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**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-K/A**







**ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES** **EXCHANGE
      ACT OF 1934 FOR THE FISCAL YEAR ENDED**  **DECEMBER
      31, 2004** **.**




**OR**




**TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES** **EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM** **______** **TO** **______** **.**





**Commission
      File Number:   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.)**354
                  Industry Drive, Auburn, Alabama**
              
              **36830**(Address
                  of principal executive offices)
              
              (Zip
                  Code)
  **(334)
                  502-9001**(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 whether the registrant (1) has filed all reports
                  required to
                  be filed by Section 13 or 15(d) of the Securities Exchange Act
                  of 1934
                  during the preceding 12 months (or for such shorter period that
                  the
                  registrant was required to file such reports), and (2) has been
                  subject to
                  such filing requirements for the past 90 days:
              
              **Yes
                  x **No
                  o****Indicate
                  by check mark if disclosure of delinquent filers pursuant to Item
                  405 of
                  Regulation S-K (§ 229.405 of this chapter) is not contained herein, and
                  will not be contained, to the best of registrant’s knowledge, in
                  definitive proxy or information statements incorporated by reference
                  in
                  Part III of this Form 10-K or any amendment to this Form
                  10-K.
              
              oIndicate
                  by check mark whether the registrant is an accelerated filer (as
                  defined
                  in Rule 12b-2 of the Act).
              
              **Yes
x No
                  o**The
                  aggregate market value of the registrant’s voting stock held by
                  non-affiliates of the registrant as of June 30, 2004 was approximately
                  $128,605,410 (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:
              
              **80,103,668
                  as of 3/10/05**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
      amended 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
      II**




**ITEM
                7.**
            **MANAGEMENT’S
                DISCUSSION AND ANALYSIS OF FINANCIAL CONDI-TION 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. Until September
      17,
      2003, we were known as Electric Fuel Corporation. We operate in three business
      units:




Ø
            we
                develop, manufacture and market advanced hi-tech multimedia and
                interactive digital solutions for use-of-force and driving training
                of
                military, law enforcement, security and other personnel, as well
                as
                offering security consulting and other services (our***Simulation,
                Security and Consulting 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 Security 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. Prior to the acquisition of FAAC and
      Epsilor, we were organized into two divisions: Defense and Security Products
      (consisting of IES, MDT and MDT Armor), and Electric Fuel Batteries (consisting
      of EFL and EFB). Our financial results for 2003 do not include the activities
      of
      FAAC, Epsilor or AoA and therefore are not directly comparable to our financial
      results for 2004.










***Restatement
      of Previously-Issued Financial Statements***




During
      our management’s review of our interim financial statements for the period ended
      September 30, 2004, we, after
      discussion with and based on a
      new and
      revised review of accounting treatment by our
      independent auditors, conducted
      a comprehen-sive review of the re-pricing of warrants and grant of new warrants
      to certain of our investors and others during the years 2004 and 2003. As a
      result of that review, we, upon recommendation of our management and with the
      approval of the Audit Committee of our Board of Directors after discussion
      with
      our independent auditors, reconsidered the accounting related to these
      transactions and reclassified certain expenses as a deemed dividend, a non-cash
      item, instead of as general and administrative expenses due to the recognition
      of these transactions as capital transactions that should not be expensed.
      These
      restatements did not affect our balance sheet, shareholders’ equity or cash flow
      statements. In addition and as a result of the remeasurement described above,
      we
      have reviewed assumptions used in the calculation of fair value of all warrants
      granted during the year 2003. As a result of this comprehensive review, we
      have
      decreased general and administrative expenses in the amount of $150,000, related
      to errors found in the valuation of warrants granted in the litigation
      settlement described in Note 14.f.6. of the Notes to Consolidated Financial
      Statements for the year ended December 31, 2004.




In
      addition, during
      our management’s review of our interim financial statements for the period ended
      September 30, 2004, we also **** reviewed
      our calculation of amortization of debt discount attributable to the beneficial
      conversion feature associated with our convertible debentures. As a result
      of
      this review, we found errors which increased our financial expenses in the
      amount of $568,000 for the year ended December 31, 2003. The errors were related
      to the amortization of debt discount attributable to the warrants and the
      related convertible debentures, whereby we understated the amount of
      amortization for the year ended December 31, 2003 attributable to certain of
      the
      convertible debentures.




Similar
      errors were also noted in our interim financial statements in the three-month
      period ended June 30, 2003, the nine-month period ended September 30, 2003,
      and
      the three- and six-month periods ended March 31 and June 30, 2004.




The
      impacts of these restatements with respect to the year ended December 31, 2003
      are summarized below:





-
          2
          -




*Statement
      of Operations Data:*




**For
                the Year ended December 31, 2003****Previously**
              **Reported**
            
            **Adjustment**
            
            **As
                Restated**General
                and administrative expenses
            
            $
            6,196,779
            
            $
            (338,903
            )
            $
            5,857,876Operating
                loss
            
            
            5,408,932
            
            
            (338,903
            )
            
            5,070,029Financial
                expenses, net
            
            
            3,470,459
            
            
            568,250
            
            
            4,038,709Loss
                from continuing operations
            
            
            9,118,684
            
            
            229,347
            
            
            9,348,031Net
                loss
            
            
            9,008,274
            
            
            229,347
            
            
            9,237,621Deemed
                dividend to certain stockholders of common stock
            
            
            -
            
            
            350,000
            
            
            350,000Net
                loss attributable to common stockholders
            
            $
            9,008,274
            
            $
            579,347
            
            $
            9,587,621Basic
                and diluted net loss per share from continuing operations
            
            $
            0.23
            
            $
            0.01
            
            $
            0.24Basic
                and diluted net loss per share
            
            $
            0.23
            
            $
            0.02
            
            $
            0.25





*Balance* *S* *heet* *D* *ata:*




**As
                of December 31, 2003****Previously
                Reported**
            
            **Adjustment**
            
            **As
                Restated**Other
                accounts payable and accrued expenses
            
            $
            4,180,411
            
            $
            (150,000
            )
            $
            4,030,411Total
                current liabilities
            
            
            6,859,752
            
            
            (150,000
            )
            
            6,709,752Convertible
                debenture
            
            
            881,944
            
            
            568,250
            
            
            1,450,194Total
                long term liabilities
            
            
            4,066,579
            
            
            568,250
            
            
            4,634,829Additional
                paid in capital
            
            
            135,891,316
            
            
            (188,903
            )
            
            135,702,413Accumulated
                deficit
            
            
            (109,681,893
            )
            
            (229,347
            )
            
            (109,911,240
            )Total
                shareholders’ equity
            
            
            22,044,127
            
            
            (418,250
            )
            
            21,625,877





*Cash* *F* *low* *D* *ata:*




**For
                the Year ended December 31, 2003****Previously**
              **Reported**
            
            **Adjustment**
            
            **As
                Restated**Net
                loss
            
            $
            9,008,274
            
            $
            229,347
            
            $
            9,237,621Stock
                based compensation related to repricing of warrants granted to investors
                and the grant of new warrants
            
            
            388,403
            
            
            (188,903
            )
            
            199,500Increase
                in other accounts payable and accrued expenses
            
            
            1,827,668
            
            
            (150,000
            )
            
            1,677,668Amortization
                of compensation related to beneficial conversion feature and warrants
                issued to holders of convertible debentures
            
            
            3,359,987
            
            
            568,250
            
            
            3,928,237






-
          3
          -





**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.




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.





-
          4
          -




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.




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.







-
          5
          -




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 2004,
      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.




In
      June 2004, we completed our annual impairment test and assessed the carrying
      value of goodwill as required by SFAS 142. The goodwill impairment test compared
      the carrying value of the Company’s reporting units with the fair value at that
      date. Because the market capitalization exceeded the carrying value
      significantly, no impairment arose.




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.





-
          6
          -




We
      recorded a $320,000 impairment charge in 2004 in respect of certain technology
      acquired from Bristlecone in 2003.




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.




***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.







-
          7
          -




**Recent
      Developments**




***CECOM
      IDIQ Order***




In
      March 2005 we received a new Firm
      Fixed Price, Indefinite Delivery, Indefinite Quantity (IDIQ) order from
      the U.S. Army’s Communications Electronic Command (CECOM) to
      supply up to $24 million in zinc-air batteries and adaptors to the Department
      of
      Defense over the next three years. Under the new contract, EFB will be enabled
      to deliver the BA-8180/U zinc-air battery and the three existing interface
      adapters. In addition, a new battery, the BA-8140/U, and four new adapters
      are
      included in this contract and have been ordered for First Article Testing
      (FAT).




**Executive
      Summary**




The
      following executive summary includes discussion of our new subsidiaries, FAAC
      Incorporated, Epsilor Electronic Industries, Ltd. and Armour of America
      Incorporated, that we purchased in 2004.




***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 Security 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






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          8
          -




·
            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




·
            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”).




***Overview
      of Results of Operations***




We
      incurred significant operating losses for the years ended December 31, 2004,
      2003 and 2002. 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.




We
      succeeded during 2004 in moving Arotech to a positive cash flow situation,
      for
      the first time in our history. We are focused on continuing this success in
      2005
      and beyond, and ultimately on achieving profitability. In this connection,
      we
      note that most of our business lines historically have had weaker first halves
      than second halves, and weaker first quarters than second quarters. We expect
      this to be the case for 2005 as well.




A
      portion
      of our operating loss during 2004 and 2003 arose as a result of non-cash
      charges. 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 2005, we expect to
      continue to incur such non-cash charges in the future.





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          9
          -




*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
      2005. 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.




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 and impairment in the amount
      of
      $2.8 million during 2004. 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 $4.1 million during 2004.




Additionally,
      in an effort to improve our cash situation and our shareholders’ equity, and in
      order to reduce the number of our outstanding warrants, during 2003 and 2004
      we
      induced holders of certain of our warrants to exercise their warrants by
      lowering the exercise price of the warrants to approximately market value in
      exchange for immediate exercise of such warrants, and by issuing to such
      investors a lower number of new warrants at a higher exercise price. Under
      such
      circumstances, we record a deemed dividend in an amount determined based upon
      the fair value of the new warrants. As and to the extent that we engage in
      similar warrant repricings and issuances in the future, we would incur similar
      non-cash charges.




As
      a
      result of the application of the above accounting rule, we recorded a deemed
      dividend related to warrants repricing and grant of new warrants in the amount
      of $3.3 million during 2004.







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          10
          -




*Restricted
        Share and Option Issuances*
  During
        2004, 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.
  Additionally,
        during 2003 and 2004 we issued options to employees that were subject to
        shareholder approval of a new stock option plan. While the options were issued
        at the market price of our stock on the respective dates of issuance, they
        were
        not considered by applicable accounting rules to have been finally issued
        until
        the date shareholder approval for the new stock option plan was obtained.
        In the
        interim, the market price of our stock had risen, and thus the options were
        deemed to have been issued at a below-market price. We were therefore required
        to take as a general and administrative expense the aggregate difference


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 $884,000 during
      2004.




***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
      cash-flow positive operations, a goal we achieved for the first time in our
      history in the second half of 2004. In order to do this, we focused on acquiring
      businesses with strong revenues and profitable operations.




In
      our
      Simulation and Security Division, revenues grew from approximately $8.0 million
      in 2003 to $21.5 million in 2004 (on a pro forma basis, assuming we had owned
      all components of our Simulation and Security Division since January 1, 2003,
      revenues would have grown from approximately $17.9 million in 2003 to $21.5
      million in 2004). We attribute this to a number of substantial orders, such
      as
      orders from the U.S. Army and the Chicago Transit Authority. As of December
      31,
      2004, our backlog for our Simulation and Security Division totaled $12.7
      million.




Our
      Armor
      Division had record revenues during 2004, with revenues growing from
      approximately $3.4 million in 2003 to $18.0 million in 2004 (on a pro forma
      basis, assuming we had owned all components of our Armor Division since January
      1, 2003, revenues would have grown from approximately $10.9 million in 2003
      to
      $29.2 million in 2004). Much of this growth was attributable to armoring orders
      connected with the war in Iraq. As of December 31, 2004, our backlog for our
      Armor Division totaled $4.0 million.





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          11
          -




In
      our
      Battery and Power Systems Division, revenues grew from approximately $5.9
      million in 2003 to $10.5 million in 2004 (on a pro forma basis, assuming we
      had
      owned all components of our Battery and Power Systems Division since January
      1,
      2003, revenues would have fallen from approximately $10.8 million in 2003 to
      $10.5 million in 2004). As of December 31, 2004, our backlog for our Battery
      and
      Power Systems Division totaled $8.3 million.




**Results
      of Operations**




***Preliminary
      Note***




*Summary*




Results
      of operations for the year ended December 31, 2004 include the results of FAAC,
      Epsilor and AoA for the periods following our acquisition of each such company
      during 2004. However, the results of these subsidiaries were not included in
      our
      operating results for the year ended December 31, 2003. Accordingly, the
      following year-to-year comparisons should not necessarily be relied upon as
      indications of future performance.




Following
      is a table summarizing our results of operations for the years ended December
      31, 2004 and 2003, after which we present a narrative discussion and
      analysis:




**Year
                      Ended December 31,****2004**
                  
                  **2003******Revenues:***Simulation
                      and Security Division
                  
                  $
                  21,464,406
                  
                  $
                  8,022,026Armor
                      Division
                  
                  
                  17,988,687
                  
                  
                  3,435,716Battery
                      and Power Systems Division
                  
                  
                  10,500,753
                  
                  
                  5,868,899$
                  49,953,846
                  
                  $
                  17,326,641***Cost
                      of revenues:***Simulation
                      and Security Division
                  
                  $
                  11,739,690
                  
                  $
                  3,944,701Armor
                      Division
                  
                  
                  15,449,084
                  
                  
                  2,621,550Battery
                      and Power Systems Division
                  
                  
                  6,822,320
                  
                  
                  4,521,589$
                  34,011,094
                  
                  $
                  11,087,840***Research
                      and development expenses:***Simulation
                      and Security Division
                  
                  $
                  395,636
                  
                  $
                  132,615Armor
                      Division
                  
                  
                  17,065
                  
                  
                  84,186Battery
                      and Power Systems Division
                  
                  
                  1,318,678
                  
                  
                  836,607$
                  1,731,379
                  
                  $
                  1,053,408***Sales
                      and marketing expenses:***Simulation
                      and Security Division
                  
                  $
                  3,185,001
                  
                  $
                  2,237,386Armor
                      Division
                  
                  
                  565,981
                  
                  
                  180,631Battery
                      and Power Systems Division
                  
                  
                  1,171,235
                  
                  
                  926,872All
                      Other
                  
                  
                  -
                  
                  
                  187,747$
                  4,922,217
                  
                  $
                  3,532,636***General
                      and administrative expenses:***Simulation
                      and Security Division
                  
                  $
                  2,852,969
                  
                  $
                  1,001,404Armor
                      Division
                  
                  
                  1,323,982
                  
                  
                  518,053Battery
                      and Power Systems Division
                  
                  
                  965,058
                  
                  
                  188,655All
                      Other
                  
                  
                  5,514,857
                  
                  
                  4,149,764$
                  10,656,866
                  
                  $
                  5,857,876
   -
                12
                -




**Year
                Ended December 31,****2004**
            
            **2003******Financial
                expense (income):***Simulation
                and Security Division
            
            $
            27,842
            
            $
            (119,750
            )Armor
                Division
            
            
            13,503
            
            
            (19,918
            )Battery
                and Power Systems Division
            
            
            54,511
            
            
            7,936All
                Other
            
            
            4,133,109
            
            
            4,170,441$
            4,228,965
            
            $
            4,038,709***Tax
                expenses:***Simulation
                and Security Division
            
            $
            77,811
            
            $
            30,130Armor
                Division
            
            
            134,949
            
            
            363,173Battery
                and Power Systems Division
            
            
            320,878
            
            
            -All
                Other
            
            
            52,471
            
            
            2,890$
            586,109
            
            $
            396,193***Amortization
                of intangible assets and impairment losses:***Simulation
                and Security Division
            
            $
            1,643,682
            
            $
            720,410Armor
                Division
            
            
            661,914
            
            
            144,500Battery
                and Power Systems Division
            
            
            509,239
            
            
            -$
            2,814,835
            
            $
            864,910***Minority
                interest in loss (profit) of subsidiaries:***Simulation
                and Security Division
            
            $
            -
            
            $
            -Armor
                Division
            
            
            (44,694
            )
            
            156,900Battery
                and Power Systems Division
            
            
            -
            
            
            -$
            (44,694
            )
            $
            156,900***Loss
                from continuing operations******:***Simulation
                and Security Division
            
            $
            1,541,775
            
            $
            75,130Armor
                Division
            
            
            (222,485
            )
            
            (299,559
            )Battery
                and Power Systems Division
            
            
            (661,166
            )
            
            (612,760
            )All
                Other
            
            
            (9,700,437
            )
            
            (8,510,842
            )$
            (9,042,313
            )
            $
            (9,348,031
            )***Income
                from discontinued operations:***Simulation
                and Security Division
            
            $
            -
            
            $
            -Armor
                Division
            
            
            -
            
            
            -Battery
                and Power Systems Division
            
            
            -
            
            
            110,410$
            -
            
            $
            110,410***Net
                loss******:***Simulation
                and Security Division
            
            $
            1,541,775
            
            $
            75,130Armor
                Division
            
            
            (222,485
            )
            
            (299,559
            )Battery
                and Power Systems Division
            
            
            (661,166
            )
            
            (502,350
            )All
                Other
            
            
            (9,700,437
            )
            
            (8,510,842
            )$
            (9,042,313
            )
            $
            (9,237,621
            )






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          13
          -




**Year
                    Ended December 31,****2004**
                
                **2003******Revenues:***Simulation
                    and Security Division
                
                $
                21,464,406
                
                $
                8,022,026Armor
                    Division
                
                
                17,988,687
                
                
                3,435,716Battery
                    and Power Systems Division
                
                
                10,500,753
                
                
                5,868,899$
                49,953,846
                
                $
                17,326,641***Cost
                    of revenues:***Simulation
                    and Security Division
                
                $
                11,739,690
                
                $
                3,944,701Armor
                    Division
                
                
                15,449,084
                
                
                2,621,550Battery
                    and Power Systems Division
                
                
                6,822,320
                
                
                4,521,589$
                34,011,094
                
                $
                11,087,840***Research
                    and development expenses:***Simulation
                    and Security Division
                
                $
                395,636
                
                $
                132,615Armor
                    Division
                
                
                17,065
                
                
                84,186Battery
                    and Power Systems Division
                
                
                1,318,678
                
                
                836,607$
                1,731,379
                
                $
                1,053,408***Sales
                    and marketing expenses:***Simulation
                    and Security Division
                
                $
                3,185,001
                
                $
                2,237,386Armor
                    Division
                
                
                565,981
                
                
                180,631Battery
                    and Power Systems Division
                
                
                1,171,235
                
                
                926,872All
                    Other
                
                
                -
                
                
                187,747$
                4,922,217
                
                $
                3,532,636***General
                    and administrative expenses:***Simulation
                    and Security Division
                
                $
                2,852,969
                
                $
                1,001,404Armor
                    Division
                
                
                1,323,982
                
                
                518,053Battery
                    and Power Systems Division
                
                
                965,058
                
                
                188,655All
                    Other
                
                
                5,514,857
                
                
                4,149,764$
                10,656,866
                
                $
                5,857,876




*  Restated
      (see Note 1.b. of Notes to Consolidated Financial Statements).




