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**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-K**




ý **ANNUAL
        REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES**


**EXCHANGE
      ACT OF 1934 FOR THE FISCAL YEAR ENDED**  **** **** **DECEMBER
      31, 2005** **** **.**




 ̈ **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**
            
            **95-4302784**(State
                or other jurisdiction of incorporation or organization)
            
            (I.R.S.
                Employer Identification No.)**1229
                Oak Valley Drive, Ann Arbor, Michigan**
            
            **48108**(Address
                of principal executive offices)
            
            (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**
            
            **Name
                of each exchange on which registered**None
            
            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
       ̈** **No
      ý**




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  ̈** **No
      ý**




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 ý** **No
       ̈**




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. ** ̈**




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: ** ̈**
            
            Accelerated filer: **ý**
            Non-accelerated
              filer: ** ̈**





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




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: **95,490,846
      as of 3/15/06**




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**




This
      annual report contains historical information and forward-looking statements
      within the meaning of the Private Securities Litigation Reform Act of 1995
      with
      respect to our business, financial condition and results of operations. The
      words “estimate,” “project,” “intend,” “expect” and similar expressions are
      intended to identify forward-looking statements. These forward-looking
      statements are subject to risks and uncertainties that could cause actual
      results to differ materially from those contemplated in such forward-looking
      statements. Further, we operate in an industry sector where securities values
      may be volatile and may be influenced by economic and other factors beyond
      our
      control. In the context of the forward-looking information provided in this
      annual report and in other reports, please refer to the discussions of risk
      factors detailed in, as well as the other information contained in, our other
      filings with the Securities and Exchange Commission.




Electric
      Fuel ® is a
      registered trademark and ArotechTM is a trademark of Arotech Corporation,
      formerly known as Electric Fuel Corporation. All company and product names
      mentioned may be trademarks or registered trademarks of their respective
      holders. ** Unless
      otherwise indicated, “we,” “us,” “our” and similar terms refer to Arotech and
      its subsidiaries.







**PART
      I**


**ITEM
      1.**  **BUSINESS**




**General**




We
      are a
      defense and security products and services company, engaged in three business
      areas: high-level armoring for military and nonmilitary air and ground vehicles;
      interactive simulation for military, law enforcement and municipal markets;
      and
      batteries and charging systems for the military. Until September 17, 2003,
      we
      were known as Electric Fuel Corporation. We
      operate primarily through our various subsidiaries, which we have organized
      into
      three divisions. Our divisions and subsidiaries (all 100% owned by us, unless
      otherwise noted) are as follows:




Ø
            We
                develop, manufacture and market advanced high-tech multimedia and
                interactive digital solutions for use-of-force training and driving
                training of military, law enforcement, security and other personnel
                through our***Simulation
                and Training Division***:




·
            We
                provide simulators, systems engineering and software products to
                the
                United States military, government and private industry through our
                subsidiary FAAC Incorporated, located in Ann Arbor, Michigan (“FAAC”);
                and




·
            We
                provide specialized “use of force” training for police, security personnel
                and the military through our subsidiary IES Interactive Training,
                Inc.,
                currently being relocated from Littleton, Colorado to Ann Arbor,
                Michigan
                (“IES”).




Ø
            We
                utilize sophisticated lightweight materials and advanced engineering
                processes to manufacture aviation armor and to armor vehicles through
                our***Armor
                Division***:




·
            We
                manufacturer ballistic and fragmentation armor kits for rotary and
                fixed
                wing aircraft and marine armor through our subsidiary Armour of America,
                currently being relocated from Los Angeles, California, to Auburn,
                Alabama
                (“AoA”); and




·
            We
                use state-of-the-art lightweight armoring materials, special ballistic
                glass and advanced engineering processes to fully armor military
                and
                civilian SUV’s, buses and vans,through
                our subsidiaries MDT Protective Industries, Ltd., located in Lod,
                Israel(“MDT”), of which we own 75.5%, andMDT
                Armor Corporation, located in Auburn, Alabama (“MDT Armor”),
                of which we own 88%.




Ø
            We
                manufacture and sell lithium and Zinc-Air batteries for defense and
                security products and other military applications and we pioneer
                advancements in Zinc-Air technology for electric vehicles through
                our***Battery
                and Power Systems
                Division***




·
            We
                develop and sell rechargeable and primary lithium batteries and smart
                chargers to the military and to private defense industry in the Middle
                East, Europe and Asia through our subsidiary Epsilor Electronic
                Industries, Ltd., located in Dimona, Israel (in Israel’s Negev desert
                area) (“Epsilor”);







·
            We
                manufacture and sell Zinc-Air batteries and battery electronics for
                the
                military, focusing on applications that demand high energy and light
                weight, through our subsidiary Electric Fuel Battery Corporation,
                located
                in Auburn, Alabama (“EFB”); and




·
            We
                produce water-activated lifejacket lights for commercial aviation
                and
                marine applications, and we conduct our Electric Vehicle effort,
                through
                our subsidiary Electric Fuel (E.F.L.) Ltd., located in Beit Shemesh,
                Israel (“EFL”).




***Background***




We
      were
      incorporated in Delaware in 1990 under the name “Electric Fuel Corporation,” and
      we changed our name to “Arotech Corporation” on September
      17, 2003 .
      Unless
      the context requires otherwise, all references to us refer collectively to
      Arotech Corporation and Arotech’s wholly-owned Israeli subsidiaries, EFL and
      Epsilor; Arotech’s majority-owned subsidiaries, MDT (in Israel) and MDT Armor
      (in the U.S.); and Arotech’s wholly-owned United States subsidiaries, EFB, IES,
      FAAC and AoA.




For
      financial information concerning the business segments in which we operate,
      see
      Note 16 of the Notes to the Consolidated Financial Statements. For financial
      information about geographic areas in which we engage in business, see Note
      16.c
      of the Notes to the Consolidated Financial Statements.




***Facilities***




Our
      principal executive offices have recently been relocated to 1229 Oak Valley
      Drive, Ann Arbor, Michigan 48108 ,
      and our
      toll-free telephone number at our executive offices is (800) 281-0356. Our
      corporate website is www.arotech.com .
      Our
      periodic reports, as well as recent filings relating to transactions in our
      securities by our executive officers and directors, that have been filed with
      the Securities and Exchange Commission in EDGAR format are made available
      through hyperlinks located on the investor relations page of our website, at http://www.arotech.com/compro/investor.html ,
      as soon
      as reasonably practicable after such material is electronically filed with
      or
      furnished to the SEC. Reference to our websites does not constitute
      incorporation of any of the information thereon or linked thereto into this
      annual report.




The
      offices and facilities of three of our principal subsidiaries, EFL, MDT and
      Epsilor, are located in Israel (in Beit Shemesh, Lod and Dimona, respectively,
      all of which are within Israel’s pre-1967 borders). Most of the members of our
      senior management work extensively out of EFL’s facilities. IES’s offices and
      facilities are located in Littleton, Colorado, FAAC’s home offices and
      facilities are located in Ann Arbor, Michigan, AoA’s offices and facilities are
      located in Gardena, California, and the offices and facilities of EFB and MDT
      Armor are located in Auburn, Alabama. In order to achieve greater efficiency
      and
      cost-savings, we began the process, early in 2006, of moving AoA’s offices from
      Gardena, California to MTD Armor’s offices in Auburn, Alabama, and IES’s offices
      from Littleton, Colorado to FAAC’s offices in Ann Arbor, Michigan.




2


**Simulation
      and Training Division**




We
      develop, manufacture and market advanced high-tech multimedia and interactive
      digital solutions for use-of-force training and driving training of military,
      law enforcement, security and other personnel through our Simulation and
      Training Division, the largest of our three divisions. During
      2005, 2004 and 2003 revenues from our Simulation and Training Division were
      approximately $26.8 million, $21.5 million and $8.0 million, respectively (on
      a
      pro forma basis, assuming we had owned all components of our Simulation and
      Training Division since January 1, 2003, revenues in 2005, 2004 and 2003 would
      have been approximately $26.8 million, $21.5 million and $17.9 million,
      respectively).




***Vehicle
      Driving Simulators and Incident Command Training***




We
      provide simulators,
      systems engineering and software products such as our Incident Command Training
      product to the United States military, government and private industry
      t hrough
      our wholly-owned subsidiary, FAAC Corporation ,
      based
      in Ann Arbor, Michigan . Our
      fully
      interactive driver-training systems feature state-of-the-art vehicle simulator
      technology enabling training in situation awareness, risk analysis and decision
      making, emergency reaction and avoidance procedures, and conscientious equipment
      operation. We have an installed base of over 270 simulators that have
      successfully trained hundreds of thousands of drivers. Our customer base
      includes all branches of the U.S. Department of Defense, state and local
      governments, and municipal entities.




*Introduction*




We
      conduct our vehicle simulator business in two primary areas: Vehicle Driving
      Simulations, which focuses on the development and delivery of complete driving
      simulations for a wide range of vehicle types - such as trucks, automobiles,
      buses, fire trucks, police cars, ambulances, airport ground vehicles, and
      military vehicles - for municipal, governmental and foreign customers; and
      Military Operations, which conducts tactical air and land combat analysis and
      develops analytical models, simulations, and “turnkey” training systems for the
      U.S. military. In 2005, Vehicle Simulations accounted for approximately 85%
      of
      our vehicle simulation revenues, and Military Operations accounted for
      approximately 15% of our vehicle simulation revenues.




In
      the
      area of Military Operations, we are a premier developer of validated, high
      fidelity analytical models and simulations of tactical air and land warfare
      for
      all branches of the Department of Defense and its related industrial
      contractors. Our simulations are found in systems ranging from instrumented
      air
      combat and maneuver ranges (such as Top Gun) to full task training devices
      such
      as the F-18 Weapon Tactics Trainer. We are also the leading supplier of wheeled
      vehicle simulators to the U.S. Armed Forces for mission-critical vehicle
      training.




We
      supply
      on-board software to support weapon launch decisions for the F-15, F-18, and
      Joint Strike Fighter (JSF) fighter aircraft. Pilots benefit by having highly
      accurate presentations of their weapon’s capabilities, including susceptibility
      to target defensive reactions. We designed and developed an instructor operator
      station, mission operator station and real-time, database driven electronic
      combat environment for the special operational forces aircrew training system.
      The special operational forces aircrew training system provides a full range
      of
      aircrew training, including initial qualification, mission qualification,
      continuation, and upgrade training, as well as combat mission
      rehearsal.




3


Simulators
      are cost-effective solutions, enabling users to reduce overall aircraft and
      ground vehicle usage, vehicle maintenance costs, fuel costs, repairs, and spares
      expenditures. For example, our Medium Tactical Vehicle Replacement (MTVR)
      simulators have reduced total driver training time by 35%. Many customers have
      reduced actual “behind-the-wheel” time by up to 50% while still maintaining or
      improving safety. Additionally, for customers with multiple simulators, the
      corresponding increase in the student to instructor ratio has reduced instructor
      cost per student.




The
      imp l ementation
      of our vehicle driving simulators has led to measurable benefits. North American
      Van Lines, one of our earliest vehicle simulator customers, has shown a 22%
      reduction in preventable accidents since it began using our simulators. The
      German Army, one of our earliest Military Vehicle customers, showed better
      driver testing scores in 14 of 18 driver skills compared to classroom and live
      driver training results. Additionally, the New York City Transit Authority
      documented a 43% reduction in preventable accidents over its first six months
      of
      use and has reduced its driver hiring and training “washout” by
      50%.




Simulators
      can produce more drastic situations than can traditional training, which
      inherently produces drivers that are more skilled in diverse driving
      c o nditions.
      For example, while many first-time drivers will learn to drive during the summer
      months, they are not trained to drive in wintry conditions. Simulators can
      produce these and other situations, such as a tire blowout or having to react
      to
      a driver cutting off the trainee, effectively preparing the driver for adverse
      conditions.




We
      believe that we have held a 100% market share in U.S. military wheeled vehicle
      operator driver training simulators since 1999 and hold a market share in excess
      of 50% in U.S. municipal wheeled vehicle simulators.




*Product
      Lines*




Below
      is
      a description of our vehicle simulator products and product lines.




*Vehicle
      Driving Simulations*




Military
      Vehicles




Military
      Vehicles comprise the majority of our vehicle simulation business. Military
      vehicle simulators are highly realistic vehicle simulators that include variable
      reactive traffic and road conditions, the capacity to customize driving
      conditio n s
      to be
      geography-specific, and training in hazardous and emergency conditions. We
      have
      several large contracts and task orders in the Military Vehicles business,
      including (i) a multi-year IDIQ task-order contract for the development of
      vehicle simulators and related training services for the U.S. armed services;
      (ii) a series of scheduled General Services Administration purchases of
      simulators; (iii) Congressional plus-up funding for three simulators to the
      National Guard in three states; and (iv) a contract to develop a series of
      Common Driver Trainers for the U.S. Army, the first task order of which is
      for
      nine Stryker simulators and a second award for 26 Interim Tactical Wheeled
      Vehicle Simulators.




4


Our
      military vehicle simulators provide complete training capabilities, based on
      integrated, effective simulation solutions, to military vehicle operators in
      the
      U.S. Armed Forces. Our flagship military vehicle simulation product is our
      Military Operator Driver Simulator, initially developed for the USMC and
      subsequently reconfigured and delivered to support the U.S. Army and U.S. Naval
      Construction Battalion. The MIL ODS concept is centered on a pod of up to six
      Student Training Stations (STS) and a single controlling Instructor Operator
      Station (IOS). The STS realistically simulates the form, fit, and feel of the
      vehicle being modeled. The high-fidelity version of the STS consists of a
      modified production cab unit mounted on a full six-degree-of-freedom motion
      platform. Other versions with industry exclusive seat-motion and generic
      reconfigurable cabs are available. The STS provides a field of view of over
      180-degrees into a realistically depicted virtual world, simulating a variety
      of
      on-road and off-road conditions. The IOS is the main simulation control point
      supporting the instructor’s role in simulator training. The IOS initializes and
      configures the attached STS, conducts training scenarios, assesses student
      performance, and maintains scenarios and approved curriculum.




Our
      software solution provides a complete operator training curriculum based upon
      integrated simulation training. Military vehicle simulators enable students
      to
      learn proper operational techniques under all terrain, weather, road, and
      traffic conditions. Instructors can use simulators as the primary instructional
      device, quantitatively evaluating student performance under controlled,
      repeatable scenarios. This monitoring, combined with the ability to create
      hazardous and potentially dangerous situations without risk to man or material,
      results in well-trained students at significantly less cost than through the
      use
      of traditional training techniques. In addition to standard on-road driver
      training, our military vehicle simulators can provide training in such tasks
      as:




Ø
            Off-road
                driving on severe slopes, including muddy or swampy terrain;




Ø
            Driving
                in night vision goggle and blackout conditions;




Ø
            Convoy
                training; and




Ø
            The
                use of the Central Tire Inflation System in response to changing
                terrain.




In
      addition to simulation systems, we offer on-site operator and maintenance staff,
      train-the-trainer courses, curriculum development, scenario development, system
      maintenance, software upgrades, and warranty packages to our U.S. Armed Forces
      customers.




Municipal
      Vehicles




The
      Municipal Vehicles business is comprised of technology similar to that of the
      Military Vehicles product line and also is customized to reflect the specific
      vehicle being simulated. We serve four primary customer bases in the Municipal
      Vehicles business: transit, commercial, airport, and other municipal
      customers.




*Transit*




Transit
      customers represent an attractive customer base as they generally have access
      to
      their own funds, which often exempts them from the lengthy and complex process
      of requesting funds from a governing body. We have provided bus simulators
      to
      many of the leading U.S. transit authorities, including the New York City
      Transit Authority, Washington, D.C. Metro, Los Angeles MTA, Dallas Area Rapid
      Transit, and the Chicago Transit Authority. **** Our
      first
      European bus simulator was installed in London this year, **** and
      we
      were competitively awarded a major rail simulator program with New York City
      Transit.




5


*Public
      Safety*




We
      target
      municipal customers in police departments, hospitals, fire departments, and
      departments of transportation for sales of our municipal product. Our customers
      include the Mexico Department of Education, California Department of
      Transportation, and the Fire Department of New York. We are developing an
      industry advisory group focusing on the municipal market to identify and address
      customer needs. Additionally, we have developed a simulator module to extend
      the
      simulation once police, fire, or emergency medical service personnel reach
      the
      incident location. We believe that this represents another of our bases of
      differentiation over our competition.




One
      of
      our newest products is our
      Incident Command Training (ICT) system. Our custom ICT systems includes a
      comprehensive suite of simulation tools to promote both strategic and tactical
      training for firefighters facing incidents that require a well defined command
      and control structure. The ICT system, the first of which has been installed
      at
      the new Los Angeles Fire Fighter Training Academy, includes a broad range of
      incidents typically faced by firefighters as well as incidents involving weapons
      of mass destruction (WMD) and other acts of terrorism. The ICT system will
      provide immersive training for single agency incidents involving the fire
      service alone, as well as interagency incidents requiring a unified command
      structure including fire, police, emergency medical services, utilities, and
      other emergency response agencies.




*Corporate*




We
      target
      corporate fleets and “for-hire” haulers as customers of the corporate simulator
      product. These customers use simulators to train personnel effectively as well
      as to avoid the brand damage that could be associated with poor driver
      performance. To date, we have provided simulators to customers such as
      Challenger Transportation, Schlumberger Oil Services, Kramer Entertainment,
      and
      North American Van Lines.




*Military
      Operations*




We
      provide air combat range software, missile launch envelope decision support
      software, the SimBuilderTM simulation software product, and Weapon System Trainer
      software through the Military Operations business line.




Air
      Combat Range Software




We
      serve
      the U.S. Air Force Air Combat Training System and U.S. Navy Tactical Aircrew
      Training System with our air combat training range software. Air combat training
      ranges allow pilots to train and evaluate new tactics in a controlled airborne
      environment. Air “battles” are extremely realistic, with our software
      determining the outcome of weapon engagements based on launch conditions and
      the
      target aircraft defensive reactions.




Missile
      Launch Envelope Software




Onboard
      weapon decision-making software enables pilots to assimilate the complex
      information presented to them. In 2005, we added the F-16 to the F-15, F-18
      and
      Joint Strike Fighter (JSF) fighter to strengthen the list of aircraft fielding
      FAAC MLE software. We provide our missile launch envelope software to the U.S.
      Navy and Air Force through our subcontracting relationships with Boeing and
      Raytheon.




6


Weapon
      System Trainer Software




We
      have
      successfully transitioned software from U.S. Navy Tactical Aircrew Training
      Systems to over 15 Weapon Systems Trainers built by prime contractors such
      as
      L-3, Boeing, Northrop Grumman, and Lockheed Martin.




SimBuilderTM




The
      SimBuilderTM simulation software product is designed to provide weapons
      simulation models for use in training environments for launched weapons. This
      software enables foreign end-users to use weapons simulation models similar
      to
      the U.S. military without classified U.S. weapons data. Militaries of Australia,
      the United Arab Emirates, Canada, Taiwan, and Singapore currently use
      SimBuildersTM.




*Marketing*




Our
      sales
      and marketing effort focuses on developing new business opportunities as well
      as
      generating follow-on sales of simulators and upgrades. Through FAAC, we
      currently employ four dedicated sales representatives who focus on Municipal
      Vehicles, Military Operations, and Military Vehicles opportunities. Furthermore,
      two additional employees spend a significant portion of their time in sales.
      Various members of FAAC’s senior management serve as effective sales
      representatives in the generation of municipal, military, and corporate
      business. We also retain the services of several independent consultants who
      act
      as marketing agents on our behalf. These representatives are largely
      commission-based agents who focus on particular products and/or regions (such
      as
      airport customers, Texas, California, and Eglin Air Force Base). Finally, we
      have four customers that have agreements wherein the companies support our
      marketing efforts and market our products themselves in exchange for commissions
      and/or free upgrade services.




Our
      sales
      representatives are salaried employees with minimal commission-based revenue.
      Independent consultants generally do not receive a base salary and receive
      5% to
      10% commissions on the amount of business that they generate each year. The
      majority of our sales representatives have engineering backgrounds that they
      leverage to anticipate the technical needs of our customer base and targeted
      markets. Additionally, the program manager and service department assist us
      in
      gaining repeat business.




Developing
      a pipeline of follow-on work is one of the tasks for all program managers.
      We
      have a long history of repeat and follow-on work with programs such as F-15
      and
      F-18 ZAP (over 20 contracts with Boeing), the U.S. Navy Tactical Aircrew
      Training System (a series of 6 sequential contracts over the last 25 years),
      and
      F-18 Weapon Tactics Trainer (series of 20 contracts with the simulator
      manufacturer).




*Customers*




We
      have
      long-term relationships, many of over ten years’ duration, with the U.S. Air
      Force, U.S. Navy, U.S. Army, U.S. Marine Corps, and most major Department of
      Defense training and simulation prime contractors and related subcontractors.
      The quality of our customer relationships is illustrated by the multiple program
      contract awards we have earned from many of our customers.




7


*Competition*




Our
      technical excellence, superior product reliability, and high customer
      satisfaction have enabled us to develop market leadership and an attractive
      competitive position. Several potential competitors in the military segment
      are
      large, diversified defense and aerospace conglomerates who do not focus on
      our
      specific niches. As such, we are able to provide service on certain large
      military contracts through strategic agreements with these organizations or
      can
      compete directly with these organizations based on our strength in developing
      higher quality software solutions. In municipal market applications, we compete
      against smaller, less sophisticated software companies. Many of our competitors
      have financial, technical, marketing, sales, manufacturing, distribution and
      other resources significantly greater than ours.




We
      differentiate ourselves from our competition on several bases:




Ø
            Leading
                Technology− We
                believe that we offer better-developed, more dynamic software than
                our
                competitors. Additionally, we incorporate leading graphics and
                motion-cueing technologies in our systems to provide customers with
                the
                most realistic simulation experience on the market.




Ø
            Long
                History in the Simulation Software Business− As
                a market leader in the simulation software business for more than
                thirty
                years, FAAC’s professionals understand customer requirements and operating
                environments. Thus, we build our software to meet and exceed demanding
                customers’ expectations.




Ø
            Low-Cost
                Research and Development Capabilities for New Products− Our
                customers benefit from government and commercial funding of research
                and
                development and the low cost of subsequent adaptation. As such, internally
                funded new product development costs have been less than $100,000
                per year
                since 1999.




Ø
            Service
                Reputation− We
                are known for providing strong customer service, a characteristic
                that
                drives new business within our chosen markets.




Ø
            Standardized
                Development Processes− We
                generally deliver our products to market quickly and at high quality
                due
                to our standardized development processes.




Below
      is
      a description of our competition organized by product lines.




*Vehicle
      Simulations*




Military
      Vehicles




FAAC
      has
      been the sole provider of wheeled vehicle simulation solutions to the U.S.
      military since 1999. Our devotion to developing realistic, comprehensive
      products for a wide range of vehicle types positions us as a preferred
      simulation provider within this market niche. Our strategy of identifying a
      training need, isolating government funds, and then developing a customized
      training solution has led to considerable successes. This approach, which
      differs from the “build first and market later” strategy employed by a number of
      our competitors, effectively identifies market opportunities and provides a
      better product to the military customer. Diversified defense companies and
      municipal simulation providers have attempted to enter the military wheeled
      vehicle market but have been unsuccessful thus far. Although we believe that
      market penetration by these companies is ultimately inevitable, the established
      FAAC brand, understanding of customer requirements, and engineering expertise
      provide us with a competitive advantage in this market segment. Our primary
      competitors for military vehicle simulation solutions include Lockheed Martin
      Corporation’s Information & Technology Services Group, L-3 Communications
      Holdings, Raydon Corporation, and the Cubic Defense Applications division of
      Cubic Corporation.




8


Municipal
      Vehicles




A
      handful
      of simulation product and service companies currently compete with our targeted
      municipal driving simulator markets. However, our marketing and development
      of
      selected municipal market segments has positioned us as a leading provider
      of
      municipal simulation solutions. Competition within each market segment varies,
      but the following companies generally participate in selected driving simulator
      market opportunities: L-3 Communications Holdings, Doron Precision Systems,
      Lockheed-Martin Corporation’s LMIS Division, Global SIM, and USADriveSafe,
      Inc.




*Military
      Operations*




Currently
      no significant competitors participate in the market for our tactical
      environment software, and there are essentially no independent competitors
      that
      exist in the market for our decision support software. Competition for software
      to support tactical environment requirements in aircraft weapon systems trainers
      comes from the manufacturers of the simulators themselves and from a handful
      of
      companies who produce tactical environment software. Our primary competitors
      for
      training range software, decision support software, and weapons system trainer
      software solutions include Lockheed Martin Corporation, L-3 Communications
      Holdings, Raytheon Company, Science Applications International Corporation,
      Dynetics, Inc., and Georgia Tech Research Institute.




***Use-of-Force
      Training***




We
      are a
      leading provider of interactive, multimedia, fully digital training simulators
      for law enforcement, security, military and similar applications. With a
      customer base of over 700 customers in over twenty countries around the world,
      we are a leader in the supply of simulation training products to military,
      law
      enforcement and corporate client communities. We believe, based on our general
      knowledge of the size of the interactive use-of-force market, our specific
      knowledge of the extent of our sales, and discussions we have held with
      customers at trade shows, etc., that we provide more than 25% of the worldwide
      market for government and military judgment training simulators. We conduct
      our
      interactive training activities through our subsidiary IES Interactive Training,
      Inc. (“IES”), a Delaware corporation based in Littleton, Colorado, the offices
      of which we are in the process of relocating to Ann Arbor,
      Michigan.




*Introduction*




We
      offer
      consumers the following interactive training products and services:




Ø
            *Range
                3000*-
                providing use-of-force simulation for military and law enforcement.
                We
                believe that the Range 3000 is the most technologically advanced
                judgment
                training simulator in the world.




Ø
            *A2Z
                Classroom Trainer*-
                a state-of-the-art computer based training (CBT) system that allows
                students to interact with realistic interactive scenarios projected
                life-size in the classroom.




9


Ø
            *Range
                FDU (Firearms Diagnostic Unit)*-
                a unique combination of training and interactive technologies that
                give
                instructors a first-person perspective of what trainees are seeing
                and
                doing when firing a weapon.




Ø
            *Milo
                (Multiple Interactive Learning/training Objectives)*-
                a simulator designed with “plug in” modules to customize the training
                system to meet end user needs.




Ø
            *Summit
                Training International*-
                providing relevant, cost-effective professional training services
                and
                interactive courseware for law enforcement, corrections and corporate
                clients.




Ø
            *IES
                Studio Productions*-
                providing cutting edge multimedia video services for law enforcement,
                military and security agencies, utilizing the newest equipment to
                create
                the training services required by the most demanding authorities.




Our
      products feature state of the art all digital video formats, ultra-advanced
      laser-based lane detection for optimal accuracy and performance, customer-based
      authoring of training scenarios, and 95% COTS (commercial off-the-shelf)-based
      system.




*Products*




Below
      is
      a description of each of the core products and services in the IES
      line.




*Range
      3000 “Use of Force” Simulator*




We
      believe that the Range 3000, which was launched in late 2002, combines the
      most
      powerful operational hardware and software available, and delivers performance
      superior to competing products presently on the market.




The
      Range
      3000 simulator allows training with respect to the full “Use of Force”
continuum. Training can be done on an individual basis, or as many as four
      members of a team can participate simultaneously and be scored and recorded
      individually. Topics of training include (but are not limited to):




Ø
            *Officer’s
                Presence and Demeanor*-
                Picture-on-picture digital recordings of the trainee’s actions allows
                visual review of the trainee’s reaction, body language and weapons
                handling during the course of the scenario, which then can be played
                back
                for debriefing of the trainee’s actions.




10


Ø
            *Verbalization*-
                Correct phrases, timing, manner and sequence of an officer’s dialogue is
                integrated within the platform of the system, allowing the situation
                to
                escalate or de-escalate through the officer’s own words in the context of
                the scenario and in conjunction with the trainer.




Ø
            *Less-Than-Lethal
                Training*-
                Training in the use of non-lethal devices such asTASER,
                OC (pepper spray), batons and other devices can be used with the
                video
                training scenarios with appropriate reactions of each. We produce
                an
                interactive system especially forTASERproducts called the TASERTM Judgmental Trainer, which delivers advance
                simulated training for law enforcement and government agencies deploying
                TASER non-lethal devices.




Ø
            *Soft
                Hand Tactics*-
                Low level physical control tactics with the use of additional equipment
                such as take-down dummies can be used.




Ø
            *Firearms
                Training and Basic Marksmanship*-
                Either utilizing laser based training weapons or in conjunction with
                a
                live-fire screen, the use of “Live Ammunition” training can be employed on
                the system.




The
      interactive training scenarios are projected either through single or multiple
      screens and projectors, allowing us to immerse a trainee in true-to-life
      training scenarios and incorporating one or all the above training issues in
      the
“Use of Force” continuum.




*A2Z
      Classroom Trainer*




The
      A2Z
      is a state-of-the-art Computer Based Training (CBT) system that allows students
      to interact with realistic interactive scenarios projected life-size in the
      classroom.




Using
      individual hand-held keypads, the students can answer true/false or multiple
      choice questions. Based on the student’s performance, the scenario will branch
      and unfold to a virtually unlimited variety of different possible outcomes
      of
      the student’s actions. The system logs and automatically scores each and every
      trainee’s response and answer. At the end of the scenario, the system displays a
      session results summary from which the trainer can debrief the
      class.




The
      advanced A2Z Courseware Authoring Tools allow the trainer easily to create
      complete customized interactive courses and scenarios.




The
      Authoring Tools harness advances in digital video and multimedia, allowing
      the
      trainer to capture video and graphics from any source. The A2Z allows the
      trainer to combine his or her insight, experience and skills to recreate a
      realistic learning environment. The A2Z Training System is based on the
      well-known PC-Pentium technology and Windows XP TM operated. The menu and mouse operation make the A2Z user-friendly.




The
      individual keypads are connected “wirelessly.” The system is completely portable
      and may be setup within a matter of minutes.




11


Key
      advantages:




Ø
            Provides
                repeatable training to a standard based on established
                policy




Ø
            Quick
                dissemination and reinforcement of correct behavior and
                policies




Ø
            Helps
                reduce liability




Ø
            More
                efficient than “traditional and redundant” role-playing
                methods




Ø
            Realistic
                scenarios instead of outdated “play-acting”




Ø
            Interactive
                training of up to 250 students simultaneously with wireless
                keypads




Ø
            Easy
                Self-Authoring of interactive training
                content




Ø
            PC-Pentium
                platform facilitates low cost of
                ownership




Ø
            Easy
                to use Windows XP-based software




Ø
            Easy
                to deploy in any classroom




*Range
      FDU*




The
      Range
      FDU (firearm diagnostics unit) is a unique combination of training and
      interactive technologies that gives instructors a first-person perspective
      of
      what trainees are seeing and doing when firing a weapon.




With
      the
      Range FDU, firearms instructors can see the trainees’ actual sight alignment to
      the target as well as measure trigger pressure against proper trigger pressure
      graphs, making corrective instruction simple and effective. In addition, the
      Range FDU records a trainee’s recoil control, grip and stance - allowing the
      instructor to playback the information in slow motion or real time to better
      analyze the trainee’s actions and more accurately diagnose any
      deficiencies.




The
      Range
      FDU also has the ability to record the firearm instruction session to either
      DVD
      or VHS, allowing both the trainee and the instructor to review it at a later
      time. Trainees now have a diagnostic tool that they can learn from, even after
      their training has been completed. In addition, instructors can build a library
      for each trainee to record progress.




The
      Range
      FDU provides the following benefits:




Ø
            Fall
                of shot feedback




Ø
            Trigger
                pressure analysis




12


Ø
            Recoil
                control, grip and stance assessment




Ø
            Sight
                alignment




Ø
            Sight
                picture analysis and target
                reacquisition




*Milo*




Milo
      (Multiple Interactive Learning/training Objectives) is a simulator designed
      with
“plug in” modules to customize the trainings system to meet end user needs, and
      is designed to expand the market for sales of our IES products to include
      organizations involved in all aspects of public safety, and not just law
      enforcement.




*Professional
      Conferences and Courseware*




We
      provide relevant, cost-effective professional training seminars, consulting
      services, and interactive courseware for law enforcement, corrections, and
      corporate clients through Summit Training International (STI), a wholly-owned
      subsidiary of IES. The emphasis and goal of our conferences and courseware
      is to
      create a “total training” environment designed to address the cutting edge
      issues faced today. We provide conferences throughout the United States, and
      develop courseware dealing with these important topics. The incorporation of
      IES
      Interactive Systems in our conferences creates an intense learning environment
      and adds to the realism of the trainee’s experience.




Conferences




We
      have
      provided conferences throughout the United States, on such topics
      as:




Ø
            Recruiting
                and Retention of Law Enforcement and Corrections
                Personnel




Ø
            Ethics
                and Integrity




Ø
            Issues
                of Hate Crimes




Ø
            Traffic
                Stops and Use of Force




Ø
            Community
                and Corporate Partnerships for Public
                Safety




Ø
            Creating
                a Safe School Environment




In
      addition to these national and regional conferences, we design and produce
      training to address specific department issues. We have a distinguished cadre
      of
      instructors that allows adaptation of programs to make them specifically focused
      for a more intense learning experience. The A2Z Classroom Trainer is
      incorporated into the “live” presentation creating a stimulating interactive
      training experience.




Courseware




We
      develop courseware for use exclusively with IES’s interactive systems. Courses
      are designed to addresses specific department issues, and can be customized
      to
      fit each agency’s needs. These courses are available in boxed sets that provide
      the customer with a turn-key training session. The A2Z Classroom Trainer and
      the
      Range 3000 XP-4 are used to deliver the curriculum and create a virtual world
      that the trainees respond and react to. Strategic relationships with high
      profile companies such as H&K Firearms, and TASER International, provide customers with training that deals with cutting edge
      issues facing law enforcement today. The incorporation of our courseware library
      along with simulation systems allows training to remain consistent and
      effective, giving customers more value for their training dollar.




13


*IES
      Studio Productions*




Through
      IES Studio Productions, a division of IES, we provide multimedia video services
      for law enforcement, military and security agencies, and others and create
      interactive courseware and interactive scenarios for the Range 3000, Video
      Training Scenarios and all types of video production services. With the latest
      in media equipment, we provide all media and marketing services to IES
      Interactive Training in-house.




*Marketing*




We
      market
      our IES products and services to domestic and international law enforcement,
      military and other federal agencies and to various companies that serve them,
      through attendance and presentations at conferences, exhibits at trade shows,
      seminars at law enforcement academies and government agencies, through its
      web
      pages on the Internet, and to its compiled database of prospect and customer
      names. Our IES salespeople are also its marketing team. We believe that this
      is
      effective for several reasons: (1) customers appreciate talking directly with
      salespeople who can answer a wide range of technical questions about methods
      and
      features, (2) our salespeople benefit from direct customer contact through
      gaining an appreciation for the environment and problems of the customer, and
      (3) the relationships we build through peer-to-peer contact are useful in the
      military, police and federal agency market.




We
      also
      uses our IES web pages on our Internet site for such activities as providing
      product information and software updates.




We
      market
      augmentative and alternative law enforcement products through a network of
      employee representatives and independent resellers. These products include
      but
      are not limited to products manufactured by:




Ø
            Bristlecone
                Products




Ø
            Fox
                Valley Technical College




Ø
            TASERInternational, Inc.




Ø
            Force
                Science Research Center




Ø
            H&K
                Training Centers




At
      the
      present time, we have two full-time and two part-time sales representatives
      based in Denver, two domestic independent distributors, and ten independent
      resellers / representatives overseas. We also have inside sales/support persons
      who answer telephone inquiries on IES’s 800 line and Internet, and who can also
      provide technical support.




We
      typically participate in over thirty industry conferences annually, held
      throughout the United States and in other countries, that are attended by our
      potential customers and their respective purchasing and budgeting decision
      makers. A significant percentage of our sales of IES products, both software
      and
      hardware, are sold through leads developed at these shows.




We
      and
      others in the industry demonstrate products at these conferences and present
      technical papers that describe the application of their technologies and the
      effectiveness of their products. We also advertise in selected publications
      of
      interest to potential customers.




14


*Customers*




Most
      of
      the customers for our IES products are law enforcement agencies, both in the
      United States (federal, state and local) and worldwide. Purchasers of IES
      products have included (in the United States) the FBI, the Secret Service,
      the
      Bureau of Alcohol, Tobacco and Firearms, the Customs Service, the Federal
      Protective Service, the Border Patrol, the Bureau of Engraving and Printing,
      the
      Coast Guard, the Federal Law Enforcement Training Centers, the Department of
      Health and Human Services, the California Department of Corrections, NASA,
      police departments in Texas (Houston), Michigan (Detroit), Washington, D.C.,
      California (Fresno and the California Highway Patrol), Massachusetts
      (Brookline), Virginia (Newport News and the State Police Academy), Arizona
      (various counties), universities and nuclear power plants, as well as
      international users such as the Israeli Defense Forces, the German National
      Police, the Royal Thailand Army, the Hong Kong Police, the Russian Security
      Police, users in Mexico and the United Kingdom, and over 700 other training
      departments worldwide.




The
      mix
      of customers has historically been approximately 40% city and state agencies,
      30% federal agencies, and 30% international.




*Competition*




We
      compete against a number of established companies that provide similar products
      and services, many of which have financial, technical, marketing, sales,
      manufacturing, distribution and other resources significantly greater than
      ours.
      There are also companies whose products do not compete directly, but are
      sometimes closely related. Firearms Training Systems, Inc., Advanced Interactive
      Systems, Inc., and LaserShot Inc. are IES’s main competitors.




