class**
                None
            **Name
                of each exchange on which registered**
                Not
                  applicable




Securities
      registered pursuant to Section 12(g) of the Act: **Common
      Stock, $0.01 par value**




Indicate
      by check mark if
      the
      registrant is a well-known seasoned issuer, as defined in Rule 405 of the
      Securities Act .


**Yes** o**** **No** x




Indicate
      by check mark if
      the
      registrant is not required to file reports pursuant to Section 13 or Section
      15(d) of the Act).


**Yes** o**** **No** x




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** x**** **No** o****




Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not
      be contained, to the best of registrant’s knowledge, in definitive proxy or
      information statements incorporated by reference in Part III of this Form 10-K
      or any amendment to this Form 10-K. o****




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




Large
                accelerated filer: o****
            Accelerated
                filer:x
            Non-accelerated
                filer: o****




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




The
      aggregate market value of the registrant’s voting stock held by non-affiliates
      of the registrant as of June 30, 2005 was approximately $84,064,177 (based
      on
      the last sale price of such stock on such date as reported by The Nasdaq
      National Market and assuming, for the purpose of this calculation only, that
      all
      of the registrant’s directors and executive officers are
      affiliates).




*(Applicable
      only to corporate registrants)* Indicate
      the number of shares outstanding of each of the registrant’s classes of common
      stock, as of the latest practicable date: **8,468,957
      as of 7/5/06**




Documents
      incorporated by reference: **None**







**Potential
      persons who are to respond to the collection of**


**information
        contained in this form are not required to respond**
 **unless
        the form displays a currently valid OMB control number.**




**PRELIMINARY
      NOTE**




Arotech
      Corporation is filing this Amendment No. 2 to its Annual Report on Form 10-K
      for
      the year ended December 31, 2005, as filed with the Securities and Exchange
      Commission on March 31, 2006, and as amended by Amendment No. 1 as filed with
      the Securities and Exchange Commission on June 16, 2006. The sole purpose of
      this amendment is to re-file the following document under Item 8, “Financial
      Statements and Supplementary Data,” which document was previously filed under
      Item 9A, “Controls and Procedures”:




·
              the
                  report on internal control over financial reporting from Kost,
                  Forer,
                  Gabbay & Kasierer, a member of Ernst & Young Global, Independent
                  Registered Public Accounting
                  Firm.




The
      foregoing documents does not contain any changes from the version of such
      document most recently filed with the Securities and Exchange
      Commission.




We
      are
      also filing a new version of our financial statements giving effect to a
      one-for-fourteen reverse stock split effected on June 21, 2006. As a result,
      we
      are filing the following documents under Item 8, “Financial Statements and
      Supplementary Data”:




·
            the
                  report of Kost, Forer, Gabbay & Kasierer, a member of Ernst &
                  Young Global, Independent Registered Public Accounting
                  Firm;




·
            the
                  report of Stark Winter Schenkein & Co., LLP, Independent Registered
                  Public Accounting Firm; and




·
            Arotech
                  Corporation’s financial statements for the year ended December 31,
                  2005.




None
      of
      the foregoing documents contains any changes from the versions of such documents
      most recently filed with the Securities and Exchange Commission, except that
      the
      financial statements have been restated to give effect to a one-for-fourteen
      reverse stock split effected on June 21, 2006. Except in respect of the reverse
      stock split, the restated financial statements do not reflect the restatement
      of
      any previously reported financial statements, results of operations or any
      other
      related financial disclosures.




Additionally,
      as required by SEC regulations, we are:




·
            Providing
                  additional Consents of Kost, Forer, Gabbay & Kasierer, a member of
                  Ernst & Young Global, and Stark Winter Schenkein & Co., LLP,
                  Independent Registered Public Accounting Firms;
                  and




·
            Replacing
                  the Section 302 and Section 906 certifications from the Chairman
                  and Chief
                  Executive Officer and the Vice President –
                  Finance and
                  Chief Financial Officer.









**PART
      II**




**ITEM
                8.**
            **FINANCIAL
                STATEMENTS AND SUPPLEMENTARY
                DATA**




**In** **dex
      to Financial Statements**




**Page****Consolidated
                Financial Statements**Reports
                of Independent Registered Public Accounting Firms
            F-1Consolidated
                Balance Sheets
            F-8Consolidated
                Statements of Operations
            F-10Statements
                of Changes in Shareholders’ Equity
            F-11Consolidated
                Statements of Cash Flows
            F-14Notes
                to Consolidated Financial Statements
            F-17**Supplementary
                Financial Data**Quarterly
                Financial Data (unaudited) forthe two years ended December 31,
                2005
            F-64**Financial
                Statement Schedule**Schedule
                II – Valuation and Qualifying Accounts
            F-65




***The
      financial statements have been restated to give effect to a one-for-fourteen
      reverse stock split effected on June 21, 2006.***




-2-


ernstyoung logo
              nKost
                  Forer Gabbay
                  & Kasierer
                3
                   Aminadav St.
                Tel-Aviv
                  67067, Israel
              nPhone:
                    972-3-6232525
                  Fax:    
                       972-3-5622555





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




**To
      the Stockholders of**




**AROTECH
      CORPORATION**




We
      have
      audited the accompanying consolidated balance sheets of Arotech Corporation
      (the
“Company”) and its subsidiaries as of December 31, 2005 and 2004, and the
      related consolidated statements of operations, changes in stockholders’ equity
      and cash flows for each of the three years in the period ended December 31,
      2005. Our audits also included the financial statement schedule listed in Item
      15(a)(2) of the Company’s 10-K. These financial statements and schedule are the
      responsibility of the Company’s management. Our responsibility is to express an
      opinion on these financial statements and schedule based on our audits. We
      did
      not audit the financial statements of “Armor of America Incorporated”, a
      wholly-owned subsidiary of the Company, financial statements of which reflect
      total assets of 2.8% of the consolidated assets of the Company as of December
      31, 2005, and total revenues of 8.8% of the consolidated revenues of the Company
      for the year then ended, or of “IES Interactive Training, Inc.”, a wholly-owned
      subsidiary of the Company, financial statements of which reflect total assets
      of
      3.5% of the consolidated assets of the Company as of December 31, 2005, and
      total revenues of 11.8% of the consolidated revenues of the Company for the
      year
      then ended. Those statements were audited by other auditors whose report has
      been furnished to us, and our opinion, insofar as it relates to the data
      included for this subsidiary, is based solely on the report of the other
      auditors.




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




In
      our
      opinion based on our audits and the other auditors the consolidated financial
      statements referred to above present fairly, in all material respects, the
      consolidated financial position of the Company and its subsidiaries as of
      December 31, 2005 and 2004, and the consolidated results of their operations
      and
      their cash flows for each of the three years in the period ended December 31,
      2005, in conformity with U.S. generally accepted accounting principles.
      Additionally, in our opinion the related financial statement schedule, when
      considered in relation to the basic financial statements and schedule taken
      as a
      whole, present fairly in all material respects the information set forth
      therein.




We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of the Company’s internal
      control over financial reporting as of December 31, 2005, based on criteria
      established in Internal Control – Integrated Framework issued by the
      Committee of Sponsoring Organizations of the Treadway Commission (COSO) and
      our
      report dated
      June 15, 2006 expressed an unqualified opinion on management’s assessment of and
      an adverse opinion on the effectiveness of internal control over financial
      reporting.




/s/
                Kost, Forer, Gabbay & KasiererTel
                Aviv, Israel
                March
                  30, 2006,
                except
                  for the final paragraph above,
                as
                  to which the date is June 15, 2006and for Note 13.h., as to which
                  the date is July 24, 2006
            KOST,
                  FORER, GABBAY & KASIERER
              A
                Member of Ernst & Young Global




F-1


ernstyoung logo
              nKost
                  Forer Gabbay
                  & Kasierer
                3
                   Aminadav St.
                Tel-Aviv
                  67067, Israel
              nPhone:
                    972-3-6232525
                  Fax:    
                       972-3-5622555


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




**The
      Board of Directors and Shareholders of**




**AROTECH
      CORPORATION**




We
      have
      audited management’s assessment, included in the accompanying “Management’s
      Report on Internal Control Over Financial Reporting,” that Arotech Corporation
      (“Arotech” or “Company”) did not maintain effective internal control over
      financial reporting as of December 31, 2005, because of the effect of the
      material weakness related to revenue recognition identified in management’s
      assessment, based on criteria established in Internal Control - Integrated
      Framework issued by the Committee of Sponsoring Organizations of the Treadway
      Commission (the COSO criteria). Arotech’s management is responsible for
      maintaining effective internal control over financial reporting and for its
      assessment of the effectiveness of internal control over financial reporting.
      Our responsibility is to express an opinion on management’s assessment and an
      opinion on the effectiveness of the company’s internal control over financial
      reporting based on our audit. We did not examine the effectiveness of internal
      control over financial reporting of Armor of America Incorporated or IES
      Interactive Training Inc., wholly owned subsidiaries, whose financial statements
      in the aggregate reflect total assets and revenues constituting 6.3% and 20.6%,
      respectively, of the related consolidated financial statement amounts as of
      and
      for the year ended December 31, 2005. The effectiveness of Armor of America
      Incorporated’s and IES Interactive Training Inc.’s internal control over
      financial reporting was audited by other auditors whose reports have been
      furnished to us, and our opinion, insofar as it relates to the effectiveness
      of
      Armor of America Incorporated’s and IES Interactive Training Inc.’s internal
      control over financial reporting, is based solely on the reports of the other
      auditors.




We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether effective
      internal control over financial reporting was maintained in all material
      respects. Our audit included obtaining an understanding of internal control
      over
      financial reporting, evaluating management’s assessment, testing and evaluating
      the design and operating effectiveness of internal control, and performing
      such
      other procedures as we considered necessary in the circumstances. We believe
      that our audit and the reports of the other auditors provide a reasonable basis
      for our opinion




A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company’s internal control over
      financial reporting includes those policies and procedures that (1) pertain
      to
      the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company; (2)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company are
      being made only in accordance with authorizations of management and directors
      of
      the company; and (3) provide reasonable assurance regarding
      prevention or timely detection of unauthorized acquisition, use, or disposition
      of the company’s assets that could have a material effect on the financial
      statements.




F-2




Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.




In
      our
      report dated March 30, 2006, we disclaimed an opinion on management’s assessment
      and on the effectiveness of the Company’s internal control over financial
      reporting as of December 31, 2005, because management had not yet completed
      its
      assessment of the Company’s internal control over financial reporting.
      Management has subsequently completed its assessment of internal control over
      financial reporting as of December 31, 2005. Accordingly, our present report
      on
      the effectiveness of the Company’s internal control over financial reporting as
      of December 31, 2005, as presented herein, is different from our previous report
      dated March 30, 2006.




A
      material weakness is a control deficiency, or combination of control
      deficiencies, that results in more than a remote likelihood that a material
      misstatement of the annual or interim financial statements will not be prevented
      or detected. The following material weakness has been identified and included
      in
      management’s assessment: The Company did not maintain effective controls over
      the monitoring, review and approval of revenue recognition calculations at
      FAAC
      INC. Specifically, these calculations were not being reviewed by appropriate
      accounting personnel at FAAC INC. to determine that revenue is recognized in
      accordance with company policy and generally accepted accounting principles.
      This material weakness affects the Company’s revenue and unbilled receivable
      accounts. This material weakness was considered in determining the nature,
      timing, and extent of audit tests applied in our audit of the 2005 financial
      statements, and this report does not affect our report dated March 30, 2006,
      except for the final paragraph of our report as to which the date is June 15,
      2006, on those financial statements.




In
      our
      opinion, based on our audit and the reports of the other auditors, management’s
      assessment that Arotech did not maintain effective internal control over
      financial reporting as of December 31, 2005, is fairly stated, in all material
      respects, based on the COSO control criteria. Also, in our opinion, based on
      our
      audit and the reports of the other auditors, because of the effect of the
      material weakness described above on the achievement of the objectives of the
      control criteria, Arotech has not maintained effective internal control over
      financial reporting as of December 31, 2005, based on the COSO control criteria.




/s/
                Kost, Forer, Gabbay & KasiererTel
                Aviv, Israel
                June
                  15, 2006
            KOST,
                FORER, GABBAY & KASIERER
                A
                  Member of Ernst & Young
                  Global




F-3









REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To
      the
      Board of Directors


IES
      Interactive Training, Inc. and Subsidiary





We
      have
      audited the accompanying consolidated balance sheets of IES Interactive
      Training, Inc. and Subsidiary as of December 31, 2005, and the related
      consolidated statements of operations, stockholder’s (deficit) and cash flows
      for the year ended December 31, 2005. We also have audited management’s
      assessment, included in the accompanying Management’s
      Report on Internal Control Over Financial Reporting ,
      that
      IES Interactive Training, Inc. and Subsidiary maintained effective internal
      control over financial reporting as of December 31, 2005, based on criteria
      established in *Internal
      Control—Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
      IES Interactive Training, Inc. and Subsidiary’s management is responsible for
      these consolidated financial statements, for maintaining effective internal
      control over financial reporting, and for its assessment of the effectiveness
      of
      internal control over financial reporting. Our responsibility is to express
      an
      opinion on these consolidated financial statements, an opinion on management’s
      assessment, and an opinion on the effectiveness of the company’s internal
      control over financial reporting based on our audit.





We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement and whether effective internal
      control over financial reporting was maintained in all material respects. Our
      audit of financial statements included examining, on a test basis, evidence
      supporting the amounts and disclosures in the financial statements, assessing
      the accounting principles used and significant estimates made by management,
      and
      evaluating the overall financial statement presentation. Our audit of internal
      control over financial reporting included obtaining an understanding of internal
      control over financial reporting, evaluating management’s assessment, testing
      and evaluating the design and operating effectiveness of internal control,
      and
      performing such other procedures as we considered necessary in the
      circumstances. We believe that our audit provides a reasonable basis for our
      opinions.





A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company’s
      internal control over financial reporting includes those policies and procedures
      that (1) pertain to the maintenance of records that, in reasonable detail,
      accurately and fairly reflect the transactions and dispositions of the assets
      of
      the company; (2) provide reasonable assurance that transactions are recorded
      as
      necessary to permit preparation of financial statements in accordance with
      generally accepted accounting principles, and that receipts and expenditures
      of
      the company are being made only in accordance with authorizations of management
      and directors of the company; and (3) provide reasonable assurance regarding
      prevention or timely detection of unauthorized acquisition, use, or disposition
      of the company’s assets that could have a material effect on the financial
      statements.




7535
      EAST
      HAMPDEN
      AVENUE  ♦  SUITE
      109  ♦  DENVER,
      COLORADO
      80231


PHONE:
      303.694.6700 ♦ FAX:
      303.694.6761 ♦ TOLL
      FREE:
      888.766.3985 ♦ WWW.SWSCPAS.COM




F-4




Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of IES Interactive Training,
      Inc. and Subsidiary as of December 31, 2005, and the results of its operations
      and its cash flows for the year ended December 31, 2005, in conformity with
      accounting principles generally accepted in the United States of America. Also,
      in our opinion, management’s assessment that IES Interactive Training, Inc. and
      Subsidiary maintained effective internal control over financial reporting as
      of
      December 31, 2005 is fairly stated, in all material respects, based on criteria
      established in *Internal
      Control—Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
      Furthermore, in our opinion, IES Interactive Training, Inc. and Subsidiary
      maintained, in all material respects, effective internal control over financial
      reporting as of December 31, 2005, based on criteria established in *Internal
      Control—Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission
      (COSO).










Denver,
      Colorado


March
      10,
      2006




STARK♦WINTER♦SCHENKEIN& CO.,
        LLP♦*Certified
        Public Accountants*♦***Financial
        Consultants*
 7535
        EAST
        HAMPDEN
        AVENUE  ♦  SUITE
        109  ♦  DENVER,
        COLORADO
        80231
 PHONE:
        303.694.6700 ♦ FAX:
        303.694.6761 ♦ TOLLFREE:
        888.766.3985 ♦ WWW.SWSCPAS.COM




F-5









**Report
      of Independent Registered Public Accounting Firm**




To
      the
      Shareholder


Armour
      of
      America, Inc.


Gardena,
      California




We
      have
      audited the accompanying balance sheet of Armour of America, Inc. as of December
      31, 2005, and the related statements of operations, stockholder’s equity and
      cash flows for the period August 11, 2004 to December 2004 and the year ended
      December 31, 2005. We also have audited management’s assessment, included in the
      accompanying Management’s Report on Internal Control Over Financial Reporting ,
      that Armour of America, Inc. maintained effective internal control over
      financial reporting as of December 31, 2005, based on criteria established
      in *Internal
      Control—Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
      Armour of America, Inc.’s management is responsible for these financial
      statements, for maintaining effective internal control over financial reporting,
      and for its assessment of the effectiveness of internal control over financial
      reporting. Our responsibility is to express an opinion on these financial
      statements, an opinion on management’s assessment, and an opinion on the
      effectiveness of the company’s internal control over financial reporting based
      on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audits to obtain reasonable assurance about whether the
      financial statements are free of material misstatement and whether effective
      internal control over financial reporting was maintained in all material
      respects. Our audit of the financial statements included examining, on a test
      basis, evidence supporting the amounts and disclosures in the financial
      statements, assessing the accounting principles used and significant estimates
      made by management, and evaluating the overall financial statement presentation.
      Our audit of internal control over financial reporting included obtaining an
      understanding of internal control over financial reporting, evaluating
      management’s assessment, testing and evaluating the design and operating
      effectiveness of internal control, and performing such other procedures as
      we
      considered necessary in the circumstances. We believe that our audits provide
      a
      reasonable basis for our opinions.





A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company’s internal control over
      financial reporting includes those policies and procedures that (1) pertain
      to
      the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company; (2)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company are
      being made only in accordance with authorizations of management and directors
      of
      the company; and (3) provide reasonable assurance regarding prevention or timely
      detection of unauthorized acquisition, use, or disposition of the company’s
      assets that could have a material effect on the financial
      statements.




STARK♦WINTER♦SCHENKEIN& CO.,
          LLP♦*Certified
          Public Accountants*♦***Financial
          Consultants*
 7535
          EAST
          HAMPDEN
          AVENUE  ♦  SUITE
          109  ♦  DENVER,
          COLORADO
          80231
 PHONE:
          303.694.6700 ♦ FAX:
          303.694.6761 ♦ TOLL
FREE:
          888.766.3985 ♦ WWW.SWSCPAS.COM




F-6





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the financial position of Armour of America, Inc. as of
      December 31, 2005, and the related statements of operations, stockholder’s
      equity and cash flows for the period August 11, 2004 to December 2004 and the
      year ended December 31, 2005, in conformity with accounting principles generally
      accepted in the United States of America. Also, in our opinion, management’s
      assessment that Armour of America, Inc. maintained effective internal control
      over financial reporting as of December 31, 2005 is fairly stated, in all
      material respects, based on criteria established in *Internal
      Control—Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
      Furthermore, in our opinion, Armour of America, Inc. maintained, in all material
      respects, effective internal control over financial reporting as of December
      31,
      2005, based on criteria established in *Internal
      Control—Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission
      (COSO).








Denver,
      Colorado


January
      31, 2006


7535
          EAST
          HAMPDEN
          AVENUE  ♦  SUITE
          109  ♦  DENVER,
          COLORADO
          80231
 PHONE:
          303.694.6700 ♦ FAX:
          303.694.6761 ♦ TOLL
FREE:
          888.766.3985 ♦ WWW.SWSCPAS.COM




F-7


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**





**In
      U.S. dollars**




**December
                31,****2005**
            
            **2004****ASSETS**CURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            6,150,652
            
            $
            6,734,512Restricted
                collateral deposits and restricted held-to-maturity
                securities
            
            
            3,897,113
            
            
            6,962,110Available
                for sale marketable securities
            
            
            35,984
            
            
            135,568Trade
                receivables (net of allowance for doubtful accounts in the amounts
                of
                $176,180 and $55,394 as of December 31, 2005 and 2004, respectively)
            
            
            11,747,876
            
            
            8,266,880Unbilled
                receivables
            
            
            5,228,504
            
            
            2,881,468Other
                accounts receivable and prepaid expenses
            
            
            2,264,331
            
            
            1,339,393Inventories
            
            
            7,815,806
            
            
            7,277,301Total
                current assets
            
            
            37,140,266
            
            
            33,597,232SEVERANCE
                PAY FUND
            
            
            2,072,034
            
            
            1,980,047RESTRICTED
                DEPOSITS
            
            
            779,286
            
            
            4,000,000PROPERTY
                AND EQUIPMENT, NET
            
            
            4,252,931
            
            
            4,600,691INVESTMENT
                IN AFFILIATED COMPANY
            
            
            37,500
            
            
            —OTHER
                INTANGIBLE ASSETS, NET
            
            
            11,027,499
            
            
            14,368,701GOODWILL
            
            
            29,559,157
            
            
            39,745,516$
            84,868,673
            
            $
            98,292,187


The
        accompanying notes are an integral part of the consolidated financial
        statements.
  F-8
  AROTECH CORPORATION AND
        ITS SUBSIDIARIES


**CONSOLIDATED
      BALANCE SHEETS**





**In
      U.S. dollars**








**December
                31,****2005**
            
            **2004****LIABILITIES
                AND STOCKHOLDERS’ EQUITY**CURRENT
                LIABILITIES:Trade
                payables
            
            $
            5,830,820
            
            $
            6,177,546Other
                accounts payable and accrued expenses
            
            
            5,630,108
            
            
            5,818,188Current
                portion of promissory notes due to purchase of subsidiaries
            
            
            603,764
            
            
            13,585,325Short
                term bank credit and current portion of long term loans
            
            
            2,036,977
            
            
            181,352Deferred
                revenues
            
            
            603,022
            
            
            618,229Convertible
                debenture
            
            
            11,492,238
            
            
            —Liabilities
                of discontinued operations
            
            
            120,000
            
            
            —Total
                current liabilities
            
            
            26,316,929
            
            
            26,380,640LONG
                TERM LIABILITIESAccrued
                severance pay
            
            
            3,657,328
            
            
            3,422,951Convertible
                debenture
            
            
            8,590,233
            
            
            1,754,803Deferred
                revenues
            
            
            —
            
            
            163,781Long
                term loan
            
            
            —
            
            
            20,891Long-term
                portion of promissory note due to purchase of subsidiaries
            
            
            —
            
            
            980,296Total
                long-term liabilities
            
            
            12,247,561
            
            
            6,342,722COMMITMENTS
                AND CONTINGENT LIABILITIES (Note 11)MINORITY
                INTEREST
            
            
            38,927
            
            
            95,842STOCKHOLDERS’
                EQUITY:Share
                capital -Common
                stock - $0.01 par value each;Authorized:
                250,000,000 shares as of December 31, 2004 and 2003; Issued: 6,221,194
                shares and 5,759,786 shares as of December 31, 2005 and 2004,
                respectively; Outstanding - 6,181,527 shares and 5,720,119 shares
                as of
                December 31, 2005 and 2004, respectively
            
            
            870,969
            
            
            806,370Preferred
                shares - $0.01 par value each;Authorized:
                1,000,000 shares as of December 31, 2005 and 2004; No shares issued
                and
                outstanding as of December 31, 2005 and 2004
            
            
            —
            
            
            —Additional
                paid-in capital
            
            
            193,949,882
            
            
            189,266,103Accumulated
                deficit
            
            
            (142,996,964
            )
            
            (118,953,553
            )Deferred
                stock compensation
            
            
            (389,303
            )
            
            (1,258,295
            )Treasury
                stock, at cost (common stock - 39,667 shares as of December 31, 2005
                and
                2004)
            
            
            (3,537,106
            )
            
            (3,537,106
            )Notes
                receivable from stockholders
            
            
            (1,256,777
            )
            
            (1,222,871
            )Accumulated
                other comprehensive income
            
            
            (375,445
            )
            
            372,335Total
                stockholders’ equity
            
            
            46,265,256
            
            
            65,472,983$
            84,868,673
            
            $
            98,292,187




The
      accompanying notes are an integral part of the
      consolidated financial statements.