***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






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          14
          -




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).




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 Security 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 Security
      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 Security 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).





-
          15
          -




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.




***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 to certain
                potential acquisitions, that 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:





-
          16
          -




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.




***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*** **.** 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 14.f.4. and
      14.f.5. to the financial statements) compared to $9.6 million in 2003, an
      increase of 2.8 million, or 29%.




***Fiscal
      Year 2003 compared to Fiscal Year 2002***




***Revenues*** **.** During
      2003, we (through our subsidiaries) recognized revenues as follows:




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




Ø
            MDT
                recognized revenues from payments under vehicle armoring contracts
                and for
                service and repair of armored
                vehicles;




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




Ø
            Arocon
                recognized revenues under consulting agreements;
                and






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          17
          -




Ø
            EFL
                recognized revenues from the sale of lifejacket lights and from
                subcontracting fees received in connection with Phase III of the
                United
                States Department of Transportation (DOT) electric bus program, which
                began in October 2002 and was completed in March 2004. Phase IV of
                the DOT
                program, which began in October 2003, did not result in any revenues
                during 2003.




Revenues
      from continuing operations for the year ended December 31, 2003 totaled $17.3
      million, compared to $6.4 million for 2002, an increase of $10.9 million, or
      170%. This increase was primarily the result of increased sales attributable
      to
      IES and EFB, as well as the inclusion of IES and MDT in our results for the
      full
      year of 2003 but only part of 2002.




In
      2003,
      revenues were $8.0 million for the Simulation and Security Division (compared
      to
      $2.0 million in 2002, an increase of $6.0 million, or 305%, due primarily to
      the
      inclusion of IES in our results for the full year of 2003 but only part of
      2002), $5.9 million for the Battery and Power Systems Division (compared to
      $1.7
      million in the comparable period in 2002, an increase of $4.2 million, or 249%,
      due primarily to increased sales to the U.S. Army on the part of EFB), and
      $3.4
      million for the Armor Division (compared to $2.7 million in 2002, an increase
      of
      $691,000, or 25%, due primarily to the inclusion of MDT in our results for
      the
      full year of 2003 but only part of 2002).




***Cost
      of revenues and gross profit.*** **** Cost
      of
      revenues totaled $11.1 million during 2003, compared to $4.4 million in
      2002, **** an
      increase of $6.7 million, or 151%, **** due
      to
      increased cost of goods sold, particularly by IES and EFB, as well as the
      inclusion of IES and MDT in our results for the full year of 2003 but only
      part
      of 2002.




Direct
      expenses for our three divisions during 2003 were $7.3 million for the
      Simulation and Security Division (compared to $2.0 million in 2002, **** an
      increase of $5.3 million, or 259%, due primarily to increased sales attributable
      to the inclusion of IES in our results for the full year of 2003 but only part
      of 2002), $5.9 million for the Battery and Power Systems Division (compared
      to
      $3.1 million in the comparable period in 2002, **** an
      increase of $2.9 million, or 94%, due primarily to increased sales on the part
      of EFB to the U.S. Army), and $3.6 million for the Armor Division (compared
      to
      $2.3 million in 2002, an increase of $1.3 million, or 55%, due primarily to
      the
      inclusion of MDT in our results for the full year of 2003 but only part of
      2002).




Gross
      profit was $6.2 million during 2003, compared to $2.0 million during 2002,
      an
      increase of $4.3 million, or 214%. This increase was the direct result of all
      factors presented above, most notably the increased sales of IES and EFB, as
      well as the inclusion of IES and MDT in our results for the full year of 2003
      but only part of 2002. In 2003, IES contributed $4.1 million to our gross
      profit, EFB contributed $1.6 million, and MDT contributed $833,000.




***Research
      and development expenses*** **.** Research
      and development expenses for 2003 were $1.1 million, compared to $686,000 in
      2002, an increase of $367,000, or 54%. This increase was primarily because
      certain research and development personnel who had worked on the discontinued
      consumer battery operations during 2002 (the expenses of which are not reflected
      in the 2002 number above) were reassigned to military battery research and
      development in 2003.





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          18
          -




***Sales
      and marketing expenses*** **.** Sales
      and marketing expenses for 2003 were $3.5 million, compared to $1.3 million
      in
      2002, an increase of $ 2.2 million,
      or 170%. This increase was primarily attributable to the following
      factors:




Ø
            The
                inclusion of the sales and marketing expenses of IES and MDT in our
                results for the full year of 2003 but only part of
                2002;




Ø
            An
                increase in IES’s sales activity during 2003, which resulted in both
                increased sales and increased sales and marketing expenses during
                2003;
                and




Ø
            We
                incurred expenses for consultants in the amount of $810,000 in connection
                with our CECOM battery program with the U.S. Army and $345,000 in
                connection with our security consulting
                business.




***General
      and administrative expenses*** **.** General
      and administrative expenses for 2003 were $5.9 million, compared to $4.0 million
      in 2002, an increase of $1.8 million, or 46%. This increase was primarily
      attributable to the following factors:




Ø
            The
                inclusion of the general and administrative expenses of IES and MDT
                in our
                results for the full year of 2003 but only part of
                2002;




Ø
            Expenses
                in 2003 in connection with a litigation settlement agreement, in
                the
                amount of $714,000, that were not present in
                2002;




Ø
            Expenses
                in 2003 in connection with warrant grants, in the amount of $199,500,
                that
                were not present in 2002;




Ø
            Legal
                and consulting expenses in 2003 in connection with our convertible
                debentures, in the amount of $484,000, that were not present in 2002;
                and




Ø
            Expenses
                in 2003 in connection with the start-up of our security consulting
                business in the United States and with the beginning of operations
                of MDT
                Armor, in the amount of $250,000, that were not present in
                2002.




***Financial
      income (expense)*** **.** Financial expense totaled approximately $4.0 million in 2003 compared to
      financial income of $100,000 **** in
      2002,
      an increase of $4.1 million. This increase was due primarily to amortization
      of
      compensation related to the issuance of convertible debentures issued in
      December 2002 and during 2003 in the amount of $3.9 million, and interest
      expenses related to those debentures in the amount of $376,000.




***Tax
      expenses.*** **** We
      and
      our Israeli subsidiary EFL incurred net operating losses during 2003 and 2002
      and, accordingly, we were not required to make any provision for income taxes.
      MDT and IES had taxable income, and accordingly we were required to make
      provision for income taxes in the amount of $396,000 in 2003. We were able
      to
      offset IES’s federal taxes against our loss carryforwards. In 2002 we did not
      accrue any tax expenses due to our belief that we would be able to utilize
      our
      loss carryforwards against MDT’s taxable income, estimation was revised in 2003.
      Of the amount accrued in 2003, approximately $352,000 was accrued on account
      of
      income in 2002.





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          19
          -




***Amortization
      of intangible assets and in-process research and
      development*** **.** Amortization of intangible assets totaled $865,000 in 2003, compared to $649,000
      in 2002, **** an
      increase of $215,000, or 33%, resulting from amortization of these assets
      subsequent to our acquisition of IES and MDT in 2002. Of this $215,000 increase,
      $169,000 was attributable to IES and $46,000 was attributable to
      MDT.




***Loss
      from continuing operations*** **.** Due to
      the factors cited above, we reported a net loss from continuing operations
      of
      $ 9.3 million
      in 2003, compared to a net loss of $4.9 million in 2002, an increase of
      $ 4.4
      million ,
      or 90% .




***Profit
      (loss) from discontinued operations.*** **** In
      the
      third quarter of 2002, we decided to discontinue operations relating to the
      retail sales of our consumer battery products. Accordingly, all revenues and
      expenses related to this segment have been presented in our consolidated
      statements of operations for the years ended December 31, 2003 and 2002 in
      an
      item entitled “Loss from discontinued opera-tions.”




Income
      from discontinued operations in 2003 was $110,000, compared to a loss of $13.6
      million in 2002, a decrease of $13.7 million .
      This
      decrease was the result of the elimination of the losses from these discontinued
      operations beginning with the fourth quarter of 2002. The income from
      discontinued operations was primarily from cancellation of past accruals made
      unnecessary by the closing of the discontinued operations.




***Net
      loss before deemed dividend.*** Due to
      the factors cited above, we reported a net loss before deemed dividend of $9.2
      million in 2003, compared to a net loss of $18.5 million in 2002, a decrease
      of
      $9.3 million, or 50 %.




***Net
      loss after deemed dividend of common stock to certain
      stockholders.*** Due to
      the factors cited above, we reported a net loss after deemed dividend of $9.6
      million in 2003, compared to a net loss of $18.5 million in 2002, a decrease
      of
      $8.9 million, or 48 %.




**Liquidity
      and Capital Resources**




As
      of
      December 31, 2004, 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, as compared to at December 31, 2003,
      when we had $13.7 million in cash and $706,000 in restricted cash deposits
      due
      within one year. The decrease in cash was primarily the result of the costs
      of
      the acquisitions of FAAC, Epsilor and AoA, and working capital needed in our
      other segments.




We
      used
      available funds in 2004 primarily for acquisitions, sales and marketing,
      continued research and development expenditures, and other working capital
      needs. We increased our investment in fixed assets by $1.7 million during the
      year ended December 31, 2004, primarily in the Battery and Power Systems
      Division and in the Simulation and Security Division. Our net fixed assets
      amounted to $4.6 million as at year end.




Net
      cash
      used in operating activities for 2004 and 2003 was $852,000 and $3.3 million,
      respectively, a decrease of $2.5 million, or 75%. This decrease was primarily
      the result of an increase in our adjusted net income in 2004 (net income in
      statement of operations less non-cash charges such as depreciation,
      amortization, non-cash financial expenses and non-cash expenses related to
      options and warrants).





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          20
          -




Net
      cash
      used in investing activities for 2004 and 2003 was $50.5 million and $1.8
      million, respectively, an increase of $48.7 million. This increase was primarily
      the result of our investment in the acquisition of FAAC, Epsilor and AoA in
      2004.




Net
      cash
      provided by financing activities for 2004 and 2003 was $44.4 million and $17.4
      million, respectively, an increase of $27.0 million, or 156%. This increase
      was
      primarily the result of higher amounts of funds raised through sales of our
      securities in 2004 compared to 2003.




During
      2004, certain of our employees exercised options under our registered employee
      stock option plan. The proceeds to us from the exercised options were
      approximately $1.1 million.




We
      have
      approximately $5.5 million in long-term debt outstanding (not including accrued
      severance pay), of which $4.5 million was related to convertible debt
      (unamortized financial expenses related to the beneficial conversion feature
      of
      these convertible debentures amounted to approximately $2.8 million at year
      end), and approximately $13.7 million in short-term debt (not including trade
      payables and other accounts payable), of which $13.4 million relates to the
      earn-out provision in connection with our acquisition of FAAC.




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 and
      anticipated cash flows from operations should be sufficient to satisfy our
      current estimated cash requirements through at least the twelve months. This
      belief is based on certain assumptions that our management believes to be
      reasonable, some of which are subject to the risk factors detailed below. Over
      the long term, we will need to become profitable, at least on a cash-flow basis,
      and maintain that profitability in order to avoid future capital requirements.
      Additionally, we would need to raise additional capital in order to fund any
      future acquisitions.




**Effective
      Corporate Tax Rate**




We
      and
      certain of our subsidiaries incurred net operating losses during the years
      ended
      December 31, 2002, 2003 and 2004, 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 2004, we were able to offset federal taxes against our net
      operating loss carryforward, which amounted to $23 million as of December 31,
      2004. 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 2004, 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 35% (less, in the
      case of companies that have “approved enterprise” status as discussed in Note 15
      to the Notes to Financial Statements).





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          21
          -




As
      of
      December 31, 2004, we had a U.S. net operating loss carryforward of
      approximately $23.0 million that is available to offset future taxable income
      under certain circumstances, expiring primarily from 2009 through 2024, and
      foreign net operating and capital loss carryforwards of approximately $87.0
      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, 2004, 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*
                
                $
                5,558,391
                
                $
                -
                
                $
                5,558,391
                
                $
                -
                
                $
                -Short-term
                    debt**
                
                $
                13,766,677
                
                $
                13,766,677
                
                $
                -
                
                $
                -
                
                $
                -Operating
                    lease obligations
                
                $
                1,427,965
                
                $
                762,636
                
                $
                641,017
                
                $
                24,312
                
                $
                -Severance
                    obligations***
                
                $
                1,642,801
                
                $
                223,333
                
                $
                1,240,871
                
                $
                -
                
                $
                178,597


Includes
          convertible debentures in the gross amount of $4,537,500. Unamortized financial
          expenses related to the beneficial conversion feature of these convertible
          debentures amounted to $2,782,697 at year end.
 **  Includes
          sums owed in respect of an earn-out provision related to our acquisition
          of
          FAAC, in the amount of $13.4 million.
 ***  Includes
          obligations related to special severance pay arrangements in addition to
          the
          severance amounts due to certain employees pursuant to Israeli severance
          pay
          law.




**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, 2004, we had an accumulated deficit of
      approximately $119.0 million. 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.





-
          22
          -




***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 aggregated approximately $5.5 million as of
      December 31, 2004. Accordingly, we are subject to the risks associated with
      indebtedness, including:




·
            we
                must dedicate a portion of our cash flows from operations to pay
                debt
                service costs and, as a result, we have less funds available for
                operations, future acquisitions of consumer receivable portfolios,
                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 or 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 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.




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




A
      failure
      to comply with the obligations contained in our debenture agreements could
      result in an event of default under such agreements which could result in an
      acceleration of the debentures 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 or other
      indebtedness were to be accelerated, there can be no assurance that our assets
      would be sufficient to repay in full such indebtedness.




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




Our
      debentures 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.





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          23
          -




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




We
      require substantial funds to market our products and develop and market new
      products. To the extent that we are unable to fully fund our operations through
      profitable sales of our products and services, we may continue to seek
      additional funding, including through the issuance of equity or debt securities.
      However, there can be no assurance that we will obtain any such additional
      financing in a timely manner, on acceptable terms, or at all. If additional
      funds are raised by issuing equity securities, stockholders may incur further
      dilution. If additional funding is not secured, we will have to modify, reduce,
      defer or eliminate parts of our anticipated future commitments and/or
      programs.




***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 hi-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
      acquisition strategy involves various risks.***




Part
      of
      our strategy is to grow through the acquisition of 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 therein. 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, 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 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. 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 could place 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.




***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. MDT has already experienced a slowdown in orders from
      the
      Ministry of Defense due to budget constraints and a requirement of U.S. aid
      to
      Israel that a substantial proportion of such aid be spent in the U.S., where
      MDT
      has only recently opened a factory.




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.





-
          24
          -




***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.




A
      negative audit by the U.S. government could adversely affect our business,
      and
      we might not be reimbursed by the government for costs that we have expended
      on
      our contracts.




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.




***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






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·
            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.




***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.




***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.





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***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
      steadily increasing orders from the U.S. military for armoring of vehicles
      and
      military batteries. These orders are the result, in substantial part, from
      the
      particular combat situations encountered by the U.S. military in Iraq. We cannot
      be certain, therefore, 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.




***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.





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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.




***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.





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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 presidents of our IES, FAAC and AoA subsidiaries 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, President and Chief
      Executive Officer, Robert S. Ehrlich. The loss of Mr. Ehrlich 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 2005, and we may not be able
      to
      renew such contract on terms acceptable to us, or at all. We do not have key-man
      life insurance on Mr. Ehrlich.




***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 2004, 2003 and 2002, without taking account
      of
      revenues derived from discontinued operations, 19%, 42% and 56%, 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.




***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;






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·
            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;




·
            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 National Market
      is
      the maintenance of a $1.00 bid price. Our stock price has traded below $1.00
      in
      the past. If our bid price were to go and remain below $1.00 for 30 consecutive
      business days, Nasdaq could notify us of our failure to meet the continued
      listing standards, after which we would have 180 calendar days to correct such
      failure or be delisted from the Nasdaq National 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 National
      Market. If our common stock were to be delisted from the Nasdaq National Market,
      we might apply to be listed on the Nasdaq SmallCap market; however, there can
      be
      no assurance that we would be approved for listing on the Nasdaq SmallCap
      market, which has the same $1.00 minimum bid and other similar requirements
      as
      the Nasdaq National Market. If we were to move to the Nasdaq SmallCap market,
      current Nasdaq regulations would give us the opportunity to obtain an additional
      180-day grace period and an additional 90-day grace period after that if we
      meet
      certain net income, stockholders’ equity or market capitalization criteria.
      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. 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.




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          30
          -




***We
      expect our auditors to report a material weakness 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.***




Pursuant
      to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with this
      Annual Report on Form 10-K for the fiscal year ending December 31, 2004,
      we
      are required to furnish a report by our management on our internal control
      over
      financial reporting.




Pursuant
      to Securities and Exchange Commission Release No. 34-50754, which, subject
      to
      certain conditions, provides up to 45 additional days beyond the due date of
      this Form 10-K for the filing of management’s annual report on internal control
      over financial reporting required by Item 308(a) of Regulation S-K, and the
      related attestation report of the independent registered public accounting
      firm,
      as required by Item 308(b) of Regulation S-K, management’s report on internal
      control over financial reporting and the associated report on the audit of
      management’s assessment of the effectiveness of the Company’s internal control
      over financial reporting as of December 31, 2004, are not filed herein and
      are
      expected to be filed no later than May 2, 2005.




The
      internal control report must contain (i) a statement of management’s
      responsibility for establishing and maintaining adequate internal control over
      financial reporting, (ii) a statement identifying the framework used
      by
      management to conduct the required evaluation of the effectiveness of our
      internal control over financial reporting, (iii) management’s assessment of
      the effectiveness of our internal control over financial reporting as of the
      end
      of our most recent fiscal year, including a statement as to whether or not
      internal control over financial reporting is effective, and (iv) a
      statement that our independent registered public accounting firm has issued
      an
      attestation report on management’s assessment of internal control over financial
      reporting.




We
      expect that our auditors will inform us, although they have not yet done so,
      that they identified significant deficiencies that constitute a material
      weakness under standards established by the American Institute of Certified
      Public Accountants (AICPA). 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. We expect that
      our
      auditors will report to us that at December 31, 2004, we had a significant
      deficiency in our financial statement closing process and related processes
      because the size our accounting and finance department and the press of work
      related to our recent acquisitions caused us to be unable independently to
      comply with the selection and application of generally accepted accounting
      principles related to highly complex financial transactions applicable to equity
      issuances and business combinations.