We
      believe the key factors in our competing successfully in this field will be
      our
      ability to develop simulation software and related products and services to
      effectively train law enforcement and military to today’s standards, our ability
      to develop and maintain a proprietary technologically advanced hardware, and
      our
      ability to develop and maintain relationships with departments and government
      agencies.




**Armor
      Division**




We
      manufacture aviation and other armor and we armor vehicles through
      our Armor Division. During
      2005, 2004 and 2003 revenues from our Armor Division were approximately $12.3
      million, $18.0 million and $3.4 million, respectively (on a pro forma basis,
      assuming we had owned all components of our Armor Division since January 1,
      2003, revenues in 2005, 2004 and 2003 would have been approximately $12.3
      million, $29.2 million and $10.9 million, respectively).




***Aircraft
      Armoring***




*Introduction*




Through
      our subsidiary Armour of America, presently located in Gardena, California
      and
      being relocated to Auburn, Alabama, we manufacturer ballistic and fragmentation
      armor kits for rotary and fixed wing aircraft, marine armor, personnel armor,
      military vehicles, architectural applications, including both the LEGUARD
      Tactical Leg Armor and the Armourfloat Ballistic Floatation Device, which is
      a
      unique armored floatation vest that is certified by the U.S. Coast
      Guard.




15


For
      over
      thirty years, AoA has delivered ballistic armor equipment to users worldwide.
      Initially, AoA designed and manufactured “soft” ballistic armor only, such as
      covert and overt ballistic vests, military assault vests, tactical vests and
      specially designed vests for military and law enforcement users both in the
      U.S.
      and abroad. By 1982, AoA had started to design and manufacture “hard” ballistic
      armor to stop military rifle fire up to and including .50 caliber Armor Piercing
      Incendiary (API) and European 12.7 mm API rounds. This “hard” ballistic armor is
      used as chest protection for the full line of personal vests, as well as on
      fixed wing aircraft (airplanes) and rotary wing aircraft (helicopters), military
      ships, military vehicles and architectural applications.




Our
      proprietary designs have been developed to meet a wide variety of customer
      and
      industry needs.




*The
      Armoring Process*




Each
      hard
      armor kit starts out with detailed templates generated at the aircraft or
      vehicle, with close fitting around pedals, consoles and other obstructions.
      These templates are converted into wood patterns that are exact
      three-dimensional reproductions of the armor to be manufactured, including
      as to
      the thickness. These patterns are fitted back into the user’s aircraft or
      vehicle and approved. At this point, fiberglass over wood production molds
      are
      produced for each part, which will guarantee that each production panel will
      be
      exactly the same and fit perfectly within the kit. In addition, each kit has
      a
      complete set of installation hardware that includes everything required to
      install the armor kit to the aircraft or vehicle. This total kit package allows
      the armor to be installed at any location with a minimum of tools
      required.




Soft
      armor is manufactured in the same manner as hard armor. Detailed cut and sew
      patterns are developed from the requirements driven by the customer. These
      requirements are normally dealing with collar height, placement of pockets
      and
      location of plate pockets. Once these patterns are completed, two processes
      start simultaneously. The first involves spreading multiple plies of ballistic
      material on a special cutting table. The material is then dusted with pattern
      powder to mark the packs for cutting. After each pack is cut to size, it is
      routed to the sew shop for stitching. At the same time, nylon covers are being
      cut and sewn using sew patterns made from the cut patterns. Upon completion
      of
      both the ballistic pack and the cover, the pack is inserted into the cover
      and
      sewn closed.




*Product
      Lines*




We
      produce two kinds of armor, soft armor and hard armor, to support customer
      armor
      requirements. Soft armor, which is capable of protecting against all handguns
      and 9mm sub guns, is used in our ballistic and fragmentation vest, military
      vehicle, marine, architectural and special application armor lines. Hard armor,
      which is capable of protecting against rifle fire up to 50cal/12.7mm API, is
      used in our ballistic chest plate, aircraft, military vehicle, marine and
      architectural armor lines. Within these two basic kinds of armor, we offer
      the
      product lines listed below.




*Fixed
      and Rotary Wing Aircraft Armor Systems*




We
      design
      and manufacture ballistic armor systems for a wide variety of fixed and rotary
      wing aircraft. These systems are in the form of kits, with individual contoured
      panels which cover the entire aircraft’s floor, walls, seats, bulkheads, walls,
      oxygen containers, avionics and doors. All of our ballistic armor kits include
      a
      complete installation hardware kit containing all items required for
      installation. The supplied hardware is designed for each individual application
      in accordance with the installation hardware certification, which has been
      provided by Lockheed-Martin. Additionally, the fixed and rotary wing aircraft
      kits have been certified, by an independent test facility that is approved
      by
      the FAA, to meet flammability requirements of FAA/FAR 25.853, 12 Second Vertical
      Test and MIL-STD-810 Environmental Testing.




16


These
      kits have been sold to both the original airframe manufacturers and end users
      worldwide. Armor kits for rotary wing aircraft including Bell Helicopter’s B206,
      B212, B407, B412, B427, and UH-1H; Boeing’s CH-46 and CH-47; MD Helicopter’s MD
      500, MD 600, and MD 900; Agusta Helicopter’s A109; Eurocopter’s EC-120, EC-135,
      BK117, and BO-105; Aerospatiale’s AS 330, AS 332, and AS 355; Sikorsky’s UH-60
      and S-61; MIL MI-8 and MI-17; Robinson’s R-22 and R-44; and Kaman’s K-MAX.




Fixed
      wing aircraft kits include Lockheed’s C-130H, C-130J , and P-3; Boeing’s C-17;
      Alenia’s G-222 and C-27J; Ayers’ T-65; Rockwell’s OV-10; CASA CN 235 and CN 295;
      and special configurations of the Citation, Beechcraft and Cessna
      models.




*Military
      Vehicles Armor Kits*




For
      the
      military vehicle market, we provide ballistic armor kits to protect against
      fragmentation and rifle fire, 21⁄2- and 5-ton trucks, HEMTT wreckers and various
      construction vehicles. These kits offer varying levels of protection for doors,
      floors, fuel tanks, air bottles, cargo beds, troop seat backs, critical
      components and glass. To date, we have protected vehicles deployed in Iraq,
      Afghanistan, and Kuwait. All of the provided kits are designed for easy field
      level installation and include required hardware and instructions.




*Marine
      Armor Kits*




For
      the
      marine market, we manufacture armor kits for the gun mounts on naval ships
      and
      riverine patrol boats. During Operation Desert Storm, we designed and
      manufactured .50 cal AP ballistic panels and deck mount brackets for the U.S.
      Navy. Since then, we have designed and manufactured armor to fit both the .50
      cal and 25mm gun mounts on frigates, destroyers, cruisers and aircraft carriers.
      The result of this effort is that we have delivered armor systems to individual
      ships in the class and currently are pursuing armoring additional classes of
      ships throughout the Navy Command.




Additionally,
      we have designed program-specific armor for riverine and small boats throughout
      the world. While the majority of these armoring programs were limited to a
      small
      number of boats, the areas of coverage included complete coverage of the
      exterior walls of the wheel house, forward and aft gun placements, fire boxes,
      fuel tanks and engines. Unlike designing armor kits for aircraft, this type
      of
      armoring requires unique installation methods to allow for interference caused
      by surface mounted hardware and the impact of “green water” impacting the armor
      during rough weather.




*Ballistic
      Vests and Plates and Body Armor*




We
      manufacture a complete line of personal body armor, including concealable,
      external and special application armor. The concealable armor vest offers
      complete front, side and back protection using soft, lightweight, high strength
      proprietary woven ballistic fabrics.




Our
      external vest line includes assault, tactical, riot, stab and T-panel designs.
      Each of these designs can be modified to meet the individual wearer of
      customer’s requirements. Special application vests include the Armourfloat,
      which to our knowledge is currently the only ballistic/floatation vest approved
      by the U.S. Coast Guard; the Zip Out armor jacket, which offers covert
      protection in both a lightweight jacket or vest design; and our helicopter
      vest,
      which incorporates a unique protection/comfort design.




17


We
      offer
      a complete line of personal body armor including concealable ballistic vests,
      military vests and external tactical vests as well as a line of products
      specially designed for U.S. Navy Seal Teams and various law enforcement agencies
      in the United States and overseas. Our hard ballistic armor, designed to stop
      military rifle fire up to and including .50 caliber and European 12.7 mm Armor
      Piercing Incendiary (API) rounds, is used primarily on fixed and rotary wing
      aircraft, military ships and military vehicles, as well as in architectural
      applications.




We
      have
      designed and manufactured special operations personal armor including ballistic
      hand held shields and the LEGUARD Tactical Leg Armor, which offers complete
      front protection for the lower thigh, knee, shin and instep.




*Other
      Armor for Specialty Applications*




In
      addition to aircraft, marine, vehicle and vest armor, we also manufacture
      ballistic and fragmentation blankets and curtains for numerous specialty
      applications. These applications include operator protection around test
      equipment; rupture protection of pressure vessels, mechanical failure of
      production machinery and high pressure piping. Additionally, we have supplied
      armor for office use in protection of occupants from blast and glass fragments
      of windows and isolation of security rooms from surrounding
      environments.




*Sales,
      Marketing and Customers*




We
      maintain broad relationships throughout the aerospace and defense communities,
      including U.S. federal, state and local government and law enforcement agencies,
      along with many foreign government end users and procurement
      agencies.




We
      market
      our products directly to both the original airframe manufacturer, such as
      Alenia, Agusta, Bell-Textron, Boeing, EADS (Eurocopter), Lockheed-Martin and
      MD
      Helicopter, as well as, aircraft completion operations and end users worldwide.
      We maintain a strong presence in Europe, Southeast Asia, Asia, Central America
      and South America, utilizing key representatives located in each
      country.




Because
      of our constant contact with both engineering and marketing at the various
      airframe manufacturers, we have access to their new and existing model aircraft
      so that we can always update and/or design new ballistic armor kits to protect
      the flight deck, cabin, bulkhead and engine areas as required.




At
      the
      request of an airframe manufacturer or end user, we send a technical
      representative to meet the customer at the aircraft to review the layout of
      areas to be armored, develop templates if required and to determine any unique
      characteristics that the customer or end user desires incorporated into the
      armor. After the templates are converted to full size armor mock-up panels,
      they
      are taken back to the aircraft for review and approval by either the OEM or
      the
      user prior to production. This approach has proven to be the most effective
      in
      obtaining both OEM certification of each of our systems and in ensuring that
      our
      ballistic armor systems meet or exceed the end users’ operational and ballistic
      demands.




18


Our
      commercial customers have included Bell Helicopter, MD Helicopter, Robinson
      Helicopter, Sikorsky Helicopter, Schweitzer Helicopter, Agusta, and
      Lockheed-Martin in the United States, as well as Eurocopter (Germany), Alenia
      Aerospazio (Italy), EADS (Spain), and Bell (Canada).




Our
      U.S.
      military customers have included NAVSEA, NAVAIR, Army, Coast Guard, Marines,
      State Department, Border Patrol, and various SEAL and Small Boat
      Units.




Our
      foreign military customers have included the air forces of New Zealand,
      Australia, Thailand, Malaysia, Spain, Belgium, Sweden, Norway, Italy, Sri Lanka,
      Indonesia, Brazil, Argentina, and Turkey; the navies of Singapore, Thailand,
      Malaysia, Ecuador, Mexico, Colombia, Spain, Australia, and Japan; the armies
      of
      Thailand, Malaysia, Sri Lanka, Colombia, Mexico, Ecuador, Venezuela and
      Peru.




*Manufacturing*




Our
      manufacturing facilities are in the process of being relocated from Gardena,
      California to Auburn, Alabama, and are divided into hard and soft armor
      production areas. Dedicated cells are established for machining, pressing,
      cutting, molding, lay-up, assembly and creation of the hard armor panels. The
      soft armor production area has cells for cutting, sewing and packaging. All
      of
      our hard armor is manufactured using AoA-designed production molds, which ensure
      proper fit of each panel into the total ballistic armor kit.




AoA’s
      entire administrative and manufacturing operations are directed and controlled
      by procedures conforming to ISO 9001-2000. AoA was certified as ISO 9001-2000
      in
      December 2003.




*Competition*




Aircraft
      armor competition includes LAST Armor (a division of Foster-Miller, Inc.),
      Simula Inc. (a subsidiary of Armor Holdings, Inc.), and Protective Materials
      Company (a division of The Protective Group, Inc.). Military vehicle armor
      competition includes: O’Gara-Hess & Eisenhardt (a subsidiary of Armor
      Holdings, Inc.), ArmorWorks Harl Facility, Protective Materials Company, and
      Ceradyne, Inc. Ballistic vests competition includes: Point Blank Body Armor,
      Inc. (a subsidiary of DHB Industries, Inc.), Second Chance Body Armor, Inc.,
      Protective Materials Company, American Body Armor (a subsidiary of Armor
      Holdings, Inc.), Protech Armor Systems (a subsidiary of Armor Holdings, Inc.)
      and Safariland, Ltd. (a subsidiary of Armor Holdings, Inc.). Marine armor
      competition includes Protective Materials Company. Many of our competitors
      have
      financial, technical, marketing, sales, manufacturing, distribution and other
      resources significantly greater than ours.




***Vehicle
      Armoring***




*Introduction*




We
      specialize in using state-of-the-art lightweight ceramic materials, special
      ballistic glass and advanced engineering processes to fully armor vans and
      SUVs
      through our majority-owned subsidiaries, MDT
      Protective Industries Ltd., located in Lod, Israel, and MDT Armor Corporation,
      located in Auburn, Alabama .
      We are
      a leading supplier to the Israeli military, Israeli special forces and special
      services. Our products have been proven in intensive battlefield situations
      and
      under actual terrorist attack conditions, and are designed to meet the demanding
      requirements of governmental and private sector customers
      worldwide.




19


We
      have
      acquired many years of battlefield experience in Israel. Our vehicles have
      provided proven life-saving protection for their passengers in incidents of
      rock
      throwing, handgun and assault rifle attack at point-blank range, roadside
      bombings and suicide bombings. In fact, to our knowledge an MDT-armored vehicle
      has never experienced bullet penetration into a vehicle cabin under attack.
      We
      also use our technology to protect vehicles against vandalism.




In
      2003,
      we established MDT Armor’s operations in a new facility in Auburn, Alabama. Soon
      thereafter, the United States General Services Administration (GSA) awarded
      us a
      five-year contract for vehicle armoring, establishing a pricing schedule for
      armoring of GM Suburban and Toyota Land Cruiser SUVs and of GM Savana/Express
      passenger vans. With this contract, these armored vehicles became available
      for
      purchase directly by all federal agencies beginning December 1, 2003, and we
      received our first U.S. orders for vehicle armoring products during
      2004.




*The
      Armoring Process*




Armoring
      a vehicle involves much more than just adding “armor plates.” It includes
      professional and secure installation of a variety of armor components - inside
      doors, behind dashboards, and all other areas of passenger and engine
      compartments. We use overlapping sections to ensure protection from all angles,
      and install armored glass in the windshield and windows. We have developed
      certain unique features, such as new window operation mechanisms that can raise
      windows rapidly despite their increased weight, gun ports, run-flat tires,
      and
      more. We developed the majority of the materials that we use in-house or in
      conjunction with Israeli companies specializing in protective
      materials.




In
      order
      to armor a vehicle, we first disassemble the vehicle and remove the interior
      paneling, passenger seats, doors, windows, etc. We then fortify the entire
      body
      of the vehicle, including the walls, pillars, floors, roof and other critical
      components, and reinforce the door hinges. We achieve firewall protection from
      frontal assault with carefully designed overlapping armor. Options, such as
      air-conditioning, seating modifications and run-flat tires, are also available.
      We fix the armoring into the shell of the vehicle, ensuring that the
      installation and finishing is according to the standards set for that particular
      model. We then reassemble the vehicle as close to its original appearance as
      possible.




Once
      we
      have ensured full vehicle protection, we place a premium on retaining the
      original vehicle’s look and feel to the extent possible, including enabling full
      serviceability of the vehicle, thereby rendering the armoring process
“invisible.” We work with our customers to understand their requirements, and
      together with the customer develop an optimized armoring solution. A flexible
      design-to-cost process helps evaluate tradeoffs between heavy and light
      materials and various levels of protection.




20


By
      working within the vehicle manufacturer’s specifications, we maintain stability,
      handling, center-of-gravity and overall integrity. Our methods minimize impact
      on payload, and do not obstruct the driver’s or passengers’ views. In many cases
      all the original warranties provided by the manufacturer are still in
      effect.




*Armoring
      Materials*




We
      offer
      a variety of armoring materials, optimized to the customer’s requirements. We
      use ballistic steel, composite materials (including Kevlar ® ,
      Dyneema ® and
      composite armor steel) as well as special ceramics, together with special
      armored glass. We use advanced engineering techniques and “light” composite
      materials, and avoid, to the extent possible, using traditional “heavy”
materials such as armored steel because of the added weight, which impairs
      the
      driving performance and handling of the vehicle. We also sell certain kinds
      of
      vehicles pre-armored.




All
      materials that we use meet not only international ballistic standards, but
      also
      the far more stringent requirements set down by the Israeli military, the
      Israeli Ministries of Defense and Transport, and the Israel Standards Institute.
      Our facilities have also been granted the ISO 9001:200 quality standards
      award.




*Products
      and Services*




We
      armor
      a variety of vehicles for both commercial and military markets.




In
      the
      military market, we armor:




Ø
            The
                David, an Ultra Light Armored Vehicle based on a Land Rover or Mercedes
                platform;




Ø
            Command
                vehicles (such as the Land Rover Defender 110);
                and




Ø
            Pickup
                trucks such as the Defender 130.




In
      the
      commercial market, we armor:




Ø
            Sports
                utility vehicles (such as the GM Suburban, the Toyota Land Cruiser
                and the
                Land Rover Defender);




Ø
            Trucks,
                such as the Ford F550;




Ø
            Passenger
                vans (such as the Chevrolet Express, the General Motors Savana and
                the
                Ford Econoline); and




Ø
            Small
                buses (based on vehicles in the Mercedes-Benz Vario and Sprinter
                lines).




*Sales,
      Marketing and Customers*




Most
      of
      our vehicle armoring business has historically come from Israel, although we
      have armored vehicles under contracts from companies in Yugoslavia, Mexico,
      Colombia, South Africa, Nigeria and Singapore. Our principal customer at present
      is the Israeli Ministry of Defense. Other customers include Israeli and American
      government ministries and agencies, private companies, medical services and
      private clients. In the United States, we armor vehicles for U.S. operations
      in
      Iraq.




21


In
      Israel, we market our vehicle armoring through vehicle importers, both pursuant
      to marketing agreements and otherwise, and directly to private customers in
      the
      public and private sectors. Most sales are through vehicle
      importers.  In
      the
      U.S., vehicles are sold to the Army or to businesses operating in
      Iraq.




We
      hold
      exclusive armoring contracts with Israel’s sole General Motors and Chevrolet
      distributors. This means that these distributors will continue to honor the
      original vehicle warranty on armored versions of vehicles sold by them only
      if
      the armoring was done by us.




We
      are
      also partners in a joint venture with two prominent Indian companies for the
      design and manufacture of armored vehicles in India. The joint venture, called
      Concord Safety Solutions Limited, will offer armored vehicles to the Indian
      military and paramilitary organizations.




*Competition*




The
      global armored car industry is highly fragmented. Major suppliers include both
      vehicle manufacturers and aftermarket specialists. As a highly labor-intensive
      process, vehicle armoring is numerically dominated by relatively small
      businesses. Industry estimates place the number of companies doing vehicle
      armoring in the range of around 500 suppliers globally. While certain large
      companies may armor several hundred cars annually, most of these companies
      are
      smaller operations that may armor in the range of five to fifty cars per year.




Among
      vehicle manufacturers, we believe Mercedes-Benz to have the largest
      vehicle-armoring market share. Among aftermarket specialists, we believe the
      largest share of the vehicle-armoring market is held by O’Gara-Hess &
Eisenhardt, a subsidiary of Armor Holdings, Inc. Other aftermarket specialists
      include International Armoring Corp., Lasco, Texas Armoring and Chicago Armor
      (Moloney). Many of these companies have financial, technical, marketing, sales,
      manufacturing, distribution and other resources significantly greater than
      ours.




We
      believe the key factor in our competing successfully in this field will be
      our
      ability to penetrate new military and paramilitary markets outside of Israel,
      particularly those operating in Iraq and Afghanistan.




**Battery
      and Power Systems Division**




We
      manufacture and sell lithium and Zinc-Air batteries for defense and security
      products and other military applications and we pioneer advancements in Zinc-Air
      technology for electric vehicles through our Battery and Power Systems
      Division . During
      2005, 2004 and 2003 revenues from our Battery and Power Systems Division were
      approximately $9.9 million, $10.5 million and $5.9 million, respectively (on
      a
      pro forma basis, assuming we had owned all components of our Battery and Power
      Systems Division since January 1, 2003, revenues in 2005, 2004 and 2003 would
      have been approximately $9.9 million, $10.5 million and $10.8 million,
      respectively).




22


***Lithium
      Batteries and Charging Systems for the Military***




*Introduction*




We
      sell
      lithium batteries and charging systems to the military through our subsidiary
      Epsilor Electronic Industries, Ltd., an Israeli corporation established in
      1985
      that we purchased early in 2004.




We
      specialize in the design and manufacture of primary and rechargeable batteries,
      related electronic circuits and associated chargers for military applications.
      We have experience in working with government agencies, the military and large
      corporations. Our technical team has significant expertise in the fields of
      electrochemistry, electronics, software and battery design, production,
      packaging and testing.




We
      have
      opened a lithium battery production and marketing facility at our current Auburn
      premises. The goal is to penetrate the military lithium battery market in the
      United States, and also enable U.S.-produced lithium batteries and chargers
      to
      be sold using funding from the Foreign Military Sales (FMS) program to countries
      such as Israel and Turkey.




*Products*




We
      currently produce over 50 different products in the following
      categories:




Ø
            Primary
                batteries;




Ø
            Rechargeable
                batteries;




Ø
            Smart
                chargers;




Ø
            State
                of charge indicators; and




Ø
            Control
                and monitoring battery circuits




Our
      lithium batteries are based on commercially-available battery cells that we
      purchase from several leading suppliers, with proprietary energy management
      circuitry and software. Our battery packs are designed to withstand harsh
      environments, and have a track record of years of service in armies worldwide.




We
      produce a wide range of primary batteries based on the following chemistries:
      lithium sulfur dioxide, lithium manganese dioxide and alkaline. The
      rechargeable battery chemistries that we employ are: nickel cadmium, nickel
      metal hydride and lithium-ion. We
      manufacture single and multi-channel smart chargers for nickel cadmium, nickel
      metal hydride and lithium-ion batteries.




We
      have
      designed a number of sophisticated state of charge indicators. These are
      employed in our Epsilor products and are also sold as components to other
      battery pack manufacturers. We also develop and manufacture control systems
      for
      high rate primary battery-packs and monitoring systems for rechargeable
      battery-packs.




23


*Markets/Applications*




Our
      target markets for our lithium batteries are military and security entities
      seeking high-end solutions for their power source needs. By their nature, the
      sell-in cycles are long and the resultant entry barriers are high. This is
      due
      to the high cost of developing custom designs and the long period needed to
      qualify any product for military use.




Our
      present customers include:




Ø
            Armed
                forces in the Middle East and Asia;




Ø
            Military
                original equipment manufacturers (OEMs);
                and




Ø
            Various
                battery manufacturers.




*Competition*




The
      main
      competitors for our lithium battery products are Bren-tronics Inc. in the United
      States, which controls much of the U.S. rechargeable market, AEA Battery Systems
      (a wholly owned subsidiary of AEA Technology plc) in the United Kingdom, which
      has the majority of the English military market, and Ultralife Batteries, Inc.
      On the primary end of the market there are a host of players who include the
      cell manufacturers themselves, including Saft S.A. and Ultralife Batteries,
      Inc.




It
      should
      be noted that a number of OEMs, such as Motorola, have internal engineering
      groups that can develop competitive products in-house. Additionally, many of
      our
      competitors have financial, technical, marketing, sales, manufacturing,
      distribution and other resources significantly greater than ours.




*Marketing*




We
      market
      to our existing customers through direct sales. To generate new customers and
      applications, we rely on our working relationship with a selection of OEMs,
      with
      the intent of having these OEMs design our products into their equipment,
      thereby creating a market with a high entry barrier. Another avenue for market
      entry is via strategic relationships with major cell manufacturers.




*Manufacturing*




Our
      battery production lines for military batteries and chargers have been ISO-9001
      certified since 1994. We believe that Epsilor’s 19,000 square foot facility in
      Dimona, Israel has the necessary capabilities and operations to support our
      production cycle.




***Zinc-Air
      Fuel Cells, Batteries and Chargers for the Military***




*Introduction*




We
      base
      our strategy in the field of Zinc-Air military batteries on the development
      and
      commercialization of our Zinc-Air fuel cell technology, as applied in the
      batteries we produce for the U.S. Army’s Communications and Electronics Command
      (CECOM) through our subsidiary Electric Fuel Battery Corporation. We will
      continue to seek new applications for our technology in defense projects,
      wherever synergistic technology and business benefits may exist. We intend
      to
      continue to develop our battery products for defense agencies, and plan to
      sell
      our products either directly to such agencies or through prime contractors.
      We
      will also look to extend our reach to military markets outside the United
      States.




24


Since
      1998 we have received and performed a series of contracts from CECOM to develop
      and evaluate advanced primary Zinc-Air fuel cell packs. Pursuant to these
      contracts, we developed and began selling in 2002 a 12/24 volt, 800 watt-hour
      battery pack for battlefield power, which is based on our Zinc-Air fuel cell
      technology, weighs only six pounds and has approximately twice the energy
      capacity per pound of the U.S. Army’s standard lithium-sulfur dioxide battery
      packs - the BA-8180/U battery.




In
      the
      second half of 2002, our five-year program with CECOM to develop a Zinc-Air
      battery for battlefield power culminated in the assignment of a National Stock
      Number and a $2.5 million delivery order for the newly designated BA-8180/U
      battery. Subsequent to this initial $2.5 million delivery order, we received
      additional follow-on orders from the Army.




Our
      batteries have been used in both Afghanistan (Operation Enduring Freedom) and
      in
      Iraq (Operation Iraqi Freedom). In June of 2004, our BA-8180 Zinc-Air battery
      was recognized by the U.S Army Research, Development and Engineering Command
      as
      one of the top ten inventions of 2003.




Our
      Zinc-Air batteries, rechargeable batteries and battery chargers for the military
      are manufactured through our Electric Fuel Battery Corporation subsidiary.
      In
      2003, our EFB facilities were granted ISO 9001 “Top Quality Standard”
certification.




*Products*




*Zinc-Air
      Power Packs*




BA-8180/U




Electric
      Fuel Zinc-Air power packs are lightweight, low-cost primary Zinc-Air batteries
      with up to twice the energy capacity per pound of primary lithium
      (LiSO 2 )
      battery
      packs, which are the most popular batteries used in the US military today.
      Zinc-Air batteries are inherently safe in storage, transportation, use, and
      disposal.




The
      BA-8180/U is a 12/24 volt, 800 watt-hour battery pack approximately the size
      and
      weight of a notebook computer. The battery is based on a new generation of
      lightweight, 30 ampere-hour cells developed by us over the last five years
      with partial funding by CECOM. Each BA-8180/U battery pack contains 24
      cells.




The
      battery has specific energy of up to 275 Wh/kg, which is substantially higher
      than that of any competing disposable battery available to the defense and
      security industries. By way of comparison, the BA-5590, a popular
      LiSO 2 battery
      pack, has only 175 Wh/kg. Specific energy, or energy capacity per unit of
      weight, translates into longer operating times for battery-powered electronic
      equipment, and greater portability as well. Because of lower cost per watt-hour,
      the BA-8180/U can provide substantial cost savings to the Army when deployed
      for
      longer missions, even for applications that are not man-portable.




25


CECOM
      has
      assigned a National Stock Number (NSN) to our Zinc-Air battery, making it
      possible to order and stock the battery for use by the Armed Forces. CECOM
      also
      assigned the designation BA-8180/U to our Zinc-Air battery, the first time
      an
      official US Army battery designation was ever assigned to a Zinc-Air
      battery.




Based
      on
      extensive contacts with the US and foreign military agencies, we believe that
      a
      significant market exists for the BA-8180/U both in the US Armed Forces and
      abroad.




8140/U


The
      BA-8140/U is a new product that has recently been qualified and that has already
      generated initial sales of over 5,000 batteries from CECOM. The BA-8140/U is
      a
      smaller version of our 8180/U, which we developed at the request of CECOM.
      It is
      approximately half the size, weight and capacity of our 8180/U, and is
      appropriate for smaller hand-held communications devices.




Adapters


The
      BA-8180/U is a battery, but in order to connect it or the 8140/U to a specific
      piece of equipment, an adapter must be used. In order to provide compatibility
      between the battery and various items of military equipment, we supply various
      types of electrical interface adapters for the BA-8180/U and the 8140/U,
      including equipment-specific adapters for the AN/PRC-119 SINCGARS and SINCGARS
      ASIP tactical radio sets, and a generic interface for items of equipment that
      were designed to interface with a BA-5590 or equivalent battery. Each of the
      three interfaces was also assigned a national stock number (NSN) by CECOM.
      In
      addition, we are have recently qualified four more electrical interfaces. These
      address various applications, including other radios, night vision, missile
      launchers and chemical detectors.




Hybrids


We
      have
      also developed interface adapters for other items of equipment which require
      higher power than the BA-8180/U can provide by itself. For example, we have
      developed a hybrid battery system comprising a BA-8180/U battery pack and two
      small rechargeable lead-acid packs. Even with the weight of the lead-acid
      batteries, this hybrid system powers a satellite communications terminal for
      significantly longer than an equivalent weight of BA-5590 LiSO 2 battery
      packs. We have also developed a hybrid system that incorporates ultracapacitors.
      We received our first orders for this man-portable hybrid power source from
      the
      U.S. Army late in 2005.




Forward
      Field Chargers


One
      of
      the initial goals to develop high energy density and power density Zinc-Air
      batteries was to deploy them as forward field chargers. It was envisioned that
      a
      man portable power pack would be required by the dismounted soldier to charge
      the range of rechargeable batteries now proliferating in the military. A high
      efficiency forward field charger has been developed which enables either a
      BB-390/U (NiMH) or a BB-2590/U (Li-ion) to receive multiple charges from a
      single BA-8180/U. We are also in the process of developing a forward field
      charger for the CSEL survival radio.




26


*Other
      Zinc-Air Products*




A
      fourth
      generation of Zinc-Air products is being developed for applications where volume
      is critical, and/or where the power to energy ratio needs to be significantly
      higher than that of the BA-8180/U. These “Gen4” Zinc-Air products consist of an
      air cathode folded around a zinc electrode. Gen4 was originally developed for
      the Marine Corps Dragon Eye UAV, which requires up to 200 W from a battery
      that
      fits into its sleek fuselage and which weighs less than one kilogram. Along
      the
      way, it was recognized that the Gen4 design could be applied to other battery
      missions requiring high power as well as energy density, such as Land Warrior
      and Objective Force Warrior soldier systems, where up to 500 Wh of energy are
      required of a 24 hour battery that must be worn conformably, at minimal weight.
      For these systems the battery currently limits functionality, and Gen4 zinc-air
      may be the enabling technology.  During
      2004 and 2005, we were awarded $1.65 million of congressional funds and CECOM
      funding for the first two phases of a three-phase BAA (Broad Agency
      Announcement, which is a simplified form of government solicitation for basic
      research and development) to develop this technology.




We
      are
      currently under a multi-year program with an Israeli security agency to
      demonstrate the feasibility of Zinc-Air batteries for both unmanned aerial
      vehicles (UAV) and micro-air vehicles (MAV) platforms, respectively. Flights
      have been demonstrated with a 50W, 200Wh/kg battery for a 500g MAV.




*Markets/Applications*




As
      an
      external alternative to the popular lithium based BA-5590/U, the BA-8180 can
      be
      used in many applications operated by the 5590. The BA-8180/U can be used for
      a
      variety of military applications, including:




Ø
            Tactical
                radios




Ø
            SIGINT
                systems




Ø
            Training
                systems




Ø
            SATCOM
                radios




Ø
            Nightscope
                power




Ø
            Guidance
                systems




Ø
            Surveillance
                systems




Ø
            Sensors




*Customers*




The
      principal customers for our Zinc-Air batteries during 2005 were the U.S. Army’s
      Communications-Electronics Command (CECOM) and the Defense Logistics Agency
      (DLA).




*Competition*




The
      BA-8180/U is the only Zinc-Air battery to hold a US Army battery designation.
      It
      does, however, compete with other primary (disposable) batteries, and primarily
      lithium based batteries. In some cases, primarily in training missions, it
      will
      also compete with rechargeable batteries.




27


Zinc-Air
      batteries are inherently safer than primary lithium battery packs in storage,
      transportation, use, and disposal, and are more cost effective. They are
      lightweight, with up to twice the energy capacity per pound of primary lithium
      battery packs. Zinc-Air batteries for the military are also under development
      by
      Rayovac Corporation. Rayovac’s military Zinc-Air batteries utilize cylindrical
      cells, rather than the prismatic cells that we developed. While cylindrical
      cells may provide higher specific power than our prismatic cells, we believe
      they will generally have lower energy densities and be more difficult to
      manufacture.




The
      most
      popular competing primary battery in use by the US Armed Forces is the
      BA-5590/U, which uses lithium-sulfur dioxide (LiSO 2 )
      cells.
      The largest suppliers of LiSO 2 batteries to the US military are believed to be Saft America Inc. and Eagle
      Picher Technologies LLC. The battery compartment of most military communications
      equipment, as well as other military equipment, is designed for the x90 family
      of batteries, of which the BA-5590 battery is the most commonly deployed.
      Another primary battery in this family is the BA-5390, which uses
      lithium-manganese dioxide (LiMnO 2 )
      cells.
      Suppliers of LiMnO 2 batteries include Ultralife Batteries Inc., Saft and Eagle Picher.




Rechargeable
      batteries in the x90 family include lithium-ion and nickel-metal hydride
      batteries which may be used in training missions in order to save the higher
      costs associated with primary batteries. Because of the short usage time per
      charge cycle, rechargeable batteries are not considered suitable for use in
      combat.




Our
      BA-8180 does not fit inside the battery compartment of any military equipment,
      and therefore is connected externally using an interface adapter that we also
      sell to the Army. Our battery offers greatly extended mission time, along with
      lower total mission cost, and these significant advantages often greatly
      outweigh the slight inconvenience of fielding an external battery.




*Manufacturing*




We
      maintain a battery factory for EFB in Auburn, Alabama, where we have leased
      15,000 square feet of light industrial space from the city of Auburn. We also
      have production capabilities for some battery components at the facility of
      EFL
      in Beit Shemesh, Israel. Both the facilities in Auburn and those in Beit Shemesh
      have received ISO 9001 “Top Quality Standard” certification.




***Electric
      Vehicles***




*Introduction*




We
      believe that electric buses represent a particularly important market for
      electric vehicles in the United States. An all-electric, full-size bus powered
      by the Electric Fuel system can provide to transit authorities a full day’s
      operating range for both heavy duty city and suburban routes in all weather
      conditions. We conduct our electric vehicle activities through our subsidiary
      Electric Fuel Ltd.




At
      this
      time the technical activity on our Electric Vehicle program is on hold while
      we
      seek funding to introduce this technology commercially.




28


*The
      Electric Fuel Zinc-Air Energy System for Electric Vehicles*




The
      Electric Fuel Zinc-Air Energy System consists of:




Ø
            an
                in-vehicle, Zinc-Air fuel cell unit consisting of a series of Zinc-Air
                cells and refuelable zinc-fuel anode cassettes using
                commercially-available zinc;




Ø
            a
                battery exchange unit for fast vehicle turn-around that is equivalent
                to
                the time needed to refuel a diesel bus;




Ø
            an
                automated battery refueling system for mechanically replacing depleted
                zinc-fuel cassettes with charged cassettes;
                and




Ø
            a
                regeneration system for electrochemical recycling and mechanical
                repacking
                of the discharged fuel cassettes.




With
      its
      proprietary high-power air cathode and zinc anode technologies, our Zinc-Air
      fuel cell delivers a unique combination of high-energy density and high-power
      density, which together power electric vehicles with speed, acceleration,
      driving range and driver convenience similar to that of conventionally powered
      vehicles.




*The
      Department of Transportation-Federal Transit Administration Zinc-Air All
      Electric Transit Bus Program*




In
      the
      United States, our Zinc-Air technology is the focus of a Zinc-Air All Electric
      Bus demonstration program the costs and expenditures of which are 50% offset
      by
      subcontracting fees paid by the U.S. Department of Transportation’s Federal
      Transit Administration (FTA). The test program is designed to prove that an
      all-electric bus can meet these and all other Los Angeles and New York Municipal
      Transit Authority mass transit requirements including requirements relating
      to
      performance, speed, acceleration and hill climbing.




Phase
      IV
      of the program, which we began in October 2003 and which ended in 2005, was
      a
      $1.5 million cost-shared program (half of which was funded by the FTA and the
      remainder by the program partners, including us) that explored steps necessary
      for commercializing the all-electric zinc-air/ultracapacitor hybrid bus. It
      focused on continued optimization of the propulsion system developed in previous
      phases, on additional vehicle and system testing, including testing alternative
      advanced auxiliary battery technologies, and on evaluating alternative zinc
      anodes, which are more commercially available in North America.