F-9




**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**





**In
      U.S. dollars**




**Year
                ended December 31,****2005**
            
            **2004**
            
            **2003**Revenues
            
            $
            49,044,595
            
            $
            49,953,846
            
            $
            17,326,641Cost
                of revenues
            
            
            34,383,736
            
            
            34,011,094
            
            
            11,087,840Gross
                profit
            
            
            14,660,859
            
            
            15,942,752
            
            
            6,238,801Operating
                expenses:Research
                and development, net
            
            
            1,300,429
            
            
            1,731,379
            
            
            1,053,408Selling
                and marketing expenses
            
            
            4,471,590
            
            
            4,922,217
            
            
            3,532,636General
                and administrative expenses
            
            
            14,862,435
            
            
            10,656,866
            
            
            5,857,876Amortization
                of intangible assets
            
            
            3,070,748
            
            
            2,494,556
            
            
            864,910Impairment
                of goodwill and other intangible assets
            
            
            12,256,756
            
            
            320,279
            
            
            —Total
                operating costs and expenses
            
            
            35,961,958
            
            
            20,125,297
            
            
            11,308,830Operating
                loss
            
            
            (21,301,099
            )
            
            (4,182,545
            )
            
            (5,070,029
            )Other
                income
            
            
            338,900
            
            
            —
            
            
            —Financial
                income (expenses), net
            
            
            (2,705,689
            )
            
            (4,228,965
            )
            
            (4,038,709
            )Loss
                before minorities interests in loss (earnings) of a subsidiaries
                and tax
                expenses
            
            
            (23,667,888
            )
            
            (8,411,510
            )
            
            (9,108,738
            )Income
                taxes
            
            
            (237,672
            )
            
            (586,109
            )
            
            (396,193
            )Loss
                from affiliated company
            
            
            (75,000
            )
            
            —
            
            
            —Minorities
                interests in loss (earnings) of a subsidiaries
            
            
            57,149
            
            
            (44,694
            )
            
            156,900Loss
                from continuing operations
            
            
            (23,923,411
            )
            
            (9,042,313
            )
            
            (9,348,031
            )Income
                (loss) from discontinued operations
            
            
            (120,000
            )
            
            —
            
            
            110,410Net
                loss
            
            $
            (24,043,411
            )
            $
            (9,042,313
            )
            $
            (9,237,621
            )Deemed
                dividend to certain stockholders
            
            $
            —
            
            $
            (3,328,952
            )
            $
            (350,000
            )Net
                loss attributable to common stockholders
            
            $
            (24,043,411
            )
            $
            (12,371,265
            )
            $
            (9,587,621
            )Basic
                and diluted net loss per share from continuing operations
            
            $
            (4.07
            )
            $
            (1.81
            )
            $
            (3.37
            )Basic
                and diluted net loss per share from discontinued
                operations
            
            $
            (0.02
            )
            $
            0.00
            
            $
            (0.04
            )Basic
                and diluted net loss per share
            
            $
            (4.09
            )
            $
            (2.48
            )
            $
            (3.45
            )Weighted
                average number of shares used in computing basic and diluted net
                loss per
                share
            
            
            5,872,093
            
            
            4,995,218
            
            
            2,777,870


The
        accompanying notes are an integral part of the consolidated financial
        statements.




F-10




**AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **STATEMENTS
        OF CHANGES IN STOCKHOLDERS’ EQUITY**
 
 **In
          U.S. dollars**


**Common
                  stock****Shares**
              
              **Amount**
              
              **Additional**
                **paid-in**
                **capital**
              
              **Accumulated**
                **deficit**
              
              **Deferred**
                **stock**
                **compensation**
              
              **Treasury**
                **stock**
              
              **Notes**
                **receivable**
                **from**
                **stockholders**
              
              **Accumulated
                  other**
                **comprehensive**
                **loss**
              
              **Total**
                **comprehensive**
                **income
                  (loss)**
              
              **Total**
                **stockholders’**
                **equity**Balance
                  as of January 1, 2003
              
              
              2,550,115
              
              $
              357,017
              
              $
              114,082,584
              
              $
              (100,673,619
              )
              $
              (12,000
              )
              $
              (3,537,106
              )
              $
              (1,177,589
              )
              $
              (1,786
              )
              
              
              
              $
              9,037,501Compensation
                  related to warrants issued to the holders of convertible
                  debentures
              
              
              
              
              
              
              
              
              5,157,500
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5,157,500Compensation
                  related to beneficial conversion feature of convertible
                  debentures
              
              
              
              
              
              
              
              
              5,695,543
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5,695,543Issuance
                  of shares on conversion of convertible debentures
              
              
              497,829
              
              
              69,696
              
              
              6,064,981
              
              
              
              
              
              
              
              
              
              
              
              (9,677
              )
              
              
              
              
              
              
              
              6,125,000Issuance
                  of shares on exercise of warrants
              
              
              263,071
              
              
              36,831
              
              
              3,259,422
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,296,253Issuance
                  of shares to consultants
              
              
              15,971
              
              
              2,236
              
              
              159,711
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              161,947Compensation
                  related to grant and reprcing of warrants and options issued to
                  consultants
              
              
              
              
              
              
              
              
              229,259
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              229,259Compensation
                  related to non-recourse loan granted to shareholder
              
              
              
              
              
              
              
              
              38,500
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              38,500Deferred
                  stock compensation
              
              
              
              
              
              
              
              
              4,750
              
              
              
              
              
              (4,750
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              —Amortization
                  of deferred stock compensation
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              8,286
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              8,286Exercise
                  of options by employees
              
              
              49,260
              
              
              6,896
              
              
              426,668
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              433,564Exercise
                  of options by consultants
              
              
              1,071
              
              
              150
              
              
              7,200
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              7,350Conversion
                  of convertible promissory note
              
              
              40,284
              
              
              5,640
              
              
              438,720
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              444,360Increase
                  in investment in subsidiary against common stock issuance
              
              
              9,000
              
              
              1,260
              
              
              120,960
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              122,220Accrued
                  interest on notes receivable from stockholders
              
              
              
              
              
              
              
              
              16,615
              
              
              
              
              
              
              
              
              
              
              
              (16,615
              )
              
              
              
              
              
              
              
              —Other
                  comprehensive income - foreign currency translation
                  adjustment
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              106,215
              
              $
              106,215
              
              
              106,215Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              (9,237,621
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              (9,237,621
              )
              
              (9,237,621
              )$
              (9,131,406
              )Balance
                  as of December 31, 2003
              
              
              3,426,601
              
              $
              479,726
              
              $
              135,702,413
              
              $
              (109,911,240
              )
              $
              (8,464
              )
              $
              (3,537,106
              )
              $
              (1,203,881
              )
              $
              104,429
              
              
              
              
              $
              21,625,877


The
      accompanying notes are an integral part of the consolidated financial
      statements.





F-11


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**STATEMENTS
        OF CHANGES IN STOCKHOLDERS’ EQUITY**
 
 **In
          U.S. dollars**
 **Common
                      stock****Shares**
                  
                  **Amount**
                  
                  **Additional**
                    **paid-in**
                    **capital**
                  
                  **Accumulated**
                    **deficit**
                  
                  **Deferred**
                    **stock**
                    **compensation**
                  
                  **Treasury**
                    **stock**
                  
                  **Notes**
                    **receivable**
                    **from**
                    **stockholders**
                  
                  **Accumulated
                      other**
                    **comprehensive**
                    **loss**
                  
                  **Total**
                    **comprehensive**
                    **income**
                  
                  **Total**
                    **stockholders’**
                    **equity**Balance
                      as of January 1, 2004
                  
                  
                  3,426,601
                  
                  $
                  479,726
                  
                  $
                  135,702,413
                  
                  $
                  (109,911,240
                  )
                  $
                  (8,464
                  )
                  $
                  (3,537,106
                  )
                  $
                  (1,203,881
                  )
                  $
                  104,429
                  
                  
                  
                  
                  $
                  21,625,877Issuance
                      of shares, net
                  
                  
                  1,009,892
                  
                  
                  141,384
                  
                  
                  24,252,939
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  24,394,323Issuance
                      of shares and warrants due to settlement of litigation
                  
                  
                  32,143
                  
                  
                  4,500
                  
                  
                  1,244,328
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,248,828Issuance
                      of shares to employees
                  
                  
                  2,857
                  
                  
                  400
                  
                  
                  92,800
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  93,200Conversion
                      of convertible debentures
                  
                  
                  274,552
                  
                  
                  38,437
                  
                  
                  3,754,279
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3,792,716Exercise
                      of warrants by investors and others
                  
                  
                  811,667
                  
                  
                  113,633
                  
                  
                  19,119,638
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  19,233,271Issuance
                      of shares to consultants
                  
                  
                  6,444
                  
                  
                  902
                  
                  
                  198,489
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  199,391Reclassification
                      to liability in connection with warrants granted
                  
                  
                  
                  
                  
                  
                  
                  
                  (10,841,020
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (10,841,020
                  )Reclassification
                      of liability to equity related to the fair value of
                      warrants
                  
                  
                  
                  
                  
                  
                  
                  
                  10,514,181
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  10,514,181Compensation
                      related to non-recourse loan granted to shareholder
                  
                  
                  
                  
                  
                  
                  
                  
                  (10,000
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (10,000
                  )Deferred
                      stock compensation related to options and restricted stock
                  
                  
                  52,857
                  
                  
                  7,400
                  
                  
                  2,074,057
                  
                  
                  
                  
                  
                  (2,081,457
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  —Amortization
                      of deferred stock compensation
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  831,626
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  831,626Exercise
                      of options by employees
                  
                  
                  64,089
                  
                  
                  8,972
                  
                  
                  1,101,172
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,110,144Exercise
                      of options by consultants
                  
                  
                  2,687
                  
                  
                  376
                  
                  
                  50,799
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  51,175Issuance
                      of shares in respect of FAAC acquisition
                  
                  
                  71,704
                  
                  
                  10,039
                  
                  
                  1,993,639
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2,003,678Accrued
                      interest on notes receivable from stockholders
                  
                  
                  
                  
                  
                  
                  
                  
                  18,990
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (18,990
                  )
                  
                  
                  
                  
                  
                  
                  
                  —Other
                      comprehensive income - foreign currency translation
                      adjustment
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  263,404
                  
                  $
                  263,404
                  
                  
                  263,404Other
                      comprehensiveincome-
                      realized gain on available for sale marketable securities
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  4,502
                  
                  
                  4,502
                  
                  
                  4,502Net
                      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (9,042,313
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (9,042,313
                  )
                  
                  (9,042,313
                  )$
                  (8,774,407
                  )Balance
                      as of December 31, 2004
                  
                  
                  5,755,493
                  
                  $
                  805,769
                  
                  $
                  189,266,704
                  
                  $
                  (118,953,553
                  )
                  $
                  (1,258,295
                  )
                  $
                  (3,537,106
                  )
                  $
                  (1,222,871
                  )
                  $
                  372,335
                  
                  
                  
                  
                  $
                  65,472,983




The
        accompanying notes are an integral part of the consolidated financial
        statements.
  F-12
  **AROTECH
          CORPORATION AND ITS SUBSIDIARIES**
 **STATEMENTS
            OF CHANGES IN STOCKHOLDERS’ EQUITY**
 
 In
            U.S. dollars  **Common
                        stock****Shares**
                    
                    **Amount**
                    
                    **Additional**
                      **paid-in**
                      **capital**
                    
                    **Accumulated**
                      **deficit**
                    
                    **Deferred**
                      **stock**
                      **compensation**
                    
                    **Treasury**
                      **stock**
                    
                    **Notes**
                      **receivable**
                      **from**
                      **stockholders**
                    
                    **Accumulated**
                      **other**
                      **comprehensive**
                      **income
                        (loss)**
                    
                    **Total**
                      **comprehensive**
                      **income
                        (loss)**
                    
                    **Total**
                      **stockholders’**
                      **equity**Balance
                        as of January 1, 2005
                    
                    
                    5,759,786
                    
                    $
                    806,370
                    
                    $
                    189,266,103
                    
                    $
                    (118,953,553
                    )
                    $
                    (1,258,295
                    )
                    $
                    (3,537,106
                    )
                    $
                    (1,222,871
                    )
                    $
                    372,335
                    
                    
                    
                    
                    $
                    $65,472,983Issuance
                        of shares, net
                    
                    
                    339,640
                    
                    
                    47,551
                    
                    
                    3,898,185
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3,945,736Shares
                        issued to convertible debenture holders
                    
                    
                    82,976
                    
                    
                    11,617
                    
                    
                    441,434
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    453,051Shares
                        issued to consultant
                    
                    
                    36,232
                    
                    
                    5,073
                    
                    
                    516,200
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    521,273Compensation
                        related to non-recourse loan granted to shareholder
                    
                    
                    
                    
                    
                    
                    
                    
                    (28,500
                    )
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (28,500
                    )Employee
                        options exercise
                    
                    
                    1,132
                    
                    
                    158
                    
                    
                    17,034
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    17,192Shares
                        issued to employees
                    
                    
                    714
                    
                    
                    100
                    
                    
                    (100
                    )
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    —Deferred
                        stock compensation related to options and restricted stock
                    
                    
                    3,571
                    
                    
                    500
                    
                    
                    50,500
                    
                    
                    
                    
                    
                    (51,000
                    )
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    —Amortization
                        of deferred stock compensation
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    674,712
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    674,712Cancellation
                        of deferred stock compensation as a result of forfeitures
                    
                    
                    (2,857
                    )
                    
                    (400
                    )
                    
                    (244,880
                    )
                    
                    
                    
                    
                    245,280
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    —Interest
                        accrued on notes receivable from shareholders
                    
                    
                    
                    
                    
                    
                    
                    
                    33,906
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (33,906
                    )
                    
                    
                    
                    
                    
                    
                    
                    —Other
                        comprehensive loss - foreign currency translation
                        adjustment
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (746,016
                    )
                    
                    (746,016
                    )
                    
                    (746,016
                    )Other
                        comprehensive loss - unrealized gain on available for sale
                        marketable
                        securities
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (1,764
                    )
                    
                    (1,764
                    )
                    
                    (1,764
                    )Net
                        loss
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (24,043,411
                    )
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (24,043,411
                    )
                    
                    (24,043,411
                    )Total
                        comprehensive loss
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    (24,791,191
                    )Balance
                        as of December 31, 2005
                    
                    
                    6,221,194
                    
                    $
                    870,969
                    
                    $
                    193,949,882
                    
                    $
                    (142,996,964
                    )
                    $
                    (389,303
                    )
                    $
                    (3,537,106
                    )
                    $
                    (1,256,777
                    )
                    $
                    (375,445
                    )
                    
                    
                    
                    $
                    46,265,256




The
        accompanying notes are an integral part of the consolidated financial
        statements.
  F-13


**AROTECH
          CORPORATION AND ITS SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 **In
          U.S. dollars**


**Year
                  ended December 31,****2005**
              
              **2004**
              
              **2003**Cash
                  flows from operating activities:Net
                  loss
              
              $
              (24,043,411
              )
              $
              (9,042,313
              )
              $
              (9,237,621
              )Less
                  loss (profit) for the period from discontinued operations
              
              
              120,000
              
              
              —
              
              
              (110,410
              )Adjustments
                  required to reconcile net loss to net cash used in operating
                  activities:Minorities
                  interests in earnings (loss) of subsidiary
              
              
              (57,149
              )
              
              44,694
              
              
              (156,900
              )Loss
                  from affiliated company
              
              
              75,000
              
              
              —
              
              
              —Depreciation
              
              
              1,373,580
              
              
              1,199,465
              
              
              730,159Amortization
                  of intangible assets, capitalized software costs and impairment
                  of
                  intangible assets
              
              
              15,453,584
              
              
              2,888,226
              
              
              879,311Remeasurement
                  of liability in connection to warrants granted
              
              
              (377,803
              )
              
              (326,839
              )
              
              —Accrued
                  severance pay, net
              
              
              68,839
              
              
              (441,610
              )
              
              3,693Amortization
                  of deferred stock compensation and compensation related to shares
                  issued
                  to employees
              
              
              674,713
              
              
              884,826
              
              
              8,286Mark
                  up of loans to stockholders
              
              
              —
              
              
              (32,397
              )
              
              (12,519
              )Write-off
                  of inventories
              
              
              1,062,336
              
              
              121,322
              
              
              96,350Impairment
                  of property and equipment
              
              
              34,243
              
              
              —
              
              
              68,945Amortization
                  of compensation related to warrants issued to the holders of convertible
                  debentures and beneficial conversion feature
              
              
              1,702,753
              
              
              4,142,109
              
              
              3,928,237Amortization
                  of deferred charges related to convertible debentures
                  issuance
              
              
              329,152
              
              
              222,732
              
              
              483,713Amortization
                  of prepaid financial expenses
              
              
              —
              
              
              —
              
              
              236,250Stock-based
                  compensation related to grant of new warrants and repricing of
                  warrants
                  granted to consultants
              
              
              —
              
              
              —
              
              
              229,259Stock-based
                  compensation related to shares issued and to be issued to consultants
                  and
                  shares granted as a donation
              
              
              538,058
              
              
              89,078
              
              
              161,947Stock-based
                  compensation related to non-recourse note granted to
                  stockholder
              
              
              (28,500
              )
              
              (10,000
              )
              
              38,500Interest
                  accrued or paid on promissory notes due to acquisition
              
              
              19,704
              
              
              39,311
              
              
              (66,793
              )Interest
                  accrued on restricted collateral deposits
              
              
              —
              
              
              (267,179
              )
              
              —Capital
                  loss (gain) from sale of marketable securities
              
              
              2,695
              
              
              (4,247
              )
              
              —Amortization
                  of premium related to restricted held to maturity
                  securities
              
              
              42,234
              
              
              202,467
              
              
              —Capital
                  loss (gain) from sale of property and equipment
              
              
              3,172
              
              
              (16,479
              )
              
              (11,504
              )Decrease
                  (increase) in trade receivables
              
              
              (3,608,950
              )
              
              732,828
              
              
              (820,137
              )Decrease
                  (increase) in other accounts receivable and prepaid
                  expenses
              
              
              (75,982
              )
              
              (49,513
              )
              
              40,520Decrease
                  (increase) in deferred tax assets
              
              
              65,376
              
              
              (89,823
              )
              
              —Increase
                  in inventories
              
              
              (1,710,528
              )
              
              (2,040,854
              )
              
              (193,222
              )Increase
                  in unbilled revenues
              
              
              (2,347,036
              )
              
              (1,581,080
              )
              
              —Decrease
                  in deferred revenues
              
              
              (178,988
              )
              
              (91,271
              )
              
              —Increase
                  (decrease) in trade payables
              
              
              (224,987
              )
              
              2,913,623
              
              
              (986,022
              )Increase
                  (decrease) in other accounts payable and accrued expenses
              
              
              32,269
              
              
              (125,231
              )
              
              1,677,668Net
                  cash used in operating activities from continuing operations
              
              
              (11,055,626
              )
              
              (638,155
              )
              
              (3,012,290
              )Net
                  cash used in operating activities from discontinued
                  operations
              
              
              —
              
              
              (214,041
              )
              
              (313,454
              )Net
                  cash used in operating activities
              
              $
              (11,055,626
              )
              $
              (852,196
              )
              $
              (3,325,744
              )




The
        accompanying notes are an integral part of the consolidated financial
        statements.
  F-14





**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


CONSOLIDATED
      STATEMENTS OF CASH FLOWS


In
        U.S. dollars


**Year
                ended December 31,****2005**
            
            **2004**
            
            **2003**Cash
                flows from investing activities:Purchase
                of property and equipment
            
            
            (1,224,752
            )
            
            (1,659,688
            )
            
            (580,949
            )Increase
                in capitalized software costs
            
            
            (651,611
            )
            
            (365,350
            )
            
            (209,616
            )Loans
                granted to stockholders
            
            
            —
            
            
            (1,036
            )
            
            (13,737
            )Repayment
                of loans granted to stockholders
            
            
            —
            
            
            32,397
            
            
            9,280Proceeds
                from sale of property and equipment
            
            
            104,175
            
            
            114,275
            
            
            16,753Proceeds
                from sale of marketable securities
            
            
            91,936
            
            
            90,016
            
            
            —Investment
                in marketable securities
            
            
            —
            
            
            (89,204
            )
            
            —Investment
                in affiliated company
            
            
            (112,500
            )
            
            —
            
            
            —Payment
                of transaction expenses in relation to previous year investment in
                subsidiary
            
            
            (12,945
            )
            
            —
            
            
            —Acquisition
                of Epsilor (1)
            
            
            —
            
            
            (7,190,777
            )
            
            —Acquisition
                of FAAC (2)
            
            
            —
            
            
            (12,129,103
            )
            
            —Acquisition
                of AoA (3)
            
            
            —
            
            
            (17,339,522
            )
            
            —Repayment
                of promissory notes related to acquisition of subsidiaries
                (1)(2)
            
            
            (14,588,298
            )
            
            (2,000,000
            )
            
            (750,000
            )Purchase
                of certain tangible and intangible assets
            
            
            (150,000
            )
            
            (150,000
            )
            
            (196,331
            )Increase
                in restricted cash and held to maturity securities
            
            
            4,748,178
            
            
            (9,809,091
            )
            
            (72,840
            )Net
                cash used in investing activities
            
            
            (11,795,817
            )
            
            (50,497,083
            )
            
            (1,797,440
            )Cash
                flows from financing activities:Proceeds
                from issuance of shares, net
            
            
            3,945,736
            
            
            24,361,750
            
            
            (6,900
            )Proceeds
                from exercise of options to employees and consultants
            
            
            17,192
            
            
            1,148,819
            
            
            440,914Proceeds
                from exercise of warrants
            
            
            —
            
            
            19,233,271
            
            
            3,296,254Proceeds
                from issuance of convertible debentures, net of issuance
                expenses
            
            
            16,430,767
            
            
            —
            
            
            13,708,662Long
                term loan received
            
            
            —
            
            
            69,638
            
            
            —Repayment
                of long term loan
            
            
            (71,238
            )
            
            (65,674
            )
            
            —Increase
                (decrease) in short term bank credit
            
            
            1,914,892
            
            
            (376,783
            )
            
            (74,158
            )Payment
                on capital lease obligation
            
            
            —
            
            
            (4,145
            )
            
            (4,427
            )Net
                cash provided by financing activities
            
            
            22,237,349
            
            
            44,366,876
            
            
            17,360,345Increase
                (decrease) in cash and cash equivalents
            
            
            (614,094
            )
            
            (6,982,403
            )
            
            12,237,161Cash
                erosion due to exchange rate differences
            
            
            30,234
            
            
            31,790
            
            
            (9,562
            )Cash
                and cash equivalents at the beginning of the year
            
            
            6,734,512
            
            
            13,685,125
            
            
            1,457,526Cash
                and cash equivalents at the end of the year
            
            $
            6,150,652
            
            $
            6,734,512
            
            $
            13,685,125Supplementary
                information on non-cash transactions:Issuance
                of shares and warrants against accrued expenses and restricted
                deposit
            
            $
            56,577
            
            $
            1,310,394
            
            $
            —Purchase
                of intangible assets against note receivable
            
            $
            —
            
            $
            —
            
            $
            300,000Increase
                of investment in subsidiary against issuance of shares of common
                stock
            
            $
            —
            
            $
            —
            
            $
            123,480Conversion
                of promissory note to shares of common stock
            
            $
            —
            
            $
            —
            
            $
            450,000Payment
                of principle installment of convertible debenture in
                shares
            
            $
            453,051
            
            $
            —
            
            $
            —Liability
                in connection to warrants granted
            
            $
            44,231
            
            $
            —
            
            $
            —Conversion
                of convertible debenture to shares of common stock
            
            $
            —
            
            $
            3,837,500
            
            $
            6,125,000Benefit
                due to convertible debentures and warrants
            
            $
            —
            
            $
            —
            
            $
            10,853,043Accrual
                for earn out in regard to subsidiary acquisition
            
            $
            603,764
            
            $
            13,435,325
            
            $
            —Supplemental
                disclosure of cash flows activities:Cash
                paid during the year for:Interest
            
            $
            1,401,681
            
            $
            532,750
            
            $
            39,412Taxes
                on income
            
            $
            737,080
            
            $
            969,009
            
            $
            527,053




The
        accompanying notes are an integral part of the consolidated financial
        statements.