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.





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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 mis-statements 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.




***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 February 28, 2005, we had 80,103,668 shares
      of common stock issued and outstanding. Of these shares, most are freely
      transferable without restriction under the Securities Act of 1933, 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
      February 28, 2005, there were outstanding warrants to purchase a total of
      16,961,463 shares of our common stock at a weighted average exercise price
      of
      $1.55 per share, options to purchase a total of 9,102,761 shares of our common
      stock at a weighted average exercise price of $1.28 per share, of which
      7,002,390 were vested, at a weighted average exercise price of $1.28 per share,
      and outstanding debentures convertible into a total of 3,156,298 shares of
      our
      common stock at a weighted average conversion price of $1.44 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;






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          32
          -




·
            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.




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. 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.





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          -






***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 2004, the inflation adjusted NIS appreciated against
      the dollar, which raised the dollar cost of our Israeli operations.




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




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


**Page****Consolidated
                Financial Statements**Reports
                of Independent Registered Public Accounting Firms
            F-2Consolidated
                Balance Sheets
            F-4Consolidated
                Statements of Operations
            F-6Statements
                of Changes in Shareholders’ Equity
            F-7Consolidated
                Statements of Cash Flows
            F-10Notes
                to Consolidated Financial Statements
            F-14**Supplementary
                Financial Data**Quarterly
                Financial Data (unaudited) for the two years ended December 31,
                2004
            F-61**Financial
                Statement Schedule**Schedule
                II - Valuation and Qualifying Accounts
            F-62






-
          34
          -




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




**Evaluation
      of Disclosure Controls and Procedures**




As
      of
      December 31, 2004, 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
      objective 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.




Based
      on
      their evaluation as of December 31, 2004, and solely because of the material
      weaknesses described below, our principal executive officer and principal
      financial officer concluded 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.




In
      light
      of the material weakness described below, our management performed additional
      analyses and other post-closing procedures to ensure our consolidated financial
      statements are 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. Our management has evaluated the effectiveness of our
      internal controls, pursuant to the requirements of Sarbanes-Oxley
      Section 404, as of the end of the period covered by this Annual Report
      on
      Form 10-K for December 31, 2004. In making our assessment of internal
      control over financial reporting, management used the criteria set forth by
      the
      Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission in *Internal
      Control - Integrated Framework* .
      In
      accordance with the rules of the SEC, we did not assess the internal control
      over financial reporting of Armour of America, Incorporated, which we acquired
      in August 2004, financial statements of which reflect total assets of 4% of
      our
      consolidated assets as of December 31, 2004, and total revenues of 5% of our
      consolidated revenues for the year then ended. In our Annual Report on Form
      10-K
      for the year ending December 31, 2005, we will be required to provide an
      assessment of our compliance that takes into account an assessment of Armour
      of
      America, Incorporated and all of our other currently existing subsidiaries
      as of
      December 31, 2005.





-
          35
          -




For
      the reasons described below, we have concluded that there were material
      weaknesses in our internal controls at December 31, 2004. 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, 2004, and their report dated
      March 24, 2005 expressed an unqualified opinion with respect
      thereto.




On
      November 22, 2004, the Audit Committee of our Board of Directors, on the
      recommendation of our management and after discussion with our Independent
      Registered Public Accounting Firm, made an internal determination and concluded
      that our Annual Report on Form 10-K for the year ended December 31, 2003,
      including the financial statements that our Independent Registered Public
      Accounting Firm had previously audited that are contained therein, contained
      certain errors related to the re-pricing of warrants and grant of additional
      warrants to certain of our investors and others and the amortization of debt
      discount arising from the allocation of the debt discount between the
      convertible debentures and their detachable warrants. The net effect of these
      errors, which generally related to the timing and characterization of certain
      non-cash expenses, was (i) to increase our net loss attributable to common
      stockholders for 2003 by approximately $579,000 and to decrease our net loss
      for
      the first half of 2004 by approximately $608,000, and (ii) to decrease our
      net
      loss attributable to common stockholders for the nine and three months ended
      September 30, 2004 by approximately $1,583,778 and $976,129, respectively.
      The
      Audit Committee of our Board of Directors therefore concluded to restate certain
      previously issued financial statements contained in our Annual Report on Form
      10-K for the year ended December 31, 2003. The
      decision to restate these financial statements was made by our Audit Committee,
      upon the recommendation of our management and with the concurrence of our Independent
      Registered Public Accounting Firm .




As
      a
      result of the restatement referred to in the preceding paragraph, we
      have identified material weaknesses for inadequate controls related to the financial
      statement close process, convertible debentures and share capital processes
      as
      it applies to non-routine and highly complex financial transactions. A material
      weakness is a control deficiency (within the meaning of the Public Company
      Accounting Oversight Board (“PCAOB”) Auditing Standard No. 2), or combination of
      control deficiencies, that results in more than a remote likelihood that a
      material misstatement of the annual or interim financial statements will not
      be
      prevented or detected. The material weaknesses arise from insufficient staff
      with technical accounting expertise to independently apply our accounting
      policies, as they relate to non-routine and highly complex transactions, in
      accordance with U.S. generally accepted accounting principles. Management has
      identified that due to the reasons described above, we did not consistently
      follow established internal control over financial reporting procedures related
      to the analysis, documentation and review of selection of the appropriate
      accounting treatment for non-routine and highly complex transactions. Because
      of
      these material weaknesses, we have concluded that we did not maintain effective
      internal control over financial reporting as of December 31, 2004, based
      on
      the criteria in *Internal
      Control-Integrated Framework* .





-
          36
          -




The
      foregoing management assessment of the effectiveness of our internal control
      over financial reporting as of December 31, 2004, has been audited by Kost,
      Forer, Gabbay and Kassierer, a member of Ernst & Young Global, the
      registered public accounting firm that audited the financial statements included
      in our annual report, as stated in their report which is included
      below.




**Management’s
      Response to the Material Weaknesses**




In
      response to the material weaknesses described above, we have undertaken to
      take
      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 2005, during which we expect to continue
      pursuing appropriate corrective actions, including the following:




Ø
            Preparing
                appropriate written documentation of our financial control
                procedures;




Ø
            Adding
                additional qualified staff to our finance
                department;




Ø
            Scheduling
                training for accounting staff to heighten awareness of generally
                accepted
                accounting principles applicable to complex transactions;




Ø
            Strengthening
                our internal review procedures in conjunction with our ongoing work
                to
                enhance our internal controls so as to enable us to identify and
                adjust
                items proactively;




Ø
            Engaging
                an outside accounting firm to support our Sarbanes-Oxley Section
                404
                compliance activities and to provide technical expertise in the selection
                and application of generally accepted accounting principles related
                to
                complex transactions to identify areas that require control or process
                improvements and to consult with us on the appropriate accounting
                treatment applicable to complex transactions;
                and




Ø
            Implementing
                the recommendations of our outside accounting
                consultants.




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 weaknesses will be fully remediated.
      However, because remediation will not be completed until we have added finance
      staff and strengthened pertinent controls, we presently anticipate that we
      will
      report in our Quarterly Report on Form 10-Q for the second quarter of
      fiscal 2005 that material weaknesses continue to exist.





-
          37
          -




**Changes
      in Internal Controls Over Financial Reporting**




Except
      as
      noted above, 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.






-
          38
          -


****


**PART
      IV**




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




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


(1)
                  Financial
                      Statements - See Index to Financial Statements on 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***23.1
              Consent
                  of Kost, Forer, Gabbay & Kassierer, 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




* Filed
        herewith
   -
            39
            -








**SIGNATURES**




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the Registrant has duly caused this amended report to be signed on its
      behalf by the undersigned, thereunto duly authorized, on August 15 ,
      2005.




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






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




**Signature**
            
            **Title**
            
            **Date**/s/
                Robert S. Ehrlich
              Robert
                S. Ehrlich
            
            Chairman,
                President, Chief Executive Officer and Director
              (Principal
                Executive Officer)
            
            August15,
                2005/s/
                Avihai Shen
              Avihai
                Shen
            
            Vice
                President - Finance
              (Principal
                Financial Officer)
            
            August15,
                2005/s/
                Danny Waldner
              Danny
                Waldner
            
            Controller
              (Principal
                Accounting Officer)
            
            August15,
                2005/s/
                Steven Esses
              Steven
                Esses
            
            Executive
                Vice President, Chief Operating Officer and Director
            
            August15,
                2005/s/
                Jay M. Eastman
              Dr.
                Jay M. Eastman
            
            Director
            
            August15,
                2005/s/
                Lawrence M. Miller
              Lawrence
                M. Miller
            
            Director
            
            August15,
                2005Jack
                E. Rosenfeld
            
            Director
            
            August,
                2005/s/
                Seymour Jones
              Seymour
                Jones
            
            Director
            
            August15,
                2005Edward
                J. Borey
            
            Director
            
            August,
                2005








-
          40
          -




**AROTECH
      CORPORATION AND ITS SUBSIDIARIES**




**CONSOLIDATED
      FINANCIAL STATEMENTS**




**AS
      OF DECEMBER 31, 2004**




**IN
      U.S. DOLLARS**




**INDEX**




**Page**Reports
                of Independent Registered Public Accounting Firms
            2
                -
                3Consolidated
                Balance Sheets
            4
                -
                5Consolidated
                Statements of Operations
            6Statements
                of Changes in Stockholders’ Equity
            7
                -
                9Consolidated
                Statements of Cash Flows
            10
                - 13Notes
                to Consolidated Financial Statements
            14
                - 60






























**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, 2004 and 2003, 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,
      2004. 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,” a wholly-owned
      subsidiary of the Company, financial statements of which reflect total assets
      of
      4% of the consolidated assets of the Company as of December 31, 2004, and total
      revenues of 5% 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, 2004 and 2003, and the consolidated results of their operations
      and
      their cash flows for each of the three years in the period ended December 31,
      2004, 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.




As
      discussed in Note 1.b., the Consolidated Financial Statements at December 31,
      2003 and for the year then ended have been restated for the matters set forth
      therein.




Tel
                Aviv, Israel
            KOST,
                FORER, GABBAY & KASIERERMarch
                24, 2005
            A
                Member of Ernst & Young Global






F-2














**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




**To
      the Stockholders of**




**AROTECH
      CORPORATION**




We
      have
      audited management’s assessment, included in the accompanying “Report of
      Management on Internal Control Over Financial Reporting,” that Arotech
      Corporation did not maintain effective internal control over financial reporting
      as of December 31, 2004, because of the effect of material weaknesses in
      internal controls related to the financial statement close process ,
      the convertible
      debentures and share capital processes as it applies to non-routine and highly
      complex financial transactions, based on criteria established in Internal
      Control - Integrated Framework issued by the Committee of Sponsoring
      Organizations of the Treadway Commission (the COSO criteria). Arotech
      Corporation’s management is responsible for maintaining effective internal
      control over financial reporting and for its assessment of the effectiveness
      of
      internal control over financial reporting. Our responsibility is to express
      an
      opinion on management’s assessment and an opinion on the effectiveness of the
      company’s internal control over financial reporting based on our audit.




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




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




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.





F-3




A
      material weakness is a control deficiency, or combination of control
      deficiencies, that results in more than a remote likelihood that a material
      misstatement of the annual or interim financial statements will not be prevented
      or detected. The following material weaknesses have been identified and included
      in management’s assessment. Management identified material weaknesses for
      inadequate controls related to the financial statement close process,
      convertible debentures and share capital processes as it applies to non-routine
      and highly complex financial transactions. The material weaknesses arise from
      insufficient staff with technical accounting expertise to independently apply
      the Company’s accounting policies, as they relate to non-routine and highly
      complex transactions, in accordance with U.S. generally accepted accounting
      principles (“GAAP”). Management has identified that due to the reasons described
      above, the Company did not consistently follow established internal control
      over
      financial reporting procedures related to the analysis, documentation and review
      of selection of the appropriate accounting treatment for non-routine and highly
      complex transactions. These material weaknesses resulted in a restatement of
      the
      2003 consolidated financial statements and quarterly unaudited consolidated
      financial statements for each of the quarters through September 30, 2004 and
      related to the errors in the appropriate accounting treatment to be applied
      to
      (i) re-pricing of warrants and grant of additional warrants to certain investors
      and others, and (ii) amortization of debt discount arising from the allocation
      of the debt discount between the convertible debentures and their detachable
      warrants. The net effect of these errors, which generally related to the timing
      and characterization of certain non-cash expenses, was (i) to increase net
      loss
      attributable to common stockholders for 2003 by approximately $579,000 and
      to
      decrease net loss for the first half of 2004 by approximately $608,000, and
      (ii)
      to decrease net loss attributable to common stockholders for the nine and three
      months ended September 30, 2004 by approximately $1,583,778 and $976,129,
      respectively. The above material weaknesses resulted in the material
      misstatement of amount of convertible debentures, finance expenses related
      to
      convertible debentures and stockholders’ equity.




These
      material weaknesses were considered in determining the nature, timing, and
      extent of audit tests applied in our audit of the December 31, 2004 consolidated
      financial statements, and this report does not affect our report dated March
      24,
      2005 on those consolidated financial statements.




As
      indicated in the accompanying “Report of Management on Internal Control Over
      Financial Reporting,” management’s assessment of and conclusion on the
      effectiveness of internal control over financial reporting did not include
      the
      internal controls of Armour of America Inc., a wholly-owned subsidiary whose
      total assets and total revenues represent 4% and 5%, respectively, of the
      related consolidated financial statement amounts as of and for the year ended
      December 31, 2004, which was acquired by the Company in a purchase business
      combination during 2004. Our audit of internal control over financial reporting
      of Arotech Corporation also did not include an evaluation of the internal
      control over financial reporting of Armour of America Inc.




In
      our
      opinion, management’s assessment that Arotech Corporation did not maintain
      effective internal control over financial reporting as of December 31, 2004,
      is
      fairly stated, in all material respects, based on the COSO control criteria.
      Also, in our opinion, because of the effect of the material weakness described
      above on the achievement of the objectives of the control criteria, Arotech
      Corporation has not maintained effective internal control over financial
      reporting as of December 31, 2004, based on the COSO control criteria.




Tel-Aviv,
                Israel
            KOST,
                FORER, GABBAY & KASIERERApril
                21, 2005
            A
                Member of Ernst & Young Global







F-4





Stark ♦ Winter ♦ Schenkein






**Report
      of Independent Registered Public Accounting Firm**




To
      the
      Shareholder Armour
      of
      America, Inc. Gardena,
      California




We
      have
      audited the accompanying balance sheets of Armour of America, Inc. as of
      December 31, 2004, and the related statements of income, stockholder’s equity
      and cash flows for the period August 11, 2004 to December 31, 2004. These
      financial statements are the responsibility of the Company’s management. Our
      responsibility is to express an opinion on these financial statements based
      on
      our audits.




We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. 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 audit provides a
      reasonable basis for our opinion.




In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the financial position of Armour of America, Inc. as of
      December 31, 2004, and the results of its operations, stockholder’s equity and
      cash flows for the period August 11, 2004 to December 31, 2004, in conformity
      with accounting principles generally accepted in the United States of
      America.




/s/
      Stark
      Winter Schenkein & Co., LLP




Denver,
      Colorado January
      31, 2005




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
 **AROTECH
          CORPORATION AND ITS SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**


**In
      U.S. dollars**




**December
                31,****2004**
            
            **2003*****ASSETS**CURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            6,734,512
            
            $
            13,685,125Restricted
                collateral deposits and restricted held-to-maturity
                securities
            
            
            6,962,110
            
            
            706,180Available
                for sale marketable securities
            
            
            135,568
            
            
            -Trade
                receivables (net of allowance for doubtful accounts in the amounts
                of
                $55,394 and $61,282 as of December 31, 2004 and 2003, respectively)
            
            
            8,266,880
            
            
            4,706,423Unbilled
                receivables
            
            
            2,881,468
            
            
            -Other
                accounts receivable and prepaid expenses
            
            
            1,339,393
            
            
            1,187,371Inventories
            
            
            7,277,301
            
            
            1,914,748Assets
                of discontinued operations
            
            
            -
            
            
            66,068Total
                current assets
            
            
            33,597,232
            
            
            22,265,915SEVERANCE
                PAY FUND
            
            
            1,980,047
            
            
            1,023,342RESTRICTED
                DEPOSITS
            
            
            4,000,000
            
            
            -PROPERTY
                AND EQUIPMENT, NET
            
            
            4,600,691
            
            
            2,292,741OTHER
                INTANGIBLE ASSETS, NET
            
            
            14,368,701
            
            
            2,375,195GOODWILL
            
            
            39,745,516
            
            
            5,064,555$
            98,292,187
            
            $
            33,021,748






The
            accompanying notes are an integral part of the consolidated financial
            statements.
 F-6
 **AROTECH
            CORPORATION AND ITS SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**





**In
      U.S. dollars**








**December
                31,****2004**
            
            **2003*****LIABILITIES
                AND STOCKHOLDERS’ EQUITY**CURRENT
                LIABILITIES:Trade
                payables
            
            $
            6,177,546
            
            $
            1,967,448Other
                accounts payable and accrued expenses
            
            
            5,818,188
            
            
            4,030,411**Current
                portion of promissory notes due to purchase of subsidiaries
            
            
            13,585,325
            
            
            150,000Short
                term bank credit and current portion of long term loans
            
            
            181,352
            
            
            40,849Deferred
                revenues
            
            
            618,229
            
            
            140,936**Liabilities
                of discontinued operations
            
            
            -
            
            
            380,108Total
                current liabilities
            
            
            26,380,640
            
            
            6,709,752LONG
                TERM LIABILITIESAccrued
                severance pay
            
            
            3,422,951
            
            
            2,814,492Convertible
                debenture
            
            
            1,754,803
            
            
            1,450,194Deferred
                revenues
            
            
            163,781
            
            
            220,143Long
                term loan
            
            
            20,891
            
            
            -Long-term
                portion of promissory note due to purchase of subsidiaries
            
            
            980,296
            
            
            150,000Total
                long-term liabilities
            
            
            6,342,722
            
            
            4,634,829COMMITMENTS
                AND CONTINGENT LIABILITIES (Note 12)MINORITY
                INTEREST
            
            
            95,842
            
            
            51,290STOCKHOLDERS’
                EQUITY:Share
                capital -Common
                stock - $0.01 par value each;Authorized:
                250,000,000 shares and 100,000,000 shares as of December 31, 2004
                and
                2003, respectively; Issued: 80,576,902 shares and 47,972,407 shares
                as of
                December 31, 2004 and 2003, respectively; Outstanding - 80,021,569
                shares
                and 47,417,074 shares as of December 31, 2004 and 2003,
                respectively
            
            
            805,769
            
            
            479,726Preferred
                shares - $0.01 par value each;Authorized:
                1,000,000 shares as of December 31, 2004 and 2003; No shares issued
                and
                outstanding as of December 31, 2004 and 2003
            
            
            -
            
            
            -Additional
                paid-in capital
            
            
            189,266,704
            
            
            135,702,413Accumulated
                deficit
            
            
            (118,953,553
            )
            
            (109,911,240
            )Deferred
                stock compensation
            
            
            (1,258,295
            )
            
            (8,464
            )Treasury
                stock, at cost (common stock - 555,333 shares as of December 31,
                2004 and
                2003)
            
            
            (3,537,106
            )
            
            (3,537,106
            )Notes
                receivable from stockholders
            
            
            (1,222,871
            )
            
            (1,203,881
            )Accumulated
                other comprehensive income
            
            
            372,335
            
            
            104,429Total
                stockholders’ equity
            
            
            65,472,983
            
            
            21,625,877$
            98,292,187
            
            $
            33,021,748


Restated
      (see Note 1.b.).