*Competition*




We
      believe that our products must be available at a price that is competitive
      with
      alternative technologies, particularly those intended for use in zero or
      low-emission vehicles. Besides other battery technologies, these include
      hydrogen fuel cells, “hybrid systems” that combine an internal combustion engine
      and battery technologies, and use of regular or low-pollution fuels such as
      gasoline, diesel, compressed natural gas, liquefied natural gas, ethanol and
      methanol. Other alternative technologies presently use costly components,
      including use of flywheels and catalytic removal of pollutants. These various
      technologies are at differing stages of development and any one of them, or
      a
      new technology, may prove to be more cost effective, or otherwise more readily
      acceptable by consumers, than the Electric Fuel Zinc-Air Energy System for
      electric vehicles. In addition, the California Air Resource Board has expressed
      to us concerns about the costs associated with the Zinc-Air regeneration
      infrastructure as compared to battery technologies that use electrical
      recharging.




29


***Lifejacket
      Lights***




Products




In
      1996,
      we began to produce and market lifejacket lights built with our patented
      magnesium-cuprous chloride batteries, which are activated by immersion in water
      (water-activated batteries), for the aviation and marine safety and emergency
      markets. Additionally, in 2004 we added two new models to our line of lifejacket
      light, based on lithium batteries. At present we have a product line consisting
      of seven lifejacket light models, five for use with marine life jackets and
      two
      for use with aviation life vests, all of which work in both freshwater and
      seawater. Each of our lifejacket lights is certified for use by relevant
      governmental agencies under various U.S. and international regulations. We
      manufacture, assemble and package all our lifejacket lights through EFL in
      our
      factory in Beit Shemesh, Israel.




*Marketing*




We
      market
      our marine safety products through our own network of distributors in Europe,
      the United States, Asia and Oceania. We market our lights to the commercial
      aviation industry through The Burkett Company of Houston, Texas, which receives
      a commission on sales.




*Competition*




Two
      of
      the largest manufacturers of aviation and marine safety products, including
      TSO
      and SOLAS-approved lifejacket lights, are ACR Electronics Inc. of Hollywood,
      Florida, and Pains Wessex McMurdo Ltd. of England. Other significant competitors
      in the marine market include Daniamant Aps of Denmark, and SIC of
      Italy.




**Backlog**




We
      generally sell our products under standard purchase orders. Orders constituting
      our backlog are subject to changes in delivery schedules and are typically
      cancelable by our customers until a specified time prior to the scheduled
      delivery date. Accordingly, our backlog is not necessarily an accurate
      indication of future sales. As of December 31, 2005 and 2004, our backlog for
      the following years was approximately $18.3 million and $25.0 million,
      respectively, divided among our divisions as follows:




**Division**
            
            **2005**
            
            **2004**Simulation
                and Training Division
            
            $
            9,379,000
            
            $
            12,691,000Battery
                and Power Systems Division
            
            
            4,523,000
            
            
            8,325,000Armor
                Division
            
            
            4,440,000
            
            
            4,002,000**TOTAL:**
            
            $
            18,342,000
            
            $
            25,018,000




**Major
      Customers**




During
      2005, including all of our divisions, various branches of the United States
      military accounted for approximately 33% of our revenues.




30


**Patents
      and Trade Secrets**




We
      rely
      on certain proprietary technology and seek to protect our interests through
      a
      combination of patents, trademarks, copyrights, know-how, trade secrets and
      security measures, including confidentiality agreements. Our policy generally
      is
      to secure protection for significant innovations to the fullest extent
      practicable. Further, we seek to expand and improve the technological base
      and
      individual features of our products through ongoing research and development
      programs.




We
      rely
      on the laws of unfair competition and trade secrets to protect our proprietary
      rights. We attempt to protect our trade secrets and other proprietary
      information through confidentiality and non-disclosure agreements with
      customers, suppliers, employees and consultants, and through other security
      measures. However, we may be unable to detect the unauthorized use of, or take
      appropriate steps to enforce our intellectual property rights. Effective trade
      secret protection may not be available in every country in which we offer or
      intend to offer our products and services to the same extent as in the United
      States. Failure to adequately protect our intellectual property could harm
      or
      even destroy our brands and impair our ability to compete effectively. Further,
      enforcing our intellectual property rights could result in the expenditure
      of
      significant financial and managerial resources and may not prove successful.
      Although we intend to protect our rights vigorously, there can be no assurance
      that these measures will be successful.




**Research
      and Development**




During
      the years ended December 31, 2005, 2004 and 2003, our gross research and product
      development expenditures were approximately $1.3 million, $1.7 million and
      $1.1
      million, respectively, including research and development in discontinued
      operations. During these periods, the Office of the Chief Scientist of the
      Israel Ministry of Industry and Trade (the “Chief Scientist”) participated in
      our research and development efforts relating to our consumer battery business,
      thereby reducing our gross research and product development expenditures in
      the
      amounts of approximately $0, $0 and $26,000 for the years 2005, 2004 and 2003,
      respectively.




EFL
      has
      certain contingent royalty obligations to Chief Scientist and the Israel-U.S.
      Binational Industrial Research and Development Foundation (BIRD, which apply
      (in
      respect of continuing operations) only to our Electric Vehicle program. As
      of
      December 31, 2005, our total outstanding contingent liability in this connection
      was approximately $11.0 million.




**Employees**




As
      of
      February 28, 2006, we had 277 full-time employees worldwide. Of these employees,
      4 hold doctoral degrees and 21 hold other advanced degrees. Of the total, 70
      employees were engaged in product research and development, 132 were engaged
      in
      production and operations, 17 were engaged in marketing and sales, and 58 were
      engaged in general and administrative functions. Our success will depend in
      large part on our ability to attract and retain skilled and experienced
      employees.




We
      and
      our employees are not parties to any collective bargaining agreements. However,
      as certain of our employees are located in Israel and employed by EFL, MDT
      or
      Epsilor, certain provisions of the collective bargaining agreements between
      the
      Histadrut (General Federation of Labor in Israel) and the Coordination Bureau
      of
      Economic Organizations (including the Manufacturers’ Association of Israel) are
      applicable to EFL’s, MDT’s and Epsilor’s employees by order (the “Extension
      Order”) of the Israeli Ministry of Labor and Welfare. These provisions
      principally concern the length of the work day and the work week, minimum wages
      for workers, contributions to a pension fund, insurance for work-related
      accidents, procedures for dismissing employees, determination of severance
      pay
      and other conditions of employment, including certain automatic salary
      adjustments based on changes in the Israeli CPI.




31


Israeli
      law generally requires severance pay upon the retirement or death of an employee
      or termination of employment without due cause; additionally, some of our senior
      employees have special severance arrangements, certain of which are described
      under “Item 11. Executive Compensation - Employment Contracts,” below. We
      currently fund our ongoing severance obligations by making monthly payments
      to
      approved severance funds or insurance policies. In addition, Israeli employees
      and employers are required to pay specified sums to the National Insurance
      Institute, which is similar to the United States Social Security Administration.
      Since January 1, 1995, such amounts also include payments for national health
      insurance. The payments to the National Insurance Institute are approximately
      15.6% of wages, of which the employee contributes approximately 62% and the
      employer contributes approximately 38%. The majority of the permanent employees
      of EFL, about a quarter of the permanent employees of MDT, and one of the
      permanent employees of Epsilor, are covered by “managers’ insurance,” which
      provides life and pension insurance coverage with customary benefits to
      employees, including retirement and severance benefits. We contribute 14.33%
      to
      15.83% (depending on the employee) of base wages to such plans and the permanent
      employees contribute 5% of their base wages.




In
      1993,
      an Israeli court held that companies that are subject to the Extension Order
      are
      required to make pension contributions exclusively through contributions to
      Mivtachim Social Institute of Employees Ltd., a pension fund managed by the
      Histadrut. We subsequently reached an agreement with Mivtachim with respect
      to
      providing coverage to certain production employees and bringing ourselves into
      conformity with the court decision. The agreement does not materially increase
      our pension costs or otherwise materially adversely affect its operations.
      Mivtachim has agreed not to assert any claim against us with respect to any
      of
      our past practices relating to this matter. Although the arrangement does not
      bind employees with respect to instituting claims relating to any nonconformity
      by us, we believe that the likelihood of the assertion of claims by employees
      is
      low and that any potential claims by employees against us, if successful, would
      not result in any material liability to us.




**ITEM
      1A.**  **RISK
      FACTORS**




The
      following factors, among others, could cause actual results to differ materially
      from those contained in forward-looking statements made in this Report and
      presented elsewhere by management from time to time.




**Business-Related
      Risks**




***We
      have had a history of losses and may incur future
      losses.***




We
      were
      incorporated in 1990 and began our operations in 1991. We have funded our
      operations principally from funds raised in each of the initial public offering
      of our common stock in February 1994; through subsequent public and private
      offerings of our common stock and equity and debt securities convertible or
      exercisable into shares of our common stock; research contracts and supply
      contracts; funds received under research and development grants from the
      Government of Israel; and sales of products that we and our subsidiaries
      manufacture. We have incurred significant net losses since our inception.
      Additionally, as of December 31, 2005, we had an accumulated deficit of
      approximately $143.0 million. In an effort to reduce operating expenses and
      maximize available resources, we intend to consolidate certain of our
      subsidiaries, shift personnel and reassign responsibilities. We have also
      substantially reduced certain senior employee salaries during 2005, cut
      directors’ fees, and taken a variety of other measures to limit spending and
      will continue to assess our internal processes to seek additional cost-structure
      improvements. Although we believe that such steps will help to reduce our
      operating expenses and maximize our available resources, there can be no
      assurance that we will ever be able to achieve or maintain profitability
      consistently or that our business will continue to exist.




32


***Our
      existing indebtedness may adversely affect our ability to obtain additional
      funds and may increase our vulnerability to economic or business
      downturns.***




Our
      bank
      and certificated indebtedness (short and long term) aggregated approximately
      $24.2 million principal amount as of December 31, 2005 (not including trade
      payables, other account payables and accrued severance pay), of which $13.3
      million is due in 2006 (not including $2.0 million short-term bank credit).
      In
      addition, we may incur additional indebtedness in the future. Accordingly,
      we
      are subject to the risks associated with significant indebtedness,
      including:




·
            we
                must dedicate a portion of our cash flows from operations to pay
                principal
                and interest and, as a result, we may have less funds available for
                operations and other purposes;




·
            it
                may be more difficult and expensive to obtain additional funds through
                financings, if available at all;




·
            we
                are more vulnerable to economic downturns and fluctuations in interest
                rates, less able to withstand competitive pressures and less flexible
                in
                reacting to changes in our industry and general economic conditions;
                and




·
            if
                we default under any of our existing debt instruments, including
                paying
                the outstanding principal when due, and if our creditors demand payment
                of
                a portion or all of our indebtedness, we may not have sufficient
                funds to
                make such payments.




The
      occurrence of any of these events could materially adversely affect our results
      of operations and financial condition and adversely affect our stock
      price.




The
      agreements governing the terms of our debentures and notes contain numerous
      affirmative and negative covenants that limit the discretion of our management
      with respect to certain business matters and place restrictions on us, including
      obligations on our part to preserve and maintain our assets and restrictions
      on
      our ability to incur or guarantee debt, to merge with or sell our assets to
      another company, and to make significant capital expenditures without the
      consent of the debenture holders. Our ability to comply with these and other
      provisions of such agreements may be affected by changes in economic or business
      conditions or other events beyond our control.




33


***Failure
      to comply with the terms of our indebtedness could result in a default that
      could have material adverse consequences for us.***




A
      failure
      to comply with the obligations contained in the agreements governing our
      indebtedness could result in an event of default under such agreements which
      could result in an acceleration of the debentures and notes and the acceleration
      of debt under other instruments evidencing indebtedness that may contain
      cross-acceleration or cross-default provisions. If the indebtedness under the
      debentures, notes or other indebtedness were to be accelerated, there can be
      no
      assurance that our future cash flow or assets would be sufficient to repay
      in
      full such indebtedness.




***We
      may not generate sufficient cash flow to service all of our debt
      obligations.***




Our
      ability to make payments on and to refinance our indebtedness and to fund our
      operations depends on our ability to generate cash in the future. Our future
      operating performance is subject to market conditions and business factors
      that
      are beyond our control. Consequently, we cannot assure you that we will generate
      sufficient cash flow to pay the principal and interest on our debt. If our
      cash
      flows and capital resources are insufficient to allow us to make scheduled
      payments on our debt, we may have to reduce or delay capital expenditures,
      sell
      assets, seek additional capital or restructure or refinance our debt. We cannot
      assure you that the terms of our debt will allow for these alternative measures
      or that such measures would satisfy our scheduled debt service obligations.
      In
      addition, in the event that we are required to dispose of material assets or
      restructure or refinance our debt to meet our debt obligations, we cannot assure
      you as to the terms of any such transaction or how quickly such transaction
      could be completed. Our ability to refinance our indebtedness or obtain
      additional financing will depend on, among other things:




·
            our
                financial condition at the time;




·
            restrictions
                in the agreements governing our other indebtedness;
                and




·
            other
                factors, including the condition of the financial markets and our
                industry.




***We
      need significant amounts of capital to operate and grow our business and to
      pay
      our debt.***




We
      require substantial funds to operate our business, including to market our
      products and develop and market new products and to pay our outstanding debt
      as
      it comes due. To the extent that we are unable to fully fund our operations,
      including repaying our outstanding debt, through profitable sales of our
      products and services, we will need to seek additional funding, including
      through the issuance of equity or debt securities. In addition, based on our
      internal forecasts, the assumptions described under “Liquidity and Capital
      Resources” above, and subject to the other risk factors described herein, we
      believe that our present cash position and anticipated cash flows from
      operations, lines of credit and anticipated additions to paid-in capital should
      be sufficient to satisfy our current estimated cash requirements through the
      next twelve months. However, in the event our internal forecasts and other
      assumptions regarding our liquidity prove to be incorrect, we may need to seek
      additional funding. There can be no assurance that we will obtain any such
      additional financing in a timely manner, on acceptable terms, or at all.
      Moreover, the issuance by us of additional debt or equity is severely restricted
      by the terms of our existing indebtedness. If additional funds are raised by
      issuing equity securities or convertible debt securities, stockholders may
      incur
      further dilution. If we incur additional indebtedness, we may be subject to
      affirmative and negative covenants that may restrict our ability to operate
      or
      finance our business. If additional funding is not secured, we will have to
      modify, reduce, defer or eliminate parts of our present and anticipated future
      commitments and/or programs.




34


***The
      payment by us of our secured convertible notes in stock or the conversion of
      such notes by the holders could result in substantial numbers of additional
      shares being issued, with the number of such shares increasing if and to the
      extent our market price declines, diluting the ownership percentage of our
      existing stockholders.***




In
      September 2005, we issued $17.5 million in secured convertible notes due March
      31, 2008. The Notes are convertible at the option of the holders at a fixed
      conversion price of $1.00. We will repay the principal amount of the notes
      over
      the next two and one-half years, with the principal amount being amortized
      in
      twelve payments payable at our option in cash and/or stock, by requiring the
      holders to convert a portion of their Notes into shares of our common stock,
      provided certain conditions are met. The failure to meet such conditions could
      make us unable to pay our notes, causing us to default. If the price of our
      common stock is above $1.00, the holders of our notes will presumably convert
      their notes to stock when payments are due, or before, resulting in the issuance
      of additional shares of our common stock.




We
      made
      the first two scheduled repayments of principal on our Notes in stock by
      requiring the holders to convert a portion of their Notes. In the event we
      continue to elect to make payments of principal on our convertible notes in
      stock by requiring the holders to convert a portion of their Notes, either
      because our cash position at the time makes it necessary or we otherwise deem
      it
      advisable, the price used to determine the number of shares to be issued on
      conversion will be calculated using an 8% discount to the average trading price
      of our common stock during 17 of the 20 consecutive trading days ending two
      days
      before the payment date. Accordingly, the lower the market price of our common
      stock at the time at which we make payments of principal in stock, the greater
      the number of shares we will be obliged to issue and the greater the dilution
      to
      our existing stockholders.




In
      either
      case, the issuance of the additional shares of our common stock could adversely
      affect the market price of our common stock.




We
      can
      require the holder of our Notes to convert a portion of their Notes into shares
      of our common stock at the time principal payments are due only if such shares
      are registered for resale and certain other conditions are met. Based on the
      current price of our stock, we do not have a sufficient number of shares of
      our
      stock registered for resale in order to continue requiring the holders to
      convert a portion of their Notes past a portion of the payment due May 31,
      2006.
      We would accordingly have to file a registration statement with the SEC to
      register for resale more shares of our common stock in order to continue
      requiring conversion of our Notes upon principal payment becoming due. Any
      delay
      in the registration process, including through routine SEC review of our
      registration statement or other filings with the SEC, could result in our having
      to pay scheduled principal repayments on our Notes in cash, which would
      negatively impact our cash position and, if we do not have sufficient cash
      to
      make such payments in cash, could cause us to default on our Notes.




35


***We
      have pledged a substantial portion of our assets to secure our borrowings.***




Our
      debentures and notes are secured by a substantial portion of our assets. If
      we
      default under the indebtedness secured by our assets, those assets would be
      available to the secured creditors to satisfy our obligations to the secured
      creditors, which could materially adversely affect our results of operations
      and
      financial condition and adversely affect our stock price.




***Any
      inability to continue to make use from time to time of our subsidiaries’ current
      working capital lines of credit could have an adverse effect on our ability
      to
      do business.***




From
      time
      to time our working capital needs are partially dependent on our subsidiaries’
lines of credit, which are themselves dependent upon our subsidiaries’ inventory
      and receivables. In the event that we are unable to continue to make use of
      our
      subsidiaries’ lines of credit for working capital on economically feasible
      terms, including because of any diminution in our subsidiaries’ inventory and
      receivables, our business, operating results and financial condition could
      be
      adversely affected.




***We
      may not be successful in operating new businesses.***




Prior
      to
      the acquisitions of IES and MDT in 2002 and the acquisitions of FAAC and Epsilor
      in January 2004 and AoA in August 2004, our primary business was the marketing
      and sale of products based on primary and refuelable Zinc-Air fuel cell
      technology and advancements in battery technology for defense and security
      products and other military applications, electric vehicles and consumer
      electronics. As a result of our acquisitions, a substantial component of our
      business is the marketing and sale of high-tech multimedia and interactive
      training solutions and **** sophisticated
      lightweight materials and advanced engineering processes used to armor vehicles.
      These are relatively new businesses for us and our management group has limited
      experience operating these types of businesses. Although we have retained our
      acquired companies’ management personnel, we cannot assure that such personnel
      will continue to work for us or that we will be successful in managing these
      new
      businesses. If we are unable to successfully operate these new businesses,
      our
      business, financial condition and results of operations could be materially
      impaired.




***Our
      earnings will decline if we write off additional goodwill and other intangible
      assets.***




As
      of
      December 31, 2004, we had recorded goodwill of $39.7 million. On January 1,
      2002, we adopted SFAS No. 142, “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 our 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. We performed the required annual impairment
      test of goodwill, based on our projections and using expected future discounted
      operating cash flows. As of December 31, 2005, we identified in AoA an
      impairment of goodwill in the amount of $11.8 million.




36


Our
      and
      our 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,” 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, we identified
      an
      impairment of other intangible assets identified with the IES acquisition
      and, as a result, we recorded an impairment loss in the amount of $320,000.
      As
      of December 31, 2005, we identified an impairment of other intangible
      assets identified with the AoA acquisition and, as a result, we recorded an
      impairment loss in the amount of $499,000.




We
      will
      continue to assess the fair value of our goodwill annually or earlier if events
      occur or circumstances change that would more likely than not reduce the fair
      value of our goodwill below its carrying value. These events or circumstances
      would include a significant change in business climate, including a significant,
      sustained decline in an entity's market value, legal factors, operating
      performance indicators, competition, sale or disposition of a significant
      portion of the business, or other factors. If we determine that significant impairment has
      occurred, we would be required to write off the impaired portion of goodwill. Impairment charges
      could have a material adverse effect on our financial condition and
      results.




***Failure
      to comply with the earnout provisions of our acquisition agreements could have
      material adverse consequences for us.***




A
      failure
      to comply with the obligations contained in our acquisition agreements to make
      the earnout payments required under such agreements as ultimately determined
      in
      arbitration or litigation could result in actions for damages, a possible right
      of rescission on the part of the sellers, and the acceleration of debt under
      instruments evidencing indebtedness that may contain cross-acceleration or
      cross-default provisions. If we are unable to raise capital in order to pay
      the
      earnout provisions of our acquisition agreements, there can be no assurance
      that
      our future cash flow or assets would be sufficient to pay such
      obligations.




In
      this
      connection, we note that we have received preliminary indications that there
      may
      be a dispute regarding the amount that we owe the former shareholders of FAAC
      Incorporated in respect of their earnout for 2005. Pursuant to the purchase
      agreement and a side letter, we are 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 to an additional amount of $3.5 million. We have taken 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, and that we
      therefore owe an additional amount of only $604,000. If this issue is ultimately
      decided in favor of the former shareholders of FAAC, the need to pay additional
      earnout sums to them could have a material adverse effect on our cash flows
      and
      financial condition.




37


***We
      may consider acquisitions in the future to grow our business, and such activity
      could subject us to various risks.***




We
      may
      consider acquiring companies that will complement our existing operations or
      provide us with an entry into markets we do not currently serve. Growth through
      acquisitions involves substantial risks, including the risk of improper
      valuation of the acquired business and the risk of inadequate integration.
      There
      can be no assurance that suitable acquisition candidates will be available,
      that
      we will be able to acquire or manage profitably such additional companies or
      that future acquisitions will produce returns that justify our investments
      in
      such companies. In addition, we may compete for acquisition and expansion
      opportunities with companies that have significantly greater resources than
      we
      do. Furthermore, acquisitions could disrupt our ongoing business, distract
      the
      attention of our senior officers, increase our expenses, make it difficult
      to
      maintain our operational standards, controls and procedures and subject us
      to
      contingent and latent risks that are different, in nature and magnitude, than
      the risks we currently face.




We
      may
      finance future acquisitions with cash from operations or additional debt or
      equity financings. There can be no assurance that we will be able to generate
      internal cash or obtain financing from external sources or that, if available,
      such financing will be on terms acceptable to us. The issuance of additional
      common stock to finance acquisitions may result in substantial dilution to
      our
      stockholders. Any debt financing may significantly increase our leverage and
      may
      involve restrictive covenants which limit our operations.




***We
      may not successfully integrate our prior
      acquisitions.***




In
      light
      of our acquisitions of IES, MDT, FAAC, Epsilor and AoA, our success will depend
      in part on our ability to manage the combined operations of these companies
      and
      to integrate the operations and personnel of these companies along with our
      other subsidiaries and divisions into a single organizational structure, and
      to
      replace those subsidiary managers who have left or may in the future leave
      our
      employ. There can be no assurance that we will be able to effectively integrate
      the operations of our subsidiaries and divisions and our acquired businesses
      into a single organizational structure. Integration of these operations could
      also place additional pressures on our management as well as on our key
      technical resources. The failure to successfully manage this integration could
      have an adverse material effect on us.




If
      we are
      successful in acquiring additional businesses, we may experience a period of
      rapid growth that could place significant additional demands on, and require
      us
      to expand, our management, resources and management information systems. Our
      failure to manage any such rapid growth effectively could have a material
      adverse effect on our financial condition, results of operations and cash
      flows.




***If
      we are unable to manage our growth, our operating results will be
      impaired.***




As
      a
      result of our acquisitions, we are currently experiencing a period of
      significant growth and development activity which has placed a significant
      strain on our personnel and resources. Our activity has resulted in increased
      levels of responsibility for both existing and new management personnel. Many
      of
      our management personnel have had limited or no experience in managing growing
      companies. We have sought to manage our current and anticipated growth through
      the recruitment of additional management and technical personnel and the
      implementation of internal systems and controls. However, our failure to manage
      growth effectively could adversely affect our results of
      operations.




38


***A
      significant portion of our business is dependent on government contracts and
      reduction or reallocation of defense or law enforcement spending could reduce
      our revenues.***




Many
      of
      the customers of IES, FAAC and AoA to date have been in the public sector of
      the
      U.S., including the federal, state and local governments, and in the public
      sectors of a number of other countries, and most of MDT’s customers have been in
      the public sector in Israel, in particular the Ministry of Defense.
      Additionally, all of EFB’s sales to date of battery products for the military
      and defense sectors have been in the public sector in the United States. A
      significant decrease in the overall level or allocation of defense or law
      enforcement spending in the U.S. or other countries could reduce our revenues
      and have a material adverse effect on our future results of operations and
      financial condition.




Sales
      to
      public sector customers are subject to a multiplicity of detailed regulatory
      requirements and public policies as well as to changes in training and
      purchasing priorities. Contracts with public sector customers may be conditioned
      upon the continuing availability of public funds, which in turn depends upon
      lengthy and complex budgetary procedures, and may be subject to certain pricing
      constraints. Moreover, U.S. government contracts and those of many international
      government customers may generally be terminated for a variety of factors when
      it is in the best interests of the government and contractors may be suspended
      or debarred for misconduct at the discretion of the government. There can be
      no
      assurance that these factors or others unique to government contracts or the
      loss or suspension of necessary regulatory licenses will not reduce our revenues
      and have a material adverse effect on our future results of operations and
      financial condition.




***Our
      U.S. government contracts may be terminated at any time and may contain other
      unfavorable provisions.***




The
      U.S.
      government typically can terminate or modify any of its contracts with us either
      for its convenience or if we default by failing to perform under the terms
      of
      the applicable contract. A termination arising out of our default could expose
      us to liability and have a material adverse effect on our ability to re-compete
      for future contracts and orders. Our U.S. government contracts contain
      provisions that allow the U.S. government to unilaterally suspend us from
      receiving new contracts pending resolution of alleged violations of procurement
      laws or regulations, reduce the value of existing contracts, issue modifications
      to a contract and control and potentially prohibit the export of our products,
      services and associated materials.




Government
      agencies routinely audit government contracts. These agencies review a
      contractor's performance on its contract, pricing practices, cost structure
      and
      compliance with applicable laws, regulations and standards. If we are audited,
      we will not be reimbursed for any costs found to be improperly allocated to
      a
      specific contract, while we would be required to refund any improper costs
      for
      which we had already been reimbursed. Therefore, an audit could result in a
      substantial adjustment to our revenues. If a government audit uncovers improper
      or illegal activities, we may be subject to civil and criminal penalties and
      administrative sanctions, including termination of contracts, forfeitures of
      profits, suspension of payments, fines and suspension or debarment from doing
      business with United States government agencies. We could suffer serious
      reputational harm if allegations of impropriety were made against us. A
      governmental determination of impropriety or illegality, or an allegation of
      impropriety, could have a material adverse effect on our business, financial
      condition or results of operations.




39


***We
      may be liable for penalties under a variety of procurement rules and
      regulations, and changes in government regulations could adversely impact our
      revenues, operating expenses and profitability.***




Our
      defense and commercial businesses must comply with and are affected by various
      government regulations that impact our operating costs, profit margins and
      our
      internal organization and operation of our businesses. Among the most
      significant regulations are the following:




·
            the
                U.S. Federal Acquisition Regulations, which regulate the formation,
                administration and performance of government contracts;




·
            the
                U.S. Truth in Negotiations Act, which requires certification and
                disclosure of all cost and pricing data in connection with contract
                negotiations; and




·
            the
                U.S. Cost Accounting Standards, which impose accounting requirements
                that
                govern our right to reimbursement under certain cost-based government
                contracts.




These
      regulations affect how we and our customers do business and, in some instances,
      impose added costs on our businesses. Any changes in applicable laws could
      adversely affect the financial performance of the business affected by the
      changed regulations. With respect to U.S. government contracts, any failure
      to
      comply with applicable laws could result in contract termination, price or
      fee
      reductions or suspension or debarment from contracting with the U.S.
      government.




***Our
      operating margins may decline under our fixed-price contracts if we fail to
      estimate accurately the time and resources necessary to satisfy our
      obligations.***




Some
      of
      our contracts are fixed-price contracts under which we bear the risk of any
      cost
      overruns. Our profits are adversely affected if our costs under these contracts
      exceed the assumptions that we used in bidding for the contract. Often, we
      are
      required to fix the price for a contract before we finalize the project
      specifications, which increases the risk that we will mis-price these contracts.
      The complexity of many of our engagements makes accurately estimating our time
      and resources more difficult. In the event we fail to estimate our time and
      resources accurately, our expenses will increase and our profitability, if
      any,
      under such contracts will decrease.




***If
      we are unable to retain our contracts with the U.S. government and subcontracts
      under U.S. government prime contracts in the competitive rebidding process,
      our
      revenues may suffer.***




Upon
      expiration of a U.S. government contract or subcontract under a U.S. government
      prime contract, if the government customer requires further services of the
      type
      provided in the contract, there is frequently a competitive rebidding process.
      We cannot guarantee that we, or if we are a subcontractor that the prime
      contractor, will win any particular bid, or that we will be able to replace
      business lost upon expiration or completion of a contract. Further, all U.S.
      government contracts are subject to protest by competitors. The termination
      of
      several of our significant contracts or nonrenewal of several of our significant
      contracts, could result in significant revenue shortfalls.




40


***The
      loss of, or a significant reduction in, U.S. military business would have a
      material adverse effect on us.***




U.S.
      military contracts account for a significant portion of our business. The U.S.
      military funds these contracts in annual increments. These contracts require
      subsequent authorization and appropriation that may not occur or that may be
      greater than or less than the total amount of the contract. Changes in the
      U.S.
      military’s budget, spending allocations and the timing of such spending could
      adversely affect our ability to receive future contracts. None of our contracts
      with the U.S. military has a minimum purchase commitment, and the U.S. military
      generally has the right to cancel its contracts unilaterally without prior
      notice. We manufacture for the U.S. aircraft and land vehicle armor systems,
      protective equipment for military personnel and other technologies used to
      protect soldiers in a variety of life-threatening or catastrophic situations,
      and batteries for communications devices. The loss of, or a significant
      reduction in, U.S. military business for our aircraft and land vehicle armor
      systems, other protective equipment, or batteries could have a material adverse
      effect on our business, financial condition, results of operations and
      liquidity.




***A
      reduction of U.S. force levels in Iraq may affect our results of operations.***




Since
      the
      invasion of Iraq by the U.S. and other forces in March 2003, we have received
      orders from the U.S. military for armoring of vehicles and military batteries.
      These orders are the result, in substantial part, of the particular combat
      situations encountered by the U.S. military in Iraq. We cannot be certain to
      what degree the U.S. military would continue placing orders for our products
      if
      the U.S. military were to reduce its force levels or withdraw completely from
      Iraq. A significant reduction in orders from the U.S. military could have a
      material adverse effect on our business, financial condition, results of
      operations and liquidity.




***There
      are limited sources for some of our raw materials, which may significantly
      curtail our manufacturing operations.***




The
      raw
      materials that we use in manufacturing our armor products include
      Kevlar ® ,
      a
      patented product of E.I. du Pont de Nemours Co., Inc. We purchase Kevlar in
      the
      form of woven cloth from various independent weaving companies. In the event
      Du
      Pont and/or these independent weaving companies were to cease, for any reason,
      to produce or sell Kevlar to us, we might be unable to replace it with a
      material of like weight and strength, or at all. Thus, if our supply of Kevlar
      were materially reduced or cut off or if there were a material increase in
      the
      price of Kevlar, our manufacturing operations could be adversely affected and
      our costs increased, and our business, financial condition and results of
      operations could be materially adversely affected.




41


***Some
      of the components of our products pose potential safety risks which could create
      potential liability exposure for us.***




Some
      of
      the components of our products contain elements that are known to pose potential
      safety risks. In addition to these risks, there can be no assurance that
      accidents in our facilities will not occur. Any accident, whether occasioned
      by
      the use of all or any part of our products or technology or by our manufacturing
      operations, could adversely affect commercial acceptance of our products and
      could result in significant production delays or claims for damages resulting
      from injuries. Any of these occurrences would materially adversely affect our
      operations and financial condition. In the event that our products, including
      the products manufactured by MDT and AoA, fail to perform as specified, users
      of
      these products may assert claims for substantial amounts. These claims could
      have a materially adverse effect on our financial condition and results of
      operations. There is no assurance that the amount of the general product
      liability insurance that we maintain will be sufficient to cover potential
      claims or that the present amount of insurance can be maintained at the present
      level of cost, or at all.




***Our
      fields of business are highly competitive.***




The
      competition to develop defense and security products and electric vehicle
      battery systems, and to obtain funding for the development of these products,
      is, and is expected to remain, intense.




Our
      defense and security products compete with other manufacturers of specialized
      training systems, including Firearms Training Systems, Inc., a producer of
      interactive simulation systems designed to provide training in the handling
      and
      use of small and supporting arms. In addition, we compete with manufacturers
      and
      developers of armor for cars and vans, including O’Gara-Hess & Eisenhardt, a
      division of Armor Holdings, Inc.




Our
      battery technology competes with other battery technologies, as well as other
      Zinc-Air technologies. The competition in this area of our business consists
      of
      development stage companies, major international companies and consortia of
      such
      companies, including battery manufacturers, automobile manufacturers, energy
      production and transportation companies, consumer goods companies and defense
      contractors.




Various
      battery technologies are being considered for use in electric vehicles and
      defense and safety products by other manufacturers and developers, including
      the
      following: lead-acid, nickel-cadmium, nickel-iron, nickel-zinc, nickel-metal
      hydride, sodium-sulfur, sodium-nickel chloride, zinc-bromine, lithium-ion,
      lithium-polymer, lithium-iron sulfide, primary lithium, rechargeable alkaline
      and Zinc-Air.




Many
      of
      our competitors have financial, technical, marketing, sales, manufacturing,
      distribution and other resources significantly greater than ours. If we are
      unable to compete successfully in each of our operating areas, especially in
      the
      defense and security products area of our business, our business and results
      of
      operations could be materially adversely affected.




42


***Our
      business is dependent on proprietary rights that may be difficult to protect
      and
      could affect our ability to compete effectively.***




Our
      ability to compete effectively will depend on our ability to maintain the
      proprietary nature of our technology and manufacturing processes through a
      combination of patent and trade secret protection, non-disclosure agreements
      and
      licensing arrangements.




Litigation,
      or participation in administrative proceedings, may be necessary to protect
      our
      proprietary rights. This type of litigation can be costly and time consuming
      and
      could divert company resources and management attention to defend our rights,
      and this could harm us even if we were to be successful in the litigation.
      In
      the absence of patent protection, and despite our reliance upon our proprietary
      confidential information, our competitors may be able to use innovations similar
      to those used by us to design and manufacture products directly competitive
      with
      our products. In addition, no assurance can be given that others will not obtain
      patents that we will need to license or design around. To the extent any of
      our
      products are covered by third-party patents, we could need to acquire a license
      under such patents to develop and market our products.




Despite
      our efforts to safeguard and maintain our proprietary rights, we may not be
      successful in doing so. In addition, competition is intense, and there can
      be no
      assurance that our competitors will not independently develop or patent
      technologies that are substantially equivalent or superior to our technology.
      In
      the event of patent litigation, we cannot assure you that a court would
      determine that we were the first creator of inventions covered by our issued
      patents or pending patent applications or that we were the first to file patent
      applications for those inventions. If existing or future third-party patents
      containing broad claims were upheld by the courts or if we were found to
      infringe third-party patents, we may not be able to obtain the required licenses
      from the holders of such patents on acceptable terms, if at all. Failure to
      obtain these licenses could cause delays in the introduction of our products
      or
      necessitate costly attempts to design around such patents, or could foreclose
      the development, manufacture or sale of our products. We could also incur
      substantial costs in defending ourselves in patent infringement suits brought
      by
      others and in prosecuting patent infringement suits against
      infringers.




We
      also
      rely on trade secrets and proprietary know-how that we seek to protect, in
      part,
      through non-disclosure and confidentiality agreements with our customers,
      employees, consultants, and entities with which we maintain strategic
      relationships. We cannot assure you that these agreements will not be breached,
      that we would have adequate remedies for any breach or that our trade secrets
      will not otherwise become known or be independently developed by
      competitors.




***We
      are dependent on key personnel and our business would suffer if we fail to
      retain them.***




We
      are
      highly dependent on the president of our FAAC subsidiary and the general
      managers of our MDT and Epsilor subsidiaries, and the loss of the services
      of
      one or more of these persons could adversely affect us. We are especially
      dependent on the services of our Chairman and Chief Executive Officer, Robert
      S.
      Ehrlich, and our President and Chief Operating Officer, Steven Esses. The loss
      of either Mr. Ehrlich or Mr. Esses could have a material adverse effect on
      us.
      We are party to an employment agreement with Mr. Ehrlich, which agreement
      expires at the end of 2007, and an employment agreement with Mr. Esses, which
      agreement expires at the end of 2006. We do not have key-man life insurance
      on
      either Mr. Ehrlich or Mr. Esses.




43


***Payment
      of severance or retirement benefits earlier than anticipated could strain our
      cash flow.***




Our
      Chairman and Chief Executive Officer, Robert S. Ehrlich, and our President
      and
      Chief Operating Officer, Steven Esses, both have employment agreements that
      provide for substantial severance payments and retirement benefits. We are
      required to fund a certain portion of these payments according to a
      predetermined schedule. Should Mr. Ehrlich or Mr. Esses leave our employ under
      circumstances entitling them to severance or retirement benefits, or become
      disabled or die, before we have funded these payments, the need to pay these
      severance or retirement benefits ahead of their anticipated schedule could
      put a
      strain on our cash flow and have a material adverse effect on our financial
      condition.