F-15


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS (Cont.)**


**In
      U.S. dollars**




(1)
            In
                January 2004, the Company acquired substantially all of the outstanding
                ordinary shares of Epsilor Electronic Industries, Ltd. (“Epsilor”). The
                net fair value of the assets acquired and the liabilities assumed,
                at the
                date of acquisition, was as
                follows:




Working
                capital, excluding cash and cash equivalents
            
            $
            (849,992
            )Property
                and equipment
            
            
            709,847Intangible
                assets and goodwill
            
            
            10,284,40710,144,262Issuance
                of shares in respect to transaction costs
            
            
            (12,500
            )Issuance
                of promissory note *)
            
            
            (2,940,985
            )$
            7,190,777





*)
            During
                2005 and 2004 amounts of $1,000,000 and $2,000,000, respectively,
                were
                repaid to the former shareholders of
                Epsilor.




(2)
            In
                January 2004, the Company acquired all of the outstanding common
                stock of
                FAAC Incorporated (“FAAC”). The net fair value of the assets acquired and
                the liabilities assumed at the date of acquisition was as
                follows:





Working
                capital, excluding cash and cash equivalents
            
            $
            1,796,791Property
                and equipment
            
            
            263,669Intangible
                assets and goodwill
            
            
            12,072,32114,132,781Issuance
                of shares, net
            
            
            (2,003,678
            )$
            12,129,103




*)
            During
                2005, an additional amount of $13,588,298 was paid to the former
                shareholders of FAAC in respect of the earnout provisions of the
                acquisition agreement. The additional amount was charged to
                goodwill.




(3)
            In
                August 2004, the Company acquired all of the outstanding common stock
                of
                Armour of America, Incorporated (“AoA”). The net fair value of the assets
                acquired and the liabilities assumed at the date of acquisition was
                as
                follows:





Working
                capital, excluding cash and cash equivalents
            
            $
            3,219,728Property
                and equipment
            
            
            997,148Intangible
                assets and goodwill
            
            
            13,122,646$
            17,339,522





See
      note
      1.d. regarding additional earnout obligation to the former shareholder of AoA.




The
      accompanying notes are an integral part of the
      consolidated financial statements.


F-16


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE** **1:–****GENERAL**




a.  Arotech
      Corporation (“Arotech” or the “Company”) and its subsidiaries are engaged in the
      development, manufacture and marketing of defense and security products,
      including advanced high-tech multimedia and interactive digital solutions for
      training of military, law enforcement and security personnel and sophisticated
      lightweight materials and advanced engineering processes to armor vehicles,
      and
      in the design, development and commercialization of its proprietary zinc-air
      battery technology for electric vehicles and defense applications. The Company
      is primarily operating through IES Interactive Training, Inc. (“IES”), a
      wholly-owned subsidiary based in
      Littleton, Colorado; FAAC Corporation, a wholly-owned subsidiary based in Ann
      Arbor, Michigan, and FAAC’s 80%-owned United Kingdom subsidiary FAAC
      Limited ;
      Electric Fuel Battery Corporation, a wholly-owned subsidiary based in Auburn,
      Alabama; Electric Fuel Ltd. (“EFL”) a wholly-owned subsidiary based in Beit
      Shemesh, Israel; Epsilor
      Electronic Industries, Ltd., a wholly-owned subsidiary located in Dimona,
      Israel; MDT
      Protective Industries, Ltd. (“MDT”), a
      majority-owned subsidiary based in Lod, Israel; MDT Armor Corporation, a
      majority-owned subsidiary based in Auburn, Alabama; and Armour of America,
      Incorporated, a wholly-owned subsidiary based in Los Angeles,
      California .




Revenues
      derived from the Company’s largest customers in 2005, 2004 and 2003 are
      described in Note 16.d.




b.  Acquisition
      of Epsilor:




In
      January 2004, the Company entered into a stock purchase agreement between itself
      and all of the shareholders of Epsilor Electronic Industries, Ltd. (“Epsilor”),
      pursuant to the terms of which the Company purchased all of the outstanding
      shares of Epsilor from Epsilor’s existing shareholders. Epsilor develops and
      sells rechargeable and primary lithium batteries and smart chargers to the
      military, and to private industry in the Middle East, Europe and Asia.




The
      Acquisition was accounted under the purchase method accounting. Accordingly,
      all
      assets and liabilities acquired were recorded at their estimated market values
      as of the date of acquisition, and results of Epsilor’s operations have been
      included in the consolidated financial statements commencing the date of
      acquisition. The total consideration of $10,144,262 (including transaction
      costs) for the shares purchased consisted of (i) cash in the amount of
      $7,000,000, and (ii) a series of three $1,000,000 promissory notes, due on
      the
      first, second and third anniversaries of the agreement, which were recorded
      at
      their fair value of $2,940,985.




Based
      upon a valuation of tangible and intangible assets acquired, Arotech has
      allocated the total cost of the acquisition to Epsilor’s net assets as
      follows:




Tangible
                assets acquired
            
            $
            2,239,848Intangible
                assetsCustomer
                list
            
            
            5,092,395Goodwill
            
            
            5,192,012Liabilities
                assumed
            
            
            (2,379,993
            )Total
                consideration
            
            $
            10,144,262




F-17


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      1:–**  **GENERAL
      (Cont.)**




Customer
      list in the amount of $5,092,395 has a useful life of approximately ten
      years.




In
      accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill
      arising from acquisitions will not be amortized. In lieu of amortization,
      Arotech is required to perform an annual impairment test. If Arotech determines,
      through the impairment review process, that goodwill has been impaired, it
      will
      record the impairment charge in its statement of operations. Arotech will also
      assess the impairment of goodwill whenever events or changes in circumstances
      indicate that the carrying value may not be recoverable.




The
      value
      assigned to tangible, intangible assets and liabilities was determined as
      follows:




1.
            To
                determine the estimated market value of Epsilor’s net current assets,
                property and equipment, and net liabilities, the “Cost Approach” was used.
                According to the valuation made, the book values for the current
                assets
                and liabilities were reasonable proxies for their market
                values.




2.
            The
                customer list is the asset that generates most of the Company’s sales.
                Hence, the “Income Approach” was used to estimate its value, resulting in
                a value of $5,092,395.




See
      Note
      1.e. for pro forma financial information.




c.  Acquisition
      of FAAC:




In
      January of 2004, the Company entered into a stock purchase agreement with the
      stockholders of FAAC Incorporated (“FAAC”), pursuant to the terms of which it
      acquired all of the issued and outstanding common stock of FAAC, a provider
      of
      driving simulators, systems engineering and software products to the United
      States military, government and private industry.




The
      Acquisition was accounted under the purchase method accounting. Accordingly,
      all
      assets and liabilities were recorded at their estimated market values as of
      the
      date acquired, and results of FAAC’s operations have been included in the
      consolidated financial statements commencing the date of acquisition. The
      consideration for the purchase consisted of (i) cash in the amount of $12.0
      million, and (ii) the issuance of a total of 71,704 shares of the Company’s
      common stock, $0.14 par value per share, having a value of approximately $2.0
      million. There was also an earn-out based on 2004 net pretax income. Based
      on
      FAAC’s 2004 net pretax income, the Company paid the former stockholders of FAAC
      an earnout of $13.6 million during 2005, in cash and through the issuance of
      a
      total of 3,479,465 shares of the Company’s common stock (see Note 13.b.5.). The
      total consideration of $27.7 million (including the earn-out as well as $137,991
      of transaction costs) was determined based upon arm’s-length negotiations
      between the Company and FAAC’s stockholders.




In
      addition, the Company has a contingent earnout obligation in an amount equal
      to
      the net income realized by the Company from certain specific programs that
      were
      identified by the Company and the former shareholders of FAAC as appropriate
      targets for revenue increases in 2005. During 2005, the Company accrued an
      amount of $603,764 in respect of such earnout obligation against FAAC’s
      goodwill. Although the former shareholders of FAAC have indicated to the Company
      their belief that the specific programs identified include more orders than
      those with respect to which the Company has made accrual in respect of this
      earnout obligation, the Company believes there is no basis for this claim (see
      note 11.e.3.).




F-18


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      1:–**  **GENERAL
      (Cont.)**




Based
      upon a valuation of tangible and intangible assets acquired, Arotech has
      allocated the total cost of the acquisition (including earnout obligation
      accrued as of December 31, 2005) to FAAC’s assets and liabilities as
      follows:




Tangible
                assets acquired
            
            $
            4,833,553Intangible
                assetsTechnology
            
            
            4,610,000Backlog
            
            
            636,000Customer
                list
            
            
            1,125,000Trademarks
            
            
            374,000Goodwill
            
            
            19,522,343Liabilities
                assumed
            
            
            (2,770,843
            )Total
                consideration
            
            $
            28,330,053




Intangible
      assets which are subject to amortization, excluding trademarks, which are not
      subject to amortization, in the amount of $6,371,000  have
      a
      weighted-average useful life of approximately eight years.




In
      accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill
      arising from acquisitions will not be amortized. In lieu of amortization,
      Arotech is required to perform an annual impairment test. If Arotech determines,
      through the impairment review process, that goodwill has been impaired, it
      will
      record the impairment charge in its statement of operations. Arotech will also
      assess the impairment of goodwill whenever events or changes in circumstances
      indicate that the carrying value may not be recoverable.




The
      value
      assigned to tangible, intangibles assets and liabilities was determined as
      follows:




1.
            To
                determine the estimated fair value of FAAC’s net current assets, property
                and equipment, and net liabilities, the “Cost Approach” was used.
                According to the valuation made, the book values for the current
                assets
                and liabilities were reasonable proxies for their market
                values.




2.
            The
                amount of the cost attributable to technology of the software,
                documentation and know-how that drives the vehicle simulators and
                the
                high-speed missile fly-out simulators is $4,610,000 and was determined
                using the “Income Approach.”




3.
            FAAC’s
                sales are all made on a contractual basis, most of which are over
                a
                relatively long period of time. At the date of the purchase FAAC
                had
                several signed contracts at various stages of completion. The value
                of the
                existing contracts was determined using the Income approach and resulting
                in a value of $636,000.




F-19


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      1:–**  **GENERAL
      (Cont.)**




4.
            FAAC’s
                customer list includes various branches of the U.S. military, major
                defense contractors, various city and country governments and others.
                Since customer relationship represent one of the most important revenue
                generating assets for FAAC, its value was estimated using the Income
                Approach, resulting in a value of
                $1,125,000.




5.
            FAAC’s
                trade name value represents the name recognition value of the FAAC
                brand
                name as a result of advertising spending by the company. The Cost
                Approach
                was used to determine the value of FAAC’s trade name in the amount of
                $374,000.




See
      Note
      1.e. for pro forma financial information.




d.  Acquisition
      of AoA:




In
      August
      2004, the Company purchased all of the outstanding stock of Armour of America,
      Incorporated, a California corporation (“AoA”), from AoA’s existing
      shareholder.  The
      assets acquired through the purchase of all of AoA’s outstanding stock consisted
      of all of AoA’s assets, including AoA’s current as-sets, property and equipment,
      and other assets (including intangible assets such as in-tellectual property
      and
      contractual rights).




The
      total
      purchase price consisted of $19,000,000 in cash, with additional possible
      earn-outs if AoA is awarded certain material contracts. An additional $3,000,000
      was to be paid into an escrow account pursuant to the terms of an escrow
      agreement, to secure a portion of the Earnout Consideration. These funds are
      currently being held by the seller of AoA. Pursuant to the purchase agreement,
      the total consideration, sale price plus Earnout Consideration, will not be
      in
      excess of $40,000,000. When the contingency on the earn-out provision is
      resolved, the additional consideration, if any, will be recorded as additional
      purchase price. The purchase price also included $131,177 of transaction costs.
      The transaction has been accounted for using the purchase method of accounting,
      and accordingly, the purchase price has been allocated to the assets acquired
      and liabilities assumed based upon their fair values at the date the acquisition
      was completed.




F-20


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      1:–**  **GENERAL
      (Cont.)**




Based
      upon a valuation of tangible and intangible assets acquired, Arotech has
      allocated the total cost of the acquisition (including earnout obligation
      accrued as of December 31, 2005), to AoA’s assets and liabilities as follows
      :




Tangible
                assets acquired
            
            
            6,346,316Intangible
                assetsCertifications
            
            
            246,969Backlog
            
            
            1,512,000Customer
                relationships
            
            
            490,000Tradename
                /Trademark
            
            
            70,000Covenants
                not to compete
            
            
            260,000Goodwill
            
            
            11,757,812Liabilities
                assumed
            
            
            (347,770
            )Total
                consideration
            
            $
            20,335,327




Intangible
      assets, excluding trademarks, which are not subject to amortization, in the
      amount of $2,508,969 have a weighted-average useful life of approximately two
      years.




In
      connection with the Company’s acquisition of AoA, the Company has a contingent
      earnout obligation in an amount equal to the revenues realized by the Company
      from certain specific programs that were identified by the Company and the
      former shareholder of AoA as appropriate targets for revenue increases. The
      earnout provides that if AoA receives certain types of orders from certain
      specific customers prior to December 31, 2006 (“Additional Orders”), then upon
      shipment of goods in connection with such Additional Orders, the former
      shareholder of AoA will be paid an earnout based on revenues, up to a maximum
      of
      an additional $6 million. During 2005, the Company accrued an amount of
      $1,204,150 in respect of such earnout obligation.




In
      accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill
      arising from acquisitions will not be amortized. In lieu of amortization,
      Arotech is required to perform an annual impairment test. If Arotech determines,
      through the impairment review process, that goodwill has been impaired, it
      will
      record the impairment charge in its statement of operations. Arotech will also
      assess the impairment of goodwill whenever events or changes in circumstances
      indicate that the carrying value may not be recoverable.




See
      Note
      1.f. for impairment information.




See
      Note
      1.e. for pro forma financial information.




e.  Pro
      forma
      results




In
      January 2004, the Company acquired FAAC and Epsilor, as more fully described
      in
“Note 1.b. - Acquisition of Epsilor” and “Note 1.c. - Acquisition of FAAC,”
above, in August 2004, the Company acquired AoA, as more fully described in
      “Note 1.d. - Acquisition of AoA,” above (the “Acquisitions”). The following
      summary pro forma information includes the effects of the Acquisitions on the
      operating results of the Company. The following unaudited pro forma data for
      2004 and 2003 are presented as if the Acquisitions had been completed on January
      1, 2004 and 2003, respectively.


F-21


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      1:–**  **GENERAL
      (Cont.)**




This pro
      forma
      financial information does not
      purport to be indicative of the results of operations that would have occurred
      had the Acquisitions taken place at the beginning of the period, nor do they
      purport to be indicative of the results of operations that will be obtained
      in
      the future.




**Year
                Ended December 31,****2004**
            
            
            **2003**(Unaudited)Total
                revenues
            
            $
            61,086,697
            
            $
            39,680,394Gross
                profit
            
            
            22,528,254
            
            
            17,214,249Net
                loss
            
            
            (5,810,114
            )
            
            (6,959,174
            )Deemed
                dividend of common stock attributable to certain
                stockholders
            
            
            (3,328,952
            )
            
            (350,000
            )Net
                loss attributable to stockholders of common stock
            
            $
            (9,139,066
            )
            $
            (7,309,174
            )Basic
                and diluted net loss per share
            
            $
            (1.83
            )
            $
            (1.93
            )Weighted
                average number of shares used in computing basic net loss per
                share
            
            
            4,995,218
            
            
            3,783,309




f.  Impairment
      of goodwill and other intangible assets:




SFAS
      No.
      142 requires goodwill to be tested for impairment on adoption of the Statement,
      at least annually thereafter, and between annual tests in certain circumstances,
      and written down when impaired, rather than being amortized as previous
      accounting standards required. Goodwill is tested for impairment by comparing
      the fair value of the Company’s reportable units with their carrying value. Fair
      value is determined using discounted cash flows. Significant estimates used
      in
      the methodologies include estimates of future cash flows, future short-term
      and
      long-term growth rates, weighted average cost of capital and estimates of market
      multiples for the reportable units.




During
      2005, the Company performed impairment test of goodwill, based on management’s
      projections and using expected future discounted operating cash flows and as
      response to several factors, including without limitation the reduced sales
      in
      AoA (a component of the Company’s Armor Division) the fact that AoA failed to
      meet its projections, the decision of the General Manager of AoA and his new
      supervisor to leave the employ of AoA and the Company, respectively, and general
      uncertainty about the market for AoA’s products in general and AoA’s business in
      particular; specifically, the delay or loss of several potential orders,
      decisions by customers to utilize methods of armor not produced by AoA (hard
      armor instead of soft armor), the change in U.S. military priorities from
      acquiring new armor to funding the ground forces in Iraq and Afghanistan.
      Furthermore, following Hurricane Katrina, substantial funds earmarked for
      defense were delayed to provide funds for hurricane relief. As of December
      31,
      2005, as a result of this impairment test, the Company identified in AoA an
      impairment of goodwill in the amount of $11,757,812.


F-22


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      1:–**  **GENERAL
      (Cont.)**




The
      Company and its subsidiaries’ long-lived assets and certain identifiable
      intangibles are reviewed for impairment in accordance with Statement of
      Financial Accounting Standard No. 144, “Accounting for the Impairment or
      Disposal of Long-Lived Assets” (“SFAS No. 144”), whenever events or changes in
      circumstances indicate that the carrying amount of an asset may not be
      recoverable. Recoverability of the carrying amount of assets to be held and
      used
      is measured by a comparison of the carrying amount of the assets to the future
      undiscounted cash flows expected to be generated by the assets. If such assets
      are considered to be impaired, the impairment to be recognized is measured
      by
      the amount by which the carrying amount of the assets exceeds the fair value
      of
      the assets. As of December 31, 2004 the Company identified an impairment of
      the
      technology previously purchased from Bristlecone and as a result has recorded
      an
      impairment loss in the amount of $320,279. As of December 31, 2005 the Company
      identified an impairment of backlog, trademarks and a covenant not to compete
      previously identified with respect to the AoA acquisition and as a result
      recorded an impairment loss in the amount of $498,944.







**NOTE
      2:–**   **SIGNIFICANT
      ACCOUNTING POLICIES**





The
      consolidated financial statements have been prepared in accordance with
      generally accepted accounting principles in the United States (“U.S.
      GAAP”).




a.  Use
      of
      estimates:




The
      preparation of financial statements in conformity with generally accepted
      accounting principles requires management to make estimates and assumptions
      that
      affect the amounts reported in the financial statements and accompanying notes.
      Actual results could differ from those estimates.




b.  Financial
      statements in U.S. dollars:




A
      majority of the revenues of the Company and most of its subsidiaries and its
      subsidiaries’ affiliates is generated in U.S. dollars. In addition, a
      substantial portion of the Company’s and most of its subsidiaries costs are
      incurred in U.S. dollars (“dollar”). Management believes that the dollar is the
      primary currency of the economic environment in which the Company and most
      of
      its subsidiaries operate. Thus, the functional and reporting currency of the
      Company and most of its subsidiaries is the dollar. Accordingly,
      monetary accounts maintained in currencies other than the U.S. dollar are
      remeasured into U.S. dollars in accordance with Statement of Financial
      Accounting Standards No. 52 “Foreign Currency Translation” (“SFAS No. 52”). All
      transaction, gains and losses from the remeasured monetary balance sheet items
      are reflected in the consolidated statements of operations as financial income
      or expenses, as appropriate.




The
      majority of transactions of MDT and Epsilor are in New Israel Shekels (“NIS”)
      and a substantial portion of MDT’s and Epsilor’s costs is incurred in NIS.
      Management believes that the NIS is the functional currency of MDT and Epsilor.
      Accordingly, the financial statements of MDT and Epsilor have been translated
      into U.S. dollars. All balance sheet accounts have been translated using the
      exchange rates in effect at the balance sheet date. Statement of operations
      amounts has been translated using the weighted average exchange rate for the
      period. The resulting translation adjustments are reported as a component of
      accumulated other comprehensive loss in stockholders’ equity




F-23


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      2:–**   **SIGNIFICANT
      ACCOUNTING POLICIES (Cont.)**




c.  Principles
      of consolidation:




The
      consolidated financial statements include the accounts of the Company and its
      wholly and majority owned subsidiaries. Intercompany balances and transactions
      have been eliminated upon consolidation.




d.  Cash
      equivalents:




Cash
      equivalents are short-term highly liquid investments that are readily
      convertible to cash with maturities of three months or less when
      acquired.




e.  Restricted
      collateral deposits




Restricted
      cash is primarily invested in highly liquid deposits which are used as a
      security for the Company’s guarantee performance, its liability to a former
      shareholder of its acquired subsidiary and for the company’s liability for
      interest payments related to its convertible debentures.




f.  Marketable
      securities




The
      Company and its subsidiaries account for investments in debt and equity
      securities in accordance with Statement of Financial Accounting Standard No.
      115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS
      No. 115”). Management determines the appropriate classification of its
      investments in debt and equity securities at the time of purchase and
      reevaluates such determinations at each balance sheet date.




At
      December 31, 2005 the Company and its subsidiaries classified its investment
      in
      marketable securities as available-for-sale.