**  Reclassified.






The
          accompanying notes are an integral part of the consolidated financial
          statements.
 F-7
 **AROTECH
          CORPORATION AND ITS SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**In
      U.S. dollars**





**Year
                ended December 31,****2004**
            
            **2003***
            
            **2002**Revenues
            
            $
            49,953,846
            
            $
            17,326,641
            
            $
            6,406,739Cost
                of revenues
            
            
            34,011,094
            
            
            11,087,840
            
            
            4,421,748Gross
                profit
            
            
            15,942,752
            
            
            6,238,801
            
            
            1,984,991Operating
                expenses:Research
                and development, net
            
            
            1,731,379
            
            
            1,053,408
            
            
            685,919Selling
                and marketing expenses
            
            
            4,922,217
            
            
            3,532,636
            
            
            1,309,669General
                and administrative expenses
            
            
            10,656,866
            
            
            5,857,876
            
            
            4,023,103Amortization
                of intangible assets and impairment losses
            
            
            2,814,835
            
            
            864,910
            
            
            623,543In-process
                research and development write-off
            
            
            -
            
            
            -
            
            
            26,000Total
                operating costs and expenses
            
            
            20,125,297
            
            
            11,308,830
            
            
            6,668,234Operating
                loss
            
            
            (4,182,545
            )
            
            (5,070,029
            )
            
            (4,683,243
            )Financial
                income (expenses), net
            
            
            (4,228,965
            )
            
            (4,038,709
            )
            
            100,451Loss
                before minorities interests in loss (earnings) of a subsidiaries
                and tax
                expenses
            
            
            (8,411,510
            )
            
            (9,108,738
            )
            
            (4,582,792
            )Income
                taxes
            
            
            (586,109
            )
            
            (396,193
            )
            
            -Minorities
                interests in loss (earnings) of a subsidiaries
            
            
            (44,694
            )
            
            156,900
            
            
            (355,360
            )Loss
                from continuing operations
            
            
            (9,042,313
            )
            
            (9,348,031
            )
            
            (4,938,152
            )Income
                (loss) from discontinued operations (including loss on disposal of
                $4,446,684 during 2002)
            
            
            -
            
            
            110,410
            
            
            (13,566,206
            )Net
                loss
            
            $
            (9,042,313
            )
            $
            (9,237,621
            )
            $
            (18,504,358
            )Deemed
                dividend to certain stockholders
            
            $
            (3,328,952
            )
            $
            (350,000
            )
            $
            -Net
                loss attributable to common stockholders
            
            $
            (12,371,265
            )
            $
            (9,587,621
            )
            $
            (18,504,358
            )Basic
                and diluted net loss per share from continuing operations
            
            $
            (0.13
            )
            $
            (0.24
            )
            $
            (0.15
            )Basic
                and diluted net loss per share from discontinued
                operations
            
            $
            0.00
            
            $
            0.00
            
            $
            (0.42
            )Basic
                and diluted net loss per share
            
            $
            (0.18
            )
            $
            (0.25
            )
            $
            (0.57
            )Weighted
                average number of shares used in computing basic and diluted net
                loss per
                share
            
            
            69,933,057
            
            
            38,890,174
            
            
            32,381,502


*  Restated
        (see Note 1.b.).








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


**STATEMENTS
      OF CHANGES IN STOCKHOLDERS’ EQUITY** 
 In
        U.S. dollars
  **Common
                    stock****Shares**
                
                **Amount**
                
                **Additional**
                  **paid-in**
                  **capital**
                
                **Accumulated**
                  **deficit**
                
                **Deferred**
                  **stock**
                  **compensation**
                
                **Treasury**
                  **stock**
                
                **Notes**
                  **receivable**
                  **from**
                  **stockholders**
                
                **Accumulated
                    other**
                  **comprehensive****loss**
                
                **Total**
                  **comprehensive**
                  **loss**
                
                **Total**
                  **stockholders’**
                  **equity**Balance
                    as of January 1, 2002
                
                
                29,059,469
                
                $
                290,596
                
                $
                105,686,909
                
                $
                (82,169,261
                )
                $
                (18,000
                )
                $
                (3,537,106
                )
                $
                (845,081
                )
                $
                -
                
                
                
                
                $
                19,408,057Adjustment
                    of notes from stockholders
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (178,579
                )
                
                
                
                
                
                
                
                (178,579
                )Repayment
                    of notes from employees
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                43,308
                
                
                
                
                
                
                
                
                43,308Issuance
                    of shares to investors
                
                
                2,041,176
                
                
                20,412
                
                
                3,209,588
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                3,230,000Issuance
                    of shares to service providers
                
                
                368,468
                
                
                3,685
                
                
                539,068
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                542,753Issuance
                    of shares to lender in respect of prepaid interest
                    expenses
                
                
                387,301
                
                
                3,873
                
                
                232,377
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                236,250Exercise
                    of options by employees
                
                
                191,542
                
                
                1,915
                
                
                184,435
                
                
                
                
                
                
                
                
                
                
                
                (36,500
                )
                
                
                
                
                
                
                
                149,850Amortization
                    of deferred stock com-pensation
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                6,000
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                6,000Stock
                    compensation re-lated to options issued to employees
                
                
                13,000
                
                
                130
                
                
                12,870
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                13,000Issuance
                    of shares in respect of acquisition
                
                
                3,640,638
                
                
                36,406
                
                
                4,056,600
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                4,093,006Accrued
                    interest on notes re-ceivable
                
                
                
                
                
                
                
                
                160,737
                
                
                
                
                
                
                
                
                
                
                
                (160,737
                )
                
                
                
                
                
                
                
                -Other
                    comprehensive loss Foreign currency translation adjustment
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (1,786
                )
                $
                (1,786
                )
                
                (1,786
                )Net
                    loss
                
                
                
                
                
                
                
                
                
                
                
                (18,504,358
                )
                
                
                
                
                
                
                
                
                
                
                
                
                
                (18,504,358
                )
                
                (18,504,358
                )Total
                    comprehensive loss
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                $
                (18,506,144
                )Balance
                    as of December 31, 2002
                
                
                35,701,594
                
                $
                357,017
                
                $
                114,082,584
                
                $
                (100,673,619
                )
                $
                (12,000
                )
                $
                (3,537,106
                )
                $
                (1,177,589
                )
                $
                (1,786
                )
                
                
                
                $
                9,037,501







The
          accompanying notes are an integral part of the consolidated financial
          statements.
 F-9
 **AROTECH
          CORPORATION AND ITS SUBSIDIARIES**


**STATEMENTS
      OF CHANGES IN STOCKHOLDERS’ EQUITY**




**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**
                **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 compensation
              
              
              
              
              
              
              
              
              4,750
              
              
              
              
              
              (4,750
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              -Amortization
                  of deferred stock compensation
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              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 receivable from stockholders
              
              
              
              
              
              
              
              
              16,615
              
              
              
              
              
              
              
              
              
              
              
              (16,615
              )
              
              
              
              
              
              
              
              -Other
                  comprehensive income - foreign currency translation
                  adjustment
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              106,215
              
              $
              106,215
              
              
              106,215Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              (9,237,621
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              (9,237,621
              )
              
              (9,237,621
              )$
              (9,131,406
              )Balance
                  as of December 31, 2003
              
              
              47,972,407
              
              $
              479,726
              
              $
              135,702,413
              
              $
              (109,911,240
              )
              $
              (8,464
              )
              $
              (3,537,106
              )
              $
              (1,203,881
              )
              $
              104,429
              
              
              
              
              $
              21,625,877


Restated
      (see Note 1.b.).









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


**STATEMENTS
      OF CHANGES IN STOCKHOLDERS’ EQUITY**


**In
        U.S. dollars**


**Common
                  stock****Shares**
              
              **Amount**
              
              **Additional**
                **paid-in**
                **capital**
              
              **Accumulated**
                **deficit**
              
              **Deferred**
                **stock**
                **compensation**
              
              **Treasury**
                **stock**
              
              **Notes**
                **receivable**
                **from**
                **stockholders**
              
              **Accumulated
                  other**
                **comprehensive****loss**
              
              **Total**
                **comprehensive**
                **loss**
              
              **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 compensation 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 receivable from stockholders
              
              
              
              
              
              
              
              
              18,990
              
              
              
              
              
              
              
              
              
              
              
              (18,990
              )
              
              
              
              
              
              
              
              -Other
                  comprehensive income - foreign currency translation
                  adjustment
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              263,404
              
              $
              263,404
              
              
              263,404Other
                  comprehensiveincome-
                  realized gain on available for sale marketable securities
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              4,502
              
              
              4,502
              
              
              4,502Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              (9,042,313
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              (9,042,313
              )
              
              (9,042,313
              )$
              (8,774,407
              )Balance
                  as of December 31, 2004
              
              
              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-11
 **AROTECH
          CORPORATION AND ITS SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


In
      U.S. dollars





**Year
                ended December 31,****2004**
            
            **2003***
            
            **2002**Cash
                flows from operating activities:Net
                loss
            
            $
            (9,042,313
            )
            $
            (9,237,621
            )
            $
            (18,504,358
            )Less
                loss (profit) for the period from discontinued operations
            
            
            -
            
            
            (110,410
            )
            
            13,566,206Adjustments
                required to reconcile net loss to net cash used in operating
                activities:Minorities
                interests in earnings (loss) of subsidiary
            
            
            44,694
            
            
            (156,900
            )
            
            355,360Depreciation
            
            
            1,199,465
            
            
            730,159
            
            
            473,739Amortization
                of intangible assets, capitalized software costs and impairment of
                intangible assets
            
            
            2,888,226
            
            
            879,311
            
            
            623,543Remeasurement
                of liability in connection to warrants granted
            
            
            (326,839
            )
            
            -
            
            
            -In-process
                research and development write-off
            
            
            -
            
            
            -
            
            
            26,000Accrued
                severance pay, net
            
            
            (441,610
            )
            
            3,693
            
            
            (357,808
            )Amortization
                of deferred stock compensation and compensation related to shares
                issued
                to employees
            
            
            884,826
            
            
            8,286
            
            
            19,000(Mark
                up) write-off of loans to stockholders
            
            
            (32,397
            )
            
            (12,519
            )
            
            542,317Write-off
                of inventories
            
            
            121,322
            
            
            96,350
            
            
            116,008Impairment
                of property and equipment
            
            
            -
            
            
            68,945
            
            
            -Amortization
                of compensation related to warrants issued to the holders of convertible
                debentures and beneficial conversion feature
            
            
            4,142,109
            
            
            3,928,237
            
            
            -Amortization
                of deferred charges related to convertible debentures
                issuance
            
            
            222,732
            
            
            483,713
            
            
            -Amortization
                of prepaid financial expenses
            
            
            -
            
            
            236,250
            
            
            -Stock-based
                compensation related to grant of new warrants and repricing of warrants
                granted to consultants
            
            
            -
            
            
            229,259
            
            
            -Stock-based
                compensation related to shares issued and to be issued to consultants
                and
                shares granted as a donation
            
            
            89,078
            
            
            161,947
            
            
            -Stock-based
                compensation related to non-recourse note granted to
                stockholder
            
            
            (10,000
            )
            
            38,500
            
            
            -Interest
                accrued on promissory notes due to acquisition
            
            
            39,311
            
            
            (66,793
            )
            
            29,829Interest
                accrued on restricted collateral deposits
            
            
            (267,179
            )
            
            -
            
            
            (3,213
            )Capital
                gain from sale of marketable securities
            
            
            (4,247
            )
            
            -
            
            
            -Amortization
                of premium related to restricted held to maturity
                securities
            
            
            202,467
            
            
            -
            
            
            -Capital
                gain from sale of property and equipment
            
            
            (16,479
            )
            
            (11,504
            )
            
            (4,444
            )Decrease
                (increase) in trade receivables
            
            
            732,828
            
            
            (820,137
            )
            
            389,516(Increase)
                decrease in other accounts receivable and prepaid expenses
            
            
            (49,513
            )
            
            40,520
            
            
            257,218Decrease
                in deferred tax assets
            
            
            (89,823
            )
            
            -
            
            
            -Increase
                in inventories
            
            
            (2,040,854
            )
            
            (193,222
            )
            
            (520,408
            )Increase
                in unbilled revenues
            
            
            (1,581,080
            )
            
            -
            
            
            -Decrease
                in deferred revenues
            
            
            (91,271
            )
            
            -
            
            
            -Decrease
                in trade payables
            
            
            2,913,623
            
            
            (986,022
            )
            
            (62,536
            )Increase
                (decrease) in other accounts payable and accrued expenses
            
            
            (125,231
            )
            
            1,677,668
            
            
            (423,664
            )Net
                cash used in operating activities from continuing operations (reconciled
                from continuing operations)
            
            
            (638,155
            )
            
            (3,012,290
            )
            
            (3,477,695
            )Net
                cash used in operating activities from discontinued operations (reconciled
                from discontinued operations)
            
            
            (214,041
            )
            
            (313,454
            )
            
            (5,456,912
            )Net
                cash used in operating activities
            
            $
            (852,196
            )
            $
            (3,325,744
            )
            $
            (8,934,607
            )


Restated.
      (see Note 1.b.)






The
          accompanying notes are an integral part of the consolidated financial
          statements.
 F-12
 **AROTECH
          CORPORATION AND ITS SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**





**In
                U.S. dollars**
            
            **Year
                ended December 31,****2004**
            
            **2003***
            
            **2002**Cash
                flows from investing activities:Purchase
                of property and equipment
            
            
            (1,659,688
            )
            
            (580,949
            )
            
            (314,876
            )Increase
                in capitalized software costs
            
            
            (365,350
            )
            
            (209,616
            )
            
            -Loans
                granted to stockholders
            
            
            (1,036
            )
            
            (13,737
            )
            
            (4,529
            )Repayment
                of loans granted to stockholders
            
            
            32,397
            
            
            9,280
            
            
            -Proceeds
                from sale of property and equipment
            
            
            114,275
            
            
            16,753
            
            
            8,199Proceeds
                from sale of marketable securities
            
            
            90,016
            
            
            -
            
            
            -Investment
                in marketable securities
            
            
            (89,204
            )
            
            -
            
            
            -Acquisition
                of IES (1)
            
            
            -
            
            
            -
            
            
            (2,958,083
            )Acquisition
                of MDT (2)
            
            
            -
            
            
            -
            
            
            (1,201,843
            )Acquisition
                of Epsilor (3)
            
            
            (7,190,777
            )
            
            -
            
            
            -Acquisition
                of FAAC (4)
            
            
            (12,129,103
            )
            
            -
            
            
            -Acquisition
                of AoA (5)
            
            
            (17,339,522
            )
            
            -
            
            
            -Repayment
                of promissory notes related to acquisition of subsidiaries
            
            
            (2,000,000
            )
            
            (750,000
            )
            
            -Purchase
                of certain tangible and intangible assets
            
            
            (150,000
            )
            
            (196,331
            )
            
            -Increase
                in restricted cash and held to maturity securities
            
            
            (9,809,091
            )
            
            (72,840
            )
            
            (595,341
            )Net
                cash used in discontinued operations (purchase of property and
                equipment)
            
            
            -
            
            
            -
            
            
            (290,650
            )Net
                cash used in investing activities
            
            
            (50,497,083
            )
            
            (1,797,440
            )
            
            (5,357,123
            )Cash
                flows from financing activities:Proceeds
                from issuance of shares, net
            
            
            24,361,750
            
            
            (6,900
            )
            
            3,230,000Proceeds
                from exercise of options to employees and consultants
            
            
            1,148,819
            
            
            440,914
            
            
            113,350Proceeds
                from exercise of warrants
            
            
            19,233,271
            
            
            3,296,254
            
            
            -Proceeds
                from issuance of convertible debentures, net
            
            
            -
            
            
            13,708,662
            
            
            -Payment
                of interest and principal on notes receivable from
                stockholders
            
            
            -
            
            
            -
            
            
            43,308Profit
                distribution to minority
            
            
            -
            
            
            -
            
            
            (412,231
            )Long
                term loan received
            
            
            69,638
            
            
            -
            
            
            -Repayment
                of long term loan
            
            
            (65,674
            )
            
            -
            
            
            -Increase
                (decrease) in short term bank credit
            
            
            (376,783
            )
            
            (74,158
            )
            
            108,659Payment
                on capital lease obligation
            
            
            (4,145
            )
            
            (4,427
            )
            
            (5,584
            )Net
                cash provided by financing activities
            
            
            44,366,876
            
            
            17,360,345
            
            
            3,077,502Increase
                (decrease) in cash and cash equivalents
            
            
            (6,982,403
            )
            
            12,237,161
            
            
            (11,214,228
            )Cash
                erosion due to exchange rate differences
            
            
            31,790
            
            
            (9,562
            )
            
            -Cash
                and cash equivalents at the beginning of the year
            
            
            13,685,125
            
            
            1,457,526
            
            
            12,671,754Cash
                and cash equivalents at the end of the year
            
            $
            6,734,512
            
            $
            13,685,125
            
            $
            1,457,526Supplementary
                information on non-cash transactions:Issuance
                of shares and warrants against accrued expenses and restricted
                deposit
            
            $
            1,310,394
            
            $
            -
            
            $
            -Issuance
                of shares to consultants in respect of prepaid interest
                expenses
            
            $
            -
            
            $
            -
            
            $
            236,250Exercise
                of options against notes receivable
            
            $
            -
            
            $
            -
            
            $
            36,500Purchase
                of intangible assets against note receivable
            
            $
            -
            
            $
            300,000
            
            $
            -Increase
                of investment in subsidiary against issuance of shares of common
                stock
            
            $
            -
            
            $
            123,480
            
            $
            -Conversion
                of promissory note to shares of common stock
            
            $
            -
            
            $
            450,000
            
            $
            -Conversion
                of convertible debenture to shares of common stock
            
            $
            3,837,500
            
            $
            6,125,000
            
            $
            -Benefit
                due to convertible debentures and warrants
            
            $
            -
            
            $
            10,853,043
            
            $
            -Accrual
                for earn out in regard to subsidiary acquisition
            
            $
            13,435,325
            
            $
            -
            
            $
            -Supplemental
                disclosure of cash flows activities:Cash
                paid during the year for:Interest
            
            $
            532,750
            
            $
            39,412
            
            $
            10,640Taxes
                on income
            
            $
            969,009
            
            $
            527,053
            
            $
            114,901


Restated
      (see Note 1.b.).