***There
      are risks involved with the international nature of our
      business.***




A
      significant portion of our sales are made to customers located outside the
      U.S.,
      primarily in Europe and Asia. In 2005, 2004 and 2003, without taking account
      of
      revenues derived from discontinued operations, 21%, 19% and 42%, respectively,
      of our revenues, were derived from sales to customers located outside the U.S.
      We expect that our international customers will continue to account for a
      substantial portion of our revenues in the near future. Sales to international
      customers may be subject to political and economic risks, including political
      instability, currency controls, exchange rate fluctuations, foreign taxes,
      longer payment cycles and changes in import/export regulations and tariff rates.
      In addition, various forms of protectionist trade legislation have been and
      in
      the future may be proposed in the U.S. and certain other countries. Any
      resulting changes in current tariff structures or other trade and monetary
      policies could adversely affect our sales to international
      customers.




***Our
      management has determined that we have material weaknesses in our internal
      controls. If we fail to achieve and maintain effective internal controls in
      accordance with Section 404 of the Sarbanes-Oxley Act, we may not be able
      to accurately report our financial results.***




Section
      404 of the Sarbanes-Oxley Act of 2002 requires us to include an internal control
      report of management in our Annual Report on Form 10-K. Our management
      acknowledges its responsibility for internal controls over financial reporting
      and seeks to continually improve those controls. In addition, in order to
      achieve compliance with Section 404 within the prescribed period, we have been
      engaged in a process to document and evaluate our internal controls over
      financial reporting. In this regard, management has dedicated internal
      resources, engaged outside consultants and adopted a work plan to (i) assess
      and
      document the adequacy of internal control over financial reporting, (ii) take
      steps to improve control processes where appropriate, (iii) validate through
      testing that controls are functioning as documented and (iv) implement a
      continuous reporting and improvement process for internal control over financial
      reporting. We believe our process for documenting, evaluating and monitoring
      our
      internal control over financial reporting is consistent with the objectives
      of
      Section 404 of Sarbanes-Oxley.




44


Our
      evaluation so far has identified a material weakness under standards established
      by the Public Company Accounting Oversight Board (PCAOB) related to our FAAC
      subsidiary and further described under “Management’s Report on Internal Controls
      over Financial Reporting,” included herein under “Item 9A, Controls and
      Procedures.” A material weakness is a condition in which the design or operation
      of one or more of the internal control components does not reduce to a
      relatively low level the risk that misstatements caused by error or fraud in
      amounts that would be material in relation to the financial statements being
      audited may occur and not be detected within a timely period by employees in
      the
      normal course of performing their assigned functions. Our management has not
      yet
      completed its assessment of the effectiveness of our internal control over
      financial reporting as of December 31, 2005. However, based on their evaluation
      procedures performed to date, management has concluded that internal controls
      over financial reporting were ineffective as of December 31, 2005. Because
      we
      have not yet completed our assessment of the effectiveness of our internal
      control over financial reporting, our independent auditors have disclaimed
      any
      opinion on our internal controls, as stated in their report which is included
      herein.




As
      a
      public company, we will have significant requirements for enhanced financial
      reporting and internal controls. The process of designing and implementing
      effective internal controls is a continuous effort that requires us to
      anticipate and react to changes in our business and the economic and regulatory
      environments and to expend significant resources to maintain a system of
      internal controls that is adequate to satisfy our reporting obligations as
      a
      public company. We cannot assure you that the measures we have taken or will
      take to remediate any material weaknesses or that we will implement and maintain
      adequate controls over our financial processes and reporting in the future
      as we
      continue our rapid growth. If we are unable to establish appropriate internal
      financial reporting controls and procedures, it could cause us to fail to meet
      our reporting obligations, result in material misstatements in our financial
      statements, harm our operating results, cause investors to lose confidence
      in
      our reported financial information and have a negative effect on the market
      price for shares of our common stock.




***Investors
      should not purchase our common stock with the expectation of receiving cash
      dividends*** *.*




We
      currently intend to retain any future earnings for funding growth and, as a
      result, do not expect to pay any cash dividends in the foreseeable
      future.




**Market-Related
      Risks**




***The
      price of our common stock is volatile.***




The
      market price of our common stock has been volatile in the past and may change
      rapidly in the future. The following factors, among others, may cause
      significant volatility in our stock price:




·
            announcements
                by us, our competitors or our
                customers;




·
            the
                introduction of new or enhanced products and services by us or our
                competitors;




·
            changes
                in the perceived ability to commercialize our technology compared
                to that
                of our competitors;




·
            rumors
                relating to our competitors or us;




45


·
            actual
                or anticipated fluctuations in our operating results;




·
            the
                issuance of our securities, including warrants, in connection with
                financings and acquisitions; and




·
            general
                market or economic conditions.




***If*** ***our
      shares were to be delisted, our stock price might decline further and we might
      be unable to raise additional capital.***




One
      of
      the continued listing standards for our stock on the Nasdaq Stock Market (both
      the Nasdaq National Market, on which our stock is currently listed, and the
      Nasdaq Capital Market (formerly known as the Nasdaq SmallCap Market)) is the
      maintenance of a $1.00 bid price. Our stock price is currently below $1.00,
      and
      has been so since August 15, 2005. On March 28, 2006, we received a Nasdaq
      Staff
      Determination indicating that we were not in compliance with the minimum bid
      price requirement for continued listing set forth in Marketplace
      Rule 4450(a) and that our securities are, therefore, subject to delisting
      from the Nasdaq National Market at the opening of business on April 6, 2006.
      The
      letter also stated that we may request a review of the Staff Determination
      to a
      Nasdaq Listing Qualifications Panel. We have requested a review of the Staff
      Determination by a Nasdaq Listing Qualifications Panel. Although there can
      be no
      assurance that the Panel will grant our request for continued listing, the
      request for review has stayed the delisting of our stock from the Nasdaq
      National Market pending the Panel’s decision.




If
      our
      common stock were to be delisted from the Nasdaq National Market, we might
      apply
      to be listed on the Nasdaq Capital Market if we then met the initial listing
      standards of the Nasdaq Capital Market (other than the $1.00 minimum bid
      standard). If we were to move to the Nasdaq Capital Market, current Nasdaq
      regulations would give us the opportunity to obtain an additional 180-day grace
      period (until September 22, 2006) if we meet certain net income, stockholders’
equity or market capitalization criteria; if at the end of that period we had
      not yet achieved compliance with the minimum bid price rule, we would be subject
      to delisting from the Nasdaq Capital Market. Although we would have the
      opportunity to appeal any potential delisting, there can be no assurances that
      this appeal would be resolved favorably. As a result, there can be no assurance
      that our common stock will remain listed on the Nasdaq Stock
      Market.




While
      our
      stock would continue to trade on the over-the-counter bulletin board following
      any delisting from the Nasdaq, any such delisting of our common stock could
      have
      an adverse effect on the market price of, and the efficiency of the trading
      market for, our common stock. Trading volume of over-the-counter bulletin board
      stocks has been historically lower and more volatile than stocks traded on
      an
      exchange or the Nasdaq Stock Market. As a result, holders of our securities
      could find it more difficult to sell their securities. Also, if in the future
      we
      were to determine that we need to seek additional equity capital, it could
      have
      an adverse effect on our ability to raise capital in the public equity
      markets.




In
      addition, if we fail to maintain Nasdaq listing for our securities, and no
      other
      exclusion from the definition of a “penny stock” under the Securities Exchange
      Act of 1934, as amended, is available, then any broker engaging in a transaction
      in our securities would be required to provide any customer with a risk
      disclosure document, disclosure of market quotations, if any, disclosure of
      the
      compensation of the broker-dealer and its salesperson in the transaction and
      monthly account statements showing the market values of our securities held
      in
      the customer’s account. The bid and offer quotation and compensation information
      must be provided prior to effecting the transaction and must be contained on
      the
      customer’s confirmation. If brokers become subject to the “penny stock” rules
      when engaging in transactions in our securities, they would become less willing
      to engage in transactions, thereby making it more difficult for our stockholders
      to dispose of their shares.




46


Additionally,
      delisting from the Nasdaq Stock Market would constitute an event of default
      under our debentures due in September 2006, which could result in acceleration
      of debt under other instruments evidencing other indebtedness that may contain
      cross-acceleration or cross-default provisions, even if the delisting were
      not
      an event of default under those other instruments.




***A
      substantial number of our shares are available for sale in the public market
      and
      sales of those shares could adversely affect our stock
      price.***




Sales
      of
      a substantial number of shares of common stock into the public market, or the
      perception that those sales could occur, could adversely affect our stock price
      or could impair our ability to obtain capital through an offering of equity
      securities. As of March 15, 2006, we had 95,490,846 shares
      of common stock issued and outstanding. Of these shares, most are freely
      transferable without restriction under the Securities Act of 1933 or pursuant
      to
      effective resale registration statements, and a substantial portion of the
      remaining shares may be sold subject to the volume restrictions, manner-of-sale
      provisions and other conditions of Rule 144 under the Securities Act of
      1933.




***Exercise
      of our warrants, options and convertible debt could adversely affect our stock
      price and will be dilutive.***




As
      of
      December 31, 2005, there were outstanding warrants to purchase a total of
      22,061,463 shares of our common stock at a weighted average exercise price
      of
      $1.43 per share, options to purchase a total of 8,651,235 shares of our common
      stock at a weighted average exercise price of $0.79 per share, of which
      8,329,272 were vested, at a weighted average exercise price of $0.76 per share,
      and outstanding debentures and notes convertible into a total of 20,203,246
      shares of our common stock at a weighted average conversion price of $1.07
      per
      share. Holders of our options, warrants and convertible debt will probably
      exercise or convert them only at a time when the price of our common stock
      is
      higher than their respective exercise or conversion prices. Accordingly, we
      may
      be required to issue shares of our common stock at a price substantially lower
      than the market price of our stock. This could adversely affect our stock price.
      In addition, if and when these shares are issued, the percentage of our common
      stock that existing stockholders own will be diluted.




***Our
      certificate of incorporation and bylaws and Delaware law contain provisions
      that
      could discourage a takeover.***




Provisions
      of our amended and restated certificate of incorporation may have the effect
      of
      making it more difficult for a third party to acquire, or of discouraging a
      third party from attempting to acquire, control of us. These provisions could
      limit the price that certain investors might be willing to pay in the future
      for
      shares of our common stock. These provisions:




·
            divide
                our board of directors into three classes serving staggered three-year
                terms;




·
            only
                permit removal of directors by stockholders “for cause,” and require the
                affirmative vote of at least 85% of the outstanding common stock
                to so
                remove; and




·
            allow
                us to issue preferred stock without any vote or further action by
                the
                stockholders.




47


The
      classification system of electing directors and the removal provision may tend
      to discourage a third-party from making a tender offer or otherwise attempting
      to obtain control of us and may maintain the incumbency of our board of
      directors, as the classification of the board of directors increases the
      difficulty of replacing a majority of the directors. These provisions may have
      the effect of deferring hostile takeovers, delaying changes in our control
      or
      management, or may make it more difficult for stockholders to take certain
      corporate actions. The amendment of any of these provisions would require
      approval by holders of at least 85% of the outstanding common
      stock.




**Israel-Related
      Risks**




***A
      significant portion of our operations takes place in Israel, and we could be
      adversely affected by the economic, political and military conditions in that
      region.***




The
      offices and facilities of three of our subsidiaries, EFL, MDT and Epsilor,
      are
      located in Israel (in Beit Shemesh, Lod and Dimona, respectively, all of which
      are within Israel’s pre-1967 borders). Most of our senior management is located
      at EFL’s facilities. Although we expect that most of our sales will be made to
      customers outside Israel, we are nonetheless directly affected by economic,
      political and military conditions in that country. Accordingly, any major
      hostilities involving Israel or the interruption or curtailment of trade between
      Israel and its present trading partners could have a material adverse effect
      on
      our operations. Since the establishment of the State of Israel in 1948, a number
      of armed conflicts have taken place between Israel and its Arab neighbors and
      a
      state of hostility, varying in degree and intensity, has led to security and
      economic problems for Israel.




Historically,
      Arab states have boycotted any direct trade with Israel and to varying degrees
      have imposed a secondary boycott on any company carrying on trade with or doing
      business in Israel. Although in October 1994, the states comprising the Gulf
      Cooperation Council (Saudi Arabia, the United Arab Emirates, Kuwait, Dubai,
      Bahrain and Oman) announced that they would no longer adhere to the secondary
      boycott against Israel, and Israel has entered into certain agreements with
      Egypt, Jordan, the Palestine Liberation Organization and the Palestinian
      Authority, Israel has not entered into any peace arrangement with Syria or
      Lebanon. Moreover, since September 2000, there has been a significant
      deterioration in Israel’s relationship with the Palestinian Authority, and a
      significant increase in terror and violence. Israel recently withdrew
      unilaterally from the Gaza Strip and certain areas in northern Samaria. It
      is
      unclear what the long-term effects of such disengagement plan will be. Efforts
      to resolve the problem have failed to result in an agreeable solution. Continued
      hostilities between the Palestinian community and Israel and any failure to
      settle the conflict may have a material adverse effect on our business and
      us.
      Moreover, the current political and security situation in the region has already
      had an adverse effect on the economy of Israel, which in turn may have an
      adverse effect on us.




48


***Service
      of process and enforcement of civil liabilities on us and our officers may
      be
      difficult to obtain.***




We
      are
      organized under the laws of the State of Delaware and will be subject to service
      of process in the United States. However, approximately 22% of our assets are
      located outside the United States. In addition, two of our directors and most
      of
      our executive officers are residents of Israel and a portion of the assets
      of
      such directors and executive officers are located outside the United
      States.




There
      is
      doubt as to the enforceability of civil liabilities under the Securities Act
      of
      1933, as amended, and the Securities Exchange Act of 1934, as amended, in
      original actions instituted in Israel. As a result, it may not be possible
      for
      investors to enforce or effect service of process upon these directors and
      executive officers or to judgments of U.S. courts predicated upon the civil
      liability provisions of U.S. laws against our assets, as well as the assets
      of
      these directors and executive officers. In addition, awards of punitive damages
      in actions brought in the U.S. or elsewhere may be unenforceable in
      Israel.




***Exchange
      rate fluctuations between the U.S. dollar and the Israeli NIS may negatively
      affect our earnings.***




Although
      a substantial majority of our revenues and a substantial portion of our expenses
      are denominated in U.S. dollars, a portion of our costs, including personnel
      and
      facilities-related expenses, is incurred in New Israeli Shekels (NIS). Inflation
      in Israel will have the effect of increasing the dollar cost of our operations
      in Israel, unless it is offset on a timely basis by a devaluation of the NIS
      relative to the dollar. In 2005, the inflation adjusted NIS depreciated against
      the dollar.




***Some
      of our agreements are governed by Israeli law.***




Israeli
      law governs some of our agreements, such as our lease agreements on our
      subsidiaries’ premises in Israel, and the agreements pursuant to which we
      purchased IES, MDT and Epsilor. While Israeli law differs in certain respects
      from American law, we do not believe that these differences materially adversely
      affect our rights or remedies under these agreements.




**ITEM
      1B.**  **UNRESOLVED
      STAFF COMMENTS**




None.




**ITEM
      2.**  **PROPERTIES**




Our
      primary executive offices are located in FAAC’s offices, consisting of
      approximately 17,800 square feet of office and warehouse space in Ann Arbor,
      Michigan, pursuant to a lease expiring in January 2008. FAAC has also leased
      10,900 square feet of office and warehouse space in Ann Arbor, Michigan pursuant
      to a lease beginning in June 2006 and expiring in January 2008, for use by
      IES.




49


EFB
      and
      MDT Armor both operate out of our Auburn, Alabama facilities, constituting
      approximately 30,000 square feet, which is leased from the City of Auburn
      through December 2008. We are in the process of moving the operations of AoA
      to
      Auburn as well.




Our
      management and administrative facilities and research, development and
      production facilities for the manufacture and assembly of our Survivor Locator
      Lights, constituting approximately 18,300 square feet, are located in Beit
      Shemesh, Israel, located between Jerusalem and Tel-Aviv (within Israel’s
      pre-1967 borders). The lease for these facilities in Israel expires on December
      31, 2007; we have the ability to terminate the lease every two years upon three
      months’ written notice. Moreover, we may terminate the lease at any time upon
      twelve months written notice. Most of the members of our senior management,
      including our Chief Executive Officer and our Chief Operating Officer, work
      extensively out of our Beit Shemesh facility. Our Chief Financial Officer works
      out of our Ann Arbor, Michigan facility.




Our
      Epsilor subsidiary rents approximately 19,000 square feet of factory, office
      and
      warehouse space in Dimona, Israel, in Israel’s Negev desert (within Israel’s
      pre-1967 borders), on a month-to-month basis .




Our
      IES
      subsidiary rents approximately 8,900 square feet of office and warehouse space
      in Littleton, Colorado, approximately ten miles outside of Denver, pursuant
      to a
      lease expiring in September 2005. This lease is currently month-to-month, and
      is
      expected to end in May 2006.




Our
      MDT
      subsidiary rents approximately 20,000 square feet of office space in Lod,
      Israel, near Ben-Gurion International airport (within Israel’s pre-1967 borders)
      pursuant to a lease renewable on an annual basis .




We
      believe that our existing and currently planned facilities are adequate to
      meet
      our current and foreseeable future needs.




**ITEM
      3.**  **LEGAL
      PROCEEDINGS**




As
      of the
      date of this filing, there were no material pending legal proceedings against
      us, except as follows:




In
      December 2004, AoA filed an action in the United States Court of Federal Claims
      against the United
      States Naval Air Systems Command (NAVAIR), seeking approximately $2.2 million
      in
      damages for NAVAIR’s alleged improper termination of a contract for the design,
      test and manufacture of a lightweight armor replacement system for the United
      States Marine Corps CH-46E rotor helicopter. NAVAIR, in its answer,
      counterclaimed for approximately $2.1 million in alleged reprocurement and
      administrative costs.




50


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




We
      held a
      Special
      Meeting of Stockholders on
      December 14, 2005. At that meeting, the stockholders voted on the following
      matters with the following results:




1.*Permitting,
                for purposes of NASD Marketplace Rule 4350(i)(1)(D)(ii), payments
                of
                principal on the Company’s Senior Secured Convertible Notes in
                stock:***Votes
                For**
            **Votes
                Against**
            **Abstentions**
            **Shares
                Not Voting**19,804,747
            3,845,135
            270,052
            49,912,774





2.*Permitting,
                for purposes of NASD Marketplace Rule 4350(i)(1)(D)(ii), adjustment
                of the
                exercise prices of certain of the Company’s outstanding
                warrants:***Votes
                For**
            **Votes
                Against**
            **Abstentions**
            **Shares
                Not Voting**16,952,408
            6,599,686
            367,841
            49,912,773





3.*Ratifying
                the appointment of Kost, Forer, Gabbay & Kasierer as the Company’s
                independent accountants for the fiscal year ending December 31,
                2005:***Votes
                For**
            **Votes
                Against**
            **Abstentions**
            **Shares
                Not Voting**70,233,322
            3,237,427
            361,959
            0





51


**PART
      II**




**ITEM** **5.** **** **MARKET
                  FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
                  OF EQUITY SECURITIES**




Our
      common stock is traded on the Nasdaq National Market. Our Nasdaq ticker symbol
      is “ARTX.” The following table sets forth, for the periods indicated, the range
      of high and low sales prices of our common stock on the Nasdaq National Market
      System:




**Year
                Ended December 31, 2005**
            
            **High**
            
            **Low**Fourth
                Quarter
            
            $
            0.76
            
            $
            0.36Third
                Quarter
            
            $
            1.19
            
            $
            0.70Second
                Quarter
            
            $
            1.46
            
            $
            1.00First
                Quarter
            
            $
            1.78
            
            $
            1.26**Year
                Ended December 31, 2004**
            
            
            **High**
            
            
            **Low**Fourth
                Quarter
            
            $
            2.16
            
            $
            1.50Third
                Quarter
            
            $
            2.14
            
            $
            1.18Second
                Quarter
            
            $
            4.34
            
            $
            1.90First
                Quarter
            
            $
            2.53
            
            $
            1.65




As
      of
      February 28, 2006 we had approximately 324 holders of record of our common
      stock.




**Dividends**




We
      have
      never paid any cash dividends on our common stock. The Board of Directors
      presently intends to retain all earnings for use in our business. Any future
      determination as to payment of dividends will depend upon our financial
      condition and results of operations and such other factors as the Board of
      Directors deems relevant.




**ITEM
      6.**  **SELECTED
      FINANCIAL DATA**




The
      selected financial information set forth below with respect to the consolidated
      statement of operations for each of the five fiscal years in the period ended
      December 31, 2005, and with respect to the balance sheets at the end of each
      such fiscal year has been derived from our consolidated financial
      statements.




The
      results of operations, including revenue, operating expenses, and financial
      income, of the consumer battery segment for the years ended December 31, 2003,
      2002 and 2001 have been reclassified in the accompanying statements of
      operations as discontinued operations. Our accompanying consolidated balance
      sheets at December 31, 2003, 2002 and 2001 give effect to the assets of the
      consumer battery business as discontinued operations within current assets
      and
      liabilities. Thus, the financial information presented herein includes only
      continuing operations.




The
      Consolidated Financial Statements at December 31, 2003 and for the year then
      ended have been restated.




52


The
      financial information set forth below is qualified by and should be read in
      conjunction with the Consolidated Financial Statements contained in Item 8
      of
      this Report and the notes thereto and “Item 7. Management’s Discussion and
      Analysis of Financial Condition and Results of Operations,” below.




**Year
                  Ended December 31,****2001**
              
              **2002**
              
              **2003********
              
              **2004**
              
              **2005****(dollars
                  in thousands, except per share data)****Statement
                  of Operations Data:**Revenues
              
              $
              2,094
              
              $
              6,407
              
              $
              17,326
              
              $
              49,954
              
              $
              49,045Research
                  and development expenses and costs of revenues
              
              
              2,448
              
              
              5,108
              
              
              12,141
              
              
              35,742
              
              
              35,684Selling,
                  general and administrative expenses and their impairment and amortization
                  of intangible assets
              
              
              3,934
              
              
              5,982
              
              
              10,255
              
              
              18,394
              
              
              34,662Operating
                  loss
              
              
              (4,288
              )
              
              (4,683
              )
              
              (5,070
              )
              
              (4,182
              )
              
              (21,301
              )Other
                  income
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              339Financial
                  income (expenses), net
              
              
              263
              
              
              100
              
              
              4,039
              
              
              4,229
              
              
              (2,706
              )Loss
                  before minority interest in (loss) earnings of subsidiary and tax
                  expenses
              
              
              (4,026
              )
              
              (4,583
              )
              
              (9,109
              )
              
              (8,411
              )
              
              (23,668
              )Taxes
                  on income
              
              
              —
              
              
              —
              
              
              (396
              )
              
              (586
              )
              
              (237
              )Loss
                  from affiliated company
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (75
              )Minority
                  interest in (loss) earnings of subsidiary
              
              
              —
              
              
              (355
              )
              
              157
              
              
              (45
              )
              
              57Loss
                  from continuing operations
              
              
              (4,026
              )
              
              (4,938
              )
              
              (9,348
              )
              
              (9,042
              )
              
              (23,923
              )Income
                  (loss) from discontinued operations
              
              
              (13,261
              )
              
              (13,566
              )
              
              110
              
              
              —
              
              
              (120
              )Net
                  loss for the period
              
              
              (17,287
              )
              
              (18,504
              )
              
              (9,238
              )
              
              (9,042
              )
              
              (24,043
              )Deemed
                  dividend to certain stockholders of common stock
              
              
              (1,197
              )
              
              —
              
              
              (350
              )
              
              (3,329
              )
              
              —Net
                  loss attributable to stockholders of common stock
              
              $
              (18,483
              )
              $
              (18,504
              )
              $
              (9,588
              )
              $
              (12,371
              )
              $
              (24,043
              )Basic
                  and diluted net loss per share from continuing operations
              
              $
              (0.21
              )
              $
              (0.15
              )
              $
              (0.24
              )
              $
              (0.13
              )
              $
              (0.29
              )Loss
                  per share for combined operations
              
              $
              (0.76
              )
              $
              (0.57
              )
              $
              (0.25
              )
              $
              (0.18
              )
              $
              (0.29
              )Weighted
                  average number of common shares used in computing basic and diluted
                  net
                  loss per share (in thousands)
              
              
              24,200
              
              
              32,382
              
              
              38,890
              
              
              69,933
              
              
              82,209**As
                  At December 31,****2001**
              
              
              **2002**
              
              
              **2003****
              
              
              **2004**
              
              
              **2005****(dollars
                  in thousands)****Balance
                  Sheet Data:**Cash,
                  cash equivalents, investments in marketable debt securities and
                  restricted
                  collateral deposits
              
              $
              12,672
              
              $
              2,091
              
              $
              14,391
              
              $
              13,832
              
              $
              10,864Receivables
                  and other assets*
              
              
              11,515
              
              
              7,895
              
              
              8,898
              
              
              25,746
              
              
              29,166Property
                  and equipment, net of depreciation
              
              
              2,221
              
              
              2,555
              
              
              2,293
              
              
              4,601
              
              
              4,253Goodwill
                  and other intangible assets, net
              
              
              —
              
              
              7,522
              
              
              7,440
              
              
              54,113
              
              
              40,586Total
                  assets
              
              $
              26,408
              
              $
              20,063
              
              $
              33,022
              
              $
              98,292
              
              $
              84,869Current
                  liabilities*
              
              $
              3,874
              
              $
              7,272
              
              $
              6,710
              
              $
              26,381
              
              $
              26,317Long-term
                  liabilities***
              
              
              3,126
              
              
              3,753
              
              
              4,686
              
              
              6,438
              
              
              12,287Stockholders’
                  equity
              
              
              19,408
              
              
              9,038
              
              
              21,626
              
              
              65,473
              
              
              46,265Total
                  liabilities and stockholders equity*
              
              $
              26,408
              
              $
              20,063
              
              $
              33,022
              
              $
              98,292
              
              $
              84,869





*
            Includes
                assets and liabilities, as applicable, from discontinued
                operations.**
            Restated.***
            Includes
                minority interest.




53


**PART
      II**




**ITEM
          7.** **MANAGEMENT’S
          DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
          OPERATION**




*The
      following Management’s Discussion and Analysis of Financial Condition and
      Results of Operations contains forward-looking statements that involve inherent
      risks and uncertainties. When used in this discussion, the words “believes,”
“anticipated,” “expects,” “estimates” and similar expressions are intended to
      identify such forward-looking statements. Such statements are subject to certain
      risks and uncertainties that could cause actual results to differ materially
      from those projected. Readers are cautioned not to place undue reliance on
      these
      forward-looking statements, which speak only as of the date hereof. We undertake
      no obligation to publicly release the result of any revisions to these
      forward-looking statements that may be made to reflect events or circumstances
      after the date hereof or to reflect the occurrence of unanticipated events.
      Our
      actual results could differ materially from those anticipated in these
      forward-looking statements as a result of certain factors including, but not
      limited to, those set forth elsewhere in this report. Please see “Risk Factors,”
below, and in our other filings with the Securities and Exchange
      Commission.*




The
      following discussion and analysis should be read in conjunction with the
      Consolidated Financial Statements contained in Item 8 of this report, and the
      notes thereto. We have rounded amounts reported here to the nearest thousand,
      unless such amounts are more than 1.0 million, in which event we have rounded
      such amounts to the nearest hundred thousand.




**General**




We
      are 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. We operate in
      three
      business units:




Ø
            we
                develop, manufacture and market advanced high-tech multimedia and
                interactive digital solutions for use-of-force and driving training
                of
                military, law enforcement, security and other personnel (our***Simulation
                and Training Division***);




Ø
            we
                manufacture aviation armor and we utilize sophisticated lightweight
                materials and advanced engineering processes to armor vehicles (our***Armoring
                Division***);and




Ø
            we
                manufacture and sell Zinc-Air and lithium batteries for defense and
                security products and other military applications and we pioneer
                advancements in Zinc-Air battery technology for electric vehicles
                (our***Battery
                and Power Systems Division***).




During
      2004, we acquired three new businesses: FAAC Corporation, located in Ann Arbor,
      Michigan, which provides simulators, systems engineering and software products
      to the United States military, government and private industry (which we have
      placed in our Simulation and Training Division); Epsilor Electronic Industries,
      Ltd., located in Dimona, Israel, which 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 (which we have placed in our
      Battery and Power Systems Division); and Armour of America, Incorporated,
      located in Los Angeles, California, which manufacturers aviation armor both
      for
      helicopters and for fixed wing aircraft, marine armor, personnel armor, armoring
      kits for military vehicles, fragmentation blankets and a unique
      ballistic/flotation vest (ArmourFloat) that is U.S. Coast Guard-certified,
      which
      we have placed in our Armor Division. Our financial results for 2004 do not
      include the activities of FAAC, Epsilor or AoA for the full year and therefore
      are not directly comparable to our financial results for 2005.




54


**Critical
      Accounting Policies**




The
      preparation of financial statements requires us to make estimates and
      assumptions that affect the reported amounts of assets and liabilities and
      the
      disclosure of contingent liabilities at the date of the financial statements
      and
      the reported amounts of revenues and expenses during the reporting period.
      On an
      ongoing basis, we evaluate our estimates and judgments, including those related
      to revenue recognition, allowance for bad debts, inventory, contingencies and
      warranty reserves, impairment of intangible assets and goodwill. We base our
      estimates and judgments on historical experience and on various other factors
      that we believe to be reasonable under the circumstances, the results of which
      form the basis for making judgments about the carrying values of assets and
      liabilities that are not readily apparent from other sources. Under different
      assumptions or conditions, actual results may differ from these
      estimates.




We
      believe the following critical accounting policies affect our more significant
      judgments and estimates used in the preparation of our consolidated financial
      statements.




***Revenue
      Recognition***




Significant
      management judgments and estimates must be made and used in connection with
      the
      recognition of revenue in any accounting period. Material differences in the
      amount of revenue in any given period may result if these judgments or estimates
      prove to be incorrect or if management’s estimates change on the basis of
      development of the business or market conditions. Management judgments and
      estimates have been applied consistently and have been reliable
      historically.




A
      portion
      of our revenue is derived from license agreements that entail the customization
      of FAAC’s simulators to the customer’s specific requirements. Revenues from
      initial license fees for such arrangements are recognized in accordance with
      Statement of Position 81-1 “Accounting for Performance of Construction - Type
      and Certain Production - Type Contracts” based on the percentage of completion
      method over the period from signing of the license through to customer
      acceptance, as such simulators require significant modification or customization
      that takes time to complete. The percentage of completion is measured by
      monitoring progress using records of actual time incurred to date in the project
      compared with 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.




55


We
      believe that the use of the percentage of completion method is appropriate
      as we
      have 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 terms of
      settlement. In all cases we expect to perform our contractual obligations and
      our licensees are expected to satisfy their obligations under the contract.
      The
      complexity of the estimation process and the issues related to the assumptions,
      risks and uncertainties inherent with the application of the percentage of
      completion method of accounting affect the amounts of revenue and related
      expenses reported in our consolidated financial statements. A number of internal
      and external factors can affect our estimates, including labor rates,
      utilization and specification and testing requirement changes.




We
      account for our other revenues from IES simulators in accordance with the
      provisions of SOP 97-2, “Software Revenue Recognition,” issued by the American
      Institute of Certified Public Accountants and as amended by SOP 98-4 and SOP
      98-9 and related interpretations. We exercise judgment and use estimates in
      connection with the determination of the amount of software license and services
      revenues to be recognized in each accounting period.




We
      assess
      whether collection is probable at the time of the transaction based on a number
      of factors, including the customer’s past transaction history and credit
      worthiness. If we determine that the collection of the fee is not probable,
      we
      defer the fee and recognize revenue at the time collection becomes probable,
      which is generally upon the receipt of cash.




***Allowance
      for Doubtful Accounts***




We
      make
      judgments as to our ability to collect outstanding receivables and provide
      allowances for the portion of receivables when collection becomes doubtful.
      Provisions are made based upon a specific review of all significant outstanding
      receivables. In determining the provision, we analyze our historical collection
      experience and current economic trends. We reassess these allowances each
      accounting period. Historically, our actual losses and credits have been
      consistent with these provisions. If actual payment experience with our
      customers is different than our estimates, adjustments to these allowances
      may
      be necessary resulting in additional charges to our statement of
      operations.




***Accounting
      for Income Taxes***




Significant
      judgment is required in determining our worldwide income tax expense provision.
      In the ordinary course of a global business, there are many transactions and
      calculations where the ultimate tax outcome is uncertain. Some of these
      uncertainties arise as a consequence of cost reimbursement arrangements among
      related entities, the process of identifying items of revenue and expense that
      qualify for preferential tax treatment and segregation of foreign and domestic
      income and expense to avoid double taxation. Although we believe that our
      estimates are reasonable, the final tax outcome of these matters may be
      different than that which is reflected in our historical income tax provisions
      and accruals. Such differences could have a material effect on our income tax
      provision and net income (loss) in the period in which such determination is
      made.




56


We
      have
      provided a valuation allowance on the majority of our net deferred tax assets,
      which includes federal and foreign net operating loss carryforwards, because
      of
      the uncertainty regarding their realization. Our accounting for deferred taxes
      under Statement of Financial Accounting Standards No. 109, “Accounting for
      Income Taxes” (“Statement 109”), involves the evaluation of a number of factors
      concerning the realizability of our deferred tax assets. In concluding that
      a
      valuation allowance was required, we primarily considered such factors as our
      history of operating losses and expected future losses in certain jurisdictions
      and the nature of our deferred tax assets. The Company and its subsidiaries
      provide valuation allowances in respect of deferred tax assets resulting
      principally from the carryforward of tax losses. Management currently believes
      that it is more likely than not that the deferred tax regarding the carryforward
      of losses and certain accrued expenses will not be realized in the foreseeable
      future. The company does not provide for US Federal Income taxes on the
      undistributed earnings of its foreign subsidiaries because such earnings are
      re-invested and, in the opinion of management, will continue to be re-invested
      indefinitely.




In
      addition, we operate within multiple taxing jurisdictions and may be subject
      to
      audits in these jurisdictions. These audits can involve complex issues that
      may
      require an extended period of time for resolution. In management’s opinion,
      adequate provisions for income taxes have been made.




***Inventories***




Our
      policy for valuation of inventory and commitments to purchase inventory,
      including the determination of obsolete or excess inventory, requires us to
      perform a detailed assessment of inventory at each balance sheet date, which
      includes a review of, among other factors, an estimate of future demand for
      products within specific time horizons, valuation of existing inventory, as
      well
      as product lifecycle and product development plans. The estimates of future
      demand that we use in the valuation of inventory are the basis for our revenue
      forecast, which is also used for our short-term manufacturing plans. Inventory
      reserves are also provided to cover risks arising from slow-moving items. We
      write down our inventory for estimated obsolescence or unmarketable inventory
      equal to the difference between the cost of inventory and the estimated market
      value based on assumptions about future demand and market conditions. We may
      be
      required to record additional inventory write-down if actual market conditions
      are less favorable than those projected by our management. For fiscal 2005,
      no
      significant changes were made to the underlying assumptions related to estimates
      of inventory valuation or the methodology applied.




***Goodwill***




Under
      Financial Accounting Standards Board Statement No. 142, “Goodwill and Other
      Intangible Assets” (SFAS 142), goodwill and intangible assets deemed to have
      indefinite lives are no longer amortized but are subject to annual impairment
      tests based on estimated fair value in accordance with SFAS 142.




During
      2005, we performed an impairment test of goodwill, based on management’s
      projections and using expected future discounted operating cash flows, as a
      response to several factors, including without limitation the reduced sales
      in
      AoA (a component of our 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 us, 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), and the change in U.S. military priorities from acquiring new
      armor
      to funding the ground forces in Iraq and Afghanistan. Furthermore, following
      Hurricane Katrina, the appropriation of substantial funds earmarked for defense
      was delayed to provide funds for hurricane relief. As of December 31, 2005,
      as a
      result of this impairment test, we identified in AoA an impairment of goodwill
      in the amount of $11,757,812.




57


In
      connection with our acquisition of AoA, we have a contingent earnout obligation
      in an amount equal to the revenues realized by us from certain specific programs
      that were identified by us 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. To date, we have
      accrued a liability of $1,204,150 in respect of such earnout
      obligation.




We
      determine fair value using discounted cash flow analysis. This type of analysis
      requires us to make assumptions and estimates regarding industry economic
      factors and the profitability of future business strategies. It is our policy
      to
      conduct impairment testing based on our current business strategy in light
      of
      present industry and economic conditions, as well as future expectations. In
      assessing the recoverability of our goodwill, we may be required to make
      assumptions regarding estimated future cash flows and other factors to determine
      the fair value of the respective assets. This process is subjective and requires
      judgment at many points throughout the analysis. If our estimates or their
      related assumptions change in subsequent periods or if actual cash flows are
      below our estimates, we may be required to record impairment charges for these
      assets not previously recorded.




***Other
      Intangible Assets***




Other
      intangible assets are amortized to the Statement of Operations over the period
      during which benefits are expected to accrue, currently estimated at two to
      ten
      years.