Investment
      in trust funds are classified as available-for-sale and stated at fair value,
      with unrealized gains and losses reported in accumulated other comprehensive
      income (loss), a separate component of stockholders’ equity, net of taxes.
      Realized gains and losses on sales of investments, as determined on a specific
      identification basis, are included in the consolidated statements of
      income.




g.  Inventories:




Inventories
      are stated at the lower of cost or market value. Inventory write-offs and
      write-down provisions are provided to cover risks arising from slow-moving
      items
      or technological obsolescence and for market prices lower than cost. The Company
      periodically evaluates the quantities on hand relative to current and historical
      selling prices and historical and projected sales volume. Based on this
      evaluation, provisions are made to write inventory down to its market value.
      In
      2005, 2004 and 2003, the Company wrote off $1,062,336, $121,322 and $96,350
      of
      obsolete inventory respectively, which has been included in the cost of
      revenues.




Cost
      is
      determined as follows:




Raw
      and
      packaging materials **–** by the average cost
      method.




F-24


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS** **In
        U.S. dollars**





**NOTE
      2:–**   **SIGNIFICANT
      ACCOUNTING POLICIES (Cont.)**




Work
      in
      progress **–** represents the cost of manufacturing with
      additions of allocable indirect manufacturing cost.




Finished
      products **–** on the basis of direct manufacturing costs with
      additions of allocable indirect manufacturing costs.




h.  Property
      and equipment:




Property
      and equipment are stated at cost net of accumulated depreciation and investment
      grants received from the State of Israel for investments in fixed assets under
      the Investment Law (no investment grants were received during 2005, 2004 and
      2003).




Depreciation
      is calculated by the straight-line method over the estimated useful lives of
      the
      assets, at the following annual rates:




**%**Computers
                and related equipment
            
            33Motor
                vehicles
            
            15Office
                furniture and equipment
            
            6
                -
                10Machinery
                and equipment
            
            10
                - 25 (mainly 10)Leasehold
                improvements
            
            By
                the shorter of the term of the lease and the life of the
                asset




i.  Goodwill:




Goodwill
      represents the excess of cost over the fair value of the net assets of
      businesses acquired. Under Statement of Financial Accounting Standard No. 142,
      “Goodwill and Other Intangible Assets” (“SFAS No, 142”) goodwill acquired in a
      business combination on or after July 1, 2001, is not amortized after January
      1,
      2002.




SFAS
      No.
      142 requires goodwill to be tested for impairment on adoption of the Statement
      and at least annually thereafter or between annual tests in certain
      circumstances, and written down when impaired, rather than being amortized
      as
      previous accounting standards required. Goodwill is tested for impairment by
      comparing the fair value of the Company’s reportable units with their carrying
      value. Fair value is determined using discounted cash flows. Significant
      estimates used in the methodologies include estimates of future cash flows,
      future short-term and long-term growth rates, weighted average cost of capital
      and estimates of market multiples for the reportable units.




See
      Note
      1.f. regarding the impairment test.




j.  Long-lived
      assets:




Intangible
      assets acquired in a business combination that are subject to amortization
      are
      amortized over their useful life using a method of amortization that reflects
      the pattern in which the economic benefits of the intangible assets are consumed
      or otherwise used up, in accordance with SFAS No. 142.


F-25


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      2:–**   **SIGNIFICANT
      ACCOUNTING POLICIES (Cont.)**




The
      acquired trademarks and tradenames are deemed to have an indefinite useful
      life
      because they are expected to contribute to cash flows indefinitely. Therefore,
      the trademarks will not be amortized until their useful life is no longer
      indefinite. The trademarks and tradenames are tested annually for impairment
      in
      accordance FAS 142.




The
      Company and its subsidiaries’ long-lived assets and certain identifiable
      intangibles are reviewed for impairment in accordance with Statement of
      Financial Accounting Standard No. 144 “Accounting for the Impairment or Disposal
      of Long-Lived Assets” (“SFAS No. 144”) whenever events or changes in
      circumstances indicate that the carrying amount of an asset may not be
      recoverable. Recoverability of the carrying amount of assets to be held and
      used
      is measured by a comparison of the carrying amount of the assets to the future
      undiscounted cash flows expected to be generated by the assets. If such assets
      are considered to be impaired, the impairment to be recognized is measured
      by
      the amount by which the carrying amount of the assets exceeds the fair value
      of
      the assets




See
      Note
      1.f. regarding the impairment test.




k.  Revenue
      recognition:




The
      Company is a defense and security products and services company, engaged in
      three business areas: interactive simulation for military, law enforcement
      and
      commercial markets; batteries and charging systems for the military; and
      high-level armoring for military, paramilitary and commercial vehicles. During
      2005, the Company and its subsidiaries recognized revenues as follows: (i)
      from
      the sale and customization of interactive training systems and from the
      maintenance services in connection with such systems (Simulation and Training
      Division); (ii) from revenues under armor contracts and for service and repair
      of armored vehicles (Armor Division); (iii) from the sale of batteries, chargers
      and adapters to the military, and under certain development contracts with
      the
      U.S. Army (Battery and Power Systems Division); and (iv) from the sale of
      lifejacket lights (Battery and Power Systems Division.




Revenues
      from the Battery and Power Systems Division products and Armor Division are
      recognized in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue
      Recognition” when persuasive evidence of an agreement exists, delivery has
      occurred, the fee is fixed or determinable, collectability is probably, and
      no
      further obligation remains.




Revenues
      from contracts that involve customization of FAAC’s simulation system to
      customer specific specifications are recognized in accordance with Statement
      Of
      Position 81-1, “Accounting for Performance of Construction-Type and Certain
      Production-Type Contracts,” using contract accounting on a percentage of
      completion method, in accordance with the “Input Method.” The amount of revenue
      recognized is based on the percentage to completion achieved. The percentage
      to
      completion is measured by monitoring progress using records of actual time
      incurred to date in the project compared to the total estimated project
      requirement, which corresponds to the costs related to earned revenues.
      Estimates of total project requirements are based on prior experience of
      customization, delivery and acceptance of the same or similar technology and
      are
      reviewed and updated regularly by management. Provisions for estimated losses
      on
      uncompleted contracts are made in the period in which such losses are first
      determined, in the amount of the estimated loss on the entire contract. As
      of
      December 31, 2005, $485,877 estimated losses were identified.




F-26


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      2:–**   **SIGNIFICANT
      ACCOUNTING POLICIES (Cont.)**




The
      Company believes that the use of the percentage of completion method is
      appropriate as the Company has the ability to make reasonably dependable
      estimates of the extent of progress towards completion, contract revenues and
      contract costs. In addition, contracts executed include provisions that clearly
      specify the enforceable rights regarding services to be provided and received
      by
      the parties to the contracts, the consideration to be exchanged and the manner
      and the terms of settlement, including in cases of terminations for convenience.
      In all cases the Company expects to perform its contractual obligations and
      its
      customers are expected to satisfy their obligations under the
      contract.





Revenues
      from simulators, which do not require significant customization, are recognized
      in accordance with Statement of Position 97-2, “Software Revenue
      Recognition,” (“SOP 97-2”). SOP 97-2 generally requires revenue earned on
      software arrangements involving multiple elements to be allocated to each
      element based on the relative fair value of the elements. The Company has
      adopted Statement of Position 98-9, “Modification of SOP 97-2, Software Revenue
      Recognition with Respect to Certain Transactions” (“SOP 98-9”). According to SOP
      No. 98-9, revenues are allocated to the different elements in the arrangement
      under the “residual method” when Vendor Specific Objective Evidence (“VSOE”) of
      fair value exists for all undelivered elements and no VSOE exists for the
      delivered elements. Under the residual method, at the outset of the arrangement
      with the customer, the Company defers revenue for the fair value of its
      undelivered elements (maintenance and support) and recognizes revenue for the
      remainder of the arrangement fee attributable to the elements initially
      delivered in the arrangement (software product) when all other criteria in
      SOP
      97-2 have been met.





Revenue
      from such simulators is recognized when persuasive evidence of an agreement
      exists, delivery has occurred, no significant obligations with regard to
      implementation remain, the fee is fixed or determinable and collectibility
      is
      probable.





Maintenance
      and support revenue included in multiple element arrangements is deferred and
      recognized on a straight-line basis over the term of the maintenance and support
      services. Revenues from training are recognized when it is performed. The VSOE
      of fair value of the maintenance, training and support services is determined
      based on the price charged when sold separately or when renewed.




Unbilled
      receivables include cost and gross profit earned in excess of
      billing.




Deferred
      revenues include unearned amounts received under maintenance and support
      services and billing in excess of costs and estimated earnings on uncompleted
      contracts.




F-27


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      2:-**   **SIGNIFICANT
      ACCOUNTING POLICIES (Cont.)**




l.  Right
      of
      return:




When
      a
      right of return exists, the Company defers its revenues until the expiration
      of
      the period in which returns are permitted.




m.  Warranty:




The
      Company offers up to one year warranty for most of its products. The specific
      terms and conditions of those warranties vary depending upon the product sold
      and country in which the Company does business. The Company estimates the costs
      that may be incurred under its basic limited warranty, including parts and
      labor. The Company estimates the costs that may be incurred under its basic
      limited warranty and records a liability in the amount of such costs as the time
      product revenue is recognized. Factors that affect the Company’s warranty
      liability include the number of installed units, historical and anticipated
      rates of warranty claims, and cost per claim. The Company periodically assesses
      the adequacy of its recorded warranty liabilities and adjusts the amounts as
      necessary. As of December 31, 2005, warranty liability is not
      material.




n.  Research
      and development cost:




SFAS
      No.
      86, “Accounting for the Costs of Computer Software to be Sold, Leased or
      Otherwise Marketed,” requires capitalization of certain software development
      costs, subsequent to the establishment of technological feasibility. Based
      on
      the Company’s product development process, technological feasibility is
      established upon the completion of a working model or a detailed program design.
      Research and development costs incurred in the process of developing product
      improvements or new products, are generally charged to expenses as incurred,
      when applicable. Significant costs incurred by the Company between completion
      of
      the working model or a detailed program design and the point at which the
      product is ready for general release, have been capitalized. Capitalized
      software costs will be amortized by the greater of the amount computed using
      the: (i) ratio that current gross revenues from sales of the software bears
      to
      the total of current and anticipated future gross revenues from sales of that
      software, or (ii) the straight-line method over the estimated useful life of
      the
      product (two to five years). The Company assesses the recoverability of this
      intangible asset on a regular basis by determining whether the amortization
      of
      the asset over its remaining life can be recovered through undiscounted future
      operating cash flows from the specific software product sold. Based on its
      most
      recent analyses, management believes that no impairment of capitalized software
      development costs exists as of December 31, 2005




o.  Income
      taxes:




The
      Company and its subsidiaries account for income taxes in accordance with
      Statement of Financial Accounting Standards No. 109, “Accounting for Income
      Taxes” (“SFAS No. 109”). This Statement prescribes the use of the liability
      method, whereby deferred tax assets and liability account balances are
      determined based on differences between financial reporting and tax bases of
      assets and liabilities and are measured using the enacted tax rates and laws
      that will be in effect when the differences are expected to reverse. The Company
      and its subsidiaries provide a valuation allowance, if necessary, to reduce
      deferred tax assets to its estimated realizable value.




F-28


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      2:–**   **SIGNIFICANT
      ACCOUNTING POLICIES (Cont.)**




p.  Concentrations
      of credit risk:




Financial
      instruments that potentially subject the Company and its subsidiaries to
      concentrations of credit risk consist principally of cash and cash equivalents,
      restricted collateral deposit and restricted held-to-maturity securities, trade
      receivables and available for sale marketable securities. Cash and cash
      equivalents are invested mainly in U.S. dollar deposits with major Israeli
      and
      U.S. banks. Such deposits in the U.S. may be in excess of insured limits and
      are
      not insured in other jurisdictions. Management believes that the financial
      institutions that hold the Company’s investments are financially sound and,
      accordingly, minimal credit risk exists with respect to these
      investments.




The
      trade
      receivables of the Company and its subsidiaries are mainly derived from sales
      to
      customers located primarily in the United States, Europe and Israel. Management
      believes that credit risks are moderated by the diversity of its end customers
      and geographical sales areas. The Company performs ongoing credit evaluations
      of
      its customers’ financial condition. An allowance for doubtful accounts is
      determined with respect to those accounts that the Company has determined to
      be
      doubtful of collection.




The
      Company’s available for sale marketable securities and held-to-maturity
      securities include investments in debentures of U.S. **** and
      Israeli corporations and state and local governments. Management believes that
      those corporations and states are institutions that are financially sound,
      that
      the portfolio is well diversified, and accordingly, that minimal credit risk
      exists with respect to these marketable securities.




The
      Company and its subsidiaries had no off-balance-sheet concentration of credit
      risk such as foreign exchange contracts, option contracts or other foreign
      hedging arrangements.




q.  Basic
      and
      diluted net loss per share:




Basic
      net
      loss per share is computed based on the weighted average number of shares of
      common stock outstanding during each year. Diluted net loss per share is
      computed based on the weighted average number of shares of common stock
      outstanding during each year, plus dilutive potential shares of common stock
      considered outstanding during the year, in accordance with Statement of
      Financial Standards No. 128, “Earnings Per Share.”




All
      outstanding stock options and warrants have been excluded from the calculation
      of the diluted net loss per common share because all such securities are
      anti-dilutive for all periods presented. The total weighted average number
      of
      shares related to the outstanding options and warrants excluded from the
      calculations of diluted net loss per share was 2,563,918, 2,250,154 and
      1,585,301 for the years ended December 31, 2005, 2004 and 2003,
      respectively.




r.  Accounting
      for stock-based compensation




The
      Company has elected to follow Accounting Principles Board Opinion No. 25
“Accounting for Stock Issued to Employees” (“APB No. 25”) and Interpretation No.
      44 “Accounting for Certain Transactions Involving Stock Compensation” in
      accounting for its employee stock option plans. Under APB No. 25, when the
      exercise price of the Company’s share options is less than the market price of
      the underlying shares on the date of grant, compensation expense is recognized.
      Under Statement of Financial Accounting Standard No. 123, “Accounting for
      Stock-Based Compensation” (“SFAS No. 123”), pro-forma information regarding
      net income and net income per share is required, and has been determined as
      if
      the Company had accounted for its employee stock options under the fair value
      method of SFAS No. 123.




F-29


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      2:-**   **SIGNIFICANT
      ACCOUNTING POLICIES (Cont.)**




The
      Company applies SFAS No. 123 and Emerging Issue Task Force No. 96-18 “Accounting
      for Equity Instruments that are Issued to Other than Employees for Acquiring,
      or
      in Conjunction with Selling, Goods or Services” (“EITF 96-18”) with respect to
      options issued to non-employees. SFAS No. 123 requires use of an option
      valuation model to measure the fair value of the options at the grant
      date.




The
      fair
      value for the options to employees was estimated at the date of grant, using
      the
      Black-Scholes Option Valuation Model, with the following weighted-average
      assumptions: risk-free interest rates of 4.28%, 3.63% and 2.54% for 2005, 2004
      and 2003, respectively; a dividend yield of 0.0% for each of those years; a
      volatility factor of the expected market price of the common stock of 0.76
      for
      2005, 0.81 for 2004 and 0.67 for 2003; and a weighted-average expected life
      of
      the option of three years for 2005, and five years for 2004 and
      2003.




The
      following table illustrates the effect on net income and earnings per share,
      assuming that the Company had applied the fair value recognition provision
      of
      SFAS No. 123 on its stock-based employee compensation:





**Year
                ended December 31,****2005**
            
            **2004**
            
            **2003**Net
                loss as reported
            
            $
            (24,043,411
            )
            $
            (9,042,313
            )
            $
            (9,237,621
            )Add:
                Stock-based compensation expenses included in reported net
                loss
            
            
            674,712
            
            
            831,626
            
            
            8,286Deduct:
                Stock-based compensation expenses determined under fair value method
                for
                all awards
            
            
            (2,461,787
            )
            
            (2,741,463
            )
            
            (1,237,558
            )$
            (25,830,486
            )
            $
            (10,952,150
            )
            $
            (10,466,893
            )Loss
                per share:Basic
                and diluted, as reported
            
            $
            (4.09
            )
            $
            (2.48
            )
            $
            (3.45
            )Diluted,
                pro forma
            
            $
            (4.40
            )
            $
            (2.19
            )
            $
            (3.77
            )





s.  Fair
      value of financial instruments:




The
      following methods and assumptions were used by the Company and its subsidiaries
      in estimating their fair value disclosures for financial
      instruments:




The
      carrying amounts of cash and cash equivalents, restricted collateral deposit
      and
      restricted held-to-maturity securities, trade receivables, short-term bank
      credit, and trade payables approximate their fair value due to the short-term
      maturity of such instruments.




The
      fair
      value of available for sale marketable securities is based on the quoted market
      price.


F-30


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      2:–**   **SIGNIFICANT
      ACCOUNTING POLICIES (Cont.)**




Long-terms
      promissory notes are estimated by discounting the future cash flows using
      current interest rates for loans or similar terms and maturities. The carrying
      amount of the long-term liabilities approximates their fair value.




t.  Severance
      pay:




The
      Company’s liability for severance pay is calculated pursuant to Israeli
      severance pay law based on the most recent salary of the employees multiplied
      by
      the number of years of employment as of the balance sheet date. Israeli
      employees are entitled to one month’s salary for each year of employment, or a
      portion thereof. The Company’s liability for all of its employees is fully
      provided by monthly deposits with severance pay funds, insurance policies and
      by
      an accrual. The value of these policies is recorded as an asset in the Company’s
      balance sheet.




In
      addition and according to certain employment agreements, the Company is
      obligated to provide for a special severance pay in addition to amounts due
      to
      certain employees pursuant to Israeli severance pay law. The Company has made
      a
      provision for this special severance pay in accordance with Statement of
      Financial Accounting Standard No. 106, “Employer’s Accounting for Post
      Retirement Benefits Other than Pensions.” As of December 31, 2005 and 2004, the
      accumulated severance pay in that regard amounted to $1,732,955 and $1,642,801,
      respectively.





Pursuant
      to the terms of the employment agreement between the Company and its Chief
      Executive Officer, funds to secure payment of the Chief Executive Officer’s
      contractual severance are to be deposited in a Rabbi Trust for the benefit
      of
      the Chief Executive Officer, with payments to the Rabbi Trust to be made
      pursuant to an agreed-upon schedule. As of December 31, 2005, the balance of
      this Rabbi Trust was $454,859. Pursuant to the terms of the Rabbi Trust, funds
      in the Rabbi Trust continue to be owned by the Company, which benefits from
      all
      gains and bears the risk of all losses resulting from investments of Rabbi
      Trust
      funds.




The
      deposited funds include profits accumulated up to the balance sheet date. The
      deposited funds may be withdrawn only upon the fulfillment of the obligation
      pursuant to Israeli severance pay law or labor agreements. The value of the
      deposited funds is based on the cash surrendered value of these policies and
      includes immaterial profits.




Severance
      expenses for the years ended December 31, 2005, 2004 and 2003 amounted to
      $639,952, $460,178 and $219,857, respectively.




u.  Advertising
      costs:




The
      Company and its subsidiaries expense advertising costs as incurred. Advertising
      expense for the years ended December 31, 2005, 2004 and 2003 was approximately
      $149,781, $13,271 and $34,732, respectively.




v.  New
      accounting pronouncements:




In
      December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based
      Payments” (“SFAS 123(R)”), which is a revision of FASB No. 123, “Accounting for
      Stock-Based Compensation” (“SFAS 123”). Generally, the approach in SFAS 123(R)
      is similar to the approach described in Statement 123. However, SFAS 123
      permitted, but not required, share-based payments to employees to be recognized
      based on their fair values while SFAS 123(R) requires all share-based payments
      to employees to be recognized based on their fair values. SFAS 123(R) also
      revises, clarifies and expands guidance in several areas, including measuring
      fair value, classifying an award as equity or as a liability and attributing
      compensation cost to reporting periods. The new standard will be effective
      for
      the Company in the first interim period beginning after December 15,
      2005.




F-31


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      2:–**   **SIGNIFICANT
      ACCOUNTING POLICIES (Cont.)**




Statement
      123(R) permits public companies to adopt its requirements using one of two
      methods:




1.  A
      “modified prospective” method in which compensation cost is recognized beginning
      with the effective date (a) based on the requirements of Statement 123(R) for
      all share-based payments granted after the effective date and (b) based on
      the
      requirements of Statement 123 for all awards granted to employees prior to
      the
      effective date of Statement 123(R) that remain unvested on the effective
      date.




2.  A
      “modified retrospective” method which includes the requirements of the modified
      prospective method described above, but also permits entities to restate based
      on the amounts previously recognized under Statement 123 for purposes of pro
      forma disclosures either (a) all prior periods presented or (b) prior interim
      periods of the year of adoption.




The
      Company plans to adopt SFAS No. 123(R) using the modified prospective
      method.




As
      permitted by Statement 123, the Company currently accounts for share-based
      payments to employees using Opinion 25’s intrinsic value method and, as such,
      generally recognizes no compensation cost for employee stock options.
      Accordingly, the adoption of Statement 123(R)’s fair value method will have a
      significant impact on the Company’s result of operations, although it will have
      no impact on the Company’s overall financial position. The impact of adoption of
      Statement 123(R) cannot be predicted at this time because it will depend on
      levels of share-based payments granted in the future. However, had the Company
      adopted Statement 123(R) in prior periods, the impact of that standard would
      have approximated the impact of Statement 123 as described in the disclosure
      of
      pro forma net income and earnings per share in Note 2.r. above to the Company’s
      consolidated financial statements. Statement 123(R) also requires the benefits
      of tax deductions in excess of recognized compensation cost to be reported
      as a
      financing cash flow, rather than as an operating cash flow as required under
      current literature.




In
      March
      2005, the SEC released Staff Accounting Bulletin No. 107, “Share-Based Payment”
(“SAB 107”). SAB 107 provides the SEC staff position regarding the application
      of SFAS No. 123R. SAB 107 contains interpretive guidance related to the
      interaction between SFAS No. 123R and certain SEC rules and regulations, as
      well
      as provides the Staff’s views regarding the valuation of share-based payment
      arrangements for public companies. SAB 107 also highlights the importance of
      disclosures made related to the accounting for share-based payment transactions.
      The Company expects that the adoption of SAB 107 will have an impact on its
      results of operations and net earnings per share as the Company will be required
      to expense the fair value of all share-based payments.




F-32


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      2:-**   **SIGNIFICANT
      ACCOUNTING POLICIES (Cont.)**




In
      May
      2005, the FASB issued Statement of Financial Accounting Standard No. 154 (“FAS
      154”), “Accounting Changes and Error Corrections,” a replacement of APB No.
      20,”Accounting Changes” and FAS No. 3, “Reporting Accounting Changes in Interim
      Financial Statements.” FAS 154 provides guidance on the accounting for and
      reporting of accounting changes and error corrections. APB Opinion 20 previously
      required that most voluntary changes in accounting principle be recognized
      by
      including in net income of the period of the change the cumulative effect of
      changing to the new accounting principle. FAS 154 requires retrospective
      application to prior periods’ financial statements of a voluntary change in
      accounting principle unless it is impracticable. FAS 154 is effective for
      accounting changes and corrections of errors made in fiscal years beginning
      after December 15, 2005. The Company is currently assessing the impact of FAS
      154 on its results of operations, financial condition and liquidity.