The
            accompanying notes are an integral part of the consolidated financial
            statements.
 F-13
 **AROTECH
            CORPORATION AND ITS SUBSIDIARIES**


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


In
      U.S. dollars




(1)
            In
                July 2002, the Company acquired substantially all of the assets of
                I.E.S.
                Electronics Industries U.S.A., Inc. (“IES”). 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
            
            $
            1,233,000Property
                and equipment, net
            
            
            396,776Capital
                lease obligation
            
            
            (15,526
            )Technology
            
            
            1,515,000Existing
                contracts
            
            
            46,000Covenants
                not to compete
            
            
            99,000In
                process research and development
            
            
            26,000Customer
                list
            
            
            527,000Trademarks
            
            
            439,000Goodwill
            
            
            4,032,7268,298,976Issuance
                of shares
            
            
            (3,653,929
            )Issuance
                of promissory note
            
            
            (1,686,964
            )$
            2,958,083








(2)
            In
                July 2002, the Company acquired 51% of the outstanding ordinary shares
                of
                MDT Protective Industries Ltd. (“MDT”). The fair value of the assets
                acquired and liabilities assumed, at the date of acquisition, was
                as
                follows:





Working
                capital, excluding cash and cash and cash equivalents
            
            $
            350,085Property,
                and equipment, net
            
            
            139,623Minority
                rights
            
            
            (300,043
            )Technology
            
            
            280,000Customer
                base
            
            
            285,000Goodwill
            
            
            886,2551,640,920Issuance
                of shares
            
            
            (439,077
            )$
            1,201,843







(3)
            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
      the year 2004 amount of $2,000,000 was repaid to the former shareholders of
      Epsilor.







The
          accompanying notes are an integral part of the consolidated financial
          statements.
 F-14
 **AROTECH
          CORPORATION AND ITS SUBSIDIARIES**


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


**In
      U.S. dollars**




(4)
            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
            
            
            25,507,64627,568,106Accrual
                of earn out payment
            
            
            (13,435,325
            )Issuance
                of shares, net
            
            
            (2,003,678
            )$
            12,129,103








(5)
            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













The
          accompanying notes are an integral part of the consolidated financial
          statements.
 F-15
 **AROTECH
          CORPORATION AND ITS SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


In
        U.S. dollars


**NOTE** **1:-****GENERAL**




a.  Arotech
      Corporation, f/k/a Electric Fuel Corporation (“Arotech” or the “Company”) and
      its subsidiaries are engaged in the development, manufacture and marketing
      of
      defense and security products, including advanced hi-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 2004, 2003 and 2002 are
      described in Note 18.







b.  Restatement
      of previously-issued financial statements:




During
      management’s review of the Company’s interim financial statements for the period
      ended September 30, 2004 the Company, after
      discussion with and based on a
      new and
      revised review of accounting treatment by its
      independent auditors, conducted
      a comprehen-sive review of the re-pricing of warrants and grant of new warrants
      to certain of its investors and others during 2003 and 2004. As a result of
      that
      review, the Company, upon recommendation of management and with the approval
      of
      the Audit Committee of the Board of Directors after discussion with the
      Company’s independent auditors, reconsidered the accounting related to these
      transactions and reclassified certain expenses as a deemed dividend, a non-cash
      item, instead of as general and administrative expenses due to the recognition
      of these transactions as capital transactions that should not be expensed.
      These
      restatements do not affect the balance sheet, the stockholders’ equity or the
      cash flow statements. In addition and as a result of the remeasurement described
      above, the Company has reviewed assumptions used in the calculation of fair
      value of all warrants granted during the year 2003. and recalculated its shares’
      volatility while eliminating high
      fluctuation in the market price of the share in 2000 and 1999, due to certain
      announcements made by the Company related to the opening of its consumer battery
      operations (since terminated). As
      a
      result of this comprehensive review, the Company has decreased its general
      and
      administrative expenses in the amount of $150,000, related to warrants granted
      in a litigation settlement.




In
      addition, during
      management’s review of the Company’s interim financial statements for the period
      ended September 30, 2004, the
      Company also reviewed its calculation of amortization of debt discount
      attributable to the beneficial conversion feature associated with the
      convertible debentures. As a result of this review, the Company found errors
      which increased its financial expenses in the amount of $568,000 for the year
      ended December 31, 2003. The errors were related to the amortization of debt
      discount attributable to the warrants and their related convertible debentures,
      whereby the Company understated the amount of amortization for the year ended
      December 31, 2003 attributable to certain of the convertible debentures. See
      Note 13.


F-16
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**


Similar
      errors were also noted in the Company’s interim financial statements in the
      three-month period ended June 30, 2003, the nine-month period ended September
      30, 2003, and the three and six-month periods ended March 31 and June 30,
      2004.




The
      annual and quarterly impacts of these restatements with respect to the year
      ended December 31, 2003 are summarized below:




*Statement
        of Operations Data:*
  **For
                  the Three Months ended June 30, 2004****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**General
                  and administrative expenses
              
              $
              3,521,461
              
              $
              (149,527
              )
              $
              3,371,934Operating
                  loss
              
              
              2,191,705
              
              
              (149,527
              )
              
              2,042,178Financial
                  expenses, net
              
              
              1,985,576
              
              
              167,235
              
              
              2,152,811Loss
                  from continuing operations
              
              
              4,378,415
              
              
              17,708
              
              
              4,396,123Net
                  loss
              
              
              4,378,415
              
              
              17,708
              
              
              4,396,123Basic
                  and diluted net loss per share from continuing operations
              
              $
              0.07
              
              $
              0.00
              
              $
              0.07Basic
                  and diluted net loss per share
              
              $
              0.07
              
              $
              0.00
              
              $
              0.07
 
 **For
                  the Six Months ended June 30, 2004****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**General
                  and administrative expenses
              
              $
              7,202,454
              
              $
              (1,742,384
              )
              $
              5,460,070Operating
                  loss
              
              
              5,228,267
              
              
              (1,742,384
              )
              
              3,485,883Financial
                  expenses, net
              
              
              3,259,530
              
              
              (28,174
              )
              
              3,231,356Loss
                  from continuing operations
              
              
              8,684,570
              
              
              (1,770,558
              )
              
              6,914,012Net
                  loss
              
              
              8,684,570
              
              
              (1,770,558
              )
              
              6,914,012Deemed
                  dividend to certain stockholders of common stock
              
              
              -
              
              
              1,163,000
              
              
              1,163,000Net
                  loss attributable to common stockholders
              
              $
              8,684,570
              
              $
              (607,558
              )
              $
              8,077,012Basic
                  and diluted net loss per share from continuing operations
              
              $
              0.14
              
              $
              (0.03
              )
              $
              0.11Basic
                  and diluted net loss per share
              
              $
              0.14
              
              $
              (0.01
              )
              $
              0.13
  F-17
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**
 
 **For
                  the Three Months ended March 31, 2004****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**General
                  and administrative expenses
              
              $
              3,680,993
              
              $
              (1,592,857
              )
              $
              2,088,136Operating
                  loss
              
              
              3,036,562
              
              
              (1,592,857
              )
              
              1,443,705Financial
                  expenses, net
              
              
              1,273,954
              
              
              (195,409
              )
              
              1,078,545Loss
                  from continuing operations
              
              
              4,306,155
              
              
              (1,788,266
              )
              
              2,517,889Net
                  loss
              
              
              4,306,155
              
              
              (1,788,266
              )
              
              2,517,889Deemed
                  dividend to certain stockholders of common stock
              
              
              -
              
              
              1,163,000
              
              
              1,163,000Net
                  loss attributable to common stockholders
              
              $
              4,306,155
              
              $
              (625,266
              )
              $
              3,680,889Basic
                  and diluted net loss per share from continuing operations
              
              $
              0.07
              
              $
              (0.03
              )
              $
              0.04Basic
                  and diluted net loss per share
              
              $
              0.07
              
              $
              (0.01
              )
              $
              0.06
 
 **For
                  the Year ended December 31, 2003****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**General
                  and administrative expenses
              
              $
              6,196,779
              
              $
              (338,903
              )
              $
              5,857,876Operating
                  loss
              
              
              5,408,932
              
              
              (338,903
              )
              
              5,070,029Financial
                  expenses, net
              
              
              3,470,459
              
              
              568,250
              
              
              4,038,709Loss
                  from continuing operations
              
              
              9,118,684
              
              
              229,347
              
              
              9,348,031Net
                  loss
              
              
              9,008,274
              
              
              229,347
              
              
              9,237,621Deemed
                  dividend to certain stockholders of common stock
              
              
              -
              
              
              350,000
              
              
              350,000Net
                  loss attributable to common stockholders
              
              $
              9,008,274
              
              $
              579,347
              
              $
              9,587,621Basic
                  and diluted net loss per share from continuing operations
              
              $
              0.23
              
              $
              0.01
              
              $
              0.24Basic
                  and diluted net loss per share
              
              $
              0.23
              
              $
              0.02
              
              $
              0.25
 F-18
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                U.S. dollars**
 
 **NOTE
                1:-**  **GENERAL
                (Cont.)**
 **For
                  the Nine Months ended September 30, 2003****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**General
                  and administrative expenses
              
              $
              3,579,371
              
              $
              (123,085
              )
              $
              3,456,286Operating
                  loss
              
              
              2,597,043
              
              
              (123,085)
              
              
              2,473,958Financial
                  expenses, net
              
              
              1,084,582
              
              
              129,000
              
              
              1,213,582Net
                  income from continuing operations
              
              
              3,854,949
              
              
              5,915
              
              
              3,860,864Net
                  loss
              
              
              3,774,066
              
              
              5,915
              
              
              3,779,981Deemed
                  dividend to certain stockholders of common stock
              
              
              -
              
              
              267,026
              
              
              267,026Net
                  loss attributable to common stockholders
              
              $
              3,774,066
              
              $
              272,941
              
              $
              4,047,007Basic
                  and diluted net loss per share from continuing operations
              
              $
              0.10
              
              $
              0.01
              
              $
              0.11Basic
                  and diluted net loss per share
              
              $
              0.10
              
              $
              0.01
              
              $
              0.11
 
 **For
                  the Three Months ended September 30, 2003****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**General
                  and administrative expenses
              
              $
              1,105,864
              
              $
              (123,085
              )
              $
              982,779Operating
                  income
              
              
              234,428
              
              
              123,085
              
              
              357,513Financial
                  expenses, net
              
              
              100,761
              
              
              (18,428
              )
              
              82,333Net
                  income from continuing operations
              
              
              77,093
              
              
              141,513
              
              
              218,606Net
                  income
              
              
              74,808
              
              
              141,513
              
              
              216,321Deemed
                  dividend to certain stockholders of common stock
              
              
              -
              
              
              (94,676
              )
              
              (94,676
              )Net
                  income attributable to common stockholders
              
              $
              74,808
              
              $
              46,837
              
              $
              121,645Basic
                  and diluted net earnings per share from continuing operations
              
              $
              0.00
              
              $
              0.00
              
              $
              0.00Basic
                  and diluted net earnings per share
              
              $
              0.00
              
              $
              0.00
              
              $
              0.00
  F-19
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                U.S. dollars**
 
 **NOTE
                1:-**  **GENERAL
                (Cont.)**
 **For
                  the Six Months ended June 30, 2003****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**Financial
                  expenses, net
              
              $
              983,821
              
              $
              147,428
              
              $
              1,131,249Loss
                  from continuing operations
              
              
              3,932,041
              
              
              147,428
              
              
              4,079,469Net
                  loss
              
              
              3,848,875
              
              
              147,428
              
              
              3,996,303Deemed
                  dividend to certain stockholders of common stock
              
              
              -
              
              
              172,350
              
              
              172,350Net
                  loss attributable to common stockholders
              
              $
              3,848,875
              
              $
              319,778
              
              $
              4,168,653Basic
                  and diluted net loss per share from continuing operations
              
              $
              0.11
              
              $
              0.00
              
              $
              0.11Basic
                  and diluted net loss per share
              
              $
              0.11
              
              $
              0.01
              
              $
              0.12
 
 **For
                  the Three Months ended June 30, 2003****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**Financial
                  expenses, net
              
              $
              725,609
              
              $
              147,428
              
              $
              873,037Loss
                  from continuing operations
              
              
              2,640,920
              
              
              147,428
              
              
              2,788,348Net
                  loss
              
              
              2,461,793
              
              
              147,428
              
              
              2,609,221Deemed
                  dividend to certain stockholders of common stock
              
              
              -
              
              
              172,350
              
              
              172,350Net
                  loss attributable to common stockholders
              
              $
              2,461,793
              
              $
              319,778
              
              $
              2,781,571Basic
                  and diluted net loss per share from continuing operations
              
              $
              0.07
              
              $
              0.01
              
              $
              0.08Basic
                  and diluted net loss per share
              
              $
              0.07
              
              $
              0.01
              
              $
              0.08
  *Balance
            sheet data:*
  **As
                      of June 30, 2004****Previously
                      Reported**
                  
                  **Adjustment**
                  
                  **As
                      Restated**Convertible
                      debenture
                  
                  $
                  737,235
                  
                  $
                  540,075
                  
                  $
                  1,277,310Total
                      long term liabilities
                  
                  
                  6,278,225
                  
                  
                  540,075
                  
                  
                  6,818,300Additional
                      paid in capital
                  
                  
                  167,789,043
                  
                  
                  (2,081,287
                  )
                  
                  165,707,756Accumulated
                      deficit
                  
                  
                  (118,366,463
                  )
                  
                  1,541,212
                  
                  
                  (116,825,257
                  )Total
                      shareholders’ equity
                  
                  
                  44,707,225
                  
                  
                  (540,075
                  )
                  
                  44,167,150
  F-20
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                U.S. dollars**
 
 **NOTE
                1:-**  **GENERAL
                (Cont.)**
 **As
                  of March 31, 2004****Previously
                  Reported**
              
              **Adjustment**
              
              **As
                  Restated**Convertible
                  debenture
              
              $
              849,037
              
              $
              372,841
              
              $
              1,221,878Total
                  long term liabilities
              
              
              6,062,891
              
              
              372,841
              
              
              6,435,732Additional
                  paid in capital
              
              
              162,331,180
              
              
              (1,931,760
              )
              
              160,399,420Accumulated
                  deficit
              
              
              (113,988,048
              )
              
              1,558,919
              
              
              (112,429,129
              )Total
                  shareholders’ equity
              
              
              44,019,328
              
              
              (372,841
              )
              
              43,646,487
 
 **As
                  of December 31, 2003****Previously
                  Reported**
              
              **Adjustment**
              
              **As
                  Restated**Other
                  accounts payable and accrued expenses
              
              $
              4,180,411
              
              $
              (150,000
              )
              $
              4,030,411Convertible
                  debenture
              
              
              881,944
              
              
              568,250
              
              
              1,450,194Total
                  long term liabilities
              
              
              4,066,579
              
              
              568,250
              
              
              4,634,829Additional
                  paid in capital
              
              
              135,891,316
              
              
              (188,903
              )
              
              135,702,413Accumulated
                  deficit
              
              
              (109,681,893
              )
              
              (229,347
              )
              
              (109,911,240
              )Total
                  shareholders’ equity
              
              
              22,044,127
              
              
              (418,250
              )
              
              (21,625,877
              )
 
 **As
                  of September 30, 2003****Previously
                  Reported**
              
              **Adjustment**
              
              **As
                  Restated**Convertible
                  debenture
              
              $
              1,115,001
              
              $
              129,000
              
              $
              1,244,001Total
                  long term liabilities
              
              
              4,178,147
              
              
              129,000
              
              
              4,307,147Additional
                  paid in capital
              
              
              120,105,276
              
              
              (123,085
              )
              
              119,982,191Accumulated
                  deficit
              
              
              (104,447,685
              )
              
              (5,915
              )
              
              (104,453,600
              )Total
                  shareholders’ equity
              
              
              11,411,175
              
              
              (129,000
              )
              
              11,282,175
 
 **As
                  of June 30, 2003****Previously
                  Reported**
              
              **Adjustment**
              
              **As
                  Restated**Convertible
                  debenture
              
              $
              988,572
              
              $
              147,428
              
              $
              1,136,000Total
                  long term liabilities
              
              
              4,358,568
              
              
              147,428
              
              
              4,505,996Accumulated
                  deficit
              
              
              (104,522,494
              )
              
              (147,428
              )
              
              (104,669,922
              )Total
                  shareholders’ equity
              
              
              10,356,181
              
              
              (147,428
              )
              
              10,208,753
  F-21
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                U.S. dollars**
 
 **NOTE
                1:-**  **GENERAL
                (Cont.)**
 *Cash
        flow data:*
  **For
                  the Six Months ended June 30, 2004****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**Net
                  loss
              
              $
              8,684,570
              
              $
              (1,770,558
              )
              $
              6,914,012Stock
                  based compensation related to repricing of warrants granted to
                  investors
                  and the grant of new warrants
              
              
              1,742,384
              
              
              (1,742,384
              )
              
              -Amortization
                  of compensation related to beneficial conversion feature and warrants
                  issued to holders of convertible debentures
              
              
              2,967,791
              
              
              (28,174
              )
              
              2,939,617
 
 **For
                  the Three Months ended March 31, 2004****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**Net
                  loss
              
              $
              4,306,155
              
              $
              (1,788,266
              )
              $
              2,517,889Stock
                  based compensation related to repricing of warrants granted to
                  investors
                  and the grant of new warrants
              
              
              1,592,857
              
              
              (1,592,857
              )
              
              -Amortization
                  of compensation related to beneficial conversion feature and warrants
                  issued to holders of convertible debentures
              
              
              1,117,093
              
              
              (195,409
              )
              
              921,684
 
 **For
                  the Year ended December 31, 2003****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**Net
                  loss
              
              $
              9,008,274
              
              $
              229,347
              
              $
              9,237,621Stock
                  based compensation related to repricing of warrants granted to
                  investors
                  and the grant of new warrants
              
              
              388,403
              
              
              (188,903
              )
              
              199,500Amortization
                  of compensation related to beneficial conversion feature and warrants
                  issued to holders of convertible debentures
              
              
              3,359,987
              
              
              568,250
              
              
              3,928,237
 F-22
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                U.S. dollars**
 
 **NOTE
                1:-**  **GENERAL
                (Cont.)**
 **For
                  the Nine Months ended September 30, 2003****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**Net
                  loss
              
              $
              3,774,066
              
              $
              5,915
              
              $
              3,779,981Stock
                  based compensation related to repricing of warrants granted to
                  investors
                  and the grant of new warrants
              
              
              152,844
              
              
              (123,085
              )
              
              29,759Amortization
                  of compensation related to beneficial conversion feature and warrants
                  issued to holders of convertible debentures
              
              
              1,005,001
              
              
              129,000
              
              
              1,134,001
 
 **For
                  the Six Months ended June 30, 2003****Previously**
                **Reported**
              
              **Adjustment**
              
              **As
                  Restated**Net
                  loss
              
              $
              3,848,875
              
              $
              147,428
              
              $
              3,996,303Amortization
                  of compensation related to beneficial conversion feature and warrants
                  issued to holders of convertible debentures
              
              
              878,572
              
              
              147,428
              
              
              1,026,000




c.  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:


F-23
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**


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




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




The
      nature of this acquisition involved a company whose primary assets were
      intangible - trademarks, intellectual property, such as technology and know-how,
      and its broad customer base. Once these assets were valued, the remainder of
      the
      purchase price over the tangible and other intangible assets was attributed
      to
      goodwill (which includes workforce). B y
      purchasing Epsilor, the Company gained potential customers ( *i.e.* ,
      its
      customer base) due to Epsilor’s very high reputation in its
      market. Additionally, Epsilor ’s
      reputation in the industry and its name recognition are also factors in the
      valuation of Epsilor ’s
      goodwill. Accordingly, the acquisition resulted in a significant allocation
      to
      goodwill due to the above factors.