The
      determination of the value of such intangible assets requires us to make
      assumptions regarding future business conditions and operating results in order
      to estimate future cash flows and other factors to determine the fair value
      of
      the respective assets. If these estimates or the related assumptions change
      in
      the future, we could be required to record additional impairment charges. As
      of
      December 31, 2004, we identified an impairment of the technology previously
      purchased from Bristlecone and, as a result, we recorded an impairment loss
      in
      the amount of $320,279. As of December 31, 2005, we identified an impairment
      of
      backlog, trademarks and a covenant not to compete previously identified with
      respect to the AoA acquisition and, as a result, we recorded an impairment
      loss
      in the amount of $498,944.




58


***Contingencies***




We
      are
      from time to time involved in legal proceedings and other claims. We are
      required to assess the likelihood of any adverse judgments or outcomes to these
      matters, as well as potential ranges of probable losses. We have not made any
      material changes in the accounting methodology used to establish our
      self-insured liabilities during the past three fiscal years.




A
      determination of the amount of reserves required, if any, for any contingencies
      are made after careful analysis of each individual issue. The required reserves
      may change due to future developments in each matter or changes in approach,
      such as a change in the settlement strategy in dealing with any contingencies,
      which may result in higher net loss.




If
      actual
      results are not consistent with our assumptions and judgments, we may be exposed
      to gains or losses that could be material.




***Warranty
      Reserves***




Upon
      shipment of products to our customers, we provide for the estimated cost to
      repair or replace products that may be returned under warranty. Our warranty
      period is typically twelve months from the date of shipment to the end user
      customer. For existing products, the reserve is estimated based on actual
      historical experience. For new products, the warranty reserve is based on
      historical experience of similar products until such time as sufficient
      historical data has been collected on the new product. Factors that may impact
      our warranty costs in the future include our reliance on our contract
      manufacturer to provide quality products and the fact that our products are
      complex and may contain undetected defects, errors or failures in either the
      hardware or the software.




**Functional
      Currency**




We
      consider the United States dollar to be the currency of the primary economic
      environment in which we and our Israeli subsidiary EFL operate and, therefore,
      both we and EFL have adopted and are using the United States dollar as our
      functional currency. Transactions and balances originally denominated in U.S.
      dollars are presented at the original amounts. Gains and losses arising from
      non-dollar transactions and balances are included in net income.




The
      majority of financial transactions of our Israeli subsidiaries MDT and Epsilor
      is 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 have been translated using the
      average exchange rate for the period. The resulting translation adjustments
      are
      reported as a component of accumulated other comprehensive loss in shareholders’
equity.




59


**Executive
      Summary**




***Divisions
      and Subsidiaries***




We
      operate primarily as a holding company, through our various subsidiaries, which
      we have organized into three divisions. Our divisions and subsidiaries (all
      100%
      owned, unless otherwise noted) are as follows:




Ø
            Our***Simulation
                and Training Division***,
                consisting of:




·
            FAAC
                Incorporated, located in Ann Arbor, Michigan, which provides simulators,
                systems engineering and software products to the United States military,
                government and private industry (“FAAC”);
                and




·
            IES
                Interactive Training, Inc., located in Littleton, Colorado, which
                provides
                specialized “use of force” training for police, security personnel and the
                military (“IES”).




Ø
            Our***Armor
                Division***,
                consisting of:




·
            Armour
                of America, located in Los Angeles, California, which manufacturers
                ballistic and fragmentation armor kits for rotary and fixed wing
                aircraft,
                marine armor, personnel armor, military vehicles and architectural
                applications, including both the LEGUARD Tactical Leg Armor and the
                Armourfloat Ballistic Floatation Device, which is a unique vest that
                is
                certified by the U.S. Coast Guard (“AoA”);




·
            MDT
                Protective Industries, Ltd., located in Lod, Israel, whichspecializes
                in using state-of-the-art lightweight ceramic materials, special
                ballistic
                glass and advanced engineering processes to fully armor vans and
                SUVs, and
                is a leading supplier to the Israeli military, Israeli special forces
                and
                special services (“MDT”) (75.5% owned);
                and




·
            MDT
                Armor Corporation, located in Auburn, Alabama, which conducts MDT’s United
                States activities (“MDT Armor”)(88% owned).




Ø
            Our***Battery
                and Power Systems Division***,
                consisting of:




·
            Epsilor
                Electronic Industries, Ltd., located in Dimona, Israel (in Israel’s Negev
                desert area), which 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 (“Epsilor”);




·
            Electric
                Fuel Battery Corporation, located in Auburn, Alabama, which manufactures
                and sells Zinc-Air fuel sells, batteries and chargers for the military,
                focusing on applications that demand high energy and light weight
                (“EFB”);
                and




60


·
            Electric
                Fuel (E.F.L.) Ltd., located in Beit Shemesh, Israel, which produces
                water-activated lifejacket lights for commercial aviation and marine
                applications, and which conducts our Electric Vehicle effort, focusing
                on
                obtaining and implementing demonstration projects in the U.S. and
                Europe,
                and on building broad industry partnerships that can lead to eventual
                commercialization of our Zinc-Air energy system for electric vehicles
                (“EFL”).




We
      are in
      the process of relocating the operations of IES to Ann Arbor, Michigan (adjacent
      to FAAC), and the operations of AoA to Auburn, Alabama (adjacent to MDT
      Armor).




***Overview
      of Results of Operations***




We
      incurred significant operating losses for the years ended December 31, 2005,
      2004 and 2003. While we expect to continue to derive revenues from the sale
      of
      products that we manufacture and the services that we provide, there can be
      no
      assurance that we will be able to achieve or maintain profitability on a
      consistent basis.




During
      2003 and 2004, we substantially increased our revenues and reduced our net
      loss,
      from $18.5 million in 2002 to $9.2 million in 2003 to $9.0 million in 2004.
      This
      was achieved through a combination of cost-cutting measures and increased
      revenues, particularly from the sale of Zinc-Air batteries to the military
      and
      from sales of products manufactured by the subsidiaries we acquired in 2002
      and
      2004. However, in 2005 our net loss increased to $23.9 million on revenues
      of
      $49.0 million. About half of this loss was the result of impairments during
      2005
      of goodwill and other intangible assets in connection with our AoA subsidiary;
      the remainder of the increase in net loss was attributable to the factors cited
      below.




A
      portion
      of our operating loss during 2005 and 2004 arose as a result of non-cash
      charges. In addition to the charges in respect of write-offs of goodwill and
      other intangible assets described under “Critical Accounting Policies -
      Goodwill,” above, these charges were primarily related to our acquisitions,
      financings and issuances of restricted shares and options to employees. Because
      we anticipate continuing certain of these activities during 2006, we expect
      to
      continue to incur such non-cash charges in the future.




*Acquisitions*




In
      acquisition of subsidiaries, part of the purchase price is allocated to
      intangible assets and goodwill, Amortization of intangible assets related to
      acquisition of subsidiaries is recorded based on the estimated expected life
      of
      the assets. Accordingly, for a period of time following an acquisition, we
      incur
      a non-cash charge related to amortization of intangible assets in the amount
      of
      a fraction (based on the useful life of the intangible assets) of the amount
      recorded as intangible assets. Such amortization charges will continue during
      2006. We are required to review intangible assets for impairment whenever events
      or changes in circumstances indicate that carrying amount of the assets may
      not
      be recoverable. If we determine, through the impairment review process, that
      intangible asset has been impaired, we must record the impairment charge in
      our
      statement of operations.




61


In
      the
      case of goodwill, the assets recorded as goodwill are not amortized; instead,
      we
      are required to perform an annual impairment review. If we determine, through
      the impairment review process, that goodwill has been impaired, we must record
      the impairment charge in our statement of operations.




As
      a
      result of the application of the above accounting rule, we incurred non-cash
      charges for amortization of intangible assets in the amount of $3.1 million
      during 2005. In addition, we incurred non-cash charges for impairment of
      goodwill and other intangible assets in the amount of $12.3 million during
      2005,
      primarily in respect of AoA. See “Critical Accounting Policies - Other
      Intangible Assets,” above.




*Financings*




The
      non-cash charges that relate to our financings occurred in connection with
      our
      issuance of convertible debentures with warrants, and in connection with our
      repricing of certain warrants and grants of new warrants. When we issue
      convertible debentures, we record a discount for a beneficial conversion feature
      that is amortized ratably over the life of the debenture. When a debenture
      is
      converted, however, the entire remaining unamortized beneficial conversion
      feature expense is immediately recognized in the quarter in which the debenture
      is converted. Similarly, when we issue warrants in connection with convertible
      debentures, we record debt discount for financial expenses that is amortized
      ratably over the term of the convertible debentures; when the convertible
      debentures are converted, the entire remaining unamortized debt discount is
      immediately recognized in the quarter in which the convertible debentures are
      converted. As and to the extent that our remaining convertible debentures are
      converted, we would incur similar non-cash charges going forward.




As
      a
      result of the application of the above accounting rule, we incurred non-cash
      charges related to amortization of debt discount attributable to beneficial
      conversion feature in the amount of $1.7 million during 2005.




*Issuances
      of Restricted Shares, Options and Warrants*




During
      2004 and 2005, we issued restricted shares to certain of our employees. These
      shares were issued as stock bonuses, and are restricted for a period of two
      years from the date of issuance. Relevant accounting rules provide that the
      aggregate amount of the difference between the purchase price of the restricted
      shares (in this case, generally zero) and the market price of the shares on
      the
      date of grant is taken as a general and administrative expense, amortized over
      the life of the period of the restriction.




As
      a
      result of the application of the above accounting rules, we incurred non-cash
      charges related to stock-based compensation in the amount of $521,000 during
      2005.




As
      a
      result of options granted to employees, we incurred non-cash charges related
      to
      stock-based compensation in the amount of $154,000 during 2005.




As
      a
      result of shares granted to consultants and shares granted as a donation, we
      incurred non-cash charges related to stock-based compensation in the amount
      of
      $538,000 during 2005.




62


As
      part
      of our Securities Purchase Agreement dated September 29, 2005 (see Note 12.d.
      of
      the Notes to Consolidated Financial Statements), we issued warrants to purchase
      up to 5,250,000 shares of common stock. Because the terms of the warrants
      referred to above provided that upon exercise of a warrant we could issue only
      stock that had been registered with the SEC (which occurred in December 2005)
      and was 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,” the fair value of the warrants
      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 one year. 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.




***Overview
      of Financial Condition and Operating Performance***




We
      shut
      down our money-losing consumer battery operations and began acquiring new
      businesses in the defense and security field in 2002. Thereafter, we
      concentrated on eliminating our operating deficit and moving Arotech to positive
      EBITDA, a goal we achieved for the first time in our history in the second
      half
      of 2004, in part through the acquisition of businesses with strong revenues
      and
      profitable operations; however, we did not achieve such results in
      2005.




In
      our
      Simulation and Training Division, revenues grew from approximately $21.5 million
      in 2004 to $26.8 million in 2005. We attribute this to the receipt by our FAAC
      subsidiary of a number of substantial orders from, for example, the United
      States Army. As of December 31, 2005, our funded backlog for our Simulation
      and
      Training Division totaled $9.4 million.




Our
      Armor
      Division had disappointing revenues during 2005, with revenues falling from
      approximately $18.0 million in 2004 to $12.3 million in 2005 (on a pro forma
      basis, assuming we had owned all components of our Armor Division since January
      1, 2004, revenues would have fallen from approximately $29.2 million in 2004
      to
      $12.3 million in 2005). We attribute this to the unsatisfactory results of
      our
      MDT Armor subsidiary. As of December 31, 2005, our backlog for our Armor
      Division totaled $9.4 million.




In
      our
      Battery and Power Systems Division, revenues fell from approximately $10.5
      million in 2004 to $9.9 million in 2005. We attribute this to reduced equipment
      purchases by one of the customers of our Epsilor subsidiary. As of December
      31,
      2005, our backlog for our Battery and Power Systems Division totaled $4.5
      million.




**Results
      of Operations**




***Preliminary
      Note***




*Summary*




Results
      of operations for the years ended December 31, 2005 and 2004 include the results
      of AoA for the period following our acquisition of AoA in August of 2004. AoA’s
      results are therefore reflected in all of 2005 but only part of 2004.
      Accordingly, the following year-to-year comparisons should not necessarily
      be
      relied upon as indications of future performance.




63


Following
      is a table summarizing our results of operations for the years ended December
      31, 2005 and 2004, after which we present a narrative discussion and
      analysis:




**Year
                  Ended December 31,****2005**
              
              **2004*****Revenues:***Simulation
                  and Training Division
              
              $
              26,805,772
              
              $
              21,464,406Armor
                  Division
              
              
              12,322,678
              
              
              17,988,687Battery
                  and Power Systems Division
              
              
              9,916,145
              
              
              10,500,753$
              49,044,595
              
              $
              49,953,846***Cost
                  of revenues:***Simulation
                  and Training Division
              
              $
              15,835,735
              
              $
              11,739,690Armor
                  Division
              
              
              11,206,442
              
              
              15,449,084Battery
                  and Power Systems Division
              
              
              7,341,559
              
              
              6,822,320$
              34,383,736
              
              $
              34,011,094***Research
                  and development expenses:***Simulation
                  and Training Division
              
              $
              209,554
              
              $
              395,636Armor
                  Division
              
              
              139,514
              
              
              17,065Battery
                  and Power Systems Division
              
              
              951,361
              
              
              1,318,678$
              1,300,429
              
              $
              1,731,379***Sales
                  and marketing expenses:***Simulation
                  and Training Division
              
              $
              2,704,880
              
              $
              3,185,001Armor
                  Division
              
              
              834,090
              
              
              565,981Battery
                  and Power Systems Division
              
              
              853,378
              
              
              1,171,235All
                  Other
              
              
              79,242
              
              
              —$
              4,471,590
              
              $
              4,922,217***General
                  and administrative expenses:***Simulation
                  and Training Division
              
              $
              3,849,881
              
              $
              2,852,969Armor
                  Division
              
              
              2,181,355
              
              
              1,323,982Battery
                  and Power Systems Division
              
              
              974,704
              
              
              965,058All
                  Other
              
              
              7,856,495
              
              
              5,514,857$
              14,862,435
              
              $
              10,656,866***Other
                  income:***Simulation
                  and Training Division
              
              $
              338,900
              
              $
              —Armor
                  Division
              
              
              —
              
              
              —Battery
                  and Power Systems Division
              
              
              —
              
              
              —All
                  Other
              
              
              —
              
              
              —$
              338,900
              
              $
              —***Financial
                  expense (income):***Simulation
                  and Training Division
              
              $
              22,294
              
              $
              27,842Armor
                  Division
              
              
              (2,463
              )
              
              13,503Battery
                  and Power Systems Division
              
              
              122,236
              
              
              54,511All
                  Other
              
              
              2,563,622
              
              
              4,133,109$
              2,705,689
              
              $
              4,228,965***Tax
                  expenses:***Simulation
                  and Training Division
              
              $
              63,976
              
              $
              77,811Armor
                  Division
              
              
              94,671
              
              
              134,949Battery
                  and Power Systems Division
              
              
              32,846
              
              
              320,878All
                  Other
              
              
              46,179
              
              
              52,471$
              237,672
              
              $
              586,109
  64
   **Year
                    Ended December 31,****2005**
              
              **2004*****Amortization
                  of intangible assets:***Simulation
                  and Training Division
              
              $
              1,213,261
              
              $
              1,323,403Armor
                  Division
              
              
              1,348,248
              
              
              661,914Battery
                  and Power Systems Division
              
              
              509,239
              
              
              509,239$
              3,070,748
              
              $
              2,494,556***Impairment
                  of goodwill and other intangible assets:***Simulation
                  and Training Division
              
              $
              —
              
              $
              320,279Armor
                  Division
              
              
              12,256,756
              
              
              —Battery
                  and Power Systems Division
              
              
              —
              
              
              —$
              12,256,756
              
              $
              320,279***Loss
                  from affiliated company:***Simulation
                  and Training Division
              
              $
              (75,000
              )
              $
              —Armor
                  Division
              
              
              —
              
              
              —Battery
                  and Power Systems Division
              
              
              —
              
              
              —$
              (75,000
              )
              $
              —***Minority
                  interest in loss (profit) of subsidiaries:***Simulation
                  and Training Division
              
              $
              —
              
              $
              —Armor
                  Division
              
              
              57,149
              
              
              (44,694
              )Battery
                  and Power Systems Division
              
              
              —
              
              
              —$
              57,149
              
              $
              (44,694
              )***Income
                  (loss) from continuing operations******:***Simulation
                  and Training Division
              
              $
              3,170,091
              
              $
              1,541,775Armor
                  Division
              
              
              (15,678,786
              )
              
              (222,485
              )Battery
                  and Power Systems Division
              
              
              (869,178
              )
              
              (661,166
              )All
                  Other
              
              
              (10,545,538
              )
              
              (9,700,437
              )$
              (23,923,411
              )
              $
              (9,042,313
              )***Loss
                  from discontinued operations:***Simulation
                  and Training Division
              
              $
              —
              
              $
              —Armor
                  Division
              
              
              —
              
              
              —Battery
                  and Power Systems Division
              
              
              (120,000
              )
              
              —$
              (120,000
              )
              $
              —***Net
                  income (loss******):***Simulation
                  and Training Division
              
              $
              3,170,091
              
              $
              1,541,775Armor
                  Division
              
              
              (15,678,786
              )
              
              (222,485
              )Battery
                  and Power Systems Division
              
              
              (989,178
              )
              
              (661,166
              )All
                  Other
              
              
              (10,545,538
              )
              
              (9,700,437
              )$
              (24,043,411
              )
              $
              (9,042,313
              )




***Fiscal
      Year 2005 compared to Fiscal Year 2004***




***Revenues*** **.** During
      2005, we recognized revenues as follows:




Ø
            IES
                and FAAC recognized revenues from the sale of interactive use-of-force
                and
                driver operator training systems and from the provision of maintenance
                services in connection with such systems;




Ø
            MDT,
                MDT Armor and AoA recognized revenues from payments under vehicle
                armoring
                contracts, for service and repair of armored vehicles, and on sale
                of
                armoring products;




Ø
            EFB
                and Epsilor recognized revenues from the sale of batteries, chargers
                and
                adapters to the military, and under certain development contracts
                with the
                U.S. Army; and




65


Ø
            EFL
                recognized revenues from the sale of lifejacket lights and from
                subcontracting fees received in connection with Phase IV of the United
                States Department of Transportation (DOT) electric bus
                program.




Revenues
      for the year ended December 31, 2005 totaled $49.0 million, compared to $50.0
      million for 2004, a decrease of $949,000, or 2%. This decrease was primarily
      attributable to the decreased revenues of our Armor Division,
      specifically  decreased
      revenues of MDT Armor ($5.1 million during 2005 compared to $13.4 million in
      2004).




These
      decreased revenues were offset to some extent by increased revenues from our
      Simulation and Training Division ($26.8 million in 2005 compared to $21.5
      million in 2004), due primarily to the increased revenues of FAAC.




In
      2005,
      revenues were as follows:




Ø
            $26.8
                million for the Simulation and Training Division, compared to $21.5
                million in 2004,****an
                increase of $5.3 million, or 25%,****due
                primarily to the increased revenues of FAAC (approximately $4.5 million).




Ø
            $12.3
                million for the Armor Division, compared to $18.0 million in
                2004,****a
                decrease of $5.7 million, or 32%,****due
                primarily to the decreased revenues from MDT Armor (approximately
                $8.3
                million) as a result of a slowdown in armoring orders related to
                the Iraq
                War. This decrease was partially offset by higher revenues recorded
                by us
                in 2005 from AoA in comparison to 2004, due to the fact that
                AoA’s revenues were included for all of 2005 but only for the last five
                months of 2004. On a pro forma basis, AoA’s revenues decreased in 2005
                versus 2004, due to 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, and, following Hurricane Katrina, the fact
                that
                substantial funds earmarked for defense were delayed to provide funds
                for
                hurricane relief.




Ø
            $9.9
                million for the Battery and Power Systems Division, compared to $10.5
                million in 2004,****a
                decrease of $585,000, or 6%, due primarily to decreased sales of
                lithium
                batteries and chargers by our Epsilor subsidiary as a result of reduced
                equipment purchases by one of its customers, offset to some extent
                by
                increased revenues from our Zinc-Air military batteries.




***Cost
      of revenues and gross profit.*** **** Cost
      of
      revenues totaled $34.4 million during 2005, compared to $34.0 million in
      2004, **** an
      increase of $373,000, or 1%, **** due
      primarily to increased cost of goods sold related to the write off of inventory
      in the Armor Division in the amount of $1.1 million in 2005.




Direct
      expenses for our three divisions during 2005 were $22.0 million for the
      Simulation and Training Division, compared to $17.9 million in 2004, **** an
      increase of $4.1 million, or 23%, **** due
      primarily to the addition of expenses associated with increased sales of driver
      training systems through FAAC (approximately $4.5 million), offset to some
      extent by decreased expenses associated with the sales of use-of-force training
      systems; $14.0 million for the Armor Division, compared to $16.4 million in
      2004, **** a
      decrease of $2.5 million, or 15%, **** due
      primarily to decreased revenues of MDT Armor ($5.1 million during 2005 compared
      to $13.4 million in 2004), offset to some extent by increased expenses
      associated with AoA, including inventory write-off; and $9.8 million for the
      Battery and Power Systems Division, compared to $10.0 million in
      2004, **** a
      decrease of $217,000, or 2%, due primarily to decreased revenues from
      Epsilor.




66


Gross
      profit was $14.7 million during 2005, compared to $15.9 million during 2004,
      a
      decrease of $1.3 million, or 8%. This decrease was the direct result of all
      factors presented above, most notably the decrease in revenues and margins
      from
      MDT Armor and Epsilor and the inventory write-off in the amount of $1.1 million
      in our Armor Division, offset to some extent by an increase in gross profit
      from
      our Simulation and Training Division.




***Research
      and development expenses*** **.** Research
      and development expenses for 2005 were $1.3 million, compared to $1.7 million
      in
      2004, a decrease of $431,000, or 25%. This decrease was primarily attributable
      to allocating research and development expenses to the cost of revenues due
      to
      research and development contracts in the Battery and Power Systems Division
      and
      due to higher capitalization of software in the amount of $286,000 in 2005
      compared to 2004.




***Sales
      and marketing expenses*** **.** Sales
      and marketing expenses for 2005 were $4.5 million, compared to $4.9 million
      in
      2004, a decrease of $451,000, or 9%. This decrease was primarily attributable
      to
      the decrease in sales commissions in the Battery and Power Systems
      Division.




***General
      and administrative expenses*** **.** General
      and administrative expenses for 2005 were $14.9 million, compared to $10.7
      million in 2004, an increase of $4.2 million, or 39%. This increase was
      primarily attributable to the following factors:




Ø
            The
                inclusion of the general and administrative expenses of AoA in our
                results
                for all of 2005 but only five months of 2004 ($836,000);




Ø
            Increases
                in general and administrative expenses in our FAAC subsidiary due
                to legal
                expenses, employee relocation, accounting, incentive pay accruals,
                and
                similar expenses ($809,000);




Ø
            Increase
                in other corporate general and administrative expenses such as auditing,
                legal and travel expenses ($800,000);
                and




Ø
            Increase
                in costs related to abandoned acquisition activities ($1.1
                million).




***Financial
      expenses, net*** **.** Financial expense, net of interest income and exchange differentials, totaled
      approximately $2.7 million in 2005, compared to $4.2 million in 2004, a decrease
      of $1.5 million, or 36%. This decrease was due primarily to the decreased
      amortization of compensation related to warrants issued to the holders of
      convertible debentures and related beneficial conversion feature.




67


***Income
      taxes.*** **** We
      and
      certain of our subsidiaries incurred net operating losses during 2005 and,
      accordingly, we were not required to make any provision for income taxes. With
      respect to some of our subsidiaries that operated at a net profit during 2005,
      we were able to offset federal taxes against our net operating loss carry
      forwards. We recorded a total of $238,000 in tax expenses in 2005, with respect
      to certain of our subsidiaries that operated at a net profit during 2005 and
      we
      are not able to offset their taxes against our net operating loss carry forwards
      and with respect to state taxes. We recorded a total of $586,000 in tax expenses
      in 2004, with respect to certain of our subsidiaries that operated at a net
      profit during 2004 and we were not able to offset their taxes against our net
      operating loss carry forwards and with respect to state taxes.




***Amortization
      of intangible assets*** **.** Amortization of intangible assets totaled $3.1 million in 2005, compared to
      $2.5
      million in 2004, **** an
      increase of $576,000, or 23%, due primarily to amortization of intangible assets
      related to our AoA subsidiary that we acquired in August 2004.




***Impairment
      of goodwill and other intangibles assets*** .
      Current
      accounting standards require us to test goodwill for impairment at least
      annually, and between annual tests in certain circumstances; when we determine
      goodwill is impaired, it must be written down, rather than being amortized
      as
      previous accounting standards required. Goodwill is tested for impairment by
      comparing the fair value of our 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, we performed an impairment test of goodwill, based on management’s
      projections and using expected future discounted operating cash flows, as a
      response to several factors, including without limitation the reduced sales
      in
      AoA (a component of our 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 us, 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), and 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, we identified in AoA an impairment of goodwill in the amount
      of
      $11.8 million.




Our
      and
      our subsidiaries’ long-lived assets and certain identifiable intangibles are
      reviewed for impairment in accordance with current accounting standards 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, we identified an impairment
      of the technology previously purchased from Bristlecone and, as a result, we
      recorded an impairment loss in the amount of $320,000. As of December 31, 2005,
      we identified an impairment of backlog, trademarks and a covenant not to compete
      previously identified with respect to the AoA acquisition and, as a result,
      we
      recorded an impairment loss in the amount of $499,000.




***Loss
      from continuing operations.*** Due to
      the factors cited above, we reported a loss from continuing operations of
      $ 23.9
      million in 2005,
      compared to $ 9.0 million
      in 2004, an increase of $ 14.9
      million ,
      or 165% .




68


***Loss
      from discontinued operations.*** Net loss
      from discontinued operations for 2005 was $120,000 **** compared
      to $0 in 2004. This is because during the second quarter of 2005 we took an
      accrual of $200,000 for a litigation contingency related to the discontinued
      operations ;
      in
      March 2006, this litigation was settled for $120,000 .




***Net
      loss before deemed dividend of common stock to certain
      stockholders.*** Due to
      the factors cited above, we reported a net loss of $24.0 million in 2005,
      compared to a net loss of $9.0 million in 2004, an increase of $15.0 million,
      or
      166%.




***Net
      loss after deemed dividend of common stock to certain
      stockholders.*** In 2004
      we had a deemed dividend of $3.3 million (see Notes 13.f.3. and 13.f.4. to
      the
      financial statements) that we did not have in 2005. Accordingly, net loss after
      deemed dividend of common stock to certain stockholders was $24.0 million in
      2005, compared to $12.4 million in 2004, an increase of $11.7 million, or
      94%.




***Fiscal
      Year 2004 compared to Fiscal Year 2003***




***Revenues*** **.** During
      2004, we recognized revenues as follows:




Ø
            From
                the sale of interactive training systems and from the provision of
                warranty services in connection with such systems (FAAC and
                IES);




Ø
            From
                payments under armor contracts and for service and repair of armored
                vehicles (AoA and MDT);




Ø
            From
                the sale of batteries, chargers and adapters to the military, and
                under
                certain development contracts with the U.S. Army (EFB and Epsilor);




Ø
            From
                the sale of lifejacket lights (EFL);
                and




Ø
            From
                subcontracting fees received in connection with Phase III of the
                United
                States Department of Transportation (DOT) electric bus program, which
                began in October 2003 and was completed in March 2004. Phase IV of
                the DOT
                program, which began in October 2004, did not result in any revenues
                during 2004 (EFL).




69


Revenues
      from continuing operations for the year ended December 31, 2004 totaled $50.0
      million, compared to $17.3 million for 2003, an increase of $32.6 million,
      or
      188%. This increase was primarily attributable to the following
      factors:




Ø
            Increased
                revenues from vehicle armoring; and




Ø
            Revenues
                generated by FAAC, Epsilor and AoA in 2004 that were not present
                in
                2003.




These
      increases were offset to some extent by decreased revenues from sales of
      interactive use-of-force training systems and decreased revenues from sales
      of
      our Zinc-Air military batteries.




In
      2004,
      revenues were $21.5 million for the Simulation and Training Division (compared
      to $8.0 million in 2003, **** an
      increase of $13.4 million, or 168%, **** due
      primarily to the added revenues from sales of driver training systems since
      we
      acquired FAAC (approximately $16.5 million), offset to some extent by decreased
      revenues from use-of-force training systems); $18.0 million for the Armor
      Division (compared to $3.4 million in 2003, **** an
      increase of $14.6 million, or 424%, **** due
      primarily to increased revenues from vehicle armoring and to the added revenues
      from aircraft armoring since we acquired AoA); and $10.5 million for the Battery
      and Power Systems Division (compared to $5.9 million in 2003, **** an
      increase of $4.6 million, or 79%, due primarily to the added revenues from
      sales
      of lithium batteries and chargers since we acquired Epsilor (approximately
      $5.3
      million), offset to some extent by decreased revenues from our Zinc-Air military
      batteries).




***Cost
      of revenues and gross profit.*** **** Cost
      of
      revenues totaled $34.0 million during 2004, compared to $11.1 million in
      2003, **** an
      increase of $22.9 million, or 207%, **** due
      to
      increased cost of goods sold, particularly in the Armor Division (partly as
      a
      result of our beginning to sell pre-armored vehicles in 2004, which requires
      us
      to purchase vehicles for pre-armoring) and in the Simulation and Training
      Division, as well as the inclusion of the cost of goods of FAAC, Epsilor and
      AoA
      in our results for 2004 but not 2003.




Direct
      expenses for our three divisions during 2004 were $17.9 million for the
      Simulation and Training Division (compared to $7.3 million in 2003, **** an
      increase of $10.6 million, or 145%, **** due
      primarily to the addition of expenses associated with sales of driver training
      systems through FAAC (approximately $12.0 million), offset to some extent by
      decreased expenses associated with the sales of use-of-force training systems);
      $16.4 million for the Armor Division (compared to $3.6 million in
      2003, **** an
      increase of $12.9 million, or 359%, **** due
      primarily to increased expenses associated with sales of vehicle armoring (a
      $12.1 million increase in 2004, including the expenses of purchasing vehicles
      for pre-armoring in 2004, which was not present in 2003), and to the addition
      beginning in August 2004 of expenses associated with sales of aircraft armoring
      through our new subsidiary AoA); and $10.0 million for the Battery and Power
      Systems Division (compared to $5.9 million in 2003, **** an
      increase of $4.0 million, or 68%, due primarily to the addition of expenses
      associated with sales of lithium batteries and chargers through our new Epsilor
      subsidiary ($4.2 million), offset to some extent by decreased expenses
      associated with the sales of Zinc-Air military batteries).




Gross
      profit was $15.9 million during 2004, compared to $6.2 million during 2003,
      an
      increase of $9.7 million, or 155%. This increase was the direct result of all
      factors presented above, most notably the inclusion of FAAC, Epsilor and AoA
      in
      our results for 2004 ($10.2 million), as well as the increased revenues from
      vehicle armoring ($1.6 million), offset to some extent by a decrease of $2.0
      million in gross profit from IES.




70


***Research
      and development expenses*** **.** Research
      and development expenses for 2004 were $1.7 million, compared to $1.1 million
      in
      2003, an increase of $678,000, or 64%. This increase was primarily the result
      of
      the inclusion of the research and development expenses of FAAC, Epsilor and
      AoA
      in our results in 2004 ($533,000) and increased research and development
      expenses of EFL and EFB.




***Sales
      and marketing expenses*** **.** Sales
      and marketing expenses for 2004 were $4.9 million, compared to $3.5 million
      in
      2003, an increase of $1.4 million, or 39%. This increase was primarily
      attributable to the inclusion of the sales and marketing expenses of FAAC,
      Epsilor and AoA in our results for 2004 ($2.0 million), offset to some extent
      by
      a decrease of $600,000 in expenses related to our military batteries and a
      decrease in sales and marketing expenses related to interactive use-of-force
      training.




***General
      and administrative expenses*** **.** General
      and administrative expenses for 2004 were $10.7 million, compared to $5.9
      million in 2003, an increase of $4.8 million, or 82%. This increase was
      primarily attributable to the following factors:




Ø
            The
                inclusion of the general and administrative expenses of FAAC, Epsilor
                and
                AoA in our results for 2004 ($2.4
                million);




Ø
            Expenses
                in 2004 in connection with grant of options and shares to employees
                that
                were not present in 2003 ($830,000);




Ø
            Costs
                associated with our compliance with Section 404 of the Sarbanes-Oxley
                Act
                of 2002 that were not present in 2003 ($150,000);
                and




Ø
            Increases
                in other general and administrative expenses, such as employee salaries
                and bonuses, travel expenses, audit fees, director fees, legal fees,
                and
                expenses related to due diligence performed in connection with certain
                potential acquisitions, which were not present in
                2003.




We
      are
      not anticipating a reduction in our general and administrative expenses in
      the
      coming year, and we expect that our travel expenses, audit fees, legal fees,
      and
      due diligence expenses will continue or increase to the extent that we continue
      to pursue acquisitions in the future.




These
      increases were offset to some extent by:




Ø
            Expenses
                in 2003 in connection with a litigation settlement agreement that
                were not
                present in 2004 ($700,000); and




Ø
            Amortization
                of legal and consulting expenses in 2003 in connection with our
                convertible debentures that were lower (by $260,000) than in
                2004.




***Financial
      expenses, net*** **.** Financial expense, net of interest income and exchange differentials, totaled
      approximately $4.2 million in 2004 compared to $4.0 million in 2003, an increase
      of $190,000, or 5%. This difference was due primarily to amortization of debt
      discount related to the issuance of convertible debentures and their conversion,
      as well as interest expenses related to those debentures.




71


***Income
      taxes.*** **** We
      and
      certain of our subsidiaries incurred net operating losses during 2004 and,
      accordingly, we were not required to make any provision for income taxes. With
      respect to some of our subsidiaries that operated at a net profit during 2004,
      we were able to offset federal taxes against our net operating loss carry
      forwards. We recorded a total of $586,000 in tax expenses in 2004, with respect
      to certain of our subsidiaries that operated at a net profit during 2004 and
      we
      are not able to offset their taxes against our net operating loss carry forwards
      and with respect to state taxes. In 2003, tax expenses were recorded with
      respect to MDT’s taxable income. Out of the $586,000 tax expense that we
      recorded in 2004, $84,000 was related to prior years and $(37,000) represented
      income from deferred taxes, net.




***Amortization
      of intangible assets and impairment*** **.** Amortization of intangible assets totaled $2.8 million in 2004, compared to
      $865,000 in 2003, **** an
      increase of $1.9 million, or 225%, resulting from the inclusion of the
      amortization of the intangible assets of FAAC, Epsilor and AoA in our results
      in
      2004 and impairment in the amount of $320,000 of technology previously purchased
      by IES from Bristlecone Technologies.




***Net
      loss before deemed dividend of common stock to certain
      stockholders.*** Due to
      the factors cited above, we reported a net loss of $9.0 million in 2004,
      compared to a net loss of $9.2 million in 2003, a decrease of $195,000, or
      2%.




***Net
      loss after deemed dividend of common stock to certain
      stockholders*** was
      $12.4 million due to a deemed dividend of $3.3 million (see Notes 13.f.3. and
      13.f.4. to the financial statements) compared to $9.6 million in 2003, an
      increase of 2.8 million, or 29%.




**Liquidity
      and Capital Resources**




As
      of
      December 31, 2005, we had $6.2 million in cash, $3.9 million in restricted
      collateral securities and restricted held-to-maturity securities due within
      one
      year, $779,000 in long-term restricted deposits, and $36,000 in
      available-for-sale marketable securities, as compared to at December 31, 2004,
      when we had $6.7 million in cash, $7.0 million in restricted collateral
      securities and restricted held-to-maturity securities due within one year,
      $4.0
      million in long-term restricted deposits, and $136,000 in available-for-sale
      marketable securities.




We
      used
      available funds in 2005 primarily for sales and marketing, continued research
      and development expenditures, expenses in connection with acquisitions and
      proposed acquisitions, and other working capital needs. We increased our
      investment in fixed assets by $1.2 million during the year ended December 31,
      2005, primarily in the Battery and Power Systems Division and in the Simulation
      and Training Division. Our net fixed assets amounted to $4.3 million as at
      year
      end.




Net
      cash
      used in operating activities for 2005 and 2004 was $11.8 million and $852,000,
      respectively, an increase of $10.2 million. This increase was primarily the
      result of increased loss in 2005 and an increase in trade receivables and
      decrease in trade payables and other account payables.




Net
      cash
      used in investing activities for 2005 and 2004 was $11.8 million and $50.5
      million, respectively, a decrease of $38.7 million. This decrease was primarily
      the result of our investment in the acquisition of FAAC, Epsilor and AoA in
      2004.




72


Net
      cash
      provided by financing activities for 2005 and 2004 was $22.2 million and $44.4
      million, respectively, a decrease of $22.1 million. This decrease was primarily
      the result of lower amounts of funds raised through sales of our securities
      in
      2005 compared to 2004.




During
      2005, certain of our employees exercised options under our registered employee
      stock option plan. The proceeds to us from the exercised options were
      approximately $17,000.