In
      November 2004, the FASB issued Statement of Financial Accounting Standard No.
      151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4.” (“SFAS No. 151”).
      SFAS No. 151 amends Accounting Research Bulletin (“ARB”) No. 43, Chapter 4, to
      clarify that abnormal amounts of idle facility expense, freight handling costs
      and wasted materials (spoilage) should be recognized as current-period charges.
      In addition, SFAS No. 151 requires that the allocation of fixed production
      overheads to the costs of conversion be based on the normal capacity of the
      production facilities. SFAS No. 151 is effective for inventory costs incurred
      during fiscal years beginning after June 15, 2005. The Company does not expect
      that the adoption of SFAS No. 151 will have a material effect on its financial
      position or results of operations





In
      November 2005, the FASB issued FASB Staff Position (“FSP”) Financial Accounting
      Standard (“FAS”) 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary
      Impairment and Its Application to Certain Investments” (“FSP 115-1”), which
      provides guidance on determining when investments in certain debt and equity
      securities are considered impaired, whether that impairment is
      other-than-temporary, and on measuring such impairment loss. FSP 115-1 also
      includes accounting considerations subsequent to the recognition of an
      other-than temporary impairment and requires certain disclosures about
      unrealized losses that have not been recognized as other-than-temporary
      impairments. FSP 115-1 is required to be applied to reporting periods beginning
      after December 15, 2005 and is required to be adopted by the Company in the
      second quarter of fiscal 2006. The Company does not expect the adoption of
      FSP
      115-1 to have a significant effect on its consolidated financial statements.





w.  Reclassification:




Certain
      prior period amounts have been reclassified to conform to the current period
      presentation.


F-33




**AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            3:-** **RESTRICTED
            COLLATERAL DEPOSITS AND RESTRICTED HELD-TO-MATURITY
            SECURITIES:**
  **December
                  31,****2005**
              
              **2004**Short-term:Restricted,
                  held to maturity, bonds in connection with FAAC earn out (Note
                  1.c.)(1)
              
              $
              —
              
              $
              5,969,413AoA
                  earnout (Note 1.d.)
              
              
              1,795,850
              
              
              —Deposits
                  in connection with FAAC projects
              
              
              548,973
              
              
              650,989Restricted
                  cash in connection with interest payment to convertible debenture
                  holders.
              
              
              1,395,079
              
              
              —Other
              
              
              157,211
              
              
              341,708Total
                  short-term
              
              
              3,897,113
              
              
              6,962,110
 Long-term:Restricted
                  cash in connection with interest payment to convertible debenture
                  holders.
              
              
              779,286
              
              
              —Restricted
                  cash in connection with AoA earn out (Note 1.d.)
              
              
              —
              
              
              3,000,000Restricted
                  deposit in connection with Epsilor acquisition (Note 1.b.)
              
              
              —
              
              
              1,000,000Total
                  long-term
              
              
              779,286
              
              
              4,000,000$
              4,676,399
              
              $
              10,962,110
 
 (1)
        The
        following is a summary of held-to-maturity securities at December 31, 2005
        and
        2004:
  **Amortized
                  cost**
              
              **Unrealized
                  losses**
              
              **Estimated
                  fair value****2005**
              
              **2004**
              
              **2005**
              
              **2004**
              
              **2005**
              
              **2004**Obligations
                  of States and political subdivisions
              
              $
              —
              
              $
              1,012,787
              
              $
              —
              
              $
              (1,870
              )
              $
              —
              
              $
              1,010,917Corporate
                  obligations
              
              
              —
              
              
              4,956,626
              
              
              —
              
              
              (11,966
              )
              
              —
              
              
              4,944,660$
              —
              
              $
              5,969,413
              
              $
              —
              
              $
              (13,836
              )
              $
              —
              
              $
              5,955,577
 
 The
        unrealized losses in the Company’s investments were caused by interest rate
        increases. It is expected that the securities would not be settled at a price
        less than the amortized cost of the Company’s investment. Based on the
        immaterial severity of the impairments and the obligation of the Company
        to hold
        these investments until maturity, the bonds were not considered to be other
        than
        temporarily impaired at December 31, 2004.
  **NOTE
        4: -**  **AVAILABLE
        FOR SALE MARKETABLE SECURITIES**
  The
        following is a summary of investments in marketable securities as of December
        31, 2005 and 2004:
  **Cost**
              
              **Unrealized
                  gains**
              
              **Estimated
                  fair value****2005**
              
              **2004**
              
              **2005**
              
              **2004**
              
              **2005**
              
              **2004**Available
                  for sale marketable securities
              
              $
              32,558
              
              $
              130,061
              
              $
              3,426
              
              $
              5,507
              
              $
              35,984
              
              $
              135,568
 
  F-34
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
        5:-**  **OTHER
        ACCOUNTS RECEIVABLE AND PREPAID EXPENSES**
  **December
                  31,****2005**
              
              **2004**Government
                  authorities
              
              $
              460,265
              
              $
              433,427Employees
              
              
              65,735
              
              
              217,948Prepaid
                  expenses
              
              
              1,360,589
              
              
              490,357Deferred
                  taxes
              
              
              64,820
              
              
              135,482Other
              
              
              312,922
              
              
              62,179$
              2,264,331
              
              $
              1,339,393
  **NOTE
        6:-**   **INVENTORIES**
  **December
                  31,****2005**
              
              **2004**Raw
                  and packaging materials
              
              $
              3,296,453
              
              $
              3,969,400Work
                  in progress
              
              
              3,697,361
              
              
              1,996,139Finished
                  products
              
              
              821,992
              
              
              1,311,762$
              7,815,806
              
              $
              7,277,301
  **NOTE
        7:-**   **PROPERTY
        AND EQUIPMENT, NET**
  a.  Composition
        of property and equipment is as follows:
 **December
                        31,****2005**
                    
                    **2004**Cost:Computers
                        and related equipment
                    
                    $
                    3,081,029
                    
                    $
                    2,788,398Motor
                        vehicles
                    
                    
                    704,718
                    
                    
                    620,001Office
                        furniture and equipment
                    
                    
                    786,958
                    
                    
                    830,621Machinery,
                        equipment and installations
                    
                    
                    7,716,598
                    
                    
                    7,464,470Leasehold
                        improvements
                    
                    
                    1,399,683
                    
                    
                    1,321,025Demo
                        inventory
                    
                    
                    369,995
                    
                    
                    141,961$
                    14,058,981
                    
                    $
                    13,166,476Accumulated
                        depreciation:Computers
                        and related equipment
                    
                    
                    2,328,549
                    
                    
                    1,995,392Motor
                        vehicles
                    
                    
                    233,745
                    
                    
                    163,817Office
                        furniture and equipment
                    
                    
                    474,127
                    
                    
                    451,998Machinery,
                        equipment and installations
                    
                    
                    5,729,563
                    
                    
                    5,143,186Leasehold
                        improvements
                    
                    
                    974,666
                    
                    
                    811,392Demo
                        inventory
                    
                    
                    65,400
                    
                    
                    —9,806,050
                    
                    
                    8,565,785Depreciated
                        cost
                    
                    $
                    4,252,931
                    
                    $
                    4,600,691
 F-35
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  b.  Depreciation
        expense amounted to $1,308,180, $1,199,465 and $730,159 for the years ended
        December 31, 2005, 2004 and 2003, respectively.
  As
        for
        liens, see Note 11.d.
  **NOTE
        8:-**   **OTHER
        INTANGIBLE ASSETS, NET**
  a.
 **Year
                  ended December 31,****2005**
              
              **2004**Cost:Technology
              
              $
              6,841,746
              
              $
              6,841,746Capitalized
                  software costs
              
              
              1,226,579
              
              
              574,967Backlog
              
              
              2,194,000
              
              
              2,194,000Covenants
                  not to compete
              
              
              359,000
              
              
              359,000Customer
                  list
              
              
              7,548,645
              
              
              7,548,645Certification
              
              
              246,969
              
              
              246,96918,416,939
              
              
              17,765,327Exchange
                  differences
              
              
              (171,587
              )
              
              125,455Less
                  - accumulated amortization
              
              
              (7,267,630
              )
              
              (4,070,802
              )Less
                  - impairment
              
              
              (819,223
              )
              
              (320,279
              )Amortized
                  cost
              
              
              10,158,499
              
              
              13,499,701Trademarks
              
              
              869,000
              
              
              869,000$
              11,027,499
              
              $
              14,368,701
 
  b.  Amortization
        and impairment expenses amounted to $3,695,772, $2,888,226 and $879,311 for
        the
        years ended December 31, 2005, 2004 and 2003.
  c.  Estimated
        amortization expenses, except capitalized software costs, for the years
        ended
  **Year
                  ended December 31,****2006**
              
              $
              1,825,331**2007**
              
              
              1,381,883**2008**
              
              
              1,276,075**2009**
              
              
              1,235,632**2010
                  and forward**
              
              
              3,467,873$
              9,186,794
  **NOTE
        9:-**   **SHORT-TERM
        BANK CREDIT AND LOANS**
  The
        Company has a $5.2 million authorized credit line from certain banks, of
        which
        $206,000 is denominated in NIS and carries an interest rate of approximately
        prime + 2.8% and $ 5.0 million of which is denominated in dollars and carries
        an
        interest rate of prime + 0.25%. As of December 31, 2005, $4.0 million was
        utilized, out of which $2.0 million is related to letter of credit issued
        to one
        of the customers of one of the Company’s subsidiaries.
  This
        line
        of credit is secured by the accounts receivable, inventory and marketable
        securities of the relevant subsidiary of the Company.
  F-36
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  In
        addition the Company has an automobile purchase loan, that will be repaid
        in
        June 2006. This loan is denominated in NIS and carries an interest rate of
        6.0%.
        The loan is secured by the automobile purchased with the proceeds of the
        loan.
  **NOTE
        10:-**  **OTHER
        ACCOUNTS PAYABLE AND ACCRUED EXPENSES**
  **December
                  31,****2005**
              
              **2004**Employees
                  and payroll accruals
              
              $
              1,443,154
              
              $
              1,534,295Accrual
                  for expected loss
              
              
              485,877
              
              
              —Accrued
                  vacation pay
              
              
              504,342
              
              
              469,527Accrued
                  expenses
              
              
              1,788,558
              
              
              1,770,348Minority
                  balance
              
              
              172,871
              
              
              243,116Government
                  authorities
              
              
              439,975
              
              
              1,036,669Advances
                  from customers
              
              
              795,331
              
              
              746,819Other
              
              
              —
              
              
              17,414$
              5,630,108
              
              $
              5,818,188
  **NOTE
        11:-**  **COMMITMENTS
        AND CONTINGENT LIABILITIES**
  a.  Royalty
        commitments:
  1.  Under
        EFL’s research and development agreements with the Office of the Chief Scientist
        (“OCS”), and pursuant to applicable laws, EFL is required to pay royalties at
        the rate of 3%-3.5% of net sales of products developed with funds provided
        by
        the OCS, up to an amount equal to 100% of research and development grants
        received from the OCS (linked to the U.S. dollars. Amounts due in respect
        of
        projects approved after year 1999 also bear interest at the Libor rate).
        EFL is
        obligated to pay royalties only on sales of products in respect of which
        OCS
        participated in their development. Should the project fail, EFL will not
        be
        obligated to pay any royalties.
  Royalties
        paid or accrued for the years ended December 31, 2005, 2004 and 2003 to the
        OCS
        amounted to $28,502, $17,406 and $435, respectively.
  As
        of
        December 31, 2005, the total contingent liability to the OCS was approximately
        $10,261,000. The Company regards the probability of this contingency coming
        to
        pass in any material amount to be low.
  2.  EFL,
        in
        cooperation with a U.S. participant, has received approval from the Israel-U.S.
        Bi-national Industrial Research and Development Foundation (“BIRD-F”) for 50%
        funding of a project for the development of a hybrid propulsion system for
        transit buses. The maximum approved cost of the project is approximately
        $1.8
        million, and the EFL’s share in the project costs is anticipated to amount to
        approximately $1.1 million, which will be reimbursed by BIRD-F at the
        aforementioned rate of 50%. Royalties at rates of 2.5%-5% of sales are payable
        up to a maximum of 150% of the grant received, linked to the U.S. Consumer
        Price
        Index. Accelerated royalties are due under certain
        circumstances.
  F-37
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  NOTE
        11:-  **COMMITMENTS
        AND CONTINGENT LIABILITIES (Cont.)**
  EFL
        is
        obligated to pay royalties only on sales of products in respect of which
        BIRD-F
        participated in their development. Should the project fail, EFL will not
        be
        obligated to pay any royalties.
  No
        royalties were paid or accrued to the BIRD-F in each of the three years in
        the
        period ended December 31, 2005.
  As
        of
        December 31, 2005, the total contingent liability to pay BIRD-F (150%) was
        approximately $772,000. The Company regards the probability of this contingency
        coming to pass in any material amount to be low.
  b.  Lease
        commitments:
  The
        Company and its subsidiaries rent their facilities under various operating
        lease
        agreements, which expire on various dates, the latest of which is in 2009.
        The
        minimum rental payments under non-cancelable operating leases are as
        follows:
  **Year
                  ended December 31****2006**
              
              $
              826,367**2007**
              
              $
              685,552**2008**
              
              $
              213,909**2009**
              
              $
              103,715**2010**
              
              $
              96,840
  Total
        rent expenses for the years ended December 31, 2005, 2004 and 2003 were
        approximately $1,022,396, $868,900 and $484,361, respectively.
  c.  Guarantees:
  The
        Company obtained bank guarantees in the amount of $202,000 in connection
        (i)
        obligations of two of the Company’s subsidiaries to the Israeli customs
        authorities and (ii) obligation of one of the Company’s subsidiaries to secure
        inventory received from one of its customers. In addition, the Company issued
        a
        letter of credit in amount of $2,000,000 to one of its subsidiary’s customers.
  The
        Company’s active United States subsidiaries act as guarantors of the Company’s
        obligations under its senior secured convertible notes.
  d.  Liens:
  As
        security for compliance with the terms related to the investment grants from
        the
        State of Israel, EFL and Epsilor have registered floating liens on all of
        its
        assets, in favor of the State of Israel.
  The
        Company has granted to the holders of its 8% secured convertible debentures
        a
        first position security interest in (i) the shares of MDT Armor Corporation,
        (ii) the assets of its IES Interactive Training, Inc. subsidiary, (iii) the
        shares of all of its subsidiaries, and (iv) any shares that the Company acquires
        in future Acquisitions (as defined in the securities purchase
        agreement).
  F-38
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  NOTE
        11:-  **COMMITMENTS
        AND CONTINGENT LIABILITIES (Cont.)**
  The
        Company has granted to the holders of its senior secured convertible notes
        (i) a
        second position security interest in the stock of MDT Armor Corporation,
        IES
        Interactive Training, Inc. and M.D.T. Protective Industries, Ltd. (junior
        to the
        security interest of the holders of its 8% secured convertible debentures)
        and
        in the assets of FAAC Incorporated (junior to the security interest of a
        bank
        that extends to FAAC Corporation a $5 million line of credit) and in any
        stock
        that the Company acquires in future Acquisitions (as defined in the securities
        purchase agreement) and (ii) a first position security interest in the assets
        of
        all of the Company’s other active United States subsidiaries.
  EFL
        has
        granted to its former CEO a security interest in certain of its property
        located
        in Beit Shemesh, Israel, to secure sums due to him pursuant to the terms
        of the
        settlement agreement with him.
  FAAC
        has
        a $5.0 million line of credit secured by all of its accounts receivable,
        unbilled revenues and inventory.
  Epsilor
        has recorded a lien on all of its assets in favor of its banks to secure
        lines
        of credit and loans received. In addition the company has a specific pledge
        on
        assets in respect of which government guaranteed loan were given.
  See
        also
        Note 7 regarding automobiles purchased in EFL and Epsilor.
  e.  Litigation
        and other claims:
  As
        of
        December 31, 2005, there were no pending legal proceedings to which the Company
        was a party, other than ordinary routine litigation incidental to its business,
        except as follows:
  1.  In
        December 2004, AoA filed an action against a U.S. government defense
        agency ,
        seeking
        approximately $2.2 million in damages for alleged improper termination of
        a
        contract. In its answer, the government agency counterclaimed, seeking
        approximately $2.1 million in reprocurement expenses. AoA is preparing its
        answer to the counterclaim. At this stage in the proceedings, the Company
        and
        its legal advisors cannot determine with any certainty whether AoA will have
        any
        liability and, if so, the extent of that liability.
  2.  In
        the
        beginning of 2005 a competitor of FAAC brought an action against FAAC and
        a
        municipal transport agency, alleging, *inter
        alia* ,
        that
        the municipal transport agency and FAAC have conspired to violate federal
        and
        state antitrust laws and have engaged in unfair competition with respect
        to this
        competitor. The competitor seeks unspecified monetary damages from FAAC and
        the
        municipal transport agency and injunctive relief. A motion to dismiss brought
        by
        FAAC and the municipal transport agency is pending. At this stage in the
        proceedings, the Company and its legal advisors cannot determine with any
        certainty whether FAAC will have any liability and, if so, the extent of
        that
        liability.
  3.  The
        Company has received a preliminary indication that there may be a dispute
        regarding the amount that it owes the former shareholders of FAAC Incorporated
        in respect of their earnout for 2005. Pursuant to the purchase agreement
        and a
        side letter, the Company is obligated to pay the former shareholders of FAAC
        an
        amount equal to “the net income realized by FAAC Incorporated from the Stryker
        Driver Simulator Program with the U.S. Army.” Subsequently, the U.S. Army added
        additional programs, all of which it classified generally as the “Common Driver
        Training Program” (CDT). The former shareholders of FAAC have indicated their
        belief that the 2005 earnout is due on the entire CDT program, which would
        equal
        an additional amount of $3.5 million. The Company, on advice of counsel,
        takes
        the position that the 2005 earnout is due only on the Stryker part of the
        CDT
        program, relying on the specific language of the side letter. While this
        is a
        factual issue as to which there can be no clear answer, the Company believes
        it
        has the stronger argument in this matter. Based on the Company’s and its
        counsel’s position, the Company accrued the amount of $603,764 in respect of
        2005 earnout as of December 31, 2005.
  F-39
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
        12:-**  **CONVERTIBLE
        DEBENTURES AND DETACHABLE WARRANTS**
  a.  9%
        Secured Convertible Debentures due June 30, 2005
  Pursuant
        to the terms of a Securities Purchase Agreement dated December 31, 2002,
        the
        Company issued and sold to a group of institutional investors an aggregate
        principal amount of 9% secured convertible debentures in the amount of $3.5
        million due June 30, 2005. These debentures are convertible at any time prior
        to
        June 30, 2005 at a conversion price of $10.50 per share, or a maximum aggregate
        of 333,333 shares of common stock. The conversion price of these debentures
        was
        adjusted to $8.96 per share in April 2003. In accordance with EITF 96-19,
        “Debtor’s Accounting for a Modification or Exchange of Debt Instruments,” the
        terms of convertible debentures were not treated as changed or modified when
        the
        cash flow effect on a present value basis was less than 10%.
  As
        part
        of the securities purchase agreement on December 31, 2002, the Company issued
        to
        the purchasers of its 9% secured convertible debentures due June 30, 2005,
        warrants, as follows: (i) Series A Warrants to purchase an aggregate of 83,336
        shares of common stock at any time prior to December 31, 2007 at a price
        of
        $11.76 per share; (ii) Series B Warrants to purchase an aggregate of 83,336
        shares of common stock at any time prior to December 31, 2007 at a price
        of
        $12.46 per share; and (iii) Series C Warrants to purchase an aggregate of
        83,336
        shares of common stock at any time prior to December 31, 2007 at a price
        of
        $13.02 per share. The exercise price of these warrants was adjusted to $8.96
        per
        share in April 2003.
  This
        transaction was accounted according to APB No. 14 “Accounting for Convertible
        debt and Debt Issued with Stock Purchase Warrants” (“APB No. 14”) and Emerging
        Issue Task Force No. 00-27 “Application of Issue No. 98-5 to Certain Convertible
        Instruments” (“EITF 00-27”). The fair value of these warrants was determined
        using Black-Scholes pricing model, assuming a risk-free interest rate of
        3.5%, a
        volatility factor 64%, dividend yields of 0% and a contractual life of five
        years.
  In
        connection with these convertible debentures, the Company recorded a deferred
        debt discount of $1,890,000 with respect to the beneficial conversion feature
        and the discount arising from fair value allocation of the warrants according
        to
        APB No. 14, which is being amortized from the date of issuance to the stated
        redemption date - June 30, 2005 - or to the actual conversion date, if earlier,
        as financial expenses.
  F-40
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
          12:-**  **CONVERTIBLE
          DEBENTURES AND DETACHABLE WARRANTS (Cont.)**
 During
        2004, the remaining principal amount of $1,150,000 of 9% secured convertible
        debentures outstanding was converted into an aggregate of 128,348 shares
        of
        common stock.
  During
        2004, the Company recorded expenses of $372,600 attributable to amortization
        due
        to conversion of the convertible debenture into shares.
  b.  8%
        Secured Convertible Debentures due September 30, 2006 and issued in September
        2003
  Pursuant
        to the terms of a Securities Purchase Agreement dated September 30, 2003,
        the
        Company issued and sold to a group of institutional investors an aggregate
        principal amount of 8% secured convertible debentures in the amount of $5.0
        million due September 30, 2006. These debentures are convertible at any time
        prior to September 30, 2006 at a conversion price of $16.10 per share, or
        a
        maximum aggregate of 310,559 shares of common stock.
  As
        of
        December 31, 2005, principal amount of $150,000 remained outstanding under
        these
        debentures.
  As
        part
        of the securities purchase agreement on September 30, 2003, the Company issued
        to the purchasers of its 8% secured convertible debentures due September
        30,
        2006, warrants to purchase an aggregate of 89,286 shares of common stock
        at any
        time prior to September 30, 2006 at a price of $20.125 per share.
  This
        transaction was accounted according to APB No. 14 “Accounting for Convertible
        Debt and Debt Issued with Stock Purchase Warrants” and Emerging Issue Task Force
        No. 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments.”
The fair value of these warrants was determined using Black-Scholes pricing
        model, assuming a risk-free interest rate of 1.95%, a volatility factor 98%,
        dividend yields of 0% and a contractual life of three years.
  In
        connection with these convertible debentures, the Company recorded a deferred
        debt discount of $2,963,043 with respect to the beneficial conversion feature
        and the discount arising from fair value allocation of the warrants according
        to
        APB No. 14, which is being amortized from the date of issuance to the stated
        redemption date - September 30, 2006 - or to the actual conversion date,
        if
        earlier, as financial expenses.
  During
        2004, an aggregate of principal amount $1,075,000 in 8% secured convertible
        debentures was converted into an aggregate of 66,770 shares.
  During
        2004 and 2005, the Company recorded expenses of $613,263 and 29,603,
        respectively, of which $191,895 and 29,603, respectively, was attributable
        to
        amortization of the beneficial conversion feature of the convertible debenture
        over its term and $421,368 and 0, respectively, was attributable to amortization
        due to conversion of the convertible debenture into shares.
  F-41
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
          12:-**  **CONVERTIBLE
          DEBENTURES AND DETACHABLE WARRANTS (Cont.)**
  c.  8%
        Secured Convertible Debentures due September 30, 2006 and issued in December
        2003
  Pursuant
        to the terms of a Securities Purchase Agreement dated September 30, 2003,
        the
        Company issued and sold to a group of institutional investors an aggregate
        principal amount of 8% secured convertible debentures in the amount of $6.0
        million due September 30, 2006. These debentures are convertible at any time
        prior to September 30, 2006 at a conversion price of $20.30 per share, or
        a
        maximum aggregate of 295,567 shares of common stock.
  As
        of
        December 31, 2005, principal amount of $4,387,500 remained outstanding under
        these convertible debentures.
  As
        a
        further part of the securities purchase agreement on September 30, 2003,
        the
        Company issued to the purchasers of its 8% secured convertible debentures
        due
        September 30, 2006, warrants to purchase an aggregate of 107,143 shares of
        common stock at any time prior to December 18, 2006 at a price of $25.375
        per
        share. Additionally, the Company issued to the investors supplemental warrants
        to purchase an aggregate of 74,143 shares of common stock at any time prior
        to
        December 31, 2006 at a price of $30.80 per share.
  This
        transaction was accounted according to APB No. 14 “Accounting for Convertible
        debt and Debt Issued with Stock Purchase Warrants” and Emerging Issue Task Force
        No. 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments.”
The fair value of these warrants was determined using Black-Scholes pricing
        model, assuming a risk-free interest rate of 2.45%, a volatility factor 98%,
        dividend yields of 0% and a contractual life of three years.
  In
        connection with these convertible debentures, the Company recorded a deferred
        debt discount of $6,000,000 with respect to the beneficial conversion feature
        and the discount arising from fair value allocation to warrants according
        to APB
        No. 14, which is being amortized from the date of issuance to the stated
        redemption date - September 30, 2006 - or to the actual conversion date,
        if
        earlier, as financial expenses.
  During
        2004 an aggregate of 107,143 shares were issued pursuant to exercise of these
        warrants. Out of these warrants, the holders of 80,357 warrants exercised
        their
        warrants on July 14, 2004 were granted an additional warrants to purchase
        80,357
        shares of common stock of the Company at an exercise price per share of $19.32.
        See also Note 13.f.3.
  During
        2004 and 2005, the Company recorded expenses of $3,156,246 and $1,562,378,
        respectively, of which $1,782,561 and $1,562,378, respectively, was attributable
        to amortization of the beneficial conversion feature of the convertible
        debenture over its term and $1,373,685 and $0, respectively, was attributable
        to
        amortization due to conversion of the convertible debenture into
        shares.
  d.  Senior
        Secured Convertible Notes due March 31, 2008
  Pursuant
        to the terms of a Securities Purchase Agreement dated September 29, 2005
        (the
“Purchase Agreement”) by and between the Company and certain institutional
        investors, the Company issued and sold to the investors an aggregate of $17.5
        million principal amount of senior secured notes having a final maturity
        date of
        March 31, 2008.
  F-42
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
          12:-**  **CONVERTIBLE
          DEBENTURES AND DETACHABLE WARRANTS (Cont.)**
  Under
        the
        terms of the Purchase Agreement, the Company granted the investors (i) a
        second
        position security interest in the stock of MDT Armor Corporation, IES
        Interactive Training, Inc. and M.D.T. Protective Industries, Ltd. (junior
        to the
        security interest of the holders of the Company’s 8% secured convertible
        debentures due September 30, 2006)and in the assets of FAAC Incorporated
        (junior
        to a bank that extends to FAAC Incorporated a $5 million line of credit)
        and in
        any stock that the Company acquires in future acquisitions, and (ii) a first
        position security interest in the assets of all of the Company’s other active
        United States subsidiaries. The Company’s active United States subsidiaries are
        also acting as guarantors of the Company’s obligations under the
        Notes.
  As
        of
        December 31, 2005, principal amount of $17.0 million remained outstanding
        under
        these convertible notes.
  The
        Notes
        are convertible at the investors’ option at a fixed conversion price of $14.00.
        The Notes bear interest at a rate equal to six month LIBOR plus 6% per annum,
        subject to a floor of 10% and a cap of 12.5%. The Company will repay the
        principal amount of the Notes over a period of two and one-half years, with
        the
        principal amount being amortized in twelve payments payable at the Company’s
        option in cash and/or stock, provided certain conditions are met. In the
        event
        the Company elects to make such payments in stock, the price used to determine
        the number of shares to be issued will be calculated using an 8% discount
        to the
        average trading price of the Company’s common stock during 17 of the 20
        consecutive trading days ending two days before the payment date.
  As
        a
        further part of the Securities Purchase Agreement dated September 29, 2005,
        the
        Company issued warrants, which are not exercisable for the six month period
        following closing, to purchase up to 375,000 shares of common stock (30%
        warrant
        coverage) at an exercise price of $15.40 per share. These warrants are
        exercisable until the one-year anniversary of the effective date of the
        registration statement registering the shares of common stock underlying
        the
        warrants.
  This
        transaction was accounted according to APB No. 14, “Accounting for Convertible
        Debt and Debt Issued with Stock Purchase Warrants” and Emerging Issue Task Force
        No. 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments”
(“EITF 00-27”). The fair value of the warrants granted in respect of convertible
        debentures was determined using Black-Scholes pricing model, assuming a
        risk-free interest rate of 3.87%, a volatility factor 53%, divi-dend yields
        of
        0% and a contractual life of one year.
  In
        connection with these convertible notes, the Company recorded a deferred
        debt
        discount of $422,034 with respect to the discount arising from fair value
        allocation of the warrants according to APB No. 14, which is being amortized
        from the date of issuance to the stated redemption date - March 31, 2008
        - or
        the actual conversion date, if earlier, as financial expenses.
  F-43
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
          12:-**  **CONVERTIBLE
          DEBENTURES AND DETACHABLE WARRANTS (Cont.)**
  The
        Company has also considered EITF No. 05-2, “The Meaning of Conventional
        Convertible Debt Instrument” in EITF Issue No. 00-19, “Accounting for Derivative
        Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
        Stock.”. Accordingly, the Company has concluded that these convertible notes
        would be considered as conventional convertible debt and therefore EITF 00-19
        do
        not apply to them.
 