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.h. for pro forma financial information.




d.  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.


F-24
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**


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 our common
      stock, $0.01 par value per share, having a value of approximately $2.0 million.
      Additionally, there is an earn-out based on 2004 net pretax income, with an
      additional earn-out on the 2005 pretax income from certain specific and limited
      programs. Based on FAAC’s 2004 net pretax income, the Company estimates its
      earn-out obligation at $13.4 million, of which $6.0 million was pre-paid into
      escrow in the form of restricted cash (See Note 3). In March 2005, the Company
      and the former stockholders of FAAC signed an agreement pursuant to which the
      Company will transfer the restricted cash to the former stockholders of FAAC
      by
      March 31, 2005, and will issue to the former stockholders of FAAC $10.0 million
      in Arotech stock by April 30, 2005, with such stock to be registered and sold
      on
      behalf of the former stockholders of FAAC by March 31, 2006 until the earn-out
      shall have been paid in full (with any remaining shares of Arotech stock after
      proceeds of the sales reach $7.4 million to be returned to the Company) ; should
      the proceeds of the sales be less than $7.4 million, the Company will pay any
      shortfall in cash). The total consideration of $27.6 million (including the
      earn-out as well as $135,131 of transaction costs) was determined based upon
      arm’s-length negotiations between the Company and FAAC’s
      stockholders.




Based
      upon a valuation of tangible and intangible assets acquired, Arotech has
      allocated the total cost of the acquisition 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
            
            
            18,762,646Liabilities
                assumed
            
            
            (2,770,843
            )Total
                consideration
            
            $
            27,570,356




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.




The
      nature of this acquisition involved a company whose primary assets were
      intangible - trademarks, intellectual property, such as technology and know-how,
      and its broad customer base. Once these assets were valued, the remainder of
      the
      purchase price over the tangible and other intangible assets was attributed
      to
      goodwill (which includes workforce). B y
      purchasing FAAC, the Company gained valuable government contacts. In
      addition, the Company believed it would gain the ability to increase sales
      of
      both its traditional products and the new products gained from the acquisition
      by cross selling into each other’s established markets. Synergies may also
      be realized through the use of some common corporate overhead
      resources. Additionally,
      FAAC’s reputation in the industry and its name recognition are also factors in
      the valuation of FAAC’s goodwill. Accordingly, the acquisition resulted in a
      significant allocation to goodwill due to the above factors.


F-25
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**


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.




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.h. for pro forma financial information.




e.  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).


F-26
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**




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. 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 $121,192
      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.




Based
      upon a valuation of tangible and intangible assets acquired, Arotech has
      allocated the total cost of the acquisition 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
            
            
            10,543,677Liabilities
                assumed
            
            
            (347,770
            )Total
                consideration
            
            $
            19,121,192




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.




The
      nature of this acquisition involved a company whose primary assets were
      intangible - trademarks, intellectual property, such as technology and know-how,
      and its broad customer base. Once these assets were valued, the remainder of
      the
      purchase price over the tangible and other intangible assets was attributed
      to
      goodwill (which includes workforce). B y
      purchasing AoA, the Company was able to purchase an armoring firm in a
      fragmented market, enter the U.S. military sales market and save time and effort
      in developing U.S. government relationships by themselves. Further,
      the
      Company expected to cross-sell some its products to AoA’s customers and sell
      some of AoA’s products to its customers. Additionally, AoA’s reputation in the industry and its name recognition are also
      factors in the valuation of AoA’s goodwill. Accordingly, there was a significant
      allocation to goodwill due to the above factors.




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.


F-27
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**


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




f.  Acquisition
      of IES:




In
      August
      2, 2002, the Company entered into an asset purchase agreement among I.E.S.
      Electronics Industries U.S.A., Inc. (“IES”), its direct and certain of its
      indirect shareholders, and its wholly-owned Israeli subsidiary, EFL, pursuant
      to
      the terms of which it acquired substantially all the assets, subject to
      substantially all the liabilities, of IES, a developer, manufacturer and
      marketer of advanced hi-tech multimedia and interactive digital solutions for
      training of military, law enforcement and security personnel. The Company
      intends to continue to use the assets purchased in the conduct of the business
      formerly conducted by IES (the “Business”). The acquisition has been accounted
      under the purchase method of accounting. Accordingly, all assets and liabilities
      were acquired as at the values on such date, and the Company consolidated IES’s
      results with its own commencing at such date.




The
      assets purchased consisted of the current assets, property and equipment, and
      other intangible assets used by IES in the conduct of the Business. The
      consideration for the assets and liabilities purchased consisted of (i) cash
      and
      promissory notes in an aggregate amount of $4,800,000 ($3,000,000 in cash and
      $1,800,000 in promissory notes, which was recorded at its fair value in the
      amount of $1,686,964) (see Note 10), and (ii) the issuance, with registration
      rights, of a total of 3,250,000 shares of our common stock, $.01 par value
      per
      share, having a value of approximately $3,653,929, which shares are the subject
      of a voting agreement on the part of IES and certain of its affiliated
      companies. The value of 3,250,000 shares issued was determined based on the
      average market price of Arotech’s Common stock over the period including two
      days before and after the terms of the acquisition were agreed to and announced.
      The total consideration of $8,354,893 (including $14,000 of transaction costs)
      was determined based upon arm’s-length negotiations between the Company and IES
      and IES’s shareholders.




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




Tangible
                assets acquired
            
            $
            2,856,951Intangible
                assetsTechnology
            
            
            1,515,000Existing
                contracts
            
            
            46,000Covenants
                not to compete
            
            
            99,000In
                process research and development
            
            
            26,000Customer
            
            
            527,000Trademarks
            
            
            439,000Goodwill
            
            
            4,032,726Liabilities
                assumed
            
            
            (1,186,784
            )Total
                consideration
            
            $
            8,354,893





F-28
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**


In
      September 2003, the Company’s IES subsidiary purchased
      selected assets of Bristlecone Corporation. The assets purchased consisted
      of
      inventories, customer lists, and certain other assets (including intangible
      assets such as intellectual property and customer lists), including the name
      “Bristlecone Training Products” and the patents for the Heads Up Display (HUD)
      and a remote trigger device, used by Bristlecone in connection with its
      designing and manufacturing firearms training devices, for a total consideration
      of $183,688 in cash and $300,000 in promissory notes, payable in four equal
      semi-annual payments of $75,000 each, to become due and payable on March 1,
      2004, August 31, 2004, February 28, 2005 and August 31, 2005. The acquired
      patents are used in the IES’s Range FDU (firearm diagnostics unit).




The
      purchase consideration was estimated as follows:




Cash
                consideration
            
            $
            183,688Present
                value of promissory notes
            
            
            289,333Transaction
                expenses
            
            
            12,643Total
                consideration
            
            $
            485,664




Based
      upon a valuation of tangible and intangible assets acquired, the Company has
      allocated the total cost of the acquisition of Bristlecone’s assets as
      follows:




Tangible
                assets acquired
            
            $
            33,668Intangible
                assetsTechnology
                and patents
            
            
            436,746Customer
                list
            
            
            15,250Total
                consideration
            
            $
            485,664




The
      Company believes that the acquisition of Bristlecone is not material to its
      business.




g.  Acquisition
      of MDT:




On
      July
      1, 2002, the Company entered into a stock purchase agreement with all of the
      shareholders of M.D.T. Protective Industries Ltd. (“MDT”), pursuant to the terms
      of which the Company purchased 51% of the issued and outstanding shares of
      MDT, a
      privately-held Israeli company that specializes in using sophisticated
      lightweight materials and advanced engineering processes to armor vehicles.
      The
      Company also entered into certain
      other ancillary agreements with MDT and its shareholders and other affiliated
      companies. The Acquisition was accounted under the purchase method accounting
      and results of MDT’s operations have been included in the consolidated financial
      statements since that date. The total consideration of $1,767,877 for the shares
      purchased consisted of (i) cash in the aggregate amount of 5,814,000 New Israeli
      Shekels ($1,231,780), and (ii) the issuance, with registration rights, of an
      aggregate of 390,638 shares of our common stock, $0.01 par value per share,
      having a value of approximately $439,077. The value of 390,638 shares issued
      was
      determined based on the average market price of Arotech’s Common stock over the
      period including two days before and after the terms of the acquisition were
      agreed to and announced.


F-29
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**


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




Tangible
                assets acquired
            
            $
            1,337,048Intangible
                assetsTechnology
            
            
            280,000Customer
                base
            
            
            285,000Goodwill
            
            
            886,255Liabilities
                assumed
            
            
            (1,020,426
            )Total
                consideration
            
            $
            1,767,877







In
      September 2003, the Company increased
      its holdings in both of its vehicle armoring subsidiaries. The Company now
      holds
      88% of MDT Armor Corporation (compared to 76% before this transaction) and
      75.5%
      of MDT Protective Industries Ltd. (compared to 51% before this transaction).
      The
      Company acquired the additional stake in MDT from AGA Means of Protection and
      Commerce Ltd. in exchange for the issuance to AGA of 126,000 shares of its
      common stock, valued at $0.98 per share based on the closing price of the
      Company’s common stock on the closing date of September 4, 2003, or a total of
      $123,480. Of this amount, a total of $75,941 was allocated to intangible assets.
      The Company did not obtain a valuation due to the immaterial nature of this
      acquisition.




h.  Pro
      forma
      results:




In
      January 2004, the Company acquired FAAC and Epsilor, as more fully described
      in
“Note 1.c. - Acquisition of Epsilor” and “Note 1.d. - Acquisition of FAAC,”
      above, in August 2004, the Company acquired AoA, as more fully described in
      “Note 1.e. - Acquisition of AoA,” above (the “Acquisitions”) and in the year
      2002 the Company acquired IES and MDT as more fully described in Note 1.f and
      Note 1.g (the “2002 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. The unaudited pro forma data for 2002 are presented as if 2002
      Acquisitions had been completed on January 1, 2002.




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.


F-30
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**


**Year
                Ended December 31,****2004**
            
            **2003***
            
            **2002**(Unaudited)Total
                revenues
            
            $
            61,086,697
            
            $
            39,680,394
            
            $
            12,997,289Gross
                profit
            
            
            22,528,254
            
            
            17,214,249
            
            
            4,424,952Net
                loss
            
            
            (5,810,114
            )
            
            (6,959,174
            )
            
            (6,103,771
            )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
            )
            $
            (6,103,771
            )Basic
                and diluted net loss per share
            
            $
            (0.13
            )
            $
            (0.14
            )
            $
            (0.18
            )Weighted
                average number of shares used in computing basic net loss per
                share
            
            
            69,933,057
            
            
            52,966,330
            
            
            34,495,185


Restated.






i.  Discontinued
      operations:




In
      September 2002, the Company committed to a plan to discontinue the operations
      of
      its retail sales of consumer battery products. The Company ceased the operation
      and disposed of all assets related to this segment by an abandonment. The
      operations and cash flows of consumer battery business have been eliminated
      from
      the operations of the Company as a result of the disposal transactions. The
      Company has no intent of continuing its activity in the consumer battery
      business. The Company’s plan of discontinuance involved (i) termination of all
      employees whose time was substantially devoted to the consumer battery line
      and
      who could not be used elsewhere in the Company’s operations, including payment
      of all statutory and contractual severance sums, by the end of the fourth
      quarter of 2002, and (ii) disposal of the raw materials, equipment and inventory
      used exclusively in the consumer battery business, since the Company has no
      reasonable expectation of being able to sell such raw materials, equipment
      or
      inventory for any sum substantially greater than the cost of disposal or
      shipping, by the end of the first quarter of 2003. The Company had previously
      reported its consumer battery business as a separate segment (Consumer
      Batteries) as called for by Statement of Financial Standards No. 131,
“Disclosures About Segments of an Enterprise and Related Information” (“SFAS No.
      131”).




The
      results of operations including revenue, operating expenses, other income and
      expense of the retail sales of consumer battery products business unit for
      2003
      and 2002 have been reclassified in the accompanying statements of operations
      as
      a discontinued operation. The Company’s balance sheets at December 31, 2003
      reflect the net liabilities of the retail sales of consumer battery products
      business as net liabilities and net assets of discontinued operation within
      current liabilities and current assets.




At
      December 31, 2002, the estimated net losses associated with the disposition
      of
      the retail sales of consumer battery products business were $13,566,206 for
      2002. These losses included approximately $6,508,522 in losses from operations
      for the period from January 1, 2002 through the measurement date of December
      31,
      2002 and $7,057,684, reflecting
      a write-down of inventory and net property and equipment of the
      retail sales of consumer battery products business, as follows:




F-31
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
              1:-**  **GENERAL
              (Cont.)**


**December
                31, 2002**Write-off
                of inventories
            
            $
            2,611,000Impairment
                of property and equipment
            
            
            4,446,684$
            7,057,684




As
      a
      result of the discontinuance of consumer battery segment, the Company ceased
      to
      use property and equipment related to this segment. In accordance with Statement
      of Financial Accounting Standard No. 144 “Accounting for the Impairment or
      Disposal of Long- Lived Assets” (“SFAS No. 144”) such assets was considered to
      be impaired. The impairment to be recognized was measured by the amount by
      which
      the carrying amount of the assets exceeds the fair value of the
      assets.




Obligations
      to employees for severance and other benefits resulting from the discontinuation
      have been reflected in the financial statements on an accrual
      basis.




Summary
      operating results from the discontinued operation for the years ended December
      31, 2004, 2003 and 2002 are as follows:




**Year
                Ended December 31,****2004**
            
            **2003**
            
            **2002**Revenues
            
            $
            -
            
            $
            117,267
            
            $
            1,100,442Cost
                of sales(1)
            
            
            -
            
            
            -
            
            
            (5,293,120
            )Gross
                profit (loss)
            
            
            -
            
            
            117,267
            
            
            (4,192,678
            )Operating
                expenses, net
            
            
            -
            
            
            6,857
            
            
            4,926,844Impairment
                of fixed assets
            
            
            -
            
            
            -
            
            
            4,446,684Operating
                profit (loss)
            
            $
            -
            
            $
            110,410
            
            $
            (13,566,206
            )


Including
      write-off of inventory in the amount of $0, $0 and $2,611,000 for the years
      ended December 31, 2004, 2003 and 2002.




**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 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.


F-32
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                U.S. dollars**
 **NOTE
        2:-**   **SIGNIFICANT
        ACCOUNTING POLICIES (Cont.)**


The
      majority of transactions of MDT and Epsilor are in New Israel Shekel (“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




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.


F-33
 **AROTECH
                  CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                  U.S. dollars**
 **NOTE
          2:-**   **SIGNIFICANT
          ACCOUNTING POLICIES (Cont.)**


e.  Restricted
      collateral deposits




Restricted
      cash is primarily invested in highly liquid deposits, held-to-maturity
      marketable securities and long-term deposits, which are used as a security
      for
      the Company’s guarantee performance and its liability to former shareholders of
      its acquired subsidiaries.




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, 2004 the Company and its subsidiaries classified its investment
      in
      marketable securities as held-to-maturity and available-for-sale.




Debt
      securities are classified as held-to-maturity, when the Company has the positive
      intent and ability to hold the securities to maturity, and are stated at
      amortized cost. The cost of held-to-maturity securities is adjusted for
      amortization of premiums and accretion of discounts to maturity. Such
      amortization, accretion and interest are included in financial income,
      net.




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
      2002, 2003 and 2004, the Company wrote off $116,008, $96,350 and $121,322 of
      obsolete inventory respectively, which has been included in the cost of
      revenues.




Cost
      is
      determined as follows:




Raw
      and
      packaging materials - by the average cost method.




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.


F-34
 **AROTECH
                  CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                  U.S. dollars**
 **NOTE
          2:-**   **SIGNIFICANT
          ACCOUNTING POLICIES (Cont.)**


h.  Property
      and equipment:




Property
      and equipment are stated at cost net of accumulated depreciation and investment
      grants (no investment grants were received during 2004, 2003 and
      2002).




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.




The
      Company performed the required annual impairment test of goodwill. Based on
      the
      management projections and using expected future discounted operating cash
      flows, no indication of goodwill impairment was identified.




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.


F-35
 **AROTECH
                  CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                  U.S. dollars**
 **NOTE
          2:-**   **SIGNIFICANT
          ACCOUNTING POLICIES (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 $320,000.




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
      2004, 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 (Interactive Training
      Division); (ii) from revenues under armor contracts and for service and repair
      of armored vehicles (Armoring Division); (iii) from the sale of batteries,
      chargers and adapters to the military, and under certain development contracts
      with the U.S. Army (Battery Division); and (iv) from the sale of lifejacket
      lights (Battery Division.




Revenues
      from the Battery division products and Armoring 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 products not delivered upon customers’ request due to lack of storage space
      at the customers’ facilities during the integration are recognized when the
      criteria of Staff Accounting Bulletin No. 104 (“SAB No. 104”) for bill-and-hold
      transactions are met.




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, 2004 no such estimated losses were identified.