We
      have
      approximately $8.8 million in long-term debt outstanding (not including accrued
      severance pay). All of this debt was convertible debt; the unamortized financial
      expenses related to the beneficial conversion feature of this convertible debt
      amounted to approximately $160,000 at year end. We also have approximately
      $15.5
      million in short-term debt (not including trade payables and other accounts
      payable), of which $604,000 relates to the earn-out provision in connection
      with
      our acquisition of FAAC and $12.8 million relates to short-term convertible
      debt.




Our
      debt
      agreements contain customary affirmative and negative operations covenants
      that
      limit the discretion of our management with respect to certain business matters
      and place restrictions on us, including obligations on our part to preserve
      and
      maintain our assets and restrictions on our ability to incur or guarantee debt,
      to merge with or sell our assets to another company, and to make significant
      capital expenditures without the consent of the debenture holders, as well
      as
      granting to our investors a right of first refusal on any future financings,
      except for underwritten public offerings in excess of $30 million. We do not
      believe that this right of first refusal will materially limit our ability
      to
      undertake future financings.




Based
      on
      our internal forecasts, we believe that our present cash position, anticipated
      cash flows from operations, lines of credit and anticipated additions to paid-in
      capital should be sufficient to satisfy our current estimated cash requirements
      through the next twelve months. This belief is based on certain earnout and
      other assumptions that our management and our subsidiaries managers believe
      to
      be reasonable, some of which are subject to the risk factors detailed under
      “Item 1A. Risk Factors,” above, including without limitation (i) that we will be
      able to refinance, restructure or convert to equity our $12.8 million in
      convertible debt (debentures and notes) that is due in 2006 (which does not
      include $2.0 million short-term bank credit), (ii) that our dispute with the
      former shareholders of FAAC will ultimately be decided substantially in our
      favor, (iii) that the severance and retirement benefits that we owe to certain
      of our senior executives will not have to be paid ahead of their anticipated
      schedule, and (iv) that no other earnout payments to the former shareholder
      of
      AoA will be required in excess of the funds being held by him in escrow to
      secure such earnout obligations. In this connection, we note that we can require
      the holder of our notes to convert a portion of their notes into shares of
      our
      common stock at the time principal payments are due only if such shares are
      registered for resale and certain other conditions are met. Based on the current
      price of our stock, we do not have a sufficient number of shares of our stock
      registered for resale in order to continue requiring the holders to convert
      a
      portion of their notes past a portion of the payment due May 31, 2006. We would
      accordingly have to file a registration statement with the SEC to register
      for
      resale more shares of our common stock in order to continue requiring conversion
      of our notes upon principal payment becoming due. Any delay in the registration
      process, including through routine SEC review of our registration statement
      or
      other filings with the SEC, could result in our having to pay scheduled
      principal repayments on our notes in cash, which would negatively impact our
      cash position and, if we do not have sufficient cash to make such payments
      in
      cash, could cause us to default on our notes. We also note that from time to
      time our working capital needs are partially dependent on our subsidiaries’
lines of credit. In the event that we are unable to continue to make use of
      our
      subsidiaries’ lines of credit for working capital on economically feasible
      terms, our business, operating results and financial condition could be
      adversely affected.




73


**Effective
      Corporate Tax Rate**




We
      and
      certain of our subsidiaries incurred net operating losses during the years
      ended
      December 31, 2005, 2004 and 2003, and accordingly no provision for income taxes
      was required. With respect to some of our U.S. subsidiaries that operated at
      a
      net profit during 2005, we were able to offset federal taxes against our net
      operating loss carryforward, which amounted to $26.0 million as of December
      31,
      2005. These subsidiaries are, however, subject to state taxes that cannot be
      offset against our net operating loss carryforward. With respect to certain
      of
      our Israeli subsidiaries that operated at a net profit during 2005, we were
      unable to offset their taxes against our net operating loss carryforward, and
      we
      are therefore exposed to Israeli taxes, at a rate of up to 34% in 2005 (less,
      in
      the case of companies that have “approved enterprise” status as discussed in
      Note 14 to the Notes to Financial Statements).




As
      of
      December 31, 2005, we had a U.S. net operating loss carryforward of
      approximately $26.0 million that is available to offset future taxable income
      under certain circumstances, expiring primarily from 2009 through 2025, and
      foreign net operating and capital loss carryforwards of approximately $82.0
      million, **** which
      are
      available indefinitely to offset future taxable income under certain
      circumstances.




**Contractual
      Obligations**




The
      following table lists our contractual obligations and commitments as of December
      31, 2005, not including trade payables and other accounts payable:




**Payment
                    Due by Period****Contractual
                    Obligations**
                
                **Total**
                
                **Less
                    Than 1
                    Year**
                
                **1-3
                    Years**
                
                **3-5
                    Years**
                
                **More
                    than 5
                    Years**Long-term
                    debt*
                
                $
                8,750,000
                
                $
                —
                
                $
                8,750,000
                
                $
                —
                
                $
                —Short-term
                    debt**
                
                $
                15,474,448
                
                $
                15,474,448
                
                $
                —
                
                $
                —
                
                $
                —Operating
                    lease obligations***
                
                $
                1,926,383
                
                $
                826,367
                
                $
                1,003,176
                
                $
                96,840
                
                $
                —Severance
                    obligations***
                
                $
                1,732,955
                
                $
                137,685
                
                $
                1,595,269
                
                $
                —
                
                $
                —





*
                    Includes
                      convertible debentures in the gross amount of $8,750,000. Unamortized
                      financial expenses related to the beneficial conversion feature of
                      these convertible debentures amounted to $160,000 at year
                      end.
 ******
                    Includes
                        sums owed in respect of an earn-out provision related to
                        our acquisition
                        of FAAC, in the amount of $604,000. Also includes $12.8 million
                        short-term
                        convertible note and $2.0 million in short-term bank
                        debt
 *******
              Includes
                  operating lease obligations related to
                  rent.
 ****
                        Includes
                            obligations related to special severance pay arrangements
                            in addition to
                            the severance amounts due to certain employees pursuant
                            to Israeli
                            severance pay law (the amount shown in the table above
                            with payment due
                            during the next 1-3 years might not be paid in the period
                            stated in the
                            event the employment agreements to which such severance
                            obligations relate
                            are
                            extended).
  74


**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) for the two years ended December 31,
                2005
            F-63**Financial
                Statement Schedule**Schedule
                II - Valuation and Qualifying Accounts
            F-64




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




None.




**ITEM
          9A.** **CONTROLS
          AND PROCEDURES**




**Evaluation
      of Disclosure Controls and Procedures**




As
      of
      December 31, 2005, our management, including the principal executive officer
      and
      principal financial officer, evaluated our disclosure controls and procedures
      related to the recording, processing, summarization, and reporting of
      information in our periodic reports that we file with the SEC. These disclosure
      controls and procedures are intended to ensure that material information
      relating to us, including our subsidiaries, is made known to our management,
      including these officers, by other of our employees, and that this information
      is recorded, processed, summarized, evaluated, and reported, as applicable,
      within the time periods specified in the SEC’s rules and forms. Due to the
      inherent limitations of control systems, not all misstatements may be detected.
      These inherent limitations include the realities that judgments in
      decision-making can be faulty and that breakdowns can occur because of simple
      error or mistake. Any system of controls and procedures, no matter how well
      designed and operated, can at best provide only reasonable assurance that the
      objectives of the system are met and management necessarily is required to
      apply
      its judgment in evaluating the cost benefit relationship of possible controls
      and procedures. Additionally, controls can be circumvented by the individual
      acts of some persons, by collusion of two or more people, or by management
      override of the control. Our controls and procedures are intended to provide
      only reasonable, not absolute, assurance that the above objectives have been
      met.




Our
      management has not yet completed its assessment of the effectiveness of our
      internal control over financial reporting. However, based on their evaluation
      as
      of December 31, 2005 and the material weakness described below, our principal
      executive officer and principal financial officer were able to conclude that
      our
      disclosure controls and procedures (as defined in Rules 13a-15(e) and
      15d-15(e) under the Securities Exchange Act of 1934) were not effective to
      ensure that the information required to be disclosed by us in the reports that
      we file or submit under the Securities Exchange Act of 1934 is recorded,
      processed, summarized and reported within the time periods specified in SEC
      rules and forms.




75


In
      light
      of the material weakness described below, our management performed additional
      analyses and other procedures to determine that our 2005 consolidated financial
      statements were prepared in accordance with generally accepted accounting
      principles in the United States (U.S. GAAP). Accordingly, management believes
      that the consolidated financial statements included in this report fairly
      present in all material respects our financial position, results of operations
      and cash flows for the periods presented.




**Management’s
      Report on Internal Control Over Financial Reporting**




Our
      management, including our principal executive and financial officers, is
      responsible for establishing and maintaining adequate internal control over
      our
      financial reporting, as such term is defined in Exchange Act Rule 13a-15(f).
      Our
      management has not yet completed its assessment of our internal control over
      financial reporting as of December 31, 2005, which it has been conducting
      pursuant to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002
      and using the criteria set forth by the Committee of Sponsoring Organizations
      (“COSO”) of the Treadway Commission in *Internal
      Control - Integrated Framework* .




However,
      based on their evaluation procedures performed to date, management has
      identified a material weakness in our internal control over financial reporting
      at December 31, 2005. A material weakness ** is
      a
      control deficiency, or a 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.




We
      have
      identified the following material weakness as of December 31, 2005, related
      to
      our FAAC subsidiary:




Ø
            *Revenue
                recognition*.
                We did not maintain effective controls over the monitoring, review
                and
                approval of revenue recognition calculations at FAAC. Specifically,
                these
                calculations were not being reviewed by appropriate accounting personnel
                to determine that revenue is recognized in accordance with company
                policy
                and generally accepted accounting principles. This material weakness
                affects the revenue and unbilled receivables
                accounts.




Because
      of this material weakness and any other material weaknesses management might
      identify upon completing its assessment, management has concluded that our
      internal control over financial reporting was not effective as of December
      31,
      2005.




Because
      we have not yet completed our assessment of the effectiveness of our internal
      control over financial reporting, our independent registered public accounting
      firm has disclaimed an opinion on management’s assessment and disclaimed an
      opinion on the effectiveness of our internal control over financial reporting,
      as stated in their report which is included herein.




We
      note
      in this connection that our Independent Registered Public Accounting Firm
      audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), our consolidated financial statements and
      financial statement schedule as of and for the year ended December 31, 2005,
      and
      their report dated March 30, 2005 expressed an unqualified opinion with respect
      thereto.




76


**Plans
      to Remediate the Material Weakness**




In
      response to the material weakness described above, we have undertaken the
      following initiatives with respect to our internal controls and procedures
      that
      we believe are reasonably likely to improve and materially affect our internal
      control over financial reporting. We anticipate that remediation will be
      continuing throughout fiscal 2006, during which we expect to continue pursuing
      appropriate corrective actions at FAAC, including the following:




Ø
            *Revenue
                recognition*.
                We will institute procedures at FAAC to determine that revenue recognition
                calculations are reviewed by an appropriate accounting
                person.




Our
      management and Audit Committee will monitor closely the implementation of our
      remediation plan. The effectiveness of the steps we intend to implement is
      subject to continued management review, as well as Audit Committee oversight,
      and we may make additional changes to our internal control over financial
      reporting.




We
      cannot
      assure you that we will not in the future identify further material weaknesses
      in our internal control over financial reporting. We currently are unable to
      determine when the above-mentioned material weakness will be fully remediated.
      However, because remediation will not be completed until we have strengthened
      pertinent controls, we presently anticipate that we will report in our Quarterly
      Report on Form 10-Q for the first quarter of fiscal 2006 that material
      weakness continues to exist.




**Changes
      in Internal Controls Over Financial Reporting**




There
      have been no changes in our internal control over financial reporting that
      occurred during our last fiscal quarter to which this Annual Report on Form
      10-K
      relates that have materially affected, or are reasonably likely to materially
      affect, our internal control over financial reporting.




**ITEM
          9B.** **OTHER
          INFORMATION**




None.




77


**PART
      III**




**ITEM
          10.** **DIRECTORS
          AND EXECUTIVE OFFICERS OF THE REGISTRANT**




**Executive
      Officers, Directors and Significant Employees**




***Executive
      Officers and Directors***




Our
      executive officers and directors and their ages as of February 28, 2006 were
      as
      follows:




**Name**
            
            **Age**
            
            **Position**Robert
                S. Ehrlich
            
            67
            
            Chairman
                of the Board and Chief Executive OfficerSteven
                Esses
            
            42
            
            President,
                Chief Operating Officer and DirectorThomas
                J. Paup
            
            57
            
            Vice
                President - Finance and Chief Financial OfficerDr.
                Jay M. Eastman
            
            57
            
            DirectorJack
                E. Rosenfeld
            
            67
            
            DirectorLawrence
                M. Miller
            
            59
            
            DirectorEdward
                J. Borey
            
            55
            
            DirectorSeymour
                Jones
            
            74
            
            Director




Our
      by-laws provide for a board of directors of one or more directors. There are
      currently seven directors. Under the terms of our certificate of incorporation,
      the board of directors is composed of three classes of similar size, each
      elected in a different year, so that only one-third of the board of directors
      is
      elected in any single year. Dr. Eastman and Mr. Esses are designated Class
      I
      directors and have been elected for a term expiring in 2006 and until their
      successors are elected and qualified; Messrs. Rosenfeld, Miller and Jones are
      designated Class II directors elected for a term expiring in 2008 and until
      their successors are elected and qualified; and Messrs. Ehrlich and Borey are
      designated Class III directors elected for a term that expires in 2007 and
      until
      their successors are elected and qualified. A majority of the Board is
“independent” under relevant SEC and Nasdaq regulations.




**Robert
      S. Ehrlich** has
      been
      our Chairman of the Board since January 1993 and our President and Chief
      Executive Officer since October 2002. In December 2006 Mr. Ehrlich ceased to
      hold the title of President. From May 1991 until January 1993, Mr. Ehrlich
      was
      our Vice Chairman of the Board, and from May 1991 until October 2002 he was
      our
      Chief Financial Officer. Mr. Ehrlich was a director of Eldat, Ltd., an Israeli
      manufacturer of electronic shelf labels, from June 1999 to July 2003. From
      1987
      to June 2003, Mr. Ehrlich served as a director of PSC Inc. (“PSCX”), a
      manufacturer and marketer of laser diode bar code scanners, and, between April
      1997 and June 2003, Mr. Ehrlich was the chairman of the board of PSCX. PSCX
      filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code
      in
      November 2002. Mr. Ehrlich received a B.S. and J.D. from Columbia University
      in
      New York, New York.




**Steven
      Esses** has been
      a director since July 2002, our Executive Vice President since January 2003,
      our
      Chief Operating Officer since February 2003 and our President since December
      2005. From 2000 until 2002, Mr. Esses was a principal with Stillwater Capital
      Partners, Inc., a New York-based investment research and advisory company (hedge
      fund) specializing in alternative investment strategies. During this time,
      Mr.
      Esses also acted as an independent consultant to new and existing businesses
      in
      the areas of finance and business development. From 1995 to 2000, Mr. Esses
      founded Dunkin’ Donuts in Israel and held the position of Managing Director and
      CEO. Prior thereto, he was Director of Retail Jewelry Franchises with Hamilton
      Jewelry, and before that he served as Executive Director of Operations for
      the
      Conway Organization, a major off-price retailer with 17 locations.




78


**Thomas
      J. Paup** has been
      our Vice President - Finance since December 2005 and our Chief Financial Officer
      since February 2006. Mr. Paup is
      currently also a Finance Lecturer at Eastern Michigan University. Mr.
      Paup was an
      Affiliated Partner with McMillan|Doolittle LLP from March 2002 until accepting
      this position with the Company, and prior thereto, he was an Executive in
      Residence and Finance Instructor at DePaul University’s Kellstadt Graduate
      School of Business. Prior
      to
      his teaching experience, Mr.
      Paup
      spent over 25 years in the retail industry. Most recently, between 1997 and
      2000, Mr. Paup was the Executive Vice President and Chief Financial Officer
      and
      member of the Board of Directors of Montgomery Ward and Company. Mr. Paup
      brings a broad background of strategic and operational management experiences
      from the department store industry, where he served as CFO of Lord & Taylor
      and Kaufmann’s and Controller of Bloomingdale’s and Robinson-May. Mr. Paup holds
      an MBA in Finance and a BBS from Eastern Michigan University.




**Dr.
      Jay M. Eastman** has been
      one of our directors since October 1993. Since November 1991, Dr. Eastman has
      served as President and Chief Executive Officer of Lucid, Inc., which is
      developing laser technology applications for medical diagnosis and treatment.
      Dr. Eastman served as Senior Vice President of Strategic Planning of PSCX from
      December 1995 through October 1997. Dr. Eastman is also a director of Dimension
      Technologies, Inc., a developer and manufacturer of 3D displays for computer
      and
      video displays. From 1981 until January 1983, Dr. Eastman was Director of the
      University of Rochester’s Laboratory for Laser Energetics, where he was a member
      of the staff from September 1975 to 1981. Dr. Eastman holds a B.S. and a Ph.D.
      in Optics from the University of Rochester in New York.




**Jack
      E. Rosenfeld** has been
      one of our directors since October 1993. Mr. Rosenfeld was President and Chief
      Executive Officer of Potpourri Group Inc. (“Potpourri”), a specialty catalog
      direct marketer, from April 1998 until June 2003; from June 2003 until February
      2005, Mr. Rosenfeld served as Chairman of Potpourri’s Board of Directors and as
      its CEO, and since February 2005, Mr. Rosenfeld has been Executive Chairman
      of
      the Potpourri Board of Directors. Mr. Rosenfeld was President and Chief
      Executive Officer of Hanover Direct, Inc., formerly Horn & Hardart Co.,
      which operates a direct mail marketing business, from September 1990 until
      December 1995, and had been President and Chief Executive Officer of its direct
      marketing subsidiary, from May 1988 until September 1990. Mr. Rosenfeld holds
      a
      B.A. from Cornell University in Ithaca, New York and an LL.B. from Harvard
      University in Cambridge, Massachusetts.




**Lawrence
      M. Miller** was
      elected to the board of directors in November 1996. Mr. Miller has been a senior
      partner in the Washington D.C. law firm of Schwartz, Woods and Miller since
      1990. He served from August 1993 through May 1996 as a member of the board
      of
      directors of The Phoenix Resource Companies, Inc., a publicly traded energy
      exploration and production company, and as a member of the Audit and
      Compensation Committee of that board. That company was merged into Apache
      Corporation in May 1996. Mr. Miller holds a B.A. from Dickinson College in
      Carlisle, Pennsylvania and a J.D. with honors from George Washington University
      in Washington, D.C. He is a member of the District of Columbia bar.




79


**Edward
      J. Borey** has
      served as a director since December 2003. Mr. Borey has been Chairman and Chief
      Executive Officer of WatchGuard Technologies, Inc., a leading provider of
      network security solutions (NasdaqNM: WGRD), since July 2004. From December
      2000
      to September 2003, Mr. Borey served as President, Chief Executive Officer and
      a
      director of PSCX. PSCX filed a voluntary petition for relief under Chapter
      11 of
      the Bankruptcy Code in November 2002. Prior to joining PSCX, Mr. Borey was
      President and CEO of TranSenda (May 2000 to December 2000).
      Previously, Mr. Borey held senior positions in the automated data
      collection industry. At Intermec Technologies Corporation (1995-1999), he was
      Executive Vice President and Chief Operating Officer and also Senior Vice
      President/General Manager of the Intermec Media subsidiary. Currently,
      Mr. Borey serves as a Board member at Mbrane (foremerly known as Centura
      Software), and he is on the Advisory Board of TranSenda Software and NextRx.
      Mr. Borey holds a B.S. in Economics from the State University of New York,
      College of Oswego; an M.A. in Public Administration from the University of
      Oklahoma; and an M.B.A. in Finance from Santa Clara University.




**Seymour
      Jones** has
      served as a director since July 2005. Mr. Jones is a clinical professor of
      accounting at New York University Stern School of Business. Professor Jones
      teaches courses in auditing, tax and legal aspects of entrepreneurism. He is
      also the Associate Director of Ross Institute of Accounting Research at Stern
      School of Business. Professor Jones has been with NYU Stern for ten years.
      His
      primary research areas include audit committees, auditing, entrepreneurship,
      financial reporting, and fraud. Professor Jones has been principal author of
      numerous books including *Conflict
      of Interest* , *The
      Cooper & Lybrand Guide to Growing Your Business* , *The
      Emerging Business* and *The
      Bankers Guide to Audit Reports and Financial Statements* .
      Before
      joining NYU Stern, Professor Jones was senior partner at Coopers & Lybrand
      and S.D. Leidesdorf & Co. Professor Jones is a certified public accountant
      in New York State. Professor Jones received a B.A. in economics from City
      College, City University of New York, and an M.B.A. from NYU Stern.




***Committees
      of the Board of Directors***




Our
      board
      of directors has an Audit Committee, a Compensation Committee, a Nominating
      Committee and an Executive and Finance Committee.




Created
      in December 1993, the purpose of the Audit Committee is to review with
      management and our independent auditors the scope and results of the annual
      audit, the nature of any other services provided by the independent auditors,
      changes in the accounting principles applied to the presentation of our
      financial statements, and any comments by the independent auditors on our
      policies and procedures with respect to internal accounting, auditing and
      financial controls. The Audit Committee was established in accordance with
      Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended. In
      addition, the Audit Committee is charged with the responsibility for making
      decisions on the engagement of independent auditors. As required by law, the
      Audit Committee operates pursuant to a charter, available
      through a hyperlink located on the investor relations page of our website,
      at http://www.arotech.com/compro/investor.html .
      The
      Audit Committee consists of Prof. Jones (Chair) and Messrs. Miller and
      Rosenfeld. We have
      determined that Prof. Jones qualifies as an “audit committee financial expert”
under applicable SEC and Nasdaq regulations. Prof.
      Jones, as well as all the other members of the Audit Committee, is
“independent,” as independence is defined in Rule 4200(a)(15) of the National
      Association of Securities Dealers’ listing standards and under Item 7(d)(3)(iv)
      of Schedule 14A of the proxy rules under the Exchange Act.




80


The
      Compensation Committee, also created in December 1993, recommends annual
      compensation arrangements for the Chief Executive Officer and Chief Financial
      Officer and reviews annual compensation arrangements for all officers and
      significant employees. The Compensation Committee consists of Dr. Eastman
      (Chair) and Messrs. Rosenfeld and Borey, all of whom are independent
      non -employee
      directors .




The
      Executive and Finance Committee, created in July 2001, exercises the powers
      of
      the Board during the intervals between meetings of the Board, in the management
      of the property, business and affairs of the Company (except with respect to
      certain extraordinary transactions). The Executive and Finance Committee
      consists of Messrs. Ehrlich (Chair), Miller, Borey and Esses.




The
      Nominating Committee, created in March 2003, identifies
      and proposes candidates to serve as members of the Board of Directors. Proposed
      nominees for membership on the Board of Directors submitted in writing by
      stockholders to the Secretary of the Company will
      be
      brought to the attention of the Nominating Committee. The Nominating Committee
      consists of Mr. Rosenfeld (Chair), Mr. Miller and Dr. Eastman, all of whom
      are
“independent,” as
      independence is defined in Rule 4200(a)(15) of the National Association of
      Securities Dealers’ listing standards and under Item 7(d)(3)(iv) of Schedule 14A
      of the proxy rules under the Exchange Act .
      The
      Nominating Committee operates under a formal charter that governs its duties.
      The Nominating Committee’s charter is publicly available through a hyperlink
      located on the investor relations page of our website, at http://www.arotech.com/compro/investor.html .




***Code
      of Ethics***




We
      have
      adopted a Code of Ethics, as required by Nasdaq listing standards and the rules
      of the SEC, that applies to our principal executive officer, our principal
      financial officer, and our principal accounting officer. The Code of Ethics
      is
      publicly available through a hyperlink located on the investor relations page
      of
      our website, at http://www.arotech.com/compro/investor.html .
      If we
      make substantive amendments to the Code of Ethics or grant any waiver, including
      any implicit waiver, that applies to anyone subject to the Code of Ethics,
      we
      will disclose the nature of such amendment or waiver on the website or in a
      report on Form 8-K in accordance with applicable Nasdaq and SEC rules.




***Code
      of Conduct***




We
      have
      adopted a general Code of Conduct, as required by Nasdaq listing standards and
      the
      rules of the SEC, that applies to all of our employees. The Code of Conduct
      is
      publicly available
      through a hyperlink located on the investor relations page of our website,
      at http://www.arotech.com/compro/investor.html .




81


***Whistleblower
      Policy***




We
      have
      adopted a Whistleblower Policy, as required by Nasdaq listing standards, in
      order to ensure compliance with the provisions of the Sarbanes-Oxley Act of
      2002. The Whistleblower Policy is publicly available through a hyperlink located
      on the investor relations page of our website, at http://www.arotech.com/compro/investor.html .
      Employees with complaints about our compliance with applicable legal and
      regulatory requirements relating to accounting, auditing and internal control
      matters may submit their complaints in person, by mail or other written
      communication or by telephone to our Complaint Administrator. The Complaint
      Administrator can be contacted anonymously, by submitting the form located
      on
      our corporate website at http://arotech.com/compro/complaint.html .
      Complaints sent in this manner will automatically be stripped of all
      computer-encoded information identifying the originating e-mail address, and
      will then automatically be forwarded to the Complaint Administrator’s regular
      e-mail address at Arotech.




***Director
      Compensation***




Non-employee
      members of our board of directors are paid $2,500 (plus expenses) for each
      board
      of directors meeting attended, $2,000 (plus expenses) for each meeting of the
      audit committee of the board of directors attended, and $1,000 (plus expenses)
      for each meeting of all other committees of the board of directors attended.
      In
      addition, we have adopted a Non-Employee Director Stock Option Plan pursuant
      to
      which non-employee directors receive an initial grant of options to purchase
      40,000 shares of our common stock upon the effective date of such plan or upon
      the date of his or her election as a director. Thereafter, non-employee
      directors will receive options to purchase 25,000 shares of our common stock
      for
      each year of service on the board. All such options are granted at fair market
      value and vest ratably over three years from the date of the grant. During
      2005,
      our directors agreed to an interim reduction in their fees of 25% as part of
      our
      overall cost-cutting strategy.




***Significant
      Employees***




Our
      significant employees as of February 28, 2006, and their ages as of December
      31,
      2005, are as follows:




**Name**
            
            **Age**
            
            **Position**Jonathan
                Whartman
            
            51
            
            Senior
                Vice PresidentYaakov
                Har-Oz
            
            48
            
            Senior
                Vice President, General Counsel and SecretaryDr.
                Neal Naimer
            
            47
            
            President,
                Battery DivisionWilliam
                Graham
            
            47
            
            Vice
                President of Government AffairsKim
                Kelly
            
            41
            
            Vice
                President - Corporate CommunicationsDanny
                Waldner
            
            34
            
            ControllerDean
                Krutty
            
            40
            
            President,
                Simulation DivisionYosef
                Bar
            
            63
            
            General
                Manager, MDT Protective IndustriesRonen
                Badichi
            
            40
            
            General
                Manager, Epsilor Electronics Industries, Ltd.Graydon
                Hansen
            
            47
            
            President,
                Electric Fuel Battery Corporation




82


**Jonathan
      Whartman** has been
      Senior Vice President since December 2000, and Vice President of Marketing
      from
      1994 to December 2000. From 1991 until 1994, Mr. Whartman was our Director
      of
      Special Projects. Mr. Whartman was also Director of Marketing of Amtec from
      its
      inception in 1989 through the merger of Amtec into Arotech in 1991. Before
      joining Amtec, Mr. Whartman was Manager of Program Management at Luz, Program
      Manager for desktop publishing at ITT Qume in San Jose, California from 1986
      to
      1987, and Marketing Director at Kidron Digital Systems, an Israeli computer
      developer, from 1982 to 1986. Mr. Whartman holds a B.A. in Economics and an
      M.B.A. from the Hebrew University, Jerusalem, Israel.




**Yaakov
      Har-Oz** has
      served as our Vice President and General Counsel since October 2000 and as
      our
      corporate Secretary since December 2000; in December 2005 Mr. Har-Oz was
      promoted to Senior Vice President. From 1994 until October 2000, Mr. Har-Oz
      was
      a partner in the Jerusalem law firm of Ben-Ze’ev, Hacohen & Co. Prior to
      moving to Israel in 1993, he was an administrative law judge and in private
      law
      practice in New York. Mr. Har-Oz holds a B.A. from Brandeis University in
      Waltham, Massachusetts and a J.D. from Vanderbilt Law School (where he was
      an
      editor of the law review) in Nashville, Tennessee. He is a member of the New
      York bar and the Israel Chamber of Advocates.




**Dr.
      Neal Naimer** has been
      a Vice President since June 1997 and our Chief Technology Officer since December
      2002. Since March 2005. Dr. Naimer has served as the President of our Battery
      Division. From 1989 to 1997, Dr. Naimer was Director of Electrode Engineering
      of
      our Air Electrode development program. From 1987 to 1989, he was the Manager
      of
      the Chemical Vapor Deposition (Thin Films) Group at Intel Electronics in
      Jerusalem, and was Project Manager of the photo voltaic IR detector development
      program at Tadiran Semiconductor Devices in Jerusalem from 1984 to 1987. Dr.
      Naimer was educated at University College of London, England, where he received
      his B.Sc. in Chemical Engineering and a Ph.D. in Chemical
      Engineering.




**William
      Graham** joined
      us
      as Vice President of Government Affairs in January 2005, after twenty years
      of
      military service highlighted by multiple commands and six years of Pentagon
      experience. During this time, Mr. Graham interacted continuously with Senators
      and their staffs to develop and execute the strategy for presenting the $300+
      billion defense budget. After retiring from the Army as a Colonel in 2001,
      Mr.
      Graham joined Washington Operations for Time Domain Corporation (TDC) as a
      Director to help the company secure Pentagon contracts and congressional support
      for those programs. Mr. Graham completed a B.S. in General Engineering at the
      U.S. Military Academy (West Point) in 1980, earned his masters from Central
      Michigan University in 1991 and was graduated from the U.S. Army War College
      in
      1999.




**Kim
      Kelly** has
      served as our Vice President - Corporate Communications since November 2004.
      Since January 2006, Ms Kelly has moved to part-time status with us. From 1993
      to
      2004, Ms Kelly held a variety of positions at ECI Telecom Ltd., a Nasdaq-listed
      company, including serving as ECI’s Director of Corporate Communications, where
      she played a significant role in ECI’s communications strategy, investor
      relations program and competitive intelligence analysis. Ms Kelly holds a B.A.
      in Social Work from Bar-Ilan University in Tel-Aviv and an M.B.A. from
      Ben-Gurion University in Beersheva, Israel.




**Danny
      Waldner** has
      served as our Controller since March 2000 and as our chief accounting officer
      since October 2002. Prior thereto, Mr. Waldner was an accountant at KPMG in
      Israel from 1996 to 2000. Mr. Waldner is a Certified Public Accountant and
      holds
      a B.A. in Accounting and Business Administration and an M.B.A. from the Rishon
      Lezion College of Administration in Israel, as well as an LL.M from Bar-Ilan
      University in Tel-Aviv.




83


**Dean
      Krutty** became
      President of Simulation Division in January 2005, after having spent the prior
      thirteen years as a member of the FAAC management team, beginning as an
      electrical engineer in the part task trainer division and most recently serving
      as FAAC’s Director of Military Operations, and five years before that working in
      other positions in the simulation industry. Mr. Krutty holds a B.S. in
      electrical engineering from the Michigan State University.




**Yosef
      Bar** established MDT Protective Industries in 1989 as one of the first bulletproofing
      companies in Israel. Under the direction of Mr. Bar, MDT moved from its initial
      emphasis on vandalism protection to bulletproofing not just windshields but
      the
      entire vehicle, as a result of which MDT became Israel’s leader in the
      state-of-the art lightweight armoring of vehicles. Mr. Bar served in the Israel
      Defense Forces, reaching the rank of Lieutenant Colonel of the paratroop
      regiment with over 1,000 jumps to his credit. He also participated in several
      anti-terrorism courses.




**Ronen
      Badichi** became
      the General Manager of Epsilor Electronic Industries in May 2005. Prior to
      joining Epsilor, Mr. Badichi served since 1999 as the General Manager of Maoz
      Industries, a high end supplier of displays to the aviation industry. Prior
      thereto, Mr. Badichi was a project manager at BAE Systems and served as the
      F-16
      Avionics Integration manager in the Israeli Air Force, with the rank of Captain.
      Mr. Badichi holds a B.Sc. in Physics and Electro-Optic Engineering from the
      Lev
      Institute of Technology in Jerusalem.




**Graydon
      Hansen** has
      served as President of EFBC since January 2005. Prior thereto, Mr. Hansen was
      Senior Vice President of Engineering with Elpac Electronics, Inc. From March
      2002 until February 2004, Mr. Hansen was Vice President of Engineering at Trojan
      Battery Corporation, where his management responsibilities included commercial
      product development and design activity, plus leadership of the Quality and
      Production Engineering groups in all of Trojan’s manufacturing facilities.
      Previously, Mr. Hansen worked at Lockheed Missiles and Space Company. Mr. Hansen
      holds a B.Sc. in electric engineering from the University of California at
      Berkeley, and is a Registered Professional Engineer and a Certified Quality
      Engineer.




**Section
      16(a) Beneficial Ownership Reporting Compliance**




Under
      the
      securities laws of the United States, our directors, certain of our officers
      and
      any persons holding more than ten percent of our common stock are required
      to
      report their ownership of our common stock and any changes in that ownership
      to
      the Securities and Exchange Commission. Specific due dates for these reports
      have been established and we are required to report any failure to file by
      these
      dates during 2005. We are not aware of any instances during 2005, not previously
      disclosed by us, where such “reporting persons” failed to file the required
      reports on or before the specified dates, except as follows:




(i)
            Mr.
                Ehrlich was required to file a Form 4 on or prior to December 31,
                2004 in
                connection with (i) the repricing of 600,000 of his existing stock
                options
                and the accelerated vesting of 33,333 of those options, (ii) his
                abandonment of 227,000 of his existing stock options, and (iii) his
                receipt of 1,500,000 new stock options. He reported these transactions
                in
                a Form 5 filed on February 14,
                2006.




84


(ii)
            Mr.
                Esses was required to file a Form 4 on or prior to December 31, 2004
                in
                connection with (i) the repricing of 885,140 of his existing stock
                options
                and the accelerated vesting of 50,000 of those options, and (ii)
                his
                receipt of 114,860 new stock options. He reported these transactions
                in a
                Form 5 filed on February 14, 2006.




(iii)
            Prof.
                Jones was required to file a Form 3 on or prior to July 21, 2005
                in
                connection with his becoming a director. He filed this Form 3 on
                February
                15, 2006. Additionally, as a result of technical problems with his
                EDGAR
                filing codes, his Form 5 that was supposed to be filed on or prior
                to
                February 14, 2006 was filed on February 15,
                2006.




(iv)
            Mr.
                Shen was required to file a Form 5 on or prior to February 14, 2006.
                He
                filed this Form 5 on February 17,
                2006.




**ITEM
      11.**  **EXECUTIVE
      COMPENSATION**




**Cash
      and Other Compensation**




***General***




Our
      Chief
      Executive Officer and the other highest paid executive officers (of which there
      were two) who were compensated at a rate of more than $100,000 in salary and
      bonuses during the year ended December 31, 2005 (collectively, the “Named
      Executive Officers”) are Israeli residents, and thus certain elements of the
      compensation that we pay them is structured as is customary in
      Israel.




During
      2005, 2004 and 2003, compensation to our Named Executive Officers took several
      forms:




Ø
            cash
                salary;




Ø
            bonus,
                some of which was paid in cash in the year in which it was earned
                and some
                of which was accrued in the year in which it was earned but paid
                in cash
                in a subsequent year;




Ø
            cash
                reimbursement for taxes paid by the Named Executive Officer and reimbursed
                by us in accordance with Israeli tax
                regulations;




Ø
            accruals
                (but not cash payments) in respect of contractual termination compensation
                in excess of the Israeli statutory
                minimum;




Ø
            accruals
                (but not cash payments) in respect of pension plans, which consist
                of a
                savings plan, life insurance and statutory severance pay benefits,
                and a
                continuing education fund (as is customary in
                Israel);




Ø
            stock
                options;




85


Ø
            grants
                of restricted stock, where the sale of such stock is prohibited for
                a
                period of two years and such stock is forfeit to us should the Named
                Executive Officer’s employment be terminated for cause, as defined in such
                Executive’s employment agreement (*e.g.*,
                fraud, reckless or willful misconduct, etc.);
                and




Ø
            other
                benefits, primarily consisting of annual statutory holiday pay and
                redemption of unused vacation days and sick
                days.




The
      specific amounts of each form of compensation paid to each Named Executive
      Officer appear in the summary compensation table and the notes thereto appearing
      under “Summary Compensation Table,” below.




***Summary
      Compensation Table***




The
      following table, which should be read in conjunction with the explanations
      provided above, shows the compensation that we paid (or accrued), in connection
      with services rendered for 2005, 2004 and 2003, to our Named Executive
      Officers.