 As
        to
        EITF 00-19, since the terms of the warrants referred to above provided that
        upon
        exercise of a warrant the Company could issue only stock that had been
        registered with the SEC (which occurred in December 2005) and therefore freely
        tradable, in accordance with Emerging Issues Task Force No 00-19 “Accounting for
        Derivative Financial Instruments Indexed to, and Potentially Settled in,
        a
        Company’s Own Stock,” their fair value was recorded as a liability at the
        closing date. Such fair value was remeasured at each subsequent cut-off date.
        The fair value of these warrants was remeasured as at December 31, 2005 using
        the Black-Scholes pricing model assuming a risk free interest rate of 3.87%,
        a
        volatility factor of 64%, dividend yields of 0% and a contractual life of
        approximately nine months. The change in the fair value of the warrants between
        the date of the grant and December 31, 2005 in the amount of $377,803 has
        been
        recorded as finance income.
  During
        2005, the Company recorded expenses of $110,771 attributable to amortization
        of
        the deferred debt discount arising from the fair value allocation of the
        warrants.
  The
        Company’s Notes provide for repayment in twelve equal installments. Installments
        may be paid in cash or, at the Company’s option (subject to certain conditions),
        in stock. If the Company elects to make a payment in stock, it must give
        notice
        24 trading days prior to the date the installment is due, and issue shares
        of
        its stock to the holders of the Note based on a conversion price of $14.00.
        Thereafter, based on a price of 92% of the average price of the stock during
        17
        of the trading days between the notice date and the installment payment date,
        the Company issues additional shares based on the amount, if any, by which
        the
        average price of the stock was less than $14.00. In December 2005, pursuant
        to
        the terms of the Notes, the Company made the first installment of a scheduled
        $1,458,333 principal repayment in shares of common stock by requesting its
        stock
        transfer agent to issue a total of 104,167 shares to the holders of the notes.
        Of these shares, 82,976 shares were issued prior to December 31, 2005, which
        at
        the share value assigned pursuant to the procedures established in the notes
        was
        equal to repayment of $453,051, and the remaining 21,191 shares were, for
        technical reasons, issued in early January 2006.
 
 e.  The
        Company’s debt agreements contain customary affirmative and negative operations
        covenants that limit the discretion of its management with respect to certain
        business matters and place restrictions on it, including obligations on the
        Company’s part to preserve and maintain assets and restrictions on its ability
        to incur or guarantee debt, to merge with or sell its assets to another company,
        and to make significant capital expenditures without the consent of the
        debenture holders, as well as granting to the Company’s investors a right of
        first refusal on any future financings, except for underwritten public offerings
        in excess of $30 million. Management does not believe that this right of
        first
        refusal will materially limit the Company’s ability to undertake future
        financings.
  F-44
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
          13:-**  **STOCKHOLDERS’
          EQUITY**
  a.  Stockholders’
        rights:
  The
        Company’s shares confer upon the holders the right to receive notice to
        participate and vote in the general meetings of the Company and right to
        receive
        dividends, if and when declared.
  b.  Issuance
        of common stock to investors and in respect of acquisitions:
  1.  In
        September 2003, the Company acquired an additional 12% interest in MDT Armor
        Corporation and an additional 24.5% interest in MDT Protective Industries,
        Ltd.
        in exchange for the issuance to AGA Means of Protection and Commerce, Ltd.
        of
        9,000 shares of its common stock.
  2.  In
        January 2004, the Company issued an aggregate of 702,888 shares of common
        stock
        at a price of $26.32 per share, or a total purchase price of $18,500,000,
        to a
        several institutional (see also Note 13.f.2.). Finance expenses in connection
        with this issuance totaled $692,500.
  3.  In
        July
        2004, pursuant to a Securities Purchase Agreement dated July 15, 2004, the
        Company issued an aggregate of 304,148 shares of common stock at a price
        of
        $21.70 per share, or a total purchase price of $6,600,000, to a group of
        investors (see also Note 13.f.3.).
  4.  In
        May
        2005, the Company issued an aggregate of 91,107 shares of common stock at
        a
        price of $14.00 per share, or a total purchase price of $1,275,500, to several
        institutional investors.
  5.  In
        connection with the satisfaction by the Company of the provision of the FAAC
        purchase agreement related to an earn-out based on 2004 net pretax income,
        the
        Company, in May 2005, issued to the former shareholders of FAAC a total of 248,533 shares,
        which together with cash paid by the Company to the former shareholders of
        FAAC,
        was sufficient to satisfy the Company’s obligation in respect of this earn-out
        provision.
  c.  Issuance
        of common stock to service providers and employees, in settlement of litigation,
        and as donations to charities
  1.  In
        July
        2003, the Company issued 15,378 shares of common stock to a consultant as
        commissions on battery orders. At the issuance date, the fair value of these
        shares was determined both by the value of the shares issued as reflected
        by the
        market price at the issuance date and by the value of the services provided
        and
        amounted to $154,331 in accordance with EITF 96-18. In accordance with EITF
        96-18, the Company recorded this compensation expense of $154,331 during
        the
        year 2003 and included this amount in marketing expenses.
  2.  In
        November 2003, the Company issued 593 shares of common stock to a consultant
        as
        commissions on battery orders. At the issuance date, the fair value of these
        shares was determined by the fair market value of the shares issued as reflected
        by their market price at the issuance date and by the value of the services
        provided and amounted to $7,616 in accordance with EITF 96-18. In accordance
        with EITF 96-18, the Company recorded this compensation expense of $7,616
        during
        the year 2003 and included this amount in marketing expenses.
  F-45
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            13:-**  **STOCKHOLDERS’
            EQUITY** **(Cont.)**
  3.  Beginning
        in January 2004, the Company entered into a consulting agreement with one
        of its
        directors pursuant to which the director agreed to aid the Company in
        identifying potential acquisition candidates, in exchange for a commission.
        The
        Company also agreed to issue to this director, at par value, a total of 2,286
        shares of its common stock, the value of which was to be deducted from any
        transaction fees paid. 1,143 of these shares were earned and issued prior
        to
        termination of this agreement in August 2004. At the issuance date, the fair
        value of these shares was determined both by the value of the shares issued
        as
        reflected by their market price at the issuance date and by the value of
        the
        services provided and amounted to $28,160 in accordance with EITF 96-18.
        In
        accordance with EITF 96-18, the Company recorded this compensation expense
        of
        $28,160 during the year 2004 and included this amount in general and
        administrative expenses
  4.  In
        February 2004, the Company issued 5,301 shares of common stock to a consultant
        as commissions on battery orders. At the issuance date, the fair value of
        these
        shares was determined both by the value of the shares issued as reflected
        by
        their market price at the issuance date and by the value of the services
        provided and amounted to $171,680 in accordance with EITF 96-18. In accordance
        with EITF 96-18, the Company accrued this compensation expense of $171,680
        during the year 2003 and included this amount in selling and marketing
        expenses.
  5.  In
        June
        2004 the Company sold 2,857 shares of the Company’s common stock at a price of
        $14.00 per share to one of its employees. At the issuance date, the fair
        value
        of these shares was determined by the fair market value of the shares issued
        as
        reflected by their market price at the issuance date in accordance with APB
        No.
        25. In accordance with APB No. 25, the Company recorded this compensation
        expense of $53,200 during the year 2004 and included this amount in general
        and
        administrative expenses
  6.  In
        December 2004, the Company donated 2,857 shares of its common stock to a
        charitable organization recognized by the Internal Revenue Service as tax-exempt
        under Section 501(c)(3) of the Internal Revenue Code of 1986, as amended. At
        the
        issuance date, the fair value of these shares was determined by the value
        of the
        shares issued as reflected by their market price at the issuance date and
        amounted to $69,200 in accordance with EITF 96-18. This compensation expense
        will be amortized over the course of one year due to legal restrictions on
        selling these shares for that period of time. In accordance with EITF 96-18,
        the
        Company recorded compensation expense of $4,361 and $64,839 during the years
        2004 and 2005, respectively, and included this amount in general and
        administrative expenses.
  7.  In
        May
        2005, the Company issued 5,190 shares of common stock to a consultant as
        commissions on battery orders as a part of a marketing agreement with the
        consultant whereby he helped procure orders and ensured payment by a specified
        military agency for Zinc-Air batteries and complementary products. At the
        issuance date, the fair value of these shares was determined by the value
        of the
        shares issued as reflected by their market price at the issuance date and
        amounted to $89,363 in accordance with EITF 96-18. In accordance with EITF
        96-18, the Company accrued compensation expenses of $56,577 and $32,786 during
        the years 2004 and 2005, respectively, and included these amounts in selling
        and
        marketing expenses.
  F-46
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            13:-**  **STOCKHOLDERS’
            EQUITY** **(Cont.)**
  8.  In
        August
        2005, p ursuant
        to the terms of agreements between the Company and an investment banker,
        the
        Company issued an aggregate of 30,357 shares of common stock as
        part
        of the fee arrangements in connection with investment banking and financial
        consulting services that the investment banker rendered to it including
        arranging financing in connection with potential acquisitions. At the issuance
        date, the fair value of these shares was determined by the value of the shares
        issued as reflected by their market price at the issuance date and amounted
        to
        $423,750 in accordance with EITF 96-18. In accordance with EITF 96-18 the
        Company accrued compensation expenses of $423,750 during 2005 and included
        this
        amount in general and administrative expenses.
  9.  In
        August
        2005, pursuant to the terms of an agreement between the Company and a public
        relations firm, the Company issued 686 shares of common stock as part of
        the fee
        arrangements in connection with investor relations services that the public
        relations firm rendered to it. At the issuance date, the fair value of these
        shares was determined both by the value of the shares issued as reflected
        by
        their market price at the issuance date and by the value of the services
        provided and amounted to $8,160 in accordance with EITF 96-18. In accordance
        with EITF 96-18 the Company accrued compensation expenses of $8,160 during
        2005
        and included this amount in general and administrative expenses.
  10.  See
        Note
        13.f.5.
  d.  Issuance
        of shares to lenders
  As
        part
        of the securities purchase agreement on December 31, 2002 (see Note 12.a.),
        the
        Company issued 27,664 shares at par as consideration to lenders for the first
        nine months of interest expenses. At the issuance date, the fair value of
        these
        shares was determined both by the value of the shares issued as reflected
        by
        their market price at the issuance date and by the value of the interest
        and
        amounted to $236,250 in accordance with APB 14. During 2003 the Company recorded
        this amount as financial expenses.
  e.  Issuance
        of promissory note:
  As
        part
        of its purchase of the assets of IES Interactive Training, Inc., the Company
        issued a $450,000 convertible promissory note. This note was converted into
        an
        aggregate of 40,284 shares of common stock in August 2003.
  f.  Warrants:
  1.  As
        part
        of an investment agreement in May 2001, the Company issued to the investors
        a
        total of 192,641 warrants (the “May 2001 Warrants”) to purchase shares of common
        stock at a price of $45.08 per share; these warrants are exercisable by the
        holder at any time after November 8, 2001 and will expire on May 8,
        2006.
  In
        June
        and July 2003, the Company adjusted the purchase price of 96,970 of the May
        2001
        Warrants to $11.48 per share in exchange for immediate exercise of these
        warrants, and issued to the holders of these exercised warrants new warrants
        to
        purchase a total of 64,647 shares of common stock at a purchase price of
        $20.30
        per share (the “June 2003 Warrants”). The June 2003 Warrants were originally
        exercisable at any time from and after December 31, 2003 to June 30, 2008;
        however, in September 2003, the exercise period of 45,599 of these June 2003
        Warrants was adjusted to make them exercisable at any time from and after
        December 31, 2004 to June 30, 2009. As a result the Company recorded during
        2003
        a deemed dividend in the amount of $267,026.
  F-47
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            13:-**  **STOCKHOLDERS’
            EQUITY** **(Cont.)**
  In
        addition, with respect to an additional 27,706 May 2001 Warrants, in December
        2003 the Company adjusted the purchase price to $22.40 per share in exchange
        for
        immediate exercise of these warrants, and issued to the holders of these
        exercised warrants new warrants to purchase a total of 13,853 shares of common
        stock at a purchase price of $31.50 per share. As a result the Company recorded
        during 2003 a deemed dividend in the amount of $82,974.
  Additionally,
        in October 2003 the Company granted to three of these investors additional
        new
        warrants to purchase a total of 10,714 shares of common stock at a purchase
        price of $16.80 per share. As a result the company recorded during 2003 an
        expense of $199,500 and included this amount in general and administrative
        expenses. During 2004, 4,611 warrants were exercised.
  On
        July
        14, 2004, the Company repriced the exercise price of 17,316 warrants granted
        previously in May 2001 to $26.32 in order to induce their holders to exercise
        them immediately. In connection with the exercise of the warrants, the Company
        additionally granted five-year warrants to purchase up to an aggregate of
        10,390
        shares of the Company’s common stock at an exercise price per share of $19.32.
        The fair value of these warrants was determined using Black Scholes pricing
        model, assuming a risk-free interest rate of 3.5%, a volatility factor of
        79%,
        dividend yields of 0% and a contractual life of five years. For accounting
        treatment, please see also Notes 13.b.2. and 13.f.3.
  2.  In
        connection with the Securities Purchase Agreement referred to in Note 13.b.2
        above, the Company granted three-year warrants to purchase up to an aggregate
        of
        702,888 shares of the Company’s common stock at any time beginning six months
        after closing at an exercise price per share of $26.32.
  In
        July
        2004 an aggregate of 531,915 shares were issued pursuant to exercise of these
        warrants. In connection with the exercise of the warrants, the Company granted
        to the same investors five-year warrants to purchase up to an aggregate of
        531,915 shares of the Company’s common stock at an exercise price per share of
        $19.32. The fair value of these warrants was determined using Black Scholes
        pricing model, assuming a risk-free interest rate of 3.5%, a volatility factor
        of 79%, dividend yields of 0% and a contractual life of five years. See also
        Note 13.f.3.
  3.  On
        July
        14, 2004, warrants to purchase 629,588 shares of common stock, having an
        aggregate exercise price of $16,494,194, net of issuance expenses, were
        exercised (see also Notes 13.f.1., 13.f.2. and 12.c.). Out of the shares
        issued
        in conjunction with the exercise of these warrants, 80,357 shares were issued
        upon exercise of warrants issued in the transaction referred to in Note 12.c.
        above and 531,915 shares were issued upon exercise of warrants issued in
        the
        transaction referred to in the Note 13.f.3. above; the remaining 17,316 shares
        were issued upon exercise of a warrant that the Company issued to an investor
        in
        May 2001 referred to in Note 13.f.1. above. In connection with this transaction,
        the Company issued to the holders of those exercising warrants an aggregate
        of
        622,662 new five-year warrants to purchase shares of common stock at an exercise
        price of $19.32 per share
  F-48
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            13:-**  **STOCKHOLDERS’
            EQUITY** **(Cont.)**
  As
        a
        result of the transactions described in Notes 13.f.1., 13.f.2. and 12.c.,
        including the repricing of the warrants to the investors and the issuance
        of
        additional warrants to the investors, the Company recorded a deemed dividend
        in
        the amount of $2,165,952, to reflect the additional benefit created for these
        investors. The deemed dividend increased the loss applicable to common
        stockholders in the calculation of basic and diluted net loss per share for
        the
        year ended December 31, 2004, without any effect on total shareholder’s
        equity
  As
        all
        warrants in the July 14, 2004, securities purchase agreement were subject
        to
        shareholders approval, in accordance with Emerging Issues Task Force No.00-19,
        “Accounting for Derivative Financial Instruments Indexed to, and Potentially
        Settled in, a Company’s Own Stock” their fair value was recorded as a liability
        at the closing date. Such fair value was remeasured at each subsequent cut-off
        date. Upon obtaining stockholders approval on December 14, 2004, the warrants
        were remeasured and reclassified to equity. The fair value of these warrants
        was
        determined using the Black-Scholes pricing model, assuming a risk-free interest
        rate of 3.5%, a volatility factor 79%, dividend yields of 0% and a contractual
        life of approximately five years. The change in the fair value of the warrants
        between the date of grant and December 14, 2004 has been recorded as finance
        income in the amount of $326,839.
  4.  In
        November 2000 and May 2001, the Company issued a total of 65,476 warrants
        to an
        investor, which warrants contained certain antidilution provisions: a Series
        A
        warrant to purchase 47,619 shares of the Company’s common stock at a price of
        $49.00 per share, and a Series C warrant to purchase 17,857 shares at a price
        of
        $43.12 per share. Operation of the antidilution provisions provided that
        the
        Series A warrant should be adjusted to be a warrant to purchase 63,483 shares
        at
        a price of $37.38 per share, and the Series C warrant should be adjusted
        to be a
        warrant to purchase 23,806 shares at a price of $32.90 per share. After
        negotiations, the investor agreed in March 2004 to exercise its warrants
        immediately, in exchange for an exercise price reduction to $20.30 per share,
        and the issuance of a new six-month Series D warrant to purchase 87,289 shares
        at an exercise price of $29.40 per share. The new Series D warrant does not
        have
        similar antidilution provisions. As a result of this repricing and the issuance
        of new warrants, the Company recorded a deemed dividend in the amount of
        approximately $1,163,000 in 2004.
  5.  On
        February 4, 2004, the Company entered into an agreement settling the litigation
        brought against it in the Tel-Aviv, Israel district court by I.E.S. Electronics
        Industries, Ltd. (“IES Electronics”) and certain of its affiliates in connection
        with the Company’s purchase of the assets of its IES Interactive Training, Inc.
        subsidiary from IES Electronics in August 2002 .
        The
        litigation had sought monetary
        damages in the amount of approximately $3 million. Pursuant
        to the terms of the settlement agreement, in addition to agreeing to dismiss
        their lawsuit with prejudice, IES Electronics agreed (i) to cancel the Company’s
        $450,000 debt to them that had been due on December 31, 2003, and (ii) to
        transfer to the Company title to certain certificates of deposit in the
        approximate principal amount of $112,000. The parties also agreed to exchange
        mutual releases. In
        consideration of the foregoing, the Company issued to IES Electronics (i)
        32,143
        shares of common stock, and (ii) five-year warrants to purchase up to an
        additional 32,143 shares of common stock at a purchase price of $26.74 per
        share. The fair
        value of the warrants was determined using Black-Scholes pricing model, assuming
        a risk-free interest rate of 3.5%, a volatility factor 79%, dividend yields
        of
        0% and a contractual life of five years. The fair value of warrants was
        calculated as $483,828 and fair value of shares as $765,000.
  F-49
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            13:-**  **STOCKHOLDERS’
            EQUITY** **(Cont.)**
  In
        respect of the above settlement, the Company recorded in 2003 an expense
        of
        $688,642, representing the fair value of the warrants and shares over the
        remaining balance of the Company’s debt to IES Electronics as carried in the
        Company books at December 31, 2003, less the $112,000 certificate of deposit
        that was transferred to the Company’s name as noted above. During the year 2004,
        200,000 warrants were exercised.
  6.  As
        of
        December 31, 2005, the Company’s outstanding warrants totaled
        1,575,819.
  g.  Stock
        option and restricted stock purchase plans:
  1.  Options
        and restricted shares to employees and others (except consultants)
  a.  The
        Company has adopted the following stock option plans, whereby options and
        restricted shares may be granted for purchase of shares of the Company’s common
        stock. Under the terms of the employee plans, the Board of Directors or the
        designated committee grants options and determines the vesting period and
        the
        exercise terms.
  1)  1998
        Employee Option Plan - as amended, 339,286 shares reserved for issuance,
        of
        which 60,711 were available for future grants to employees and consultants
        as of
        December 31, 2005.
  2)  1995
        Non-Employee Director Plan - 71,429 shares reserved for issuance, of which
        15,000 stock options were issued and outstanding as of December 31, 2005.
        Pursuant to the terms of this Plan, no new options were issuable under this
        Plan
        after September 28, 2005.
  3)  2004
        Employee Option Plan - 535,714 shares reserved for issuance, of which 301,813
        were available for future grants to employees and consultants as of December
        31,
        2005.
  b.  Under
        these plans, options generally expire no later than 5-10 years from the date
        of
        grant. Each option can be exercised to purchase one share, conferring the
        same
        rights as the other common shares. Options that are cancelled or forfeited
        before expiration become available for future grants. The options generally
        vest
        over a three-year period (33.3% per annum) and restricted shares vest after
        two
        years; in the event that employment is terminated for cause within that period,
        restricted shares revert back to the Company.
  c.  A
        summary
        of the status of the Company’s plans and other share options and restricted
        shares (except for options granted to consultants) granted as of December
        31,
        2005, 2004 and 2003, and changes during the years ended on those dates, is
        presented below:
  F-50
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            13:-**  **STOCKHOLDERS’
            EQUITY** **(Cont.)**
  **2005**
              