F-36
 **AROTECH
                CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                U.S. dollars**
 **NOTE
        2:-**   **SIGNIFICANT
        ACCOUNTING POLICIES (Cont.)**




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





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







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





Maintenance
      and support revenue included in multiple element arrangements is deferred and
      recognized on a straight-line basis over the term of the maintenance and support
      services. Revenues from training are recognized when its 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-37
 **AROTECH
                  CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                  U.S. dollars**
 **NOTE
          2:-**   **SIGNIFICANT
          ACCOUNTING POLICIES (Cont.)**


l.  Right
      of
      return:




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




m.  Research
      and development cost:




Research
      and development costs, net of grants received, are charged to the statements
      of
      operations as incurred.




Software
      development costs incurred by the Company’s subsidiaries between completion of
      the working model and the point at which the product is ready for general
      release, are capitalized.




Capitalized
      software costs are amortized by using the straight-line method over the
      estimated useful life of the product (three 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 future gross revenues from the specific software product sold. Based
      on
      its most recent analyses, management identified an impairment of software
      development costs previously capitalized and as a result has recorded an
      impairment loss in the amount of $26,000.




n.  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 it’s estimated realizable value.




o.  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.


F-38
 **AROTECH
                  CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                  U.S. dollars**
 **NOTE
          2:-**   **SIGNIFICANT
          ACCOUNTING POLICIES (Cont.)**


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.




p.  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 31,502,158, 22,194,211 and
      4,394,803 for the years ended December 31, 2004, 2003 and 2002,
      respectively.




q.  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 3.63%, 2.54% and 3.5% for 2004, 2003 and 2002, 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 0.81 for 2004, 0.67 for 2003 and
      0.64 for 2002; and a weighted-average expected life of the option of 5 years
      for
      2004, 2003 and 2002.


F-39
 **AROTECH
                  CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                  U.S. dollars**
 **NOTE
          2:-**   **SIGNIFICANT
          ACCOUNTING POLICIES (Cont.)**


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,****2004**
            
            **2003***
            
            **2002**Net
                loss as reported
            
            $
            (9,042,313
            )
            $
            (9,237,621
            )
            $
            (18,504,358
            )Add:
                Stock-based compensation expenses included in reported net
                loss
            
            
            831,626
            
            
            8,286
            
            
            6,000Deduct:
                Stock-based compensation expenses determined under fair value method
                for
                all awards
            
            
            (2,741,463
            )
            
            (1,237,558
            )
            
            (2,072,903
            )$
            (10,952,150
            )
            $
            (10,466,893
            )
            $
            (20,571,261
            )Loss
                per share:Basic
                and diluted, as reported
            
            $
            (0.18
            )
            $
            (0.25
            )
            $
            (0.57
            )Diluted,
                pro forma
            
            $
            (0.16
            )
            $
            (0.27
            )
            $
            (0.64
            )


Restated
      (see Note 1.b.).





r.  Fair
      value of financial instruments:




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




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




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




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.




s.  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, 2004 and 2003, the
      accumulated severance pay in that regard amounted to $1,642,801 and $1,699,260,
      respectively.


F-40
 **AROTECH
                  CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                  U.S. dollars**
 **NOTE
          2:-**   **SIGNIFICANT
          ACCOUNTING POLICIES (Cont.)**


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, 2004, 2003 and 2002 amounted to
      $460,178, $219,857 and ($338,574) respectively.




t.  Advertising
      costs:




The
      Company and its subsidiaries expense advertising costs as incurred. Advertising
      expense for the years ended December 31, 2004, 2003 and 2002 was approximately
      $13,271, $34,732 and $294,599, respectively.




u.  New
      accounting pronouncements:




On
      December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB
      Statement No. 123 (revised 2004), “Share-Based Payment,” which is a revision of
      FASB Statement No. 123, “Accounting for Stock-Based Compensation.” Statement
      123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to
      Employees,” and amends FASB Statement No. 95, “Statement of Cash Flows.”
      Generally, the approach in Statement 123(R) is similar to the approach described
      in Statement 123. However, Statement 123(R) requires all share-based payments
      to
      employees, including grants of employee stock options, to be recognized in
      the
      income statement based on their fair values. Pro forma disclosure is no longer
      an alternative.




Statement
      123(R) must be adopted no later than July 1, 2005. Early adoption will be
      permitted in periods in which financial statements have not yet been issued.
      The
      Company expects to adopt Statement 123(R) on the first interim period beginning
      after July 1, 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 is still in the process of evaluating the method it will
      use.


F-41
 **AROTECH
                  CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                  U.S. dollars**
 **NOTE
          2:-**   **SIGNIFICANT
          ACCOUNTING POLICIES (Cont.)**


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 our result of operations, although it will have no impact
      on our 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 2r above to the Company’s consolidated financial
      statements. Statement 123(R) also requires the benefits of tax deductions in
      excess of recognized compensation cost to be reported as a financing cash flow,
      rather than as an operating cash flow as required under current
      literature.




In
      November 2004, the FASB issued Statement of Financial Accounting Standard No.
      151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4..” SFAS 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
      151
      requires that allocation of fixed production overheads to the costs of
      conversion be based on normal capacity of the production facilities. SAFS 151
      is
      effective for inventory costs incurred during fiscal years beginning after
      June
      15, 2005. The Company is still in the process of the evaluating the impact
      of
      the adoption of SFAS 151 on its financial position or results of
      operations.




**NOTE
                3:-**
            **RESTRICTED
                COLLATERAL DEPOSITS AND RESTRICTED HELD-TO-MATURITY
                SECURITIES:**




**December
                  31,****2004**
              
              **2003**Short-term:Restricted,
                  held to maturity, bonds in connection with FAAC earn out (Note
                  1.d.)(1)
              
              $
              5,969,413
              
              $
              -IES
                  deposit in connection to the Company’s litigation with IES Electronics
                  Industries Ltd.
              
              
              -
              
              
              450,000Deposits
                  in connection with FAAC projects
              
              
              650,989
              
              
              -Forward
                  Deal
              
              
              -
              
              
              205,489Property
                  lease
              
              
              -
              
              
              41,412Other
              
              
              341,708
              
              
              9,279Total
                  short-term
              
              
              6,962,110
              
              
              706,810Long-term:Restricted
                  cash in connection with AoA earn out (Note 1.e.)
              
              
              3,000,000
              
              
              -Restricted
                  deposit in connection with Epsilor acquisition (Note 1.c.)
              
              
              1,000,000
              
              
              -Total
                  long-term
              
              
              4,000,000
              
              
              -$
              10,962,110
              
              $
              706,180




F-42
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**
 
 **NOTE
                                3:-**
                            **RESTRICTED
                                COLLATERAL DEPOSIT AND OTHER RESTRICTED CASH
                                (Cont.)**







**Amortized
                cost**
            
            **Unrealized
                losses**
            
            **Estimated
                fair value****2004**
            
            **2003**
            
            **2004**
            
            **2003**
            
            **2004**
            
            **2003**Obligations
                of States and political subdivisions
            
            $
            1,012,787
            
            $
            -
            
            $
            (1,870
            )
            $
            -
            
            $
            1,010,917
            
            $
            -Corporate
                obligations
            
            
            4,956,626
            
            
            -
            
            
            (11,966
            )
            
            -
            
            
            4,944,660
            
            
            -$
            5,969,413
            
            $
            -
            
            $
            (13,836
            )
            $
            -
            
            $
            5,955,577
            
            $
            -





The
      amortized cost of held-to-maturity debt securities at December 31, 2004,
      by
      contractual maturities, is shown below *:*


**Amortized
                cost**
            
            **Unrealized
                losses**
            
            **Estimated
                fair value**Due
                in one year or less
            
            $
            5,969,413
            
            $
            (13,836
            )
            $
            5,955,577





The
      unrealized losses in the Company’s investments were caused by interest rate
      increases. It is expected that the securities would not be settled at a price
      less than the amortized cost of the Company’s investment. Based on the
      immaterial severity of the impairments and the obligation of the Company to
      hold
      these investments until maturity, the bonds were not considered to be other
      than
      temporarily impaired at December 31, 2004.




**NOTE
      4: -**  **AVAILABLE
      FOR SALE MARKETABLE SECURITIES**




The
      following is a summary of investments in marketable securities as of December
      31, 2004 and 2003:




**Cost**
            
            **Unrealized
                gains**
            
            **Estimated
                fair value****2004**
            
            **2003**
            
            **2004**
            
            **2003**
            
            **2004**
            
            **2003**Available
                for sale marketable securities
            
            $
            130,061
            
            $
            **-**
            
            $
            5,507
            
            $
            **-**
            
            $
            135,568
            
            $
            -


****


**NOTE
      5:-**  **OTHER
      ACCOUNTS RECEIVABLE AND PREPAID EXPENSES**




**December
                  31,****2004**
              
              **2003**Government
                  authorities
              
              $
              433,427
              
              $
              65,402Employees
              
              
              217,948
              
              
              246,004Prepaid
                  expenses
              
              
              490,357
              
              
              551,010Deferred
                  taxes
              
              
              135,482
              
              
              -Other
              
              
              62,179
              
              
              324,955$
              1,339,393
              
              $
              1,187,371




F-43
 **AROTECH
            CORPORATION AND ITS SUBSIDIARIES**
 NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
            U.S. dollars**




**NOTE
      6:-**   **INVENTORIES**




**December
                31,****2004**
            
            **2003**Raw
                and packaging materials
            
            $
            3,969,400
            
            $
            657,677Work
                in progress
            
            
            1,996,139
            
            
            634,221Finished
                products
            
            
            1,311,762
            
            
            622,850$
            7,277,301
            
            $
            1,914,748




**NOTE
      7:-**   **PROPERTY
      AND EQUIPMENT, NET**




a.  Composition
      of property and equipment is as follows:




**December
                31,****2004**
            
            **2003**Cost:Computers
                and related equipment
            
            $
            3,374,695
            
            $
            1,015,836Motor
                vehicles
            
            
            653,255
            
            
            288,852Office
                furniture and equipment
            
            
            872,804
            
            
            402,726Machinery,
                equipment and installations
            
            
            7,464,470
            
            
            4,866,904Leasehold
                improvements
            
            
            1,321,025
            
            
            882,047Demo
                inventory
            
            
            141,961
            
            
            150,99613,828,210
            
            
            7,607,361Accumulated
                depreciation:Computers
                and related equipment
            
            
            2,581,689
            
            
            753,593Motor
                vehicles
            
            
            197,071
            
            
            95,434Office
                furniture and equipment
            
            
            494,181
            
            
            173,301Machinery,
                equipment and installations
            
            
            5,143,186
            
            
            3,637,111Leasehold
                improvements
            
            
            811,392
            
            
            655,1819,227,519
            
            
            5,314,620Depreciated
                cost
            
            $
            4,600,691
            
            $
            2,292,741




b.  Depreciation
      expense amounted to $1,199,465, $730,159 and $473,739, for the years ended
      December 31, 2004, 2003 and 2002, respectively.




As
      for
      liens, see Note 12.d.




F-44
 **AROTECH
            CORPORATION AND ITS SUBSIDIARIES**
 NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
            U.S. dollars**


**NOTE
      8:-**   **OTHER
      INTANGIBLE ASSETS, NET**




a.


**Year
                ended December 31,****2004**
            
            **2003**Cost:Technology
            
            $
            6,841,746
            
            $
            2,231,746Capitalized
                software costs
            
            
            574,967
            
            
            209,615Backlog
            
            
            2,194,000
            
            
            46,000Covenants
                not to compete
            
            
            359,000
            
            
            99,000Customer
                list
            
            
            7,548,645
            
            
            827,250Certification
            
            
            246,969
            
            
            -17,765,327
            
            
            3,413,611Exchange
                differences
            
            
            125,455
            
            
            25,438Less
                - accumulated amortization
            
            
            (4,391,081
            )
            
            (1,502,854
            )Amortized
                cost
            
            
            13,499,701
            
            
            1,936,195Trademarks
            
            
            869,000
            
            
            439,000$
            14,368,701
            
            $
            2,375,195







b.  Amortization
      expenses amounted to $2,888,226, $879,311 and $623,543 for the years ended
      December 31, 2004, 2003 and 2002.




c.  Estimated
      amortization expenses, except capitalized software costs, for the years
      ended




**Year
                ended December 31,****2005**
            
            $
            3,280,815**2006**
            
            
            2,073,209**2007**
            
            
            1,381,883**2008**
            
            
            1,276,075**2009
                and forward**
            
            
            5,000,546$
            13,012,528




**NOTE
      9:-**   **SHORT-TERM
      BANK CREDIT AND LOANS**




The
      Company has a $ 3.2 million authorized credit line from certain banks, of which
      $ 209,000 is denominated in NIS and carries an interest rate of approximately
      prime + 2.5% and $ 3.0 million of which is denominated in dollars and carries
      an
      interest rate of prime + 0.25%. As of December 31, 2004, $ 2.1 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 two automobile purchase loans, of which the later
      one
      will be repaid in June 2006. Those loans are denominated in NIS and carry an
      interest rate of 5.2%-6.2%. Each loan is secured by the automobile purchased
      with the proceeds of the loan.




F-45
 **AROTECH
            CORPORATION AND ITS SUBSIDIARIES**
 NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
            U.S. dollars**




**NOTE
      10:-**  **PROMISSORY
      NOTES**




In
      connection with the acquisition of IES, the Company issued promissory notes
      in
      the face amount of an aggregate of $1,800,000, one of which was a note for
      $400,000 that was convertible into an aggregate of 200,000 shares of the
      Company’s common stock. The Company has accounted for these notes in accordance
      with Accounting Principles Board Opinion No. 21, “Interest on Receivables and
      Payables,” and recorded the notes at their present value in the amount of
      $1,686,964. In December 2002, the terms of these promissory notes were amended
      to (i) extinguish the $1,000,000 note due at the end of June 2003 in exchange
      for prepayment of $750,000, (ii) amend the $400,000 note due at the end of
      December 2003 to be a $450,000 note, and (iii) amend the convertible $400,000
      note due at the end of June 2004 to be a $450,000 note convertible at $0.75
      as
      to $150,000, at $0.80 as to $150,000, and at $0.85 as to $150,000. In accordance
      with EITF 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt
      Instruments,” the terms of promissory notes were not treated as changed or
      modified as the cash flow effect on a present value basis was less than 10%.
      The
      $450,000 note due at the end of June 2004 was converted into an aggregate of
      563,971 shares of common stock in August 2003. With reference to the $450,000
      note due at the end of December 2003, see Note 14.f.6.




**NOTE
      11:-**  **OTHER
      ACCOUNTS PAYABLE AND ACCRUED EXPENSES**




**December
                  31,****2004**
              
              **2003***Employees
                  and payroll accruals
              
              $
              1,534,295
              
              $
              1,232,608Accrued
                  vacation pay
              
              
              469,527
              
              
              216,768Accrued
                  expenses
              
              
              1,770,348
              
              
              842,760Minority
                  balance
              
              
              243,116
              
              
              149,441Government
                  authorities
              
              
              1,036,669
              
              
              357,095Litigation
                  settlement accrual(1)
              
              
              -
              
              
              1,163,642Advances
                  from customers
              
              
              746,819
              
              
              -Other
              
              
              17,414
              
              
              68,097$
              5,818,188
              
              $
              4,030,411


Restated
      (see Note 1.b.).


(1)  See
      Note
      14.f.6.




**NOTE
      12:-**  **COMMITMENTS
      AND CONTINGENT LIABILITIES**




a.  Royalty
      commitments:




1.  Under
      EFL’s research and development agreements with the Office of the Chief Scientist
      (“OCS”), and pursuant to applicable laws, EFL is required to pay royalties at
      the rate of 3%-3.5% of net sales of products developed with funds provided
      by
      the OCS, up to an amount equal to 100% of research and development grants
      received from the OCS (linked to the U.S. dollars. Amounts due in respect of
      projects approved after year 1999 also bear interest at the Libor rate). EFL
      is
      obligated to pay royalties only on sales of products in respect of which OCS
      participated in their development. Should the project fail, EFL will not be
      obligated to pay any royalties.




Royalties
      paid or accrued for the years ended December 31, 2004, 2003 and 2002, to the
      OCS
      amounted to $17,406, $435 and $32,801, respectively.





F-46
 **AROTECH
            CORPORATION AND ITS SUBSIDIARIES**
 NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
            U.S. dollars**
 
 **NOTE
                12:-**  **COMMITMENTS
                AND CONTINGENT LIABILITIES (Cont.)**


As
      of
      December 31, 2004, the total contingent liability to the OCS was approximately
      $10,158,000. 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, 2004.




As
      of
      December 31, 2004, 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****2005**
            
            $
            762,636**2006**
            
            $
            305,109**2007**
            
            $
            269,220**2008**
            
            $
            66,688**2009**
            
            $
            24,312




Total
      rent expenses for the years ended December 31, 2004, 2003 and 2002 were
      approximately $868,900, $484,361 and $629,101, respectively.




c.  Guarantees:




The
      Company obtained bank guarantees in the amount of $1,199,096 in connection
      with
      (i) the purchase agreement of one of the Company’s subsidiaries (ii) obligations
      of two of the Company’s subsidiaries to the Israeli customs authorities and
      (iii) obligation of one of the Company’s subsidiaries to secure inventory
      received from one of its customers. In addition, the Company issued letters
      of
      credit in amounts of $143,895 and $2,000,000 to one of its subsidiary’s
      suppliers and to one of its subsidiary’s customers respectively.


F-47
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
              U.S. dollars**
 
 **NOTE
                  12:-**  **COMMITMENTS
                  AND CONTINGENT LIABILITIES (Cont.)**


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).




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 $3 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 9 regarding automobiles purchased in EFL and Epsilor.




e.  Litigation
      and other claims:




As
      of December 31, 2004, 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:




a.  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.




b.  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. FAAC has not yet filed its
      answer in this case. 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.


F-48
 **AROTECH
              CORPORATION AND ITS SUBSIDIARIES**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **In
              U.S. dollars**
 
 **NOTE
                  12:-**  **COMMITMENTS
                  AND CONTINGENT LIABILITIES (Cont.)**


c.  There
      is
      an action against EFL brought in the matter of the bankruptcy of an intellectual
      property law firm, seeking payment of approximately $150,000, plus interest,
      fees and costs, in respect of unpaid legal fees and expenses. EFL has not yet
      filed its answer in this case. The Company and its legal advisors does not
      believe EFL’s liability in this matter will exceed $100,000.The Company has
      recorded an appropriate provision in respect of this amount.




d.  In
      2000
      and 2001, the Company sold consumer cellphone batteries and chargers to a major
      department store chain. Subsequent to these sales, in late 2001, one of the
      Company’s employees signed an agreement with the department store chain to
      price-protect the goods previously sold, with such price protection “to be
      debited from current open invoices.” The department store chain has recently
      claimed to the Company that the Company owes them approximately $517,000,
      primarily in respect of this price protection. The Company contends that
      employee who signed the price protection had no authority, actual or apparent,
      to do so, and that in any event the clear meaning of the language in the price
      protection is that the department store chain may deduct the price protection
      from sums they owe the Company, not that the Company is obligated to return
      sums
      previously paid. Settlement discussions are currently taking place. At this
      early stage, the Company and its legal advisors cannot determine with any
      certainty whether it will have any liability and, if so, the extent of that
      liability.