**SUMMARY
      COMPENSATION TABLE** **(1)**




**Annual
                      Compensation**
                  
                  **Long
                      Term Compensation**
                  
                  **All
                      Other Compensation****Name
                      and Principal Position**
                  
                  **Year**
                  
                  **Salary**
                  
                  **Bonus**
                  
                  **Tax**
                    **Reimbursement**
                  
                  **Securities**
                    **Underlying**
                    **Options**
                  
                  **Restricted**
                    **Stock**
                    ******Award****(2)**
                  
                  **Changes
                      in**
                    **Accruals
                      for**
                    **Sick
                      Days,**
                    **Vacation
                      Days,**
                    **and
                      Termination**
                    **Compensation**
                  
                  **Payment
                      to**
                    **Pension
                      and**
                    **Education**
                    **Funds**
                  
                  **Others**Robert
                      S. Ehrlich
                  
                  
                  2005
                  
                  $
                  275,362
                  
                  $
                  49,875
                  
                  $
                  26,340
                  
                  
                  0
                  (3)
                  $
                  0
                  
                  $
                  (51,363)
                  (4)
                  $
                  45,362
                  
                  $
                  112,413
                  (5)Chairman
                      of the Board, Chief Executive Officer
                  
                  
                  2004
                  
                  $
                  275,907
                  
                  $
                  175,000
                  
                  $
                  29,103
                  
                  
                  50,000
                  
                  $
                  626,350
                  
                  $
                  133,898
                  (6)
                  $
                  548,477
                  (7)
                  $
                  19,893and
                      director*
                  
                  
                  2003
                  
                  $
                  259,989
                  
                  $
                  180,000
                  (8)
                  $
                  27,211
                  
                  
                  2,035,000
                  
                  $
                  0
                  
                  $
                  80,713
                  (9)
                  $
                  48,228
                  
                  $
                  678Steven
                      Esses
                  
                  
                  2005
                  
                  $
                  56,722
                  (10)
                  $
                  112,000
                  (11)
                  $
                  22,666
                  
                  
                  114,860
                  (12)
                  $
                  0
                  
                  $
                  228,403
                  (13)
                  $
                  12,446
                  
                  $
                  13,607President,
                      Chief Operating Officer and director**
                  
                  
                  2004
                  
                  $
                  65,506
                  (14)
                  $
                  106,000
                  (15)
                  $
                  25,273
                  
                  
                  0
                  
                  $
                  221,100
                  
                  $
                  3,759
                  (16)
                  $
                  12,116
                  
                  $
                  12,9402003
                  
                  $
                  0
                  
                  $
                  0
                  
                  $
                  0
                  
                  
                  1,035,000
                  
                  $
                  0
                  
                  $
                  0
                  
                  $
                  0
                  
                  $
                  0Avihai
                      Shen
                  
                  
                  2005
                  
                  $
                  157,013
                  
                  $
                  0
                  
                  $
                  7,889
                  
                  
                  0
                  
                  $
                  0
                  
                  $
                  70,479
                  (17)
                  $
                  23,121
                  
                  $
                  39,476
                  (18)Vice
                      President - Finance and
                  
                  
                  2004
                  
                  $
                  155,845
                  
                  $
                  97,000
                  
                  $
                  6,407
                  
                  
                  18,750
                  
                  $
                  54,900
                  
                  $
                  34,972
                  (19)
                  $
                  26,889
                  
                  $
                  476Chief
                      Financial Officer***
                  
                  
                  2003
                  
                  $
                  123,988
                  
                  $
                  0
                  
                  $
                  8,653
                  
                  
                  608,750
                  
                  $
                  0
                  
                  $
                  6,471
                  (20)
                  $
                  23,133
                  
                  $
                  463


*
            Mr.
                Ehrlich ceased to hold the title of President in December
                2005.**
            Mr.
                Esses became an executive officer in January 2003. His compensation
                as an
                officer during 2003 consisted solely of stock options. In December
                2005,
                Mr. Esses became our President; prior thereto, he held the title
                of
                Executive Vice President.***
            Mr.
                Shen ceased to act as our Chief Financial Officer in February 2006,
                and
                his employment with us terminated on March 31, 2006.(1)
            We
                paid the amounts reported for each named executive officer in U.S.
                dollars
                and/or New Israeli Shekels (NIS). We have translated amounts paid
                in NIS
                into U.S. dollars at the exchange rate of NIS into U.S. dollars at
                the
                time of payment or accrual.(2)
            Based
                on the closing market price of our stock on the Nasdaq Stock Exchange
                the
                date of grant multiplied by the number of shares awarded. As of December
                31, 2004, our Named Executive Officers held 635,000 restricted shares.
                Of
                these shares, the restrictions on 530,000 shares are scheduled to
                expire
                on August 4, 2006, and the restrictions on 105,000 are scheduled
                to expire
                on December 8, 2006. The value of the restricted shares held by our
                Named
                Executive Officers on December 31, 2004, based on the closing price
                of our
                stock on the Nasdaq Stock Exchange on that date. was
                $902,350.(3)
            During
                2005, no new options were granted to Mr. Ehrlich; however, 600,000
                of Mr.
                Ehrlich’s options were repriced in 2005 from an average exercise price of
                $1.19 to a new exercise price of $0.39. See “Report on Repricing of
                Options,” below. Additionally, 784,167 of Mr. Ehrlich’s options expired or
                were cancelled during 2005.




86


(4)
            Of
                this amount, $67,024 represents our accrual for severance pay that
                will be
                payable to Mr. Ehrlich upon his leaving our employ other than if
                he is
                terminated for cause, such as a breach of trust; $(51,928) represents
                the
                decrease of the accrual for vacation days redeemable by Mr. Ehrlich;
                $(40,483) represents the decrease of the accrual for sick days redeemable
                by Mr. Ehrlich; and $(25,976) represents the decrease of our accrual
                for
                severance pay that would be payable to Mr. Ehrlich under the laws
                of the
                State of Israel if we were to terminate his employment.(5)
            Of
                this amount, $61,195 represents payment for redemption of accrued
                but
                unused vacation days, and $33,394 represents payment for redemption
                of
                accrued but unused sick days.(6)
            Of
                this amount, $76,766 represents our accrual for severance pay that
                would
                be payable to Mr. Ehrlich upon a “change of control” or upon the
                occurrence of certain other events; $28,603 represents the increase
                of the
                accrual for vacation days redeemable by Mr. Ehrlich; and $28,529
                represents the increase of our accrual for severance pay that would
                be
                payable to Mr. Ehrlich under the laws of the State of Israel if we
                were to
                terminate his employment.(7)
            Of
                this amount, $500,000 wasdeposited
                by us in a Rabbi Trust for Mr. Ehrlich’s benefit. Pursuant to the terms of
                the Rabbi Trust, funds in the Rabbi Trust continue to be owned by
                us, and
                benefit from all gains and bear the risk of all losses resulting
                from
                investments of Rabbi Trust funds. See “Employment Contracts - Robert S.
                Ehrlich,” below.(8)
            We
                paid Mr. Ehrlich $180,000 during 2004 in satisfaction of his bonus
                from
                2003 to which he was entitled according to his contract. Of this
                amount,
                we accrued $99,750 for Mr. Ehrlich in satisfaction of the 2003 bonus
                to
                which he was entitled according to his contract; the remainder was
                the
                result of the approval in 2004 by the Compensation Committee of a
                higher
                bonus for 2003 than Mr. Ehrlich’s contractual minimum.(9)
            Of
                this amount, $92,075 represents our accrual for severance pay that
                would
                be payable to Mr. Ehrlich upon a “change of control” or upon the
                occurrence of certain other events; $3,451 represents the increase
                of the
                accrual for sick leave and vacation days redeemable by Mr. Ehrlich;
                and
                $(14,813) represents the decrease of our accrual for severance pay
                that
                would be payable to Mr. Ehrlich under the laws of the State of Israel
                if
                we were to terminate his employment.(10)
            Does
                not include $178,176 that we paid in consulting fees to Sampen
                Corporation,a
                New York corporation owned by members of Steven Esses’s immediate family,
                from which Mr. Esses receives a salary. See “Item 13. Certain
                Relationships and Related Transactions - Consulting Agreement with
                Sampen
                Corporation,” below.(11)
            Includes
                a $100,000 signing bonus that was paid to Mr. Esses in 2005 and the
                $12,000 minimum bonus to which Mr. Esses is entitled pursuant to
                the terms
                of his employment contract. Does notinclude
                $30,720 that we paid as a bonus to Sampen Corporation,a
                New York corporation owned by members of Steven Esses’s immediate family,
                from which Mr. Esses receives a salary. See “Item 13. Certain
                Relationships and Related Transactions - Consulting Agreement with
                Sampen
                Corporation,” below..(12)
            In
                addition to the grant of 114,860 new options during 2005, 885,140
                of Mr.
                Esses’s options were repriced in 2005 from an average exercise price of
                $0.80 to a new exercise price of $0.39. See “Report on Repricing of
                Options,” below.(13)
            Of
                this amount, $186,707 represents the increase of our accrual for
                severance
                pay that would be payable to Mr. Esses if we were to terminate his
                employment; and $41,369 represents the increase of the accrual for
                sick
                leave and vacation days redeemable by Mr. Esses.(14)
            Does
                not include $208,100 that we paid in consulting fees to Sampen
                Corporation,a
                New York corporation owned by members of Steven Esses’s immediate family,
                from which Mr. Esses receives a salary. See “Item 13. Certain
                Relationships and Related Transactions - Consulting Agreement with
                Sampen
                Corporation,” below.(15)
            Does
                not include $110,000 that we paid as a bonus to Sampen Corporation,a
                New York corporation owned by members of Steven Esses’s immediate family,
                from which Mr. Esses receives a salary. See “Item 13. Certain
                Relationships and Related Transactions - Consulting Agreement with
                Sampen
                Corporation,” below.(16)
            Represents
                the increase of the accrual for vacation days redeemable by Mr.
                Esses.(17)
            Of
                this amount, $104,602 represents the increase of our accrual for
                severance
                pay that would be payable to Mr. Shen if we were to terminate his
                employment; $(28,597) represents the decrease of the accrual for
                sick
                leave and vacation days redeemable by Mr. Shen; and $(5,526) represents
                the decrease in our accrual for severance pay that would be payable
                to Mr.
                Shen under the laws of the State of Israel if we were to terminate
                his
                employment.Mr. Shen left our employ effective March 31, 2006, and these amounts
                were
                accordingly paid to him.(18)
            Of
                this amount, $35,131 represents payment to Mr. Shen for redemption
                of
                accrued but unused vacation days.(19)
            Of
                this amount, $21,568 represents the increase in our accrual for vacation
                days redeemable by Mr. Shen; and $13,404 represents the increase
                of our
                accrual for severance pay that would be payable to Mr. Shen under
                the laws
                of the State of Israel if we were to terminate his
                employment.(20)
            Of
                this amount, $8,369 represents the increase of the accrual for vacation
                days redeemable by Mr. Shen; and $(1,628) represents the decrease
                of our
                accrual for severance pay that would be payable to Mr. Shen under
                the laws
                of the State of Israel if we were to terminate his
                employment.




87


***Executive
      Loans***




In
      1999,
      2000 and 2002, we extended certain loans to our Named Executive Officers. These
      loans are summarized in the following table, and are further described under “Item
      13.
      Certain Relationships and Related Transactions - Officer Loans,”
below.




**Name
                of Borrower**
            
            **Date
                of Loan**
            
            **Original**
              **Principal**
              **Amount
                of Loan**
            
            **Amount**
              **Outstanding**
              **as
                of 12/31/05**
            
            **Terms
                of Loan**Robert
                S. Ehrlich
            
            
            12/28/99
            
            $
            167,975
            
            $
            201,570
            
            
            Ten-year
                non-recourse loan to purchase our stock, secured by the shares of
                stock
                purchased.Robert
                S. Ehrlich
            
            
            02/09/00
            
            $
            789,991
            
            $
            692,102
            
            
            Twenty-five-year
                non-recourse loan to purchase our stock, secured by the shares of
                stock
                purchased.Robert
                S. Ehrlich
            
            
            06/10/02
            
            $
            36,500
            
            $
            40,343
            
            
            Twenty-five-year
                non-recourse loan to purchase our stock, secured by the shares of
                stock
                purchased.




**Stock
      Options**




The
      table
      below sets forth information with respect to stock options granted to the Named
      Executive Officers for the fiscal year 2005.




**Option
      Grants in Last Fiscal Year**


**Individual
                      Grants**
                  
                  
                  
                  
                  
                  
                  **Potential
                      Realizable Value**
                    **of
                      Assumed Annual Rates**
                    **of
                      Stock Price Appreciation**
                    **for
                      Option Term****(1)****Name**
                  
                  **Number
                      of**
                    **Securities
                      Underlying**
                    **Options
                      Granted**
                  
                  **%
                      of Total Options**
                    **granted
                      to Employees**
                    **in
                      Fiscal Year**
                  
                  
                  **Exercise
                      or Base**
                    **Price
                      ($/Sh)**
                  
                  **Expiration
                      Date**
                  
                  **5%
                      ($)**
                  
                  **10%
                      ($)**Steven
                      Esses
                  
                  114,860
                  
                  6.8
                  %
                  
                  $
                  0.39
                  
                  12/29/10
                  
                  $
                  12,376
                  
                  $
                  27,348







(1)
            The
                potential realizable value illustrates value that might be realized
                upon
                exercise of the options immediately prior to the expiration of their
                terms, assuming the specified compounded rates of appreciation of
                the
                market price per share from the date of grant to the end of the option
                term. Actual gains, if any, on stock option exercise are dependent
                upon a
                number of factors, including the future performance of the common
                stock
                and the timing of option exercises, as well as the executive officer’s
                continued employment through the vesting period. The gains shown
                are net
                of the option exercise price, but do not include deductions for taxes
                and
                other expenses payable upon the exercise of the option or for sale
                of
                underlying shares of common stock. The 5% and 10% rates of appreciation
                are mandated by the rules of the Securities and Exchange Commission
                and do
                not represent our estimate or projection of future increases in the
                price
                of our stock. There can be no assurance that the amounts reflected
                in this
                table will be achieved, and unless the marketpriceof
                our common stockappreciates over the option term, novaluewill be realized from the option grants made to the executive
                officers.




88


The
      table
      below sets forth information for the Named Executive Officers with respect
      to
      aggregated option exercises during fiscal 2005 and fiscal 2005 year-end option
      values.




**Aggregated
      Option Exercises and Fiscal Year-End Option Values**




**Number
                  of Securities**
                **Underlying
                  Unexercised**
                **Options
                  at Fiscal Year End**
              
              **Value
                  of Unexercised**
                **In-the-Money
                  Options**
                **at
                  Fiscal-Year-End****(1)****Name**
              
              
              **Shares**
                **Acquired
                  on**
                **Exercise**
              
              **Value**
                **Realized**
              
              **Exercisable**
              
              **Unexercisable**
              
              **Exercisable**
              
              **Unexercisable**Robert
                  S. Ehrlich
              
              
              —
              
              $
              —
              
              
              2,100,000
              
              
              0
              
              $
              0
              
              $
              0Steven
                  Esses
              
              
              —
              
              $
              —
              
              
              1,035,000
              
              
              0
              
              $
              0
              
              $
              0Avihai
                  Shen
              
              
              —
              
              $
              —
              
              
              619,653
              
              
              0
              
              $
              0
              
              $
              0





(1)
            Options
                that are “in-the-money” are options for which the fair market value of the
                underlying securities on December 31, 2005 ($0.37) exceeds the exercise
                or
                base price of the option.




**REPORT
      OF THE COMPENSATION COMMITTEE ON OPTIONS REPRICING**




During
      2005, we approved the repricing of 600,000 of Mr. Ehrlich’s stock options from
      exercise prices ranging between $0.61 and $1.43 to a new exercise price of
      $0.39, and 885,140 of Mr. Esses’s stock options from exercise prices ranging
      between $0.43 and $1.28 to a new exercise price of $0.39. The market price
      of
      our common stock at the time of the repricing was $0.39. This repricing was
      implemented to address the substantial loss in value of the outstanding stock
      options held by Messrs. Ehrlich and Esses and the increasing inability of those
      options to serve as a meaningful performance incentive for them. Additionally,
      we accelerated vesting of 557,340 of our outstanding unvested stock options
      to
      make such options immediately vested and exercisable.  The
      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 us to treat all unvested stock options as compensation expense effective
      January 1, 2006. We believe that the acceleration of vesting of those options
      will enable us to avoid recognizing stock-based compensation expense associated
      with these options in future periods. Additional purposes of 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.




**Submitted
      by the Compensation Committee**




Dr.
      Jay
      M. Eastman


Jack
      E.
      Rosenfeld


Edward
      J.
      Borey




89


**Report
      on Repricing of Options**




The
      table
      below sets forth information for all Executive Officers with respect to
      repricing of options for the ten years preceding December 31, 2005.




**Ten-Year
      Option Repricings**




**Name
                      and Principle Position**
                    
                    **Date**
                    
                    **Number
                        of**
                      **Securities**
                      **Underlying**
                      **Options**
                      **Repriced
                        or**
                      **Amended**
                    
                    **Market**
                      **Price
                        of**
                      **Stock
                        at**
                      **Time
                        of**
                      **Repricing
                        or**
                      **Amendment**
                      **($)**
                    
                    **Exercise**
                      **Price
                        at**
                      **Time
                        of**
                      **Repricing
                        or**
                      **Amendment**
                      **($)**
                    
                    **New**
                      **Exercise**
                      **Price**
                      **($)**
                    
                    **Length
                        of**
                      **Original**
                      **Option**
                      **Term**
                      **Remaining**
                      **at
                        Date of**
                      **Repricing
                        or**
                      **Amendment**
                      **(Years)**Robert
                        S. Ehrlich
                    
                    
                    12/29/05
                    
                    
                    28,500
                    
                    $
                    0.39
                    
                    $
                    1.375
                    
                    $
                    0.39
                    
                    
                    3.84Chairman,
                        Chief Executive Officer and director
                    
                    
                    12/29/05
                    
                    
                    48,000
                    
                    $
                    0.39
                    
                    $
                    1.430
                    
                    $
                    0.39
                    
                    
                    5.8112/29/05
                    
                    
                    166,000
                    
                    $
                    0.39
                    
                    $
                    1.430
                    
                    $
                    0.39
                    
                    
                    5.6512/29/05
                    
                    
                    72,500
                    
                    $
                    0.39
                    
                    $
                    1.300
                    
                    $
                    0.39
                    
                    
                    5.8312/29/05
                    
                    
                    65,625
                    
                    $
                    0.39
                    
                    $
                    1.420
                    
                    $
                    0.39
                    
                    
                    2.0012/29/05
                    
                    
                    15,625
                    
                    $
                    0.39
                    
                    $
                    0.730
                    
                    $
                    0.39
                    
                    
                    2.0012/29/05
                    
                    
                    65,625
                    
                    $
                    0.39
                    
                    $
                    0.850
                    
                    $
                    0.39
                    
                    
                    2.0012/29/05
                    
                    
                    88,125
                    
                    $
                    0.39
                    
                    $
                    0.610
                    
                    $
                    0.39
                    
                    
                    2.0012/29/05
                    
                    
                    50,000
                    
                    $
                    0.39
                    
                    $
                    1.200
                    
                    $
                    0.39
                    
                    
                    3.61Steven
                        Esses
                    
                    
                    12/29/05
                    
                    
                    450,140
                    
                    $
                    0.39
                    
                    $
                    0.430
                    
                    $
                    0.39
                    
                    
                    2.07President,
                        Chief Operating Officer and director
                    
                    
                    12/29/05
                    
                    
                    100,000
                    
                    $
                    0.39
                    
                    $
                    0.850
                    
                    $
                    0.39
                    
                    
                    7.5312/29/05
                    
                    
                    300,000
                    
                    $
                    0.39
                    
                    $
                    1.280
                    
                    $
                    0.39
                    
                    
                    7.7912/29/05
                    
                    
                    35,000
                    
                    $
                    0.39
                    
                    $
                    1.280
                    
                    $
                    0.39
                    
                    
                    7.79


**Employment
      Contracts**




***Robert
      S. Ehrlich***




Mr.
      Ehrlich is party to an employment agreement with us executed in May 2005,
      effective as of January 1, 2005. The term of this employment agreement expires
      on December 31, 2007, and is extended automatically for additional terms of
      one
      year each unless either Mr. Ehrlich or we terminate the agreement
      sooner.




The
      employment agreement provides for a base salary of $23,750 per month in 2005,
      $25,000 per month in 2006, and $26,500 per month in 2007, as adjusted annually
      for Israeli inflation and devaluation of the Israeli shekel against the U.S.
      dollar, if any. Additionally, the board may at its discretion raise Mr.
      Ehrlich’s base salary. Mr. Ehrlich is currently receiving, with his consent, a
      reduced salary in an effort on our part to cut costs.




90


The
      employment agreement provides that we will pay a bonus, on a sliding scale,
      in
      an amount equal to a minimum of 35% of Mr. Ehrlich’s annual base salary then in
      effect, up to a maximum of 90% of his annual base salary then in effect if
      the
      results we actually attain for the year in question are 120% or more of the
      amount we budgeted at the beginning of the year.




The
      employment agreement also contains various benefits customary in Israel for
      senior executives (please see “Item 1. Business - Employees,” above), tax and
      financial planning expenses and an automobile, and contain confidentiality
      and
      non-competition covenants. Pursuant to the employment agreements, we granted
      Mr.
      Ehrlich demand and “piggyback” registration rights covering shares of our common
      stock held by him.




We
      can
      terminate Mr. Ehrlich’s employment agreement in the event of death or disability
      or for “Cause” (defined as conviction of certain crimes, willful failure to
      carry out directives of our board of directors or gross negligence or willful
      misconduct). Mr. Ehrlich has the right to terminate his employment upon a change
      in our control or for “Good Reason,” which is defined to include adverse changes
      in employment status or compensation, our insolvency, material breaches and
      certain other events. Additionally, Mr. Ehrlich may terminate his agreement
      for
      any reason upon 120 days’ notice. Upon termination of employment, the employment
      agreement provides for payment of all accrued and unpaid compensation, and
      (unless we have terminated the agreement for Cause or Mr. Ehrlich has terminated
      the agreement without Good Reason and without giving us 120 days’ notice of
      termination) bonuses due for the year in which employment is terminated (in
      an
      amount of not less than 35% of base salary) and severance pay in the amount
      of
      $1,625,400 and bonus at the minimum rate, except that in the event of
      termination of the agreement following a change of control, the amount payable
      is doubled. Furthermore, certain benefits will continue and all outstanding
      options will be fully vested.




Pursuant
      to the terms of our employment agreement Mr. Ehrlich, funds to secure payment
      of
      Mr. Ehrlich’s contractual severance are to be deposited in a Rabbi Trust for his
      benefit, with payments to the Rabbi Trust to be made pursuant to an agreed-upon
      schedule. As of December 31, 2005, a total of $454,859 had been deposited in
      this Rabbi Trust. Pursuant to the terms of the Rabbi Trust, funds in the Rabbi
      Trust continue to be owned by us, and benefit from all gains and bear the risk
      of all losses resulting from investments of Rabbi Trust funds.




***Steven
      Esses***




Mr.
      Esses
      is party to an employment agreement with us executed in May 2005, effective
      as
      of January 1, 2005. The term of this employment agreement expires on December
      31, 2006, and is extended automatically for additional terms of two years each
      unless either Mr. Esses or we terminate the agreement sooner.




The
      employment agreement provides for a base salary of $5,000 per month, as adjusted
      annually for Israeli inflation and devaluation of the Israeli shekel against
      the
      U.S. dollar, if any. Additionally, the board may at its discretion raise Mr.
      Esses’s base salary.




The
      employment agreement provides that if the results we actually attain in a given
      year are at least 90% of the amount we budgeted at the beginning of the year,
      we
      will pay a bonus, on a sliding scale, in an amount equal to a minimum of 25%
      of
      Mr. Esses’s annual base salary then in effect, up to a maximum of 75% of his
      annual base salary then in effect if the results we actually attain for the
      year
      in question are 120% or more of the amount we budgeted at the beginning of
      the
      year.




The
      employment agreement also contains various benefits customary in Israel for
      senior executives (please see “Item 1. Business - Employees,” above), tax and
      financial planning expenses and an automobile, and contain confidentiality
      and
      non-competition covenants. Pursuant to the employment agreements, we granted
      Mr.
      Esses demand and “piggyback” registration rights covering shares of our common
      stock held by him.




91


We
      can
      terminate Mr. Esses’s employment agreement in the event of death or disability
      or for “Cause” (defined as conviction of certain crimes, willful failure to
      carry out directives of our board of directors or gross negligence or willful
      misconduct). Mr. Esses has the right to terminate his employment upon a change
      in our control or for “Good Reason,” which is defined to include adverse changes
      in employment status or compensation, our insolvency, material breaches and
      certain other events. Additionally, Mr. Esses may retire (after age 65), retire
      early (after age 55) or terminate his agreement for any reason upon 150 days’
notice. Upon termination of employment, the employment agreement provides for
      payment of all accrued and unpaid compensation, and (unless we have terminated
      the agreement for Cause or Mr. Esses has terminated the agreement without Good
      Reason and without giving us 150 days’ notice of termination) bonuses due for
      the year in which employment is terminated (in an amount of not less than 20%
      of
      base salary) and severance pay in the amount of $330,000, except that in the
      event of termination of the agreement following a change of control, the amount
      payable is doubled. Furthermore, certain benefits will continue (for a shorter
      period, in the event of early retirement) and all outstanding options will
      be
      fully vested.




Pursuant
      to the terms of our employment agreement Mr. Esses, funds to secure payment
      of
      Mr. Esses’s contractual severance are to be deposited in a Rabbi Trust for his
      benefit, with payments to the Rabbi Trust to be made pursuant to an agreed-upon
      schedule. As of December 31, 2005, no funds had been deposited in this Rabbi
      Trust. Pursuant to the terms of the Rabbi Trust, funds in the Rabbi Trust
      continue to be owned by us, and benefit from all gains and bear the risk of
      all
      losses resulting from investments of Rabbi Trust funds.




See
      also
“Item 13. Certain Relationships and Related Transactions - Consulting Agreement
      with Sampen Corporation,” below.




***Thomas
      J. Paup***




Mr.
      Paup
      is party to an employment agreement with us dated December 30, 2005. Under
      the
      terms of his employment agreement, Mr. Paup is entitled to receive a base salary
      of $135,000 per annum, and will be eligible for a bonus with a target equal
      to
      between 20% and 50% of the base salary. The actual bonus payout shall be
      determined based upon the Company’s achievement level against financial and
      performance objectives determined by the Compensation Committee of our Board
      of
      Directors.




Other
      employees have entered into individual employment agreements with us. These
      agreements govern the basic terms of the individual’s employment, such as
      salary, vacation, overtime pay, severance arrangements and pension plans.
      Subject to Israeli law, which restricts a company’s right to relocate an
      employee to a work site farther than sixty kilometers from his or her regular
      work site, we have retained the right to transfer certain employees to other
      locations and/or positions provided that such transfers do not result in a
      decrease in salary or benefits. All of these agreements also contain provisions
      governing the confidentiality of information and ownership of intellectual
      property learned or created during the course of the employee’s tenure with us.
      Under the terms of these provisions, employees must keep confidential all
      information regarding our operations (other than information which is already
      publicly available) received or learned by the employee during the course of
      employment. This provision remains in force for five years after the employee
      has left our service. Further, intellectual property created during the course
      of the employment relationship belongs to us.




A
      number
      of the individual employment agreements, but not all, contain non-competition
      provisions which restrict the employee’s rights to compete against us or work
      for an enterprise which competes against us. Such provisions remain in force
      for
      a period of two years after the employee has left our service.




92


Under
      the
      laws of Israel, an employee of ours who has been dismissed from service, died
      in
      service, retired from service upon attaining retirement age, or left due to
      poor
      health, maternity or certain other reasons, is entitled to severance pay at
      the
      rate of one month’s salary for each year of service, *pro
      rata* for
      partial years of service. We currently fund this obligation by making monthly
      payments to approved private provident funds and by its accrual for severance
      pay in the consolidated financial statements. See Note 2.s. o f
      the
      Notes to the Consolidated Financial Statements.




**Compensation
      Committee Interlocks and Insider Participation**




The
      Compensation Committee of our board of directors for the 2005 fiscal year
      consisted of Dr. Jay M. Eastman, Jack E. Rosenfeld and Edward J. Borey. None
      of
      the members has served as our officers or employees.




**ITEM
          12.** **SECURITY
          OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
          MATTERS**




**Security
      Ownership of Certain Beneficial Owners and Management**




The
      following table sets forth information regarding the security ownership, as
      of
      March 15, 2006, of those persons owning of record or known by us to own
      beneficially more than 5% of our common stock and of each of our Named Executive
      Officers and directors, and the shares of common stock held by all of our
      directors and executive officers as a group.




**Name
                  and Address of Beneficial Owner****(1)**
              
              **Shares
                  Beneficially Owned****(2)(3)**
              
              **Percentage
                  of Total****Shares
                  Outstanding****(3)**Robert
                  S. Ehrlich
              
              
              2,932,546
              (4)
              
              3.0
              %Steven
                  Esses
              
              
              1,200,000
              (5)
              
              1.2
              %Avihai
                  Shen**
              
              
              630,153
              (6)
              
              *Thomas
                  J. Paup
              
              
              50,000
              (7)
              
              *Dr.
                  Jay M. Eastman
              
              
              98,334
              (8)
              
              *Jack
                  E. Rosenfeld
              
              
              100,334
              (9)
              
              *Lawrence
                  M. Miller
              
              
              496,813
              (10)
              
              *Edward
                  J. Borey
              
              
              51,000
              (11)
              
              *Prof.
                  Seymour Jones
              
              
              0
              
              
              *All
                  of our directors and executive officers as a group (9
                  persons)
              
              
              5,559,180
              (12)
              
              5.6
              %


*
            Less
                than one percent.**
            Mr.
                Shen ceased to act as our Chief Financial Officer in February 2006,
                and
                his employment with us terminated on March 31, 2006.(1)
            The
                address of each named beneficial owner is in care of Arotech Corporation,
                354 Industry Drive, Auburn, Alabama 36832.(2)
            Unless
                otherwise indicated in these footnotes, each of the persons or entities
                named in the table has sole voting and sole investment power with
                respect
                to all shares shown as beneficially owned by that person, subject
                to
                applicable community property laws.




93


(3)
            Based
                on95,490,846shares of common stock outstanding as of March 15, 2006. For purposes
                of
                determining beneficial ownership of our common stock, owners of options
                exercisable within sixty days are considered to be the beneficial
                owners
                of the shares of common stock for which such securities are exercisable.
                The percentage ownership of the outstanding common stock reported
                herein
                is based on the assumption (expressly required by the applicable
                rules of
                the Securities and Exchange Commission) that only the person whose
                ownership is being reported has converted his options into shares
                of
                common stock.(4)
            Consists
                of 618,165 shares held directly by Mr. Ehrlich, 50,000 shares held
                by Mr.
                Ehrlich’s wife (in which shares Mr. Ehrlich disclaims beneficial
                ownership), 161,381 shares held in Mr. Ehrlich’s pension plan, 3,000
                shares held by children sharing the same household (in which shares
                Mr.
                Ehrlich disclaims beneficial ownership), and 2,100,000 shares issuable
                upon exercise of options exercisable within 60 days of March 15,
                2006.(5)
            Consists
                of 165,000 shares held directly by Mr. Esses and 1,035,000 shares
                issuable
                upon exercise of options exercisable within 60 days of March 15,
                2006.(6)
            Consists
                of 40,500 shares owned directly by Mr. Shen and 584,403 shares issuable
                upon exercise of options exercisable within 60 days of March 15,
                2006.(7)
            Consists
                of 50,000 shares issuable upon exercise of options exercisable within
                60
                days of March 15, 2006.(8)
            Consists
                of 98,334 shares issuable upon exercise of options exercisable within
                60
                days of March 15, 2006.(9)
            Consists
                of 2,000 shares owned directly by Mr. Rosenfeld and 98,334 shares
                issuable
                upon exercise of options exercisable within 60 days of March 15,
                2006.(10)
            Consists
                of 11,914 shares held directly by Mr. Miller, 376,565 shares held
                by Leon
                S. Gross and Lawrence M. Miller as co-trustees of the Rose Gross
                Charitable Foundation, and 108,334 shares issuable upon exercise
                of
                options exercisable within 60 days of March 15, 2006.(11)
            Consists
                of 16,000 shares owned directly by Mr. Borey and 43,334 shares issuable
                upon exercise of options exercisable within 60 days of March 15,
                2006.(12)
            Includes
                4,117,739 shares issuable upon exercise of options exercisable within
                60
                days of March 15, 2006.




**Securities
      Authorized for Issuance Under Equity Compensation Plans**




The
      following table sets forth certain information, as of December 31, 2005, with
      respect to our 1991, 1993, 1995, 1998 and 2004 stock option plans, as well
      as
      any other stock options and warrants previously issued by us (including
      individual compensation arrangements) as compensation for goods and
      services:




**Equity
      Compensation Plan Information**




**Plan
                  Category**
              
              **Number
                  of securities to be**
                **issued
                  upon exercise**
                **of
                  outstanding options,**
                **warrants
                  and rights**
                **(a)**
              
              **Weighted-average
                  exercise price**
                **of****outstanding
                  options,**
                **warrants
                  and rights**
                **(b)**
              
              **Number
                  of securities remaining available for future issuance under equity
                  compensation plans (excluding securities reflected in column
                  (a))**
                **(c)**Equity
                  compensation plans approved by security holders(1)
              8,651,235
              
              $0.79
              
              5,285,344


(1)
            For
                a description of the material features of grants of options and warrants
                other than options granted under our employee stock option plans,
                please
                see Note 13.f. and 13.g. of the Notes to the Consolidated Financial
                Statements.




94


**ITEM
          13.** **CERTAIN
          RELATIONSHIPS AND RELATED TRANSACTIONS**




**Officer
      Loans**




On
      December 3, 1999, Robert S. Ehrlich purchased 125,000 shares of our common
      stock
      out of our treasury at the closing price of the common stock on December 2,
      1999. Payment was rendered by Mr. Ehrlich in the form of non-recourse promissory
      notes due in 2009 in the amount of $167,975, bearing simple annual interest
      at a
      rate of 2%, secured by the shares of common stock purchased and other shares
      of
      common stock previously held by him. As of December 31, 2005, the aggregate
      amount outstanding pursuant to this promissory note was $201,570.




On
      February 9, 2000, Mr. Ehrlich exercised 131,665 stock options. Mr. Ehrlich
      paid
      the exercise price of the stock options and certain taxes that we paid on his
      behalf by giving us a non-recourse promissory note due in 2025 in the amount
      of
      $789,991, bearing annual interest (i) as to $329,163, at 1% over the
      then-current federal funds rate announced from time to time by the *Wall
      Street Journal* ,
      and
      (ii) as to $460,828, at 4% over the then-current percentage increase in the
      Israeli consumer price index between the date of the loan and the date of the
      annual interest calculation, secured by the shares of our common stock acquired
      through the exercise of the options and certain compensation due to Mr. Ehrlich
      upon termination. As of December 31, 2005, the aggregate amount outstanding
      pursuant to this promissory note was $692,102.




On
      June
      10, 2002, Mr. Ehrlich exercised 50,000 stock options. Mr. Ehrlich paid the
      exercise price of the stock options by giving us a non-recourse promissory
      note
      due in 2012 in the amount of $36,500, bearing simple annual interest at a rate
      equal to the lesser of (i) 5.75%, and (ii) 1% over the then-current federal
      funds rate announced from time to time, secured by the shares of our common
      stock acquired through the exercise of the options. As of December 31, 2005,
      the
      aggregate amount outstanding pursuant to this promissory note was
      $40,343.




**Director
      Consulting Agreements**




Beginning
      in January 2004, Mr. Edward J. Borey, who became one of our directors in
      December 2003, entered into a consulting agreement with us pursuant to which
      he
      agreed to aid us in identifying potential acquisition candidates in exchange
      for
      transaction fees in respect of acquisitions in which he plays a “critical role”
(as determined by us in our sole and absolute discretion) in identifying and/or
      initiating and/or negotiating the transaction in the amount of (i) 1.5% of
      the
      value of the transaction up to $10,000,000, plus (ii) 1.0% of the value of
      the
      transaction in excess of $10,000,000 and up to $50,000,000, plus (iii) 0.5%
      of
      the value of the transaction in excess of $50,000,000. We also agreed to issue
      to Mr. Borey, at par value, a total of 32,000 shares of our common stock, the
      value of which is to be deducted from any transaction fees paid. 16,000 of
      these
      shares were earned and issued prior to termination of this agreement in August
      2004.




**Consulting
      Agreement with Sampen Corporation**




We
      have a
      consulting agreement with Sampen Corporation that we executed in March 2005,
      effective as of January 1, 2005. Sampen is a New York corporation owned by
      members of Steven Esses’s immediate family, and Mr. Esses is an employee of
      Sampen. The term of this consulting agreement expires on December 31, 2006,
      and
      is extended automatically for additional terms of two years each unless either
      Sampen or we terminate the agreement sooner.




95


Pursuant
      to the terms of our agreement with Sampen, Sampen provides one of its employees
      to us for such employee to serve as our Executive Vice President and Chief
      Operating Officer. We pay Sampen $12,800 per month, plus an annual bonus, on
      a
      sliding scale, in an amount equal to a minimum of 20% of Sampen’s annual base
      compensation then in effect, up to a maximum of 75% of its annual base
      compensation then in effect if the results we actually attain for the year
      in
      question are 120% or more of the amount we budgeted at the beginning of the
      year. We also pay Sampen, to cover the cost of our use of Sampen’s offices as an
      ancillary New York office and the attendant expenses and insurance costs, an
      amount equal to 16% of each monthly payment of base compensation.