              **2004**
              
              **2003****Amount**
              
              **Weighted
                  average**
                **exercise
                  price**
              
              **Amount**
              
              **Weighted
                  average**
                **exercise
                  price**
              
              **Amount**
              
              **Weighted
                  average**
                **exercise
                  price**$
              
              
              
              $
              
              
              
              **$**Options
                  outstanding at be-ginning of year
              
              
              703,912
              
              $
              16.66
              
              
              644,166
              
              $
              19.18
              
              
              375,741
              
              $
              31.64Changes
                  during year:Granted
                  (1) (2) (3)
              
              
              121,096
              
              $
              7.70
              
              
              160,606
              
              $
              14.84
              
              
              376,019
              
              $
              9.94Exercised
              
              
              (1,130
              )
              $
              15.26
              
              
              (64,089
              )
              $
              17.36
              
              
              (49,260
              )
              $
              8.96Forfeited
                  (3)
              
              
              (163,524
              )
              $
              26.46
              
              
              (36,771
              )
              $
              52.78
              
              
              (58,334
              )
              $
              49.14Repriced
                  (3)Old
                  exercise price
              
              
              (207,980
              )
              $
              15.40
              
              
              —
              
              
              —
              
              
              —
              
              
              —New
                  exercise price
              
              
              207,980
              
              $
              5.46
              
              
              —
              
              
              —
              
              
              —
              
              
              —Options
                  outstanding at end of year
              
              
              660,354
              
              $
              9.38
              
              
              703,912
              
              $
              16.66
              
              
              644,166
              
              $
              19.18Options
                  exercisable at end of year
              
              
              583,070
              
              $
              9.80
              
              
              461,808
              
              $
              18.48
              
              
              416,181
              
              $
              23.80
  (1)  Includes
        24,276, 66,875 and 145,358 options and restricted shares granted to directors
        and executive officers in 2005, 2004 and 2003, respectively.
  (2)  The
        Company recorded deferred stock compensation for options and restricted shares
        issued with an exercise price below the fair value of the common stock in
        the
        amount of $51,000, $2,081,457 and $4,750 as of December 31, 2005, 2004 and
        2003,
        respectively. In addition, in 2005, the Company decreased its deferred stock
        compensation in the amount of $245,280 due to cancellation of certain options
        and restricted shares of employees that their employment was terminated.
        Deferred stock compensation is amortized and recorded as compensation expenses
        ratably over the vesting period of the option or the restriction period of
        the
        restricted shares. The stock compensation expense that has been charged in
        the
        consolidated statements of operations in respect of options and restricted
        shares to employees and directors in 2005, 2004 and 2003 was $674,713, $831,626
        and $8,286, respectively.
  (3)  On
        December 29, 2005 the company repriced downwards 207,980 options with average
        exercise price of $215.6 to $76.44. In addition, 4,205 options with exercise
        price of $184.24 were forfeited and new options with exercise price of $76.44
        were given at the same day. In accordance with FIN44 the downward repricing
        resulted in a variable plan accounting. However, due to the decrease in the
        share price as of December 31, 2005 no compensation was recorded.
  d.  The
        options and restricted shares outstanding as of December 31, 2005 have been
        separated into ranges of exercise price, as follows:
  F-51
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            13:-**  **STOCKHOLDERS’
            EQUITY** **(Cont.)**
  **Total
                  options outstanding**
              
              **Exercisable
                  options outstanding****(1)****Range
                  of**
                **exercise**
                **prices**
              
              **Amount**
                **outstanding****at**
                **December
                  31,**
                **2005**
              
              **Weighted**
                **average**
                **remaining**
                **contractual
                  life**
              
              **Weighted**
                **average**
                **exercise
                  price**
              
              **Amount**
                **exercisable
                  at**
                **December
                  31, 2005**
              
              **Weighted**
                **average**
                **exercise
                  price****$**
              
              
              
              **Years**
              
              **$**
              
              
              
              **$**0.01–2.00
              
              
              630,954
              
              
              5.10
              
              
              7.42
              
              
              562,003
              
              
              7.982.01–4.00
              
              
              16,186
              
              
              3.43
              
              
              34.30
              
              
              7,853
              
              
              35.004.01–6.00
              
              
              12,143
              
              
              4.05
              
              
              69.02
              
              
              12,143
              
              
              69.026.01–8.00
              
              
              357
              
              
              1.86
              
              
              91.00
              
              
              357
              
              
              91.008.01
              
              
              714
              
              
              1.75
              
              
              126.84
              
              
              714
              
              
              126.84660,354
              
              
              5.04
              
              
              9.38
              
              
              583,070
              
              
              9.80
  On
        December 29, 2005, the Company accelerated vesting of 39,810 of its outstanding
        unvested stock options to make such options immediately vested and
        exercisable.  The
        Company’s decision to accelerate the vesting of those options and to grant fully
        vested options was based primarily upon the issuance of SFAS No. 123R, which
        will require the Company to treat all unvested stock options as compensation
        expense effective January 1, 2006. The Company believes that the acceleration
        of
        vesting of those options will enable the Company to avoid recognizing
        stock-based compensation expense associated with these options in future
        periods. Additional reasons for the fully vested grant and for the acceleration
        were to make the options more attractive to the recipients, and to avoid
        discrimination between groups of option holders, respectively.
 
 Weighted-average
        fair values and exercise prices of options and restricted shares on dates
        of
        grant are as follows:
  **Equals
                  market price**
              
              **Less
                  than market price****Year
                  ended December 31,**
              
              **Year
                  ended December 31,****2005**
              
              **2004**
              
              **2003**
              
              **2005**
              
              **2004**
              
              **2003**Weighted
                  average exercise prices
              
              $
              7.00
              
              $
              20.916
              
              $
              13.30
              
              $
              —
              
              $
              23.408
              
              $
              —Weighted
                  average fair value on grant date
              
              $
              3.64
              
              $
              14.028
              
              $
              10.22
              
              $
              —
              
              $
              24.206
              
              $
              —
  2.  Options
        issued to consultants:
  a.  The
        Company’s outstanding options to consultants as of December 31, 2005, are as
        follows:
  F-52
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            13:-**  **STOCKHOLDERS’
            EQUITY** **(Cont.)**
  **2005**
              
              **2004**
              
              **2003****Amount**
              
              **Weighted
                  average exercise price**
              
              **Amount**
              
              **Weighted
                  average exercise price**
              
              **Amount**
              
              **Weighted
                  average exercise price****$**
              
              
              
              **$**
              
              
              
              $Options
                  outstanding at beginning of year
              
              
              11,878
              
              $
              53.20
              
              
              22,422
              
              $
              64.26
              
              
              17,556
              
              $
              77.70Changes
                  during year:Granted
              
              
              —
              
              $
              —
              
              
              714
              
              $
              —
              
              
              5,937
              
              $
              13.86Exercised
              
              
              —
              
              $
              —
              
              
              (2,687
              )
              $
              14.42
              
              
              (1,071
              )
              $
              6.86Forfeited
                  or cancelled
              
              
              —
              
              $
              —
              
              
              (8,571
              )
              $
              89.60
              
              
              —
              
              $
              —Options
                  outstanding at end of year
              
              
              11,878
              
              $
              53.20
              
              
              11,878
              
              $
              53.20
              
              
              22,422
              
              $
              64.26Options
                  exercisable at end of year
              
              
              11,878
              
              $
              53.20
              
              
              11,878
              
              $
              53.20
              
              
              13,850
              
              $
              48.44
  b.  The
        Company accounted for its options to consultants under the fair value method
        of
        SFAS No. 123 and EITF 96-18. The fair value for these options was estimated
        using a Black-Scholes option-pricing model with the following weighted-average
        assumptions:
  **2005**
              
              **2004**
              
              **2003**Dividend
                  yield
              
              
              —
              
              
              0
              %
              
              0
              %Expected
                  volatility
              
              
              —
              
              
              81
              %
              
              78
              %Risk-free
                  interest
              
              
              —
              
              
              3.4
              %
              
              2.3
              %Contractual
                  life of up to
              
              
              —
              
              
              5
                  years
              
              
              10
                  years
  c.  In
        connection with the grant of stock options to consultants, the Company recorded
        stock compensation expenses totaling $0, $0 and $29,759 for the years ended
        December 31, 2005, 2004 and 2003, respectively, and included these amounts
        in
        marketing and general and administrative expenses.
  3.  Dividends:
  In
        the
        event that cash dividends are declared in the future, such dividends will
        be
        paid in U.S. dollars. The Company does not intend to pay cash dividends in
        the
        foreseeable future.
  4.  Treasury
        Stock:
  Treasury
        stock is the Company’s common stock that has been issued and subsequently
        reacquired. The acquisition of common stock is accounted for under the cost
        method, and presented as reduction of stockholders’ equity.
  h.  Reverse
          split:
  The
          Company’s stockholders approved a one-for-fourteen reverse stock split of the
          Company’s common stock on June 19, 2006, which was effected on June 21, 2006. As
          a result of the reverse stock split, every fourteen shares of Arotech common
          stock were combined into one share of common stock; any fractional shares
          created by the reverse stock split were eliminated. The reverse stock split
          affected all of Arotech’s common stock, stock options, warrants and convertible
          debt outstanding immediately prior to the effective date of the reverse
          stock
          split. All shares of common stock, options, warrants, option and warrant
          exercise prices, convertible debt conversion prices and per share date
          included
          in these financial statements for all periods presented have been retroactively
          adjusted to reflect this one-for-fourteen reverse split.
 **NOTE
        14:-**  **INCOME
        TAXES**
  a.  Taxation
        of U.S. parent company (Arotech) and other U.S. subsidiaries:
  As
        of
        December 31, 2005, Arotech has operating loss carryforwards for U.S. federal
        income tax purposes of approximately $26 million, which are available to
        offset
        future taxable income, if any, expiring in 2009 through 2025. Utilization
        of U.S
        net operating losses may be subject to substantial annual limitations due
        to the
“change in ownership” provisions of the Internal Revenue Code of 1986 and
        similar state provisions. The annual limitation may result in the expiration
        of
        net operating loses before utilization.
  F-53
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            14:-**INCOME
            TAXES**** **** **(Cont.)**
  The
        Company files consolidated tax returns with its US subsidiaries.
  b.  Israeli
        subsidiary (Epsilor):
  Tax
        benefits under the Law for the Encouragement of Capital Investments, 1959
        (the
“Investments Law”):
  Currently,
        Epsilor is operating under three programs as follows:
  1.  Program
        one:
  Epsilor’s
        expansion program of its existing enterprise in Dimona was granted the status
        of
        an “approved enterprise” under the Investments Law and was entitled to
        investments grants from the state of Israel in the amount of 24% on property
        and
        equipment located at its Dimona plant.
  The
        approved expansion program was in the amount of approximately $350,000. Epsilor
        effectively operated the program during 1999 and is entitled to the tax benefits
        available under the Investments Law.
  Taxable
        income derived from the approved enterprise is subject to a reduced tax rate
        during seven years beginning from the year in which taxable income is first
        earned (tax exemption for the first two-year period and 25% tax rate for
        the
        five remaining years).
  Those
        benefits are limited to 12 years from the year that the enterprise began
        operations, or 14 years from the year in which the approval was granted,
        whichever is earlier. Hence, this approved program expired in 2005.
  2.  Program
        two:
  Epsilor’s
        expansion program of its existing enterprise in Dimona was granted the status
        of
        an “approved enterprise” under the Investments Law and was entitled to
        investments grants from the State of Israel in the amount of 24% on property
        and
        equipment located at its Dimona plant.
  The
        approved expansion program is in the amount of approximately $600,000. Epsilor
        effectively operated the program during 2002, and is entitled to the tax
        benefits available under the Investments Law (commencing from
        2003).
  Taxable
        income derived from the approved enterprise is subject to a reduced tax rate
        during seven years beginning from the year in which taxable income is first
        earned (tax exemption for the first two-year period and 25% tax rate for
        the
        five remaining years).
  Those
        benefits are limited to 12 years from the year that the enterprise began
        operations, or 14 years from the year in which the approval was granted,
        whichever is earlier. Hence, this approved program will expire in
        2009.
  3.Program
        three:
  F-54
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            14:-**INCOME
            TAXES**** **** **(Cont.)**
  Epsilor’s
        expansion program of its existing enterprise in Dimona was granted the status
        of
        an “approved enterprise” under the Investments Law, and is entitled to
        investments grants from the State of Israel in the amount of 32% on property
        and
        equipment located at its Dimona plant.
  The
        approved expansion program is in the amount of approximately $945,000. This
        program has not yet received final approval.
  Taxable
        income derived from the approved enterprise is subject to a reduced tax rate
        during seven years beginning from the year in which taxable income is first
        earned (tax exemption for the first two-year period and 25% tax rate for
        the
        five remaining years).
  Those
        benefits are limited to 12 years from the year that the enterprise began
        operations, or 14 years from the year in which the approval was granted,
        whichever is earlier.
  The
        main
        tax benefits available to Epsilor are:
  a)  Reduced
        tax rates:
  As
        stated
        above for each specific program
  b)  Accelerated
        depreciation:
  Epsilor
        is entitled to claim accelerated depreciation in respect of machinery and
        equipment used by the “Approved Enterprise” for the first five years of
        operation of these assets.
  Income
        from sources other than the “Approved Enterprise” during the benefit period will
        be subject to tax at the regular corporate tax rate of 34%.
  If
        retained tax-exempt profits attributable to the “approved enterprise” are
        distributed, they would be taxed at the corporate tax rate applicable to
        such
        profits as if Epsilor had not elected the alternative system of benefits,
        currently 25% for an “approved enterprise.”
  Dividends
        paid from the profits of an approved enterprise are subject to tax at the
        rate
        of 15% in the hands of their recipient.
  As
        of
        December 31, 2005 there are no tax exempt profits earned by Epsilor’s “approved
        enterprises” by Israel law that will be distributed as a dividend and
        accordingly no deferred tax liability was recorded as of December 31, 2005.
        Furthermore, management has indicated that it has no intention of declaring
        any
        dividend.
  On
        April
        1, 2005, an amendment to the Investment Law came into effect (“the Amendment”)
        and has significantly changed the provisions of the Investment Law. The
        Amendment limits the scope of enterprises which may be approved by the
        Investment Center by setting criteria for the approval of a facility as a
        Privileged Enterprise, such as provisions generally requiring that at least
        25%
        of the Privileged Enterprise’s income will be derived from export. Additionally,
        the Amendment enacted major changes in the manner in which tax benefits are
        awarded under the Investment Law so that companies no longer require Investment
        Center approval in order to qualify for tax benefits.
  F-55
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            14:-**INCOME
            TAXES**** **** **(Cont.)**
 
 However,
        the Investment Law provides that terms and benefits included in any certificate
        of approval already granted will remain subject to the provisions of the
        law as
        they were on the date of such approval. Therefore, the existing Approved
        Enterprise of the Israeli subsidiary’s will generally not be subject to the
        provisions of the Amendment. As a result of the Amendment, tax-exempt income
        generated under the provisions of the Amended Investment Law, will subject
        the
        Company to taxes upon distribution or liquidation and the Company may be
        required to record deferred tax liability with respect to such tax-exempt
        income. As of December 31, 2005, the Company did not generate income under
        the
        provision of the amended Investment Law.
  c.  Other
        tax
        information about the Israeli subsidiaries:
  1.  Measurement
        of results for tax purposes under the Income Tax Law (Inflationary Adjustments),
        1985
  Results
        for tax purposes are measured in real terms of earnings in NIS after certain
        adjustments for increases in the Consumer Price Index. As explained in Note
        2.b., the financial statements are presented in U.S. dollars. The difference
        between the annual change in the Israeli consumer price index and in the
        NIS/dollar exchange rate causes a difference between taxable income and the
        income before taxes shown in the financial statements. In accordance with
        paragraph 9(f) of SFAS No. 109, EFL, Epsilor and MDT have not provided deferred
        income taxes on this difference between the reporting currency and the tax
        bases
        of assets and liabilities.
  2.  Tax
        benefits under the Law for the Encouragement of Industry (Taxation),
        1969:
  EFL
        and
        Epsilor are “industrial companies,” as defined by this law and, as such, are
        entitled to certain tax benefits, mainly accelerated depreciation, as prescribed
        by regulations published under the inflationary adjustments law, the right
        to
        claim amortization of know-how, patents and certain other intangible property
        rights as deductions for tax purposes.
  3.  Tax
        rates
        applicable to income from other sources:
  Income
        from sources other than the “Approved Enterprise,” is taxed at the regular rate
        of 34%. See also Note 14.e.
  4.  Tax
        loss
        carryforwards:
  As
        of
        December 31, 2005, EFL has operating and capital loss carryforwards for Israeli
        tax purposes of approximately $82 million, which are available, indefinitely,
        to
        offset future taxable income.
  e.  Tax
        rates
        applicable to the income of the Group companies:
 
 Until
        December 31, 2003, the regular tax rate applicable to income of companies
        (which
        are not entitled to benefits due to “approved enterprise”, as described above)
        was 36%. In June 2004, an amendment to the Income Tax Ordinance (No. 140
        and
        Temporary Provision), 2004 was passed by the “Knesset” (Israeli parliament) and
        on July 25, 2005, another law was passed, the amendment to the Income Tax
        Ordinance (No. 147) 2005, according to which the corporate tax rate is to
        be
        progressively reduced to the following tax rates: 2004 - 35%, 2005 - 34%,
        2006 -
        31%, 2007 - 29%, 2008 - 27%, 2009 - 26%, 2010 and thereafter -
        25%.
  F-56
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            14:-**INCOME
            TAXES**** **** **(Cont.)**
 
 f.  Deferred
        income taxes:
  Deferred
        income taxes reflect the net tax effects of temporary differences between
        the
        carrying amounts of assets and liabilities for financial reporting purposes
        and
        amounts used for income tax purposes. Significant components of the Company’s
        deferred tax assets resulting from tax loss carryforward are as
        follows:
  **December
                  31,****2005**
              
              **2004**Operating
                  loss carryforward(1)
              
              $
              32,326,283
              
              $
              32,532,998Reserve
                  and allowance
              
              
              2,222,333
              
              
              1,328,479Net
                  deferred tax asset before valuation allowance
              
              
              34,548,616
              
              
              33,861,477Valuation
                  allowance
              
              
              (34,483,796
              )
              
              (33,725,995
              )Total
                  deferred tax asset
              
              $
              64,820
              
              $
              135,482Deferred
                  tax liability
              
              $
              -
              
              $
              51,366
  (1)
 **December
                  31,****2005**
              
              **2004**Domestic
              
              $
              8,981,133
              
              $
              7,703,459Foreign
              
              
              23,345,150
              
              
              24,829,539$
              32,326,283
              
              $
              32,532,998
  The
        Company and its subsidiaries provided valuation allowances in respect of
        deferred tax assets resulting from tax loss carryforwards and other temporary
        differences. Management currently believes that it is more likely than not
        that
        the deferred tax assets related to the loss carryforwards and other temporary
        differences will not be realized. The change in the valuation allowance as
        of
        December 31, 2005 was $757,801.
  g.  Loss
        from
        continuing operations before taxes on income and minorities interests in
        loss
        (earnings) of a subsidiary:
  **Year
                  ended December 31****2005**
              
              **2004**
              
              **2003**Domestic
              
              $
              21,473,366
              
              $
              8,006,205
              
              $
              7,411,121Foreign
              
              
              2,269,522
              
              
              405,305
              
              
              1,697,617$
              23,742,888
              
              $
              8,411,510
              
              $
              9,108,738
  F-57
  **AROTECH
        CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **In
        U.S. dollars**
  **NOTE
            14:-**INCOME
            TAXES**** **** **(Cont.)**
  h.  Taxes
        on
        income were comprised of the following:
  **Year
                  ended December 31****2005**
              
              **2004**
              
              **2003**Current
                  state and local taxes
              
              $
              83,365
              
              $
              539,674
              
              $
              44,102Deferred
                  taxes
              
              
              14,345
              
              
              (37,857
              )
              
              —Taxes
                  in respect of prior years
              
              
              139,962
              
              
              84,292
              
              
              352,091$
              237,672
              
              $
              586,109
              
              $
              396,193Domestic
              
              $
              153,950
              
              $
              163,087
              
              $
              33,020Foreign
              
              
              83,722
              
              
              423,022
              
              
              363,173$
              237,672
              
              $
              586,109
              
              $
              396,193
 
 i.  A
        reconciliation between the theoretical tax expense, assuming all income is
        taxed
        at the statutory tax rate applicable to income of the Company and the actual
        tax
        expense as reported in the Statement of Operations is as follows:
  **Year
                  ended December 31,****2005**
              
              **2004**
              
              **2003**Loss
                  from continuing operations before taxes, as reported in the consolidated
                  statements of income
              
              $
              (23,742,888
              )
              $
              (8,411,510
              )
              $
              (9,108,738
              )Statutory
                  tax rate
              
              
              34
              %
              
              34
              %
              
              34
              %Theoretical
                  income tax on the above amount at the U.S. statutory tax
                  rate
              
              $
              (8,072,582
              )
              $
              (2,859,914
              )
              $
              (3,096,971
              )Deferred
                  taxes on losses for which valuation allowance was provided
              
              
              1,611,971
              
              
              556,692
              
              
              1,146,754Non-deductible
                  expenses
              
              
              5,669,144
              
              
              1,629,874
              
              
              1,873,129State
                  taxes
              
              
              67,470
              
              
              168,081
              
              
              33,020Accrual
                  for deferred taxes on undistributed earnings
              
              
              (49,328
              )
              
              49,416
              
              
              —Foreign
                  income in tax rates other then U.S rate
              
              
              897,617
              
              
              919,895
              
              
              86,954Taxes
                  in respect of prior years
              
              
              139,963
              
              
              84,292
              
              
              352,091Others
              
              
              (26,583
              )
              
              37,773
              
              
              1,216Actual
                  tax expense
              
              $
              237,672
              
              $
              586,109
              
              $
              396,193
  F-58


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS** **In
        U.S. dollars**




**NOTE
      15:–**  **SELECTED
      STATEMENTS OF OPERATIONS DATA**




Financial
      income (expenses), net:




**Year
                ended December 31,****2005**
            
            **2004**
            
            **2003**Financial
                expenses:Interest,
                bank charges and fees
            
            $
            (1,473,799
            )
            $
            (622,638
            )
            $
            (355,111
            )Amortization
                of compensation related to warrants issued to the holders of convertible
                debentures and beneficial conversion feature
            
            
            (1,702,753
            )
            
            (4,142,109
            )
            
            (3,928,237
            )Bonds
                premium amortization
            
            
            (47,734
            )
            
            (202,467
            )
            
            —Foreign
                currency translation differences
            
            
            (54,840
            )
            
            (71,891
            )
            
            115,538(3,279,126
            )
            
            (5,039,105
            )
            
            (4,167,810
            )Financial
                income:Interest
            
            
            192,771
            
            
            443,182
            
            
            129,101Realized
                gain from marketable securities sale
            
            
            2,863
            
            
            40,119
            
            
            —Financial
                income in connection with warrants granted (Note 12.d. and
                13.f.3.)
            
            
            377,803
            
            
            326,839
            
            
            —Total
            
            $
            (2,705,689
            )
            $
            (4,228,965
            )
            $
            (4,038,709
            )




**NOTE
      16:–**  **SEGMENT
      INFORMATION**




a.  General:




The
      Company and its subsidiaries operate primarily in three business segments (see
      Note 1.a. for a brief description of the Company’s business) and follow the
      requirements of SFAS No. 131.




Prior
      to
      its purchase of FAAC, Epsilor and AoA, the Company had managed its business
      in
      two reportable segments organized on the basis of differences in its related
      products and services. With the acquisition of FAAC and Epsilor early in 2004
      and AoA in August of 2004, the Company reorganized into three segments:
      Simulation and Training (formerly known as Simulation and Security); Armor;
      and
      Battery and Power Systems. As a result the Company restated information
      previously reported in order to comply with new segment reporting.




The
      Company’s reportable operating segments have been determined in accordance with
      the Company’s internal management structure, which is organized based on
      operating activities. The accounting policies of the operating segments are
      the
      same as those described in the summary of significant accounting policies.
      The
      Company evaluates performance based upon two primary factors, one is the
      segment’s operating income and the other is based on the segment’s contribution
      to the Company’s future strategic growth.




F-59


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      16:–**  **SEGMENT
      INFORMATION (Cont.)**




b.  The
      following is information about reported segment gains, losses and
      assets:




**Simulation
                and Training**
            
            **Armor**
            
            **Battery
                and**
              **Power
                Systems**
            
            **All
                Others(4)**
            
            **Total****2005**Revenues
                from outside customers
            
            $
            26,805,772
            
            $
            12,322,678
            
            $
            9,916,145
            
            $
            —
            
            $
            49,044,595Depreciation
                , amortization and impairment expenses(1)
            
            
            (1,645,057
            )
            
            (14,043,019
            )
            
            (909,463
            )
            
            (229,626
            )
            
            (16,827,165
            )Direct
                expenses(2)
            
            
            (21,967,755
            )
            
            (13,955,199
            )
            
            (9,757,402
            )
            
            (7,752,865
            )
            
            (53,433,221
            )Segment
                net income (loss)
            
            $
            3,192,960
            
            $
            (15,675,540
            )
            $
            (750,720
            )
            $
            (7,982,491
            )
            
            (21,215,791
            )Financial
                expenses (after deduction of minority interest)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (2,707,620
            )Net
                loss from continuing operations
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            (23,923,411
            )Segment
                assets(3)
                (4)
            
            $
            32,741,946
            
            $
            7,185,010
            
            $
            12,040,415
            
            $
            688,023
            
            $
            52,655,394**2004**Revenues
                from outside customers
            
            $
            21,464,406
            
            $
            17,988,687
            
            $
            10,500,753
            
            $
            —
            
            $
            49,953,846Depreciation
                , amortization and impairment expenses(1)
            
            
            (1,983,822
            )
            
            (1,755,847
            )
            
            (1,132,953
            )
            
            (135,613
            )
            
            (5,008,235
            )Direct
                expenses(2)
            
            
            (17,910,967
            )
            
            (16,444,476
            )
            
            (9,974,544
            )
            
            (5,431,627
            )
            
            (49,761,614
            )Segment
                net income (loss)
            
            $
            1,569,617
            
            $
            (211,636
            )
            $
            (606,744
            )
            $
            (5,567,240
            )
            
            (4,816,003
            )Financial
                expenses (after deduction of minority interest)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,226,310
            )Net
                loss from continuing operations
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            (9,042,313
            )Segment
                assets(3)
            
            $
            1,872,943
            
            $
            5,819,266
            
            $
            3,455,188
            
            $
            730,595
            
            $
            11,877,992**2003**Revenues
                from outside customers
            
            $
            8,022,026
            
            $
            3,435,716
            
            $
            5,868,899
            
            $
            —
            
            $
            17,326,641Depreciation
                expenses and amortization
            
            
            (757,997
            )
            
            (169,668
            )
            
            (527,775
            )
            
            (139,630
            )
            
            (1,595,070
            )Direct
                expenses(2)
            
            
            (7,308,649
            )
            
            (3,584,284
            )
            
            (5,945,948
            )
            
            (4,200,770
            )
            
            (21,039,651
            )Segment
                net income (loss)
            
            $
            (44,620
            )
            $
            (318,236
            )
            $
            (604,824
            )
            $
            (4,340,400
            )
            
            (5,308,080
            )Financial
                expenses (after deduction of minority interest)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,039,951
            )Net
                loss from continuing operations
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            (9,348,031
            )Segment
                assets(3)
            
            $
            898,271
            
            $
            730,291
            
            $
            2,128,062
            
            $
            450,864
            
            $
            4,207,488




(1)
            Includes
                depreciation of property and equipment, amortization expenses of
                intangible assets and impairment of goodwill and other intangible
                assets
                in the amount of $12,256,756 and $320,279 in the years 2005 and 2004,
                respectively.


(2)
            Including,*inter
                alia*,
                sales and marketing, general and administrative and tax
                expenses.


(3)
            Consisting
                of property and equipment, inventory and intangible
                assets.


(4)
            Out
                of those amounts, goodwill in the Company’s Simulation and Training,
                Battery and Power Systems and Armor Divisions stood at $23,605,069,
                $4,968,675 and $985,413 as of December 31, 2005, respectively, and
                $22,845,372, $5,308,917 and $11,591,227 as of December 31, 2004,
                respectively.




F-60


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      16:–**  **SEGMENT
      INFORMATION (Cont.)**




c.  Summary
      information about geographic areas:




The
      following presents total revenues according to end customers location for the
      years ended December 31, 2005, 2004 and 2003, and long-lived assets as of
      December 31, 2005, 2004 and 2003:




**2005**
            
            **2004**
            
            **2003****Total**
              **revenues**
            
            **Long-lived
                assets**
            
            **Total**
              **revenues**
            
            **Long-lived
                assets**
            
            **Total**
              **revenues**
            
            **Long-lived
                assets**U.S.
                dollarsU.S.A.
            
            $
            38,953,462
            
            $
            32,840,172
            
            $
            40,656,729
            
            $
            45,154,086
            
            $
            10,099,652
            
            $
            6,778,050Germany
            
            
            188,635
            
            
            —
            
            
            319,110
            
            
            —
            
            
            2,836,725
            
            
            —England
            
            
            931,008
            
            
            —
            
            
            344,261
            
            
            —
            
            
            29,095
            
            
            —Thailand
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            95,434
            
            
            —India
            
            
            1,723,031
            
            
            —
            
            
            3,061,705
            
            
            —
            
            
            —
            
            
            —Israel
            
            
            5,700,267
            
            
            11,999,415
            
            
            4,212,408
            
            
            13,560,822
            
            
            3,576,139
            
            
            2,954,441Other
            
            
            1,548,192
            
            
            —
            
            
            1,359,633
            
            
            —
            
            
            689,596
            
            
            —$
            49,044,595
            
            $
            44,839,587
            
            $
            49,953,846
            
            $
            58,714,908
            
            $
            17,326,641
            
            $
            9,732,491




d.  Revenues
      from major customers:




**Year
                ended December 31,****2005**
            
            **2004**
            
            **2003****%**Batteries
                and power systems:Customer
                A
            
            
            7
            %
            
            8
            %
            
            27
            %Armor:Customer
                B
            
            
            5
            %
            
            4
            %
            
            17
            %Customer
                C
            
            
            9
            %
            
            24
            %
            
            —Simulation
                and Training:Customer
                D
            
            
            24
            %
            
            13
            %
            
            —Customer
                E
            
            
            —
            
            
            1
            %
            
            16
            %





e.  Revenues
      from major products:




**Year
                ended December 31,****2005**
            
            **2004**
            
            **2003**Electric
                vehicle
            
            $
            205,485
            
            $
            232,394
            
            $
            408,161Water
                activated batteries
            
            
            1,181,114
            
            
            921,533
            
            
            703,084Military
                batteries
            
            
            8,515,329
            
            
            9,324,247
            
            
            4,757,116Car
                and aircraft armoring
            
            
            12,322,679
            
            
            17,988,686
            
            
            3,435,715Simulators
            
            
            26,785,772
            
            
            21,414,968
            
            
            7,961,302Other
            
            
            34,216
            
            
            72,018
            
            
            61,263Total
            
            $
            49,044,595
            
            $
            49,953,846
            
            $
            17,326,641




**NOTE
      17:–**  **SUBSEQUENT
      EVENTS**




a.  In
      March
      2006, a dispute of approximately $517,000 related to the Company’s former
      consumer cellphone battery and charger business between the Company and a major
      department store chain, in respect of which dispute the Company had made an
      accrual of $200,000 in the past, was settled for a single payment by the Company
      of $120,000 in cash. The Company’s liability accrual was updated to reflect this
      settlement agreement.




F-61


**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**In
      U.S. dollars**





**NOTE
      17:–**  **SUBSEQUENT
      EVENTS (UNAUDITED) (Cont.)**




b.  In
      March
      2006, a dispute that began in 2005 involving a claim against the Company in
      the
      amount of approximately $1.1 million was settled for an aggregate payment by
      the
      Company of $90,000 in cash, $60,000 of which was payable in 2006 and $30,000
      of
      which was payable in 2007. The Company accrued $90,000 to reflect this
      settlement agreement.




c.  In
      February 2006, the Company and one of its existing warrant holders agreed to
      amend certain of the investor’s existing warrants (consisting of 25,950 warrants
      to purchase common stock at a price of $30.80 per share and 322,455 warrants
      to
      purchase common stock at a price of $19.32 per share - a total of 348,405
      warrants) to provide for an exercise price equal to $6.165, in exchange for
      (i)
      immediate exercise by the investor of all such warrants, with the exercise
      price
      being deposited in a collateral account to secure the Company’s obligation to
      repay its 8% secured convertible debentures due in September 2006, and (ii)
      the
      issuance to the investor of 139,362 warrants, expiring on March 31, 2008, with
      an exercise price equal to $8.316 per share.




d.  In
      March
      2006, the Company and certain of its existing warrant holders (“Investors”)
      agreed to amend certain of the Investors’ existing warrants (consisting of
      29,657 warrants to purchase common stock at a price of $30.80 per share, 56,991
      warrants to purchase common stock at a price of $26.32 per share, 19,625
      warrants to purchase common stock at a price of $20.30 per share, 8,929 warrants
      to purchase common stock at a price of $20.125 per share, and 178,761 warrants
      to purchase common stock at a price of $19.32 per share -  a total of
      293,963  warrants) to provide for an exercise price equal to $5.6, in
      exchange for (i) immediate exercise by the Investors of all such warrants,
      with
      the exercise price being deposited in a collateral account to secure the
      Company’s obligation to repay its 8% secured convertible debentures due in
      September 2006, and (ii) the issuance to the Investors of a total of 117,585
      warrants, expiring on March 31, 2008, with an exercise price equal to $8.316
      per
      share.




e.  See
      Note
      13.h.









F-62




**S** **UPPLEMENTARY
      FINANCIAL DATA**




**Quarterly
      Financial Data (unaudited) for the two years ended December 31,
      2005**




**Quarter
                  Ended*****2005**
              
              **March
                  31**
              
              **June
                  30**
              
              **September
                  30**
              
              **December
                  31**Net
                  revenue
              
              $
              10,387,445
              
              $
              12,236,910
              
              $
              11,189,675
              
              $
              15,230,565Gross
                  profit
              
              $
              4,015,570
              
              $
              3,627,634
              
              $
              2,756,392
              
              $
              4,261,263Net
                  profit (loss) from continuing operations
              
              $
              (2,456,500
              )
              $
              (5,422,514
              )
              $
              (12,708,932
              )
              $
              (3,335,465
              )Net
                  profit (loss) from discontinued operations
              
              $
              —
              
              $
              (200,000
              )
              $
              —
              
              $
              80,000Net
                  profit (loss) for the period
              
              $
              (2,456,500
              )
              $
              (5,622,514
              )
              $
              (12,708,932
              )
              $
              (3,255,465
              )Deemed
                  dividend to certain stockholders of common stock
              
              $
              —
              
              $
              —
              
              $
              —
              
              $
              —Net
                  loss attributable to common stockholders
              
              $
              (2,456,500
              )
              $
              (5,622,514
              )
              $
              (12,708,932
              )
              $
              (3,255,465
              )Net
                  profit (loss) per share - basic and diluted
              
              $
              (0.43
              )
              $
              (0.97
              )
              $
              (2.16
              )
              $
              (0.53
              )Shares
                  used in per share calculation
              
              
              5,721,578
              
              
              5,770,011
              
              
              5,891,127
              
              
              6,103,348
 
 **Quarter
                  Ended****2004**
              
              **March
                  31**
              
              **June
                  30**
              
              **September
                  30**
              
              **December
                  31**Net
                  revenue
              
              $
              7,182,254
              
              $
              9,928,248
              
              $
              16,272,521
              
              $
              16,570,823Gross
                  profit
              
              $
              2,625,034
              
              $
              3,353,501
              
              $
              4,723,573
              
              $
              5,240,644Net
                  profit (loss) from continuing operations
              
              $
              (2,517,889
              )
              $
              (4,396,123
              )
              $
              1,126,845
              
              $
              (3,255,146
              )Net
                  loss from discontinued operations
              
              $
              —
              
              $
              —
              
              $
              —
              
              $
              —Net
                  profit (loss) for the period
              
              $
              (2,517,889
              )
              $
              (4,396,123
              )
              $
              1,126,845
              
              $
              (3,255,146
              )Deemed
                  dividend to certain stockholders of common stock
              
              $
              (1,163,000
              )
              $
              —
              
              $
              (2,165,952
              )
              $
              —Net
                  loss attributable to common stockholders
              
              $
              (3,680,889
              )
              $
              (4,396,123
              )
              $
              (1,039,107
              )
              $
              (3,255,146
              )Net
                  profit (loss) per share - basic and diluted
              
              $
              (0.87
              )
              $
              (0.95
              )
              $
              (0.19
              )
              $
              (0.58
              )Shares
                  used in per share calculation
              
              
              4,243,319
              
              
              4,607,078
              
              
              5,481,732
              
              
              5,648,227




F-63


**FI** **NANCIAL
      STATEMENT SCHEDULE**




**Arotech
      Corporation and Subsidiaries**




**Schedule
      II – Valuation and Qualifying Accounts**




For
      the
      Years Ended December 31, 2005, 2004 and 2003




**Description**
            
            **Balance
                at**
              **beginning**
              **of
                period**
            
            **Additions**
              **charged
                to****costs**
              **and****expenses**
            
            **Balance
                at**
              **end
                of****period****Year
                ended December 31, 2005**Allowance
                for doubtful accounts
            
            $
            55,394
            
            $
            120,786
            
            $
            176,180Allowance
                for slow moving inventory
            
            
            217,672
            
            
            1,062,336
            
            
            1,280,008Valuation
                allowance for deferred taxes
            
            
            33,725,995
            
            
            757,801
            
            
            34,483,796**Totals**
            
            $
            33,999,061
            
            $
            1,940,923
            
            $
            35,939,984**Year
                ended December 31, 2004**Allowance
                for doubtful accounts
            
            $
            61,282
            
            $
            (5,888
            )
            $
            55,394Allowance
                for slow moving inventory
            
            
            96,350
            
            
            121,322
            
            
            217,672Valuation
                allowance for deferred taxes
            
            
            34,801,887
            
            
            (1,075,892
            )
            
            33,725,995**Totals**
            
            $
            34,959,519
            
            $
            (960,458
            )
            $
            33,999,061**Year
                ended December 31, 2003**Allowance
                for doubtful accounts
            
            $
            40,636
            
            $
            20,646
            
            $
            61,282Allowance
                for slow moving inventory
            
            
            —
            
            
            96,350
            
            
            96,350Valuation
                allowance for deferred taxes
            
            
            29,560,322
            
            
            5,241,565
            
            
            34,801,887**Totals**
            
            $
            29,600,958
            
            $
            5,358,561
            
            $
            34,959,519




F-64


**PART
      IV**




**ITEM
                15.**
            **EXHIBITS,
                FINANCIAL STATEMENT
                SCHEDULES**




(a)  The
      following documents are filed as part of this amended report:




(1)
            Financial
                Statements - See Index to Financial Statements on page 2
                above.(2)
            Financial
                Statements Schedules - Schedule II - Valuation and Qualifying Accounts.
                All schedules other than those listed above are omitted because of
                the
                absence of conditions under which they are required or because the
                required information is presented in the financial statements or
                related
                notes thereto.(3)
            Exhibits
                - The following Exhibits are filed
                herewith:




**Exhibit
                No.**
            
            **Description**23.1
            
            Consent
                of Kost, Forer, Gabbay & Kasierer, a member of Ernst & Young
                Global23.2
            
            Consent
                of Stark Winter Schenkein & Co., LLP31.1
            
            Certification
                of Principal Executive Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 200231.2
            
            Certification
                of Principal Financial Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 200232.1
            
            Certification
                of Principal 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
                of Principal Financial Officer pursuant to 18 U.S.C. Section 1350,
                as
                adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002




-3-


**SIGNATURES**




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the Registrant has duly caused this amended report to be signed on its
      behalf by the undersigned, thereunto duly authorized, on July 24,
      2006.




**AROTECH
              CORPORATION**By:
            /s/ Robert
              S.
              EhrlichName:Robert
              S. EhrlichTitle:
              Chairman
              and Chief Executive Officer




Pursuant
      to the requirements of the Securities Exchange Act of 1934, this amended report
      has been signed below by the following persons on behalf of the registrant
      and
      in the capacities and on the dates indicated.




**Signature**
            
            **Title**
            
            **Date**/s/
                Robert S. Ehrlich
            
            Chairman
                Chief Executive Officer and Director
            
            July
                24, 2006Robert
                S. Ehrlich
            
            (Principal
                Executive Officer)/s/
                Thomas J. Paup
            
            Vice
                President - Finance
            
            July
                24, 2006Thomas
                  J. Paup
            
            (Principal
                  Financial Officer)July
                24, 2006/s/
                Danny Waldner
            
            ControllerDanny
                Waldner
            
            (Principal
                Accounting Officer)/s/
                Steven Esses
            
            President,
                Chief Operating Officer
            
            July
                24, 2006Steven
                Esses
            
            and
                Director/s/
                Jay M. Eastman
            
            Director
            
            July
                24, 2006Dr.
                Jay M. Eastman/s/
                Lawrence M. Miller
            
            Director
            
            July
                24, 2006Lawrence
                M. Miller/s/
                Jack E. Rosenfeld
            
            Director
            
            July
                24, 2006Jack
                E. Rosenfeld/s/
                Edward J. Borey
            
            Director
            
            July
                24, 2006Edward
                J. Borey/s/
                Seymour Jones
            
            Director
            
            July
                24, 2006Seymour
                Jones





-4-


**EXHIBIT
      INDEX**




**Exhibit**
              **Number**
            
            **Description**23.1
            
            Consent
                of Kost, Forer, Gabbay & Kasierer, a member of Ernst & Young
                Global23.2
            
            Consent
                of Stark Winter Schenkein & Co., LLP31.1
            
            Certification
                of Chief Executive Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 200231.2
            
            Certification
                of Chief Financial Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 200232.1
            
            Certification
                of Principal 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
                of Principal Financial Officer pursuant to 18 U.S.C. Section 1350,
                as
                adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002