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




In
      accordance with the requirements of the Sarbanes-Oxley Act of 2002 and the
      Audit
      Committee’s charter, all audit and audit-related work and all non-audit work
      performed by our independent accountants, Kost, Forer, Gabbay & Kasierer, is
      approved in advance by the Audit Committee, including the proposed fees for
      such
      work. The Audit Committee is informed of each service actually
      rendered.




Ø
            *Audit
                Fees.*Audit
                fees billed or expected to be billed to us by Kost, Forer, Gabbay
&
                Kasierer for the audit of the financial statements included in our
                Annual
                Report on Form 10-K, and reviews of the financial statements included
                in
                our Quarterly Reports on Form 10-Q, for the years ended December
                31, 2005
                and 2004 totaled approximately $530,000 and $594,924, respectively.




Ø
            *Audit-Related
                Fees*.
                Kost, Forer, Gabbay & Kasierer billed us $40,764 and $214,659 for the
                fiscal years ended December 31, 2005 and 2004, respectively, for
                assurance
                and related services that are reasonably related to the performance
                of the
                audit or review of our financial statements and are not reported
                under the
                caption “Audit Fees,” above.




Ø
            *Tax
                Fees.*Kost, Forer, Gabbay & Kasierer billed us an aggregate of $10,000 and
                $9,491 for the fiscal years ended December 31, 2005 and 2004,
                respectively, for tax services, principally advice regarding the
                preparation of income tax returns.




Ø
            *All
                Other Fees.*The
                Audit Committee of the Board of Directors has considered whether
                the
                provision of the Audit-Related Fees, Tax Fees and all other fees
                are
                compatible with maintaining the independence of our principal accountant.




Applicable
      law and regulations provide an exemption that permits certain services to be
      provided by our outside auditors even if they are not pre-approved. We have
      not
      relied on this exemption at any time since the Sarbanes-Oxley Act was
      enacted.




96


**PART
      IV**




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




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




(1)
            Financial
                Statements - See Index to Financial Statements on pageabove.(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 either filed herewith or have previously
                been
                filed with the Securities and Exchange Commission and are referred
                to and
                incorporated herein by reference to such
                filings:




**Exhibit
                No.**
            
            **Description**(1)
            
            3.1
            
            Amended
                and Restated Certificate of Incorporation(4)
            
            3.1.1
            
            Amendment
                to our Amended and Restated Certificate of
                Incorporation(13)
            
            3.1.2
            
            Amendment
                to our Amended and Restated Certificate of
                Incorporation(14)
            
            3.1.3
            
            Amendment
                to our Amended and Restated Certificate of
                Incorporation(2)
            
            3.2
            
            Amended
                and Restated By-Laws(14)
            
            4.1
            
            Specimen
                Certificate for shares of common stock, $.01 par value†
                (1)
            
            10.1.1
            
            Form
                of Management Employment Agreements†
                * (1)
            
            10.1.2
            
            General
                Employee Agreements*
                (1)
            
            10.2
            
            Office
                of Chief Scientist documents(2)
            
            10.2.1
            
            Letter
                from the Office of Chief Scientist to us dated January 4,
                1995***
            
            10.3
            
            Promissory
                Note dated December 3, 1999, from Robert S. Ehrlich to
                us***
            
            10.4
            
            Promissory
                Note dated February 9, 2000, from Robert S. Ehrlich to
                us***
            
            10.5
            
            Promissory
                Note dated January 12, 2001, from Robert S. Ehrlich to
                us(3)
            
            10.6
            
            Form
                of Common Stock Purchase Warrant dated May 8, 2001(4)
            
            10.7
            
            Securities
                Purchase Agreement dated December 31, 2002 between us and the
                Investors(4)
            
            10.8
            
            Form
                of 9% Secured Convertible Debenture due June 30, 2005(4)
            
            10.9
            
            Form
                of Warrant dated December 31, 2002(4)
            
            10.10
            
            Form
                of Security Agreement dated December 31, 2002(4)
            
            10.11
            
            Form
                of Intellectual Property Security Agreement dated December 31,
                2002†(5)
            
            10.12
            
            Settlement
                Agreement and Release between us and Yehuda Harats dated December
                31,
                2002(5)
            
            10.13
            
            Commercial
                lease agreement between Commerce Square Associates L.L.C. and I.E.S.
                Electronics Industries U.S.A., Inc. dated September 24,
                1997(5)
            
            10.14
            
            Amendment
                to Commercial lease agreement between Commerce Square Associates
                L.L.C.
                and I.E.S. Electronics Industries U.S.A., Inc. dated as of May 1,
                2000




97






**Exhibit
                No.**
            
            **Description**(5)
            
            10.15
            
            Agreement
                of Lease dated December 6, 2000 between Janet Nissim*et
                al*.
                and M.D.T. Protection (2000) Ltd. [English summary of Hebrew
                original(5)
            
            10.16
            
            Agreement
                of Lease dated August 22, 2001 between Aviod Building and Earthworks
                Company Ltd.*et
                al*.
                and M.D.T. Protective Industries Ltd. [English summary of Hebrew
                original](6)
            
            10.17
            
            Securities
                Purchase Agreement dated September 30, 2003 between us and the Investors
                named therein(19)
            
            10.17.1
            
            Amendment
                Agreement dated February 15, 2006 between us and Smithfield Fiduciary
                LLC


(6)
            
            10.18
            
            Form
                of 8% Secured Convertible Debenture due September 30,
                2006(6)
            
            10.19
            
            Form
                of Warrant dated September 30, 2003(6)
            
            10.20
            
            Form
                of Security Agreement dated September 30, 2003(6)
            
            10.21
            
            Form
                of Intellectual Property Security Agreement dated September 30,
                2003(7)
            
            10.22
            
            Form
                of Amendment and Exercise Agreement dated December 10,
                2003(7)
            
            10.23
            
            Form
                of Supplemental Warrant dated December 18, 2003(8)
            
            10.24
            
            Stock
                Purchase and Sale Agreement dated January 7, 2004 between us and
                the
                shareholders of FAAC Incorporated(8)
            
            10.25
            
            Securities
                Purchase Agreement dated January 7, 2004 between us and the Investors
                named therein(8)
            
            10.26
            
            Registration
                Rights Agreement dated January 7, 2004 between us and the Investors
                named
                therein(8)
            
            10.27
            
            Form
                of Warrant dated January __, 2004(9)
            
            10.28
            
            Share
                Purchase Agreement dated January __, 2004 between us and the shareholders
                of Epsilor Electronics Industries, Ltd.(9)
            
            10.29
            
            Management
                Agreement dated January __, 2004 among us, Office Line Ltd. and Hezy
                Aspis*(10)
            
            10.30
            
            Settlement
                Agreement between us and I.E.S. Electronics Industries, Ltd. dated
                February 4, 2004†(11)
            
            10.31
            
            Consulting
                agreement dated January 1, 2004 between us and Edward J.
                Borey(11)
            
            10.32
            
            Promissory
                Note dated July 1, 2002 from Robert S. Ehrlich to us(11)
            
            10.33
            
            Lease
                dated April 8, 1997, between AMR Holdings, L.L.C. and FAAC
                Incorporated(11)
            
            10.34
            
            Lease
                dated as of March 22, 2004 between us and Fisk Building Associates
                L.L.C.(12)
            
            10.35
            
            Stock
                Purchase Agreement dated as of July 15, 2004 between us and Armour
                of
                America, Incorporated and its sole shareholder(13)
            
            10.36
            
            Securities
                Purchase Agreement dated as of July 15, 2004, by and among us and
                various
                investors†(14)
            
            10.37
            
            Consulting
                Agreement, effective as of January 1, 2005, between us and Sampen
                Corporation†(15)
            
            10.38
            
            Third
                Amended and Restated Employment Agreement, effective as of January
                1, 2005
                between us, EFL and Robert S.
                Ehrlich




98








**Exhibit
                No.**
            
            **Description**†(15)
            
            10.39
            
            Employment
                Agreement, effective as of January 1, 2005 between EFL and Steven
                Esses(16)
            
            10.40
            
            Stock
                Purchase Agreement dated as of May 17, 2005, by and among us and
                various
                purchasers(17)
            
            10.41
            
            Securities
                Purchase Agreement dated September 29, 2005 between us and the Investors
                named therein(17)
            
            10.42
            
            Form
                of Senior Secured Convertible Note due March 31, 2008(17)
            
            10.43
            
            Form
                of Warrant dated September 29, 2005(17)
            
            10.44
            
            Form
                of Security Agreement dated September 29, 2005(17)
            
            10.45
            
            Form
                of Intellectual Property Security Agreement dated September 29,
                2005†
                (18)
            
            10.46
            
            Employment
                Agreement between the Company and Thomas J. Paup dated December 30,
                2005†
                (18)
            
            10.47
            
            Separation
                Agreement and Release of Claims among the Company, EFL and Avihai
                Shen
                dated January 5, 2006(19)
            
            10.48
            
            Form
                of Warrant dated February 15, 2006**
            
            10.49
            
            Lease
                dated February 10, 2006 between Arbor Development Company LLC and
                FAAC
                Incorporated(11)
            
            14.1
            
            Code
                of Ethics(14)
            
            21.1
            
            List
                of Subsidiaries of the Registrant**
            
            23.1
            
            Consent
                of Kost, Forer, Gabbay & Kasierer, a member of Ernst & Young
                Global**
            
            23.2
            
            Consent
                of Stark Winter Schenkein & Co., LLP**
            
            31.1
            
            Certification
                of Principal Executive Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002**
            
            31.2
            
            Certification
                of Principal Financial Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002**
            
            32.1
            
            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
                2002**
            
            32.2
            
            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







*
            English
                translation or summary from original Hebrew**
            Filed
                herewith***
            Re-filed
                herewith, as required by Item 10(d) of Regulation S-K.†
            Includes
                management contracts and compensation plans and
                arrangements(1)
            Incorporated
                by reference to our Registration Statement on Form S-1 (Registration
                No.
                33-73256), which became effective on February 23, 1994(2)
            Incorporated
                by reference to our Registration Statement on Form S-1 (Registration
                No.
                33-97944), which became effective on February 5, 1996(3)
            Incorporated
                by reference to our Current Report on Form 8-K filed May 7, 2001
                (EDGAR
                Film No. 1623989)(4)
            Incorporated
                by reference to our Current Report on Form 8-K filed January 6,
                2003(5)
            Incorporated
                by reference to our Annual Report on Form 10-K for the year ended
                December
                31, 2002(6)
            Incorporated
                by reference to our Current Report on Form 8-K filed October 3,
                2003(7)
            Incorporated
                by reference to our Current Report on Form 8-K filed December 23,
                2003(8)
            Incorporated
                by reference to our Current Report on Form 8-K filed January 9,
                2004(9)
            Incorporated
                by reference to our Current Report on Form 8-K filed February 4,
                2004(10)
            Incorporated
                by reference to our Current Report on Form 8-K filed February 5,
                2004




99


(11)
            Incorporated
                by reference to our Annual Report on Form 10-K for the year ended
                December
                31, 2003(12)
            Incorporated
                by reference to our Quarterly Report on Form 10-Q for the quarter
                ended
                June 30, 2004(13)
            Incorporated
                by reference to our Current Report on Form 8-K filed July 15,
                2004(14)
            Incorporated
                by reference to our Annual Report on Form 10-K for the year ended
                December
                31, 2004(15)
            Incorporated
                by reference to our Quarterly Report on Form 10-Q for the quarter
                ended
                June 30, 2004(16)
            Incorporated
                by reference to our Current Report on Form 8-K filed May 17,
                2005(17)
            Incorporated
                by reference to our Current Report on Form 8-K filed September 30,
                2005(18)
            Incorporated
                by reference to our Current Report on Form 8-K filed January 5,
                2006(19)
            Incorporated
                by reference to our Current Report on Form 8-K filed February 16,
                2006




100




n
            **Kost
                Forer Gabbay & Kasierer**
              3
                Aminadav St.
              Tel-Aviv
                67067, Israel
            n
            Phone:
                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
      were
      also engaged to audit, 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
      have
      issued our report dated March 30, 2006, which disclaimed an opinion on the
      Company’s internal controls over financial reporting.




Tel
                Aviv, Israel
            KOST,
                FORER, GABBAY & KASIERERMarch
                30, 2006
            A
                Member of Ernst & Young Global





F-1


n
              **Kost
                  Forer Gabbay & Kasierer**
                3
                  Aminadav St.
                Tel-Aviv
                  67067, Israel
              n
              Phone:
                  972-3-6232525
                Fax:
                  972-3-5622555


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





**The
      Board of Directors and Shareholders of**





**AROTECH
      CORPORATION**




We
      were
      engaged to audit management’s assessment, included in the accompanying
“Management’s Report on Internal Control Over Financial Reporting”, of Arotech
      Corporation (“Arotech” or “Company”) regarding the effectiveness of 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. 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.





As
      described in the accompanying “Management’s Report on Internal Control Over
      Financial Reporting”, the Company has not yet completed its assessment of the
      effectiveness of internal control over financial reporting as of December 31,
      2005. Accordingly, we were unable to perform auditing procedures necessary
      to
      form an opinion on management’s assessment.





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.





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.





Since
      management has not yet completed its assessment on internal control over
      financial reporting as of December 31, 2005 and we were unable to apply other
      procedures to satisfy ourselves as to the effectiveness of the Company’s
      internal control over financial reporting, the scope of our work was not
      sufficient to enable us to express, and we do not express, an opinion either
      on
      management’s assessment or on the effectiveness of the Company’s internal
      control over financial reporting.




F-2










The
      following material weakness has been identified and included in management’s
      assessment as of December 31, 2005, related to the Company’s FAAC
      subsidiary:





Ø
            *Revenue
                recognition*.
                The Company did not maintain effective controls over the monitoring,
                review and approval of revenue recognition calculations at FAAC.
                Specifically, these calculations were not being reviewed by appropriate
                accounting personnel to determine that revenue is recognized in accordance
                with company policy and generally accepted accounting principles.
                This
                material weakness affects the revenue and unbilled receivable
                accounts.





A
      material weakness ** is
      a
      control deficiency, or a 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 presence
      of
      a material weakness would preclude a conclusion that internal control over
      financial reporting is effective. The above material weakness was considered
      in
      determining the nature, timing and extent of audit tests applied in our audit
      of
      the 2005 consolidated financial statements of the Company, and this report
      does
      not affect our report dated March 30, 2006 on those financial statements.




Tel
                Aviv, Israel
            KOST,
                FORER, GABBAY & KASIERERMarch
                30, 2006
            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.




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







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.





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  ♦  Toll
              Free: 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.





F-6


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.





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




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-7


**AROTECH
        CORPORATION AND ITS SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**







**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
                ofDecember
                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**


**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: 87,096,711
                shares and 80,637,001 shares as of December 31, 2005 and 2004,
                respectively; Outstanding - 86,541,378 shares and 80,081,668 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 - 555,333 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
        BALANCE SHEETS**


**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
            
            $
            (0.29
            )
            $
            (0.13
            )
            $
            (0.24
            )Basic
                and diluted net loss per share from discontinued
                operations
            
            $
            (0.00
            )
            $
            0.00
            
            $
            0.00Basic
                and diluted net loss per share
            
            $
            (0.29
            )
            $
            (0.18
            )
            $
            (0.25
            )Weighted
                average number of shares used in computing basic and diluted net
                loss per
                share
            
            
            82,209,300
            
            
            69,933,057
            
            
            38,890,174


.


The
              accompanying notes are an integral part of the consolidated financial
              statements.
 F-10
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
  
  ****


**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
                
                
                35,701,594
                
                $
                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
                
                
                6,969,605
                
                
                69,696
                
                
                6,064,981
                
                
                
                
                
                
                
                
                
                
                
                (9,677
                )
                
                
                
                
                
                
                
                6,125,000Issuance
                    of shares on exercise of warrants
                
                
                3,682,997
                
                
                36,831
                
                
                3,259,422
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                3,296,253Issuance
                    of shares to consultants
                
                
                223,600
                
                
                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 com-pensation
                
                
                
                
                
                
                
                
                4,750
                
                
                
                
                
                (4,750
                )
                
                
                
                
                
                
                
                
                
                
                
                
                
                —Amortization
                    of deferred stock com-pensation
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                8,286
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                8,286Exercise
                    of options by employees
                
                
                689,640
                
                
                6,896
                
                
                426,668
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                433,564Exercise
                    of options by consultants
                
                
                15,000
                
                
                150
                
                
                7,200
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                7,350Conversion
                    of convertible promissory note
                
                
                563,971
                
                
                5,640
                
                
                438,720
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                444,360Increase
                    in investment in subsidiary against common stock issuance
                
                
                126,000
                
                
                1,260
                
                
                120,960
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                122,220Accrued
                    interest on notes re-ceivable 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
                
                
                47,972,407
                
                $
                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**











**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
            
            
            47,972,407
            
            $
            479,726
            
            $
            135,702,413
            
            $
            (109,911,240
            )
            $
            (8,464
            )
            $
            (3,537,106
            )
            $
            (1,203,881
            )
            $
            104,429
            
            
            
            
            $
            21,625,877Issuance
                of shares, net
            
            
            14,138,491
            
            
            141,384
            
            
            24,252,939
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            24,394,323Issuance
                of shares and warrants due to settlement of litigation
            
            
            450,000
            
            
            4,500
            
            
            1,244,328
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,248,828Issuance
                of shares to employees
            
            
            40,000
            
            
            400
            
            
            92,800
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            93,200Conversion
                of convertible debentures
            
            
            3,843,728
            
            
            38,437
            
            
            3,754,279
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            3,792,716Exercise
                of warrants by investors and others
            
            
            11,363,342
            
            
            113,633
            
            
            19,119,638
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            19,233,271Issuance
                of shares to consultants
            
            
            90,215
            
            
            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 com-pensation related to options and restricted
                stock
            
            
            740,000
            
            
            7,400
            
            
            2,074,057
            
            
            
            
            
            (2,081,457
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            —Amortization
                of deferred stock com-pensation
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            831,626
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            831,626Exercise
                of options by employees
            
            
            897,248
            
            
            8,972
            
            
            1,101,172
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,110,144Exercise
                of options by consultants
            
            
            37,615
            
            
            376
            
            
            50,799
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            51,175Issuance
                of shares in respect of FAAC acquisition
            
            
            1,003,856
            
            
            10,039
            
            
            1,993,639
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2,003,678Accrued
                interest on notes re-ceivable from stockholders
            
            
            
            
            
            
            
            
            18,990
            
            
            
            
            
            
            
            
            
            
            
            (18,990
            )
            
            
            
            
            
            
            
            —Other
                comprehensive income - foreign currency translation
                adjustment
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            263,404
            
            $
            263,404
            
            
            263,404Other
                comprehensive income - 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
            
            
            80,576,902
            
            $
            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**


**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
            
            
            80,637,001
            
            $
            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
            
            
            4,754,964
            
            
            47,551
            
            
            3,898,185
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            3,945,736Shares
                issued to convertible debenture holders
            
            
            1,161,668
            
            
            11,617
            
            
            441,434
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            453,051Shares
                issued to consultant
            
            
            507,253
            
            
            5,073
            
            
            516,200
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            521,273Compensation
                related to non-recourse loan granted to shareholder
            
            
            
            
            
            
            
            
            (28,500
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (28,500
            )Employee
                options exercise
            
            
            15,825
            
            
            158
            
            
            17,034
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            17,192Shares
                issued to employees
            
            
            10,000
            
            
            100
            
            
            (100
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            —Deferred
                stock compensation related to options and restricted stock
            
            
            50,000
            
            
            500
            
            
            50,500
            
            
            
            
            
            (51,000
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            —Amortization
                of deferred stock compensation
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            674,712
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            674,712Cancellation
                of deferred stock compensation as a result of forfeitures
            
            
            (40,000
            )
            
            (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
            
            
            87,096,711
            
            $
            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**


**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**
  
 
 **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


(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**







**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**




**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 1,003,856 shares of the Company’s
      common stock, $0.01 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**
  **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**
  **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**
  **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**
  **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
            
            
            
            
            $
            (0.13
            )
            $
            (0.14
            )Weighted
                average number of shares used in computing basic net loss per
                share
            
            
            
            
            
            69,933,057
            
            
            52,966,330




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**
  **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**
  **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.




F-24


**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
  **NOTE
          2:-****SIGNIFICANT
          ACCOUNTING
          POLICIES****(Cont.)**




Cost
      is
      determined as follows:




Raw
      and
      packaging materials - by the average cost method.




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.




F-25


**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
  **NOTE
          2:-****SIGNIFICANT
          ACCOUNTING
          POLICIES****(Cont.)**




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.




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**
  **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**
  **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**
  **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 35,894,854, 31,502,158 and
      22,194,211 for the years ended December 31, 2005, 2004 and 2003,
      respectively.




F-29


**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
  **NOTE
          2:-****SIGNIFICANT
          ACCOUNTING
          POLICIES****(Cont.)**




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.




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
            
            $
            (0.29
            )
            $
            (0.18
            )
            $
            (0.25
            )Diluted,
                pro forma
            
            $
            (0.31
            )
            $
            (0.16
            )
            $
            (0.27
            )





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.




F-30


**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
  **NOTE
          2:-****SIGNIFICANT
          ACCOUNTING
          POLICIES****(Cont.)**




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




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.




F-31


**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
  **NOTE
          2:-****SIGNIFICANT
          ACCOUNTING
          POLICIES****(Cont.)**




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.




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.




F-32


**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
  **NOTE
          2:-****SIGNIFICANT
          ACCOUNTING
          POLICIES****(Cont.)**




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.




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**
  **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
              
              
              6,962,110Long-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.




F-34


**AROTECH
            CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
          U.S. dollars
  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





**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
              
              
              62,1792,397,875$
              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**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
            
            $
            13,166,476


F-35
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
            U.S. dollars
  NOTE
            7:-   **PROPERTY
            AND EQUIPMENT, NET (Cont.)**




**December
                31,****2005**
            
            **2004**Accumulated
                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




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.




F-36


**AROTECH
            CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
          U.S. dollars
  NOTE
          8:-   OTHER
          INTANGIBLE ASSETS, NET(Cont.)




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.




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.




F-37




**AROTECH
          CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
        U.S. dollars
 **NOTE
          11:-**  **COMMITMENTS
          AND CONTINGENT LIABILITIES (Cont.)**




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.




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.




F-38


**AROTECH
            CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
          U.S. dollars
 **NOTE
            11:-**  **COMMITMENTS
            AND CONTINGENT LIABILITIES (Cont.)**




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).




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.




F-39


**AROTECH
            CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
          U.S. dollars
 **NOTE
            11:-**  **COMMITMENTS
            AND CONTINGENT LIABILITIES (Cont.)**




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.




**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 $0.75 per share, or a maximum aggregate
      of 4,666,667 shares of common stock. The conversion price of these debentures
      was adjusted to $0.64 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%.






F-40


**AROTECH
            CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
          U.S. dollars
 **NOTE
              12:-**  **CONVERTIBLE
              DEBENTURES AND DETACHABLE WARRANTS (Cont.)**


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
      1,166,700 shares of common stock at any time prior to December 31, 2007 at
      a
      price of $0.84 per share; (ii) Series B Warrants to purchase an aggregate of
      1,166,700 shares of common stock at any time prior to December 31, 2007 at
      a
      price of $0.89 per share; and (iii) Series C Warrants to purchase an aggregate
      of 1,166,700 shares of common stock at any time prior to December 31, 2007
      at a
      price of $0.93 per share. The exercise price of these warrants was adjusted
      to
      $0.64 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.




During
      2004, the remaining principal amount of $1,150,000 of 9% secured convertible
      debentures outstanding was converted into an aggregate of 1,796,875 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 $1.15 per share, or a
      maximum aggregate of 4,347,826 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 1,250,000 shares of common stock
      at
      any time prior to September 30, 2006 at a price of $1.4375 per share.






F-41


**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
            U.S. dollars
 **NOTE
                12:-**  **CONVERTIBLE
                DEBENTURES AND DETACHABLE WARRANTS (Cont.)**


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 934,784 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.




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 $1.45 per share, or a
      maximum aggregate of 4,137,931 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 1,500,000 shares of
      common stock at any time prior to December 18, 2006 at a price of $1.8125 per
      share. Additionally, the Company issued to the investors supplemental warrants
      to purchase an aggregate of 1,038,000 shares of common stock at any time prior
      to December 31, 2006 at a price of $2.20 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.






F-42


**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
            U.S. dollars
 **NOTE
                12:-**  **CONVERTIBLE
                DEBENTURES AND DETACHABLE WARRANTS (Cont.)**


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 1,500,000 shares were issued pursuant to exercise of these
      warrants. Out of these warrants, the holders of 1,125,000 warrants exercised
      their warrants on July 14, 2004 were granted an additional warrants to purchase
      1,125,000 shares of common stock of the Company at an exercise price per share
      of $1.38. 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.




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 $1.00.
      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.






F-43




**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
            U.S. dollars
 **NOTE
                12:-**  **CONVERTIBLE
                DEBENTURES AND DETACHABLE WARRANTS (Cont.)**


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 5,250,000 shares of common stock (30%
      warrant coverage) at an exercise price of $1.10 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.




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.






F-44




**AROTECH
          CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
            U.S. dollars
 **NOTE
                12:-**  **CONVERTIBLE
                DEBENTURES AND DETACHABLE WARRANTS (Cont.)**


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 $1.00.
      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 $1.00. 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 1,458,335 shares to the holders of the notes.
      Of these shares, 1,161,668 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 296,667 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.




**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
      126,000 shares of its common stock.




2.  In
      January 2004, the Company issued an aggregate of 9,840,426 shares of common
      stock at a price of $1.88 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 4,258,065 shares of common stock at a price
      of
      $1.55 per share, or a total purchase price of $6,600,000, to a group of
      investors (see also Note 13.f.3.).






F-45


**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
            U.S. dollars
 **NOTE
                  13:-**  **STOCKHOLDERS’
                  EQUITY (Cont.)**




4.  In
      May
      2005, the Company issued an aggregate of 1,275,500 shares of common stock at
      a
      price of $1.00 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 3,479,46 4
      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 215,294 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 8,306 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.




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 32,000
      shares of its common stock, the value of which was to be deducted from any
      transaction fees paid. 16,000 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 74,215 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.




F-46


**AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
            U.S. dollars
 **NOTE
                  13:-**  **STOCKHOLDERS’
                  EQUITY (Cont.)**




5.  In
      June
      2004 the Company sold 40,000 shares of the Company’s common stock at a price of
      $1.00 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 40,000 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 72,653 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.





8.  In
      August
      2005, p ursuant
      to the terms of agreements between the Company and an investment banker, the
      Company issued an aggregate of 425,000 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 9,600 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.


F-47
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
              U.S. dollars
 **NOTE
                    13:-**  **STOCKHOLDERS’
                    EQUITY (Cont.)**


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 387,301 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 563,971 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 2,696,971 warrants (the “May 2001 Warrants”) to purchase shares of
      common stock at a price of $3.22 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 1,357,577 of the
      May
      2001 Warrants to $0.82 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 905,052 shares of common stock at a purchase price of $1.45
      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 638,385 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.




In
      addition, with respect to an additional 387,879 May 2001 Warrants, in December
      2003 the Company adjusted the purchase price to $1.60 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 193,940 shares of common
      stock at a purchase price of $2.25 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 150,000 shares of common stock at a purchase
      price of $1.20 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, 64,557 warrants were exercised.




On
      July
      14, 2004, the Company repriced the exercise price of 242,424 warrants granted
      previously in May 2001 to $1.88 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
      145,454 shares of the Company’s common stock at an exercise price per share of
      $1.38. 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.


F-48
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
              U.S. dollars
 **NOTE
                    13:-**  **STOCKHOLDERS’
                    EQUITY (Cont.)**


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
      9,840,426 shares of the Company’s common stock at any time beginning six months
      after closing at an exercise price per share of $1.88.




In
      July
      2004 an aggregate of 7,446,811 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
      7,446,811 shares of the Company’s common stock at an exercise price per share of
      $1.38. 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 8,814,235 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, 1,125,000 shares were issued
      upon exercise of warrants issued in the transaction referred to in Note 12.c.
      above and 7,446,811 shares were issued upon exercise of warrants issued in
      the
      transaction referred to in the Note 13.f.3. above; the remaining 242,424 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
      8,717,265 new five-year warrants to purchase shares of common stock at an
      exercise price of $1.38 per share




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.


F-49
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
              U.S. dollars
 **NOTE
                    13:-**  **STOCKHOLDERS’
                    EQUITY (Cont.)**


4.  In
      November 2000 and May 2001, the Company issued a total of 916,667 warrants
      to an
      investor, which warrants contained certain antidilution provisions: a Series
      A
      warrant to purchase 666,667 shares of the Company’s common stock at a price of
      $3.50 per share, and a Series C warrant to purchase 250,000 shares at a price
      of
      $3.08 per share. Operation of the antidilution provisions provided that the
      Series A warrant should be adjusted to be a warrant to purchase 888,764 shares
      at a price of $2.67 per share, and the Series C warrant should be adjusted
      to be
      a warrant to purchase 333,286 shares at a price of $2.35 per share. After
      negotiations, the investor agreed in March 2004 to exercise its warrants
      immediately, in exchange for an exercise price reduction to $1.45 per share,
      and
      the issuance of a new six-month Series D warrant to purchase 1,222,050 shares
      at
      an exercise price of $2.10 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)
      450,000 shares of common stock, and (ii) five-year warrants to purchase up
      to an
      additional 450,000 shares of common stock at a purchase price of $1.91 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.




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
      22,061,463.




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.




F-50
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
              U.S. dollars
 **NOTE
                    13:-**  **STOCKHOLDERS’
                    EQUITY (Cont.)**


1)  1998
      Employee Option Plan - as amended, 4,750,000 shares reserved for issuance,
      of
      which 849,960 were available for future grants to employees and consultants
      as
      of December 31, 2005.




2)  1995
      Non-Employee Director Plan - 1,000,000 shares reserved for issuance, of which
      210,000 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 - 7,500,000 shares reserved for issuance, of which
      4,225,384 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:




**2005**
            
            **2004**
            
            **2003****Amount**
            
            **Weighted
                average**
              **exercise
                price**
            
            **Amount**
            
            **Weighted
                average**
              **exercise
                price**
            
            **Amount**
            
            **Weighted
                average**
              **exercise
                price**$
            
            
            
            $
            
            
            
            **$**Options
                outstanding at beginning of year
            
            
            9,854,761
            
            $
            1.19
            
            
            9,018,311
            
            $
            1.37
            
            
            5,260,366
            
            $
            2.26Changes
                during year:Granted
                (1) (2) (3)
            
            
            1,695,350
            
            $
            0.55
            
            
            2,248,490
            
            $
            1.06
            
            
            5,264,260
            
            $
            0.71Exercised
            
            
            (15,825
            )
            $
            1.09
            
            
            (897,248
            )
            $
            1.24
            
            
            (689,640
            )
            $
            0.64Forfeited
                (3)
            
            
            (2,289,337
            )
            $
            1.89
            
            
            (514,793
            )
            $
            3.77
            
            
            (816,675
            )
            $
            3.51Repriced
                (3)Old
                exercise price
            
            
            (2,911,715
            )
            $
            1.1
            
            
            -
            
            
            -
            
            
            -
            
            
            -New
                exercise price
            
            
            2,911,715
            
            $
            0.39
            
            
            -
            
            
            -
            
            
            -
            
            
            -Options
                outstanding at end of year
            
            
            9,244,949
            
            $
            0.67
            
            
            9,854,760
            
            $
            1.19
            
            
            9,018,311
            
            $
            1.37Options
                exercisable at end of year
            
            
            8,162,985
            
            $
            0.70
            
            
            6,465,316
            
            $
            1.32
            
            
            5,826,539
            
            $
            1.70




(1)  Includes
      339,860, 936,250 and 2,035,000 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.


F-51
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
              U.S. dollars
 **NOTE
                    13:-**  **STOCKHOLDERS’
                    EQUITY (Cont.)**


(3)  On
      December 29, 2005 the company repriced downwards 2,911,715 options with average
      exercise price of $1.1 to $0.39. In addition, 58,875 options with exercise
      price
      of $0.94 were forfeited and new options with exercise price of $0.39 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:




**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
            
            
            8,833,349
            
            
            5.10
            
            
            0.53
            
            
            7,868,050
            
            
            0.572.01-4.00
            
            
            226,600
            
            
            3.43
            
            
            2.45
            
            
            109,935
            
            
            2.504.01-6.00
            
            
            170,000
            
            
            4.05
            
            
            4.93
            
            
            170,000
            
            
            4.936.01-8.00
            
            
            5,000
            
            
            1.86
            
            
            6.50
            
            
            5,000
            
            
            6.508.01
            
            
            10,000
            
            
            1.75
            
            
            9.06
            
            
            10,000
            
            
            9.069,244,949
            
            
            5.04
            
            
            0.67
            
            
            8,162,985
            
            
            0.70






On
      December 29, 2005, the Company accelerated vesting of 557,340 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
            
            $
            0.50
            
            $
            1.494
            
            $
            0.950
            
            $
            -
            
            $
            1.672
            
            $
            -Weighted
                average fair value on grant date
            
            $
            0.26
            
            $
            1.002
            
            $
            0.730
            
            $
            -
            
            $
            1.729
            
            $
            -




F-52
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
              U.S. dollars
 **NOTE
                    13:-**  **STOCKHOLDERS’
                    EQUITY (Cont.)**




2.  Options
      issued to consultants:




a.  The
      Company’s outstanding options to consultants as of December 31, 2005, are as
      follows:




**2005**
            
            **2004**
            
            **2003****Amount**
            
            **Weighted
                average exercise price**
            
            **Amount**
            
            **Weighted
                average exercise price**
            
            **Amount**
            
            **Weighted
                average exercise price****$**
            
            
            
            $
            
            
            
            **$**Options
                outstanding at beginning of year
            
            
            166,286
            
            $
            3.80
            
            
            313,901
            
            $
            4.59
            
            
            245,786
            
            $
            5.55Changes
                during year:Granted
            
            
            -
            
            $
            -
            
            
            10,000
            
            $
            -
            
            
            83,115
            
            $
            0.99Exercised
            
            
            -
            
            $
            -
            
            
            (37,615
            )
            $
            1.03
            
            
            (15,000
            )
            $
            0.49Forfeited
                or cancelled
            
            
            -
            
            $
            -
            
            
            (120,000
            )
            $
            6.40
            
            
            -
            
            $
            -Options
                outstanding at end of year
            
            
            166,286
            
            $
            3.80
            
            
            166,286
            
            $
            3.80
            
            
            313,901
            
            $
            4.59Options
                exercisable at end of year
            
            
            166,286
            
            $
            3.80
            
            
            166,286
            
            $
            3.80
            
            
            193,901
            
            $
            3.46




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.






F-53




**AROTECH
          CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
        U.S. dollars
  **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.




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).


F-54
  **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
            U.S. dollars
 NOTE
            14:- INCOME TAXES
            (Cont.)


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:




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.




F-56
  **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 In
            U.S. dollars
 NOTE
            14:- INCOME TAXES
            (Cont.)


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.  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 (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 363,300
      warrants to purchase common stock at a price of $2.20 per share and 4,514,367
      warrants to purchase common stock at a price of $1.38 per share - a total of
      4,877,667 warrants) to provide for an exercise price equal to $0.44034, 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 1,951,067 warrants,
      expiring on March 31, 2008, with an exercise price equal to $0.594 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
      415,200 warrants to purchase common stock at a price of $2.20 per share, 797,872
      warrants to purchase common stock at a price of $1.88 per share, 274,748
      warrants to purchase common stock at a price of $1.45 per share, 125,000
      warrants to purchase common stock at a price of $1.4375 per share, and 2,502,658
      warrants to purchase common stock at a price of $1.38 per share -  a total
      of 4,115,478  warrants) to provide for an exercise price equal to $0.40, 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 1,646,192
      warrants, expiring on March 31, 2008, with an exercise price equal to $0.594
      per
      share.







-
      - - -
      - - -
      -


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
            $
            (0.03
            )
            $
            (0.07
            )
            $
            (0.15
            )
            $
            (0.04
            )Shares
                used in per share calculation
            
            80,102,089
            
            
            80,780,149
            
            
            82,475,778
            
            
            85,446,876**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
            $
            (0.06
            )
            $
            (0.07
            )
            $
            (0.01
            )
            $
            (0.04
            )Shares
                used in per share calculation
            
            59,406,466
            
            
            64,499,090
            
            
            76,744,251
            
            
            79,075,181









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




**SIGNATURES**




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the Registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized, on March 31, 2006.




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




Pursuant
      to the requirements of the Securities Exchange Act of 1934, this 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
              (Principal
                Executive Officer)
            
            March
                31, 2006Robert
                S. Ehrlich/s/
                Thomas J. Paup
            
            Vice
                President - Finance
              (Principal
                Financial Officer)
            
            March
                31, 2006Thomas
                J. Paup/s/
                Danny Waldner
            
            Controller
              (Principal
                Accounting Officer)
            
            March
                31, 2006Danny
                Waldner/s/
                Steven Esses
            
            President,
                Chief Operating Officer
              and
                Director
            
            March
                31, 2006Steven
                Esses/s/
                Jay M. Eastman
            
            Director
            
            March
                31, 2006Dr.
                Jay M. Eastman/s/
                Lawrence M. Miller
            
            Director
            
            March
                31, 2006Lawrence
                M. Miller/s/
                Jack E. Rosenfeld
            
            Director
            
            March
                31, 2006Jack
                E. Rosenfeld/s/
                Edward J. Borey
            
            Director
            
            March
                31, 2006Edward
                J. Borey/s/
                Seymour Jones
            
            Director
            
            March
                31, 2006Seymour
                Jones





101