**NOTE
      13:-**  **CONVERTIBLE
      DEBENTURES**




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%.




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.


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


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
      2003, an aggregate principal amount of $2,350,000 in 9% secured convertible
      debentures was converted into an aggregate of 3,671,875 shares of common stock
      and an aggregate of 1,500,042 shares were issued pursuant to exercises of the
      warrants.




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
      2003 and 2004, the Company recorded expenses of $1,517,400 and $372,600,
      respectively, of which $548,100 and $0, respectively, was attributable to
      amortization of the beneficial conversion feature of the convertible debenture
      over its term and $969,300 and $372,600, respectively, was 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
      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.




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.


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


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
      2003, an aggregate principal amount of $3,775,000 in 8% secured convertible
      debentures was converted into an aggregate of 3,282,608 shares of common stock
      and an aggregate of 437,500 shares were issued pursuant to exercises of the
      warrants.




During
      2004, an aggregate of principal amount $1,075,000 in 8% secured convertible
      debentures was converted into an aggregate of 934,784 shares. As of December
      31,
      2004, principal amount of $150,000 remained outstanding under these
      debentures.




During
      2003 and 2004, the Company recorded expenses of $2,298,034 and $613,263,
      respectively, of which $205,858 and $191,895, respectively, was attributable
      to
      amortization of the beneficial conversion feature of the convertible debenture
      over its term and $2,092,176 and $421,368, 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
      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.




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
        2003 the Company recorded an expense of $132,803, which represents the
        amortization of the beneficial conversion feature of the convertible debenture
        over its term.


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


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 14.f.4.




During
      2004 the Company recorded expenses of $3,156,246 of which $1,782,561 was
      attributable to amortization of the beneficial conversion feature of the
      convertible debenture over its term and $1,373,685 was attributable to
      amortization due to conversion of the convertible debenture into
      shares.




d.  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
      14:-**  **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:




1.  On
      January 18, 2002, the Company issued a total of 441,176 shares of its common
      stock at a purchase price of $1.70 per share, or a total purchase price of
      $750,000, to an investor (see also Note 14.f.2.).




2.  On
      January 24, 2002, the Company issued a total of 1,600,000 shares of its common
      stock at a purchase price of $1.55 per share, or a total purchase price of
      $2,480,000, to a group of investors.




3.  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.




4.  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 group of investors (see also Note 14.f.3.). Finance expenses in connection
      with this issuance totaled $692,500.




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


5.  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 14.f.4.).




c.  Issuance
      of common stock to service providers and employees, in settlement of litigation,
      and as donations to charities :




1.  On
      February 15, 2002 and September 10, 2002, the Company issued 318,468 and 50,000
      shares, respectively, of common stock at par consideration to a consultant
      for
      providing business development and marketing services in the United Kingdom.
      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 which amounted to $394,698 and
      $63,000, respectively, in accordance with EITF 96-18. In accordance with EITF
      96-18, the Company recorded this compensation expense of $394,698 and $63,000,
      respectively, during the year 2002 and included this amount in marketing
      expenses.




2.  On
      September 10, 2002, the Company issued an aggregate of 13,000 shares of common
      stock at par consideration to two of its employees as stock bonuses. 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 $13,000 during the year 2002 and included
      this amount in general and administrative expenses.




3.  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.




4.  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.




5.  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.




6.  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


F-53
 **AROTECH
                      CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                      TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                      U.S. dollars**
 
 **NOTE
                            14:-**STOCKHOLDERS’
                            EQUITY**** **(Cont.)**


7.  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




8.  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 during the year 2004 and
      included this amount in general and administrative expenses




9.  See
      Note
      14.f.6.




d.  Issuance
      of shares to lenders




As
      part
      of the securities purchase agreement on December 31, 2002 (see Note 13.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 (see Note 10). 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.


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


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. See also Note 1.b.




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. See also Note
      1.b.




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 14.b.4. and 14.f.4.




2.  As
      part
      of the investment agreement in January 2002 (see Note 14.b.1), the Company,
      in
      January 2002, issued to a financial consultant that provided investment banking
      services concurrently with this transaction a warrants to acquire (i) 150,000
      shares of common stock at an exercise price of $1.68 per share, and (ii) 119,000
      shares of common stock at an exercise price of $2.25 per share; these warrants
      are exercisable by the holder at any time and will expire on January 4,
      2007.




3.  In
      connection with the Securities Purchase Agreement referred to in Note 14.b.4
      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 14.f.4.


F-55
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**
 
 **NOTE
                          14:-**STOCKHOLDERS’
                          EQUITY**** **(Cont.)**


4.  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 14.f.1., 14.f.3. and 13.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 13.c
      above and 7,446,811 shares were issued upon exercise of warrants issued in
      the
      transaction referred to in the Note 14.f.4. 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 14.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 14 f.1, 14.f.3 and 13.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.




5.  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.


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


6.  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.




7.  As
      of
      December 31, 2004, the Company outstanding warrants totaled
      16,961,463.




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.




1)  1998
      Employee Option Plan - as amended, 4,750,000 shares reserved for issuance,
      of
      which no shares were available for future grants to employees and consultants
      as
      of December 31, 2004.




2)  1995
      Non-Employee Director Plan - 1,000,000 shares reserved for issuance, of which
      355,000 were available for future grants to directors as of December 31,
      2004.




3)  2004
      Employee Option Plan - 7,500,000 shares reserved for issuance, of which
      5,168,400 were available for future grants to employees and consultants as
      of
      December 31, 2004.




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.


F-57
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**
 
 **NOTE
                          14:-**STOCKHOLDERS’
                          EQUITY**** **(Cont.)**


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,
      2004, 2003 and 2002, and changes during the years ended on those dates, is
      presented below:


**2004**
              
              **2003**
              
              **2002****Amount**
              
              **Weighted
                  average**
                **exercise
                  price**
              
              **Amount**
              
              **Weighted
                  average**
                **exercise
                  price**
              
              **Amount**
              
              **Weighted
                  average exercise price**$
              
              
              
              
              
              $
              
              
              
              
              
              $Options
                  outstanding at beginning of year
              
              
              9,018,311
              
              $
              1.37
              
              
              5,260,366
              
              $
              2.26
              
              
              4,240,228
              
              $
              2.74Changes
                  during year:Granted
                  (1) (2)
              
              
              2,248,490
              
              $
              1.06
              
              
              5,264,260
              
              $
              0.71
              
              
              1,634,567
              
              $
              0.87Exercised
                  (3)
              
              
              (897,248
              )
              $
              1.24
              
              
              (689,640
              )
              $
              0.64
              
              
              (191,542
              )
              $
              1.29Forfeited
              
              
              (514,793
              )
              $
              3.77
              
              
              (816,675
              )
              $
              3.51
              
              
              (422,887
              )
              $
              1.92Options
                  outstanding at end of year
              
              
              9,854,760
              
              $
              1.19
              
              
              9,018,311
              
              $
              1.37
              
              
              5,260,366
              
              $
              2.26Options
                  exercisable at end of year
              
              
              6,465,316
              
              $
              1.32
              
              
              5,826,539
              
              $
              1.70
              
              
              4,675,443
              
              $
              2.26








(1)  Includes
      936,250, 2,035,000 and 481,435 options and restricted shares granted to related
      parties in 2004, 2003 and 2002, 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 $2,081,457, $4,750 and $0 as of December 31, 2004, 2003 and 2002,
      respectively. 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 2004, 2003 and
      2002,
      was $831,626, $8,286 and $6,000, respectively.




(3)  In
      June
      2002, the employees exercised 100,000 options for which the exercise price
      was
      not paid at the exercise date. The Company recorded the owed amount of $73,000
      as “Note receivable from stockholders” in the Statement of Changes in
      Stockholders’ Equity. In accordance with EITF 95-16, since the original option
      grant did not permit the exercise of the options through loans, and due to
      the
      Company’s history of granting non-recourse loans, this postponement in payments
      of the exercise price resulted in a variable plan accounting. However, the
      Company did not record any compensation due to the decrease in the market value
      of the Company’s shares during 2002. During 2002 the note in the amount of
      $36,500 was forgiven and appropriate compensation was recorded. During 2003
      and
      2004, the Company recorded compensation expenses and (income) in amounts of
      $38,500 and ($10,000), respectively, due to increase and decrease in the market
      value of the Company’s shares.




d.  The
      options and restricted shares outstanding as of December 31, 2004 have been
      separated into ranges of exercise price, as follows:


F-58
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**
 
 **NOTE
                          14:-**STOCKHOLDERS’
                          EQUITY**** **(Cont.)**


**Total
                  options outstanding**
              
              **Exercisable
                  options outstanding****Range
                  of**
                **exercise**
                **prices**
              
              **Amount**
                **outstanding****at**
                **December
                  31,**
                **2004**
              
              **Weighted**
                **average**
                **remaining**
                **contractual
                  life**
              
              **Weighted**
                **average**
                **exercise
                  price**
              
              **Amount**
                **exercisable
                  at**
                **December
                  31, 2004**
              
              **Weighted**
                **average**
                **exercise
                  price**$
              
              
              
              Years
              
              $
              
              
              
              $0.01-2.00
              
              
              8,944,827
              
              
              6.44
              
              
              0.87
              
              
              5,730,382
              
              
              0.882.01-4.00
              
              
              270,933
              
              
              3.79
              
              
              2.46
              
              
              95,934
              
              
              2.564.01-6.00
              
              
              594,000
              
              
              1.97
              
              
              4.80
              
              
              594,000
              
              
              4.806.01-8.00
              
              
              35,000
              
              
              1.05
              
              
              7.73
              
              
              35,000
              
              
              7.738.01
              
              
              10,000
              
              
              2.75
              
              
              9.06
              
              
              10,000
              
              
              9.069,854,760
              
              
              6.07
              
              
              1.19
              
              
              6,465,316
              
              
              1.32








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,****2004**
            
            **2003**
            
            **2002**
            
            **2004**
            
            **2003**
            
            **2002**Weighted
                average exercise prices
            
            $
            1.494
            
            $
            0.950
            
            $
            1.265
            
            $
            1.672
            
            $
            -
            
            $
            0.755Weighted
                average fair value on grant date
            
            $
            1.002
            
            $
            0.730
            
            $
            0.560
            
            $
            1.729
            
            $
            -
            
            $
            0.250







2.  Options
      issued to consultants:




a.  The
      Company’s outstanding options to consultants as of December 31, 2004, are as
      follows:




**2004**
            
            **2003**
            
            **2002****Amount**
            
            **Weighted
                average exercise price**
            
            **Amount**
            
            **Weighted
                average exercise price**
            
            **Amount**
            
            **Weighted
                average exercise price**$
            
            
            
            $
            
            
            
            **$**Options
                outstanding at beginning of year
            
            
            313,901
            
            $
            4.59
            
            
            245,786
            
            $
            5.55
            
            
            245,786
            
            $
            5.55Changes
                during year:Granted
            
            
            10,000
            
            $
            -
            
            
            83,115
            
            $
            0.99
            
            
            -
            
            $
            -Exercised
            
            
            (37,615
            )
            $
            1.03
            
            
            (15,000
            )
            $
            0.49
            
            
            -
            
            $
            -Forfeited
                or cancelled
            
            
            (120,000
            )
            $
            6.40
            
            
            -
            
            $
            -
            
            
            -
            
            $
            -Options
                outstanding at end of year
            
            
            166,286
            
            $
            3.80
            
            
            313,901
            
            $
            4.59
            
            
            245,786
            
            $
            5.55Options
                exercisable at end of year
            
            
            166,286
            
            $
            3.80
            
            
            193,901
            
            $
            3.46
            
            
            125,786
            
            $
            6.42







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:


F-59
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**
 
 **NOTE
                          14:-**STOCKHOLDERS’
                          EQUITY**** **(Cont.)**


**2004**
            
            **2003**
            
            **2002**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, $29,759 and $0 for the years ended
      December 31, 2004, 2003 and 2002, 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.




**NOTE
      15:-**  **INCOME
      TAXES**




a.  Taxation
      of U.S. parent company (Arotech) and other U.S. subsidiaries:




As
      of
      December 31, 2004, Arotech has operating loss carryforwards for U.S. federal
      income tax purposes of approximately $23 million, which are available to offset
      future taxable income, if any, expiring in 2009 through 2024. 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.


F-60
 **AROTECH
                  CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                  U.S. dollars**
 
 **NOTE
                        15:-**INCOME
                        TAXES**** **(Cont.)**


Taxable
      income derived from the approved enterprise is subject to a reduced tax rate
      during seven years beginning from the year in which taxable income is first
      earned (tax exemption for the first two-year period and 25% tax rate for the
      five remaining years).




Those
      benefits are limited to 12 years from the year that the enterprise began
      operations, or 14 years from the year in which the approval was granted,
      whichever is earlier. Hence, this approved program will expire in
      2005.




2.  Program
      two:




Epsilor’s
      expansion program of its existing enterprise in Dimona was granted the status
      of
      an “approved enterprise” under the Investments Law and was entitled to
      investments grants from the State of Israel in the amount of 24% on property
      and
      equipment located at its Dimona plant.




The
      approved expansion program is in the amount of approximately $600,000. Epsilor
      effectively operated the program during 2002, and is entitled to the tax
      benefits available under the Investments Law (commencing from
      2003).




Taxable
      income derived from the approved enterprise is subject to a reduced tax rate
      during seven years beginning from the year in which taxable income is first
      earned (tax exemption for the first two-year period and 25% tax rate for the
      five remaining years).




Those
      benefits are limited to 12 years from the year that the enterprise began
      operations, or 14 years from the year in which the approval was granted,
      whichever is earlier. Hence, this approved program will expire in
      2009.




3.  Program
      three:




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.


F-61
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**
 
 **NOTE
                          15:-**INCOME
                          TAXES**** **(Cont.)**


Income
      from sources other than the “Approved Enterprise” during the benefit period will
      be subject to tax at the regular corporate tax rate of 35%.




.
      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, 2004 approximately $370,000 were derived from tax exempt profits
      earned by Epsilor’s “approved enterprises”; by Israeli law, the Company can
      distribute only $197,000 of this amount. The Company has determined that such
      tax exempt income in the amount of $180,000 will not be distributed as
      dividends.




Tax
      liability on what can be distributed as dividends from these tax exempt profits
      and other Epsilor profits in 2004 in the hand of the recipient and on the
      company level as stated in previous section is $51,000 and accordingly deferred
      tax liability was recorded as of December 31, 2004.




c.  Israeli
      subsidiary (EFL):




1.  Tax
      benefits under the Investments Law:




A
      small
      part of EFL’s manufacturing facility has been granted “Approved Enterprise”
      status under the Investments Law, and was entitled to investment grants from
      the
      State of Israel of 38% on property and equipment located in Jerusalem, and
      10%
      on property and equipment located in its plant in Beit Shemesh, and to reduced
      tax rates on income arising from the “Approved Enterprise,” as detailed below.




The
      period of tax benefits granted by “Approved enterprise” is subject to limits of
      12 years from the commencement of production, or 14 years from the approval
      date, whichever is earlier. The approved program expired in 2004. The benefits
      were not utilized since the Company had no taxable income, since its
      incorporation.




d.
      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.


F-62
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**
 
 **NOTE
                          15:-**INCOME
                          TAXES**** **(Cont.)**


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 35%. See also Note 15.e




4.  Tax
      loss
      carryforwards:




As
      of
      December 31, 2004, EFL has operating and capital loss carryforwards for Israeli
      tax purposes of approximately $87.0 million, which are available, indefinitely,
      to offset future taxable income.




e.  Reduction
      in corporate tax rate




In
      June
      2004, the Israeli Parliament approved an amendment to the Income Tax Ordinance
      (No. 140 and Temporary Provision) (the “Amendment”), which progressively reduces
      the corporate tax rate from 36% to 35% in 2004 and to a rate of 30% in 2007.
      The
      amendment was signed and published in July 2004 and is, therefore, considered
      enacted in July 2004. As the Company currently has no taxable income, and no
      deferred taxes were recorded, the amendment does not have an impact on the
      Company’s results of operation or financial position.




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,****2004**
            
            **2003**Operating
                loss carryforward
            
            $
            32,532,998
            
            $
            33,958,434Reserve
                and allowance
            
            
            1,328,479
            
            
            843,453Net
                deferred tax asset before valuation allowance
            
            
            33,861,477
            
            
            34,801,887Valuation
                allowance
            
            
            (33,725,995
            )
            
            (34,801,887
            )Total
                deferred tax asset
            
            $
            135,482
            
            $
            -Deferred
                tax liability
            
            $
            51,366
            
            $
            -




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, 2004 was $1,075,892


F-63
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**
 
 **NOTE
                          15:-**INCOME
                          TAXES**** **(Cont.)**


g.  Loss
      from
      continuing operations before taxes on income and minorities interests in loss
      (earnings) of a subsidiary:




**Year
                ended December 31****2004**
            
            **2003***
            
            **2002****Domestic
            
            $
            8,006,205
            
            $
            7,411,121
            
            $5,250,633Foreign
            
            
            405,305
            
            
            1,697,617
            
            13,253,725$
            8,411,510
            
            $
            9,108,738
            
            $18,504,358


Restated
      (see Note 1.b.).


**
      Includes loss from discontinued operations and minority interest in
      loss **** (earnings)
      of a subsidiary







h.  Taxes
      on
      income were comprised of the following:




**Year
                ended December 31****2004**
            
            **2003**
            
            **2002**Current
                state and local taxes
            
            $
            539,674
            
            $
            44,102
            
            $
            -Deferred
                taxes
            
            
            (37,857
            )
            
            -
            
            
            -Taxes
                in respect of prior years
            
            
            84,292
            
            
            352,091
            
            
            -$
            586,109
            
            $
            396,193
            
            $
            -Domestic
            
            $
            163,087
            
            $
            33,020
            
            $
            -Foreign
            
            
            423,022
            
            
            363,173
            
            
            -$
            586,109
            
            $
            396,193
            
            $
            -





i.  The
      cumulative amount of undistributed earnings of foreign subsidiaries, which
      is
      intended to be permanently reinvested and for which U.S. income taxes have
      not
      been provided, totaled approximately $180,000 and $0 on December 31, 2004 and
      2003 respectively.




j.  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:


F-64
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**
 
 **NOTE
                          15:-**INCOME
                          TAXES**** **(Cont.)**


**Year
                ended December 31,****2004**
            
            **2003***
            
            **2002**Loss
                from continuing operations before taxes, as reported in the consolidated
                statements of income
            
            $
            (8,411,510
            )
            $
            (9,108,738
            )
            $
            (4,582,792
            )Statutory
                tax rate
            
            
            34
            %
            
            34
            %
            
            34
            %Theoretical
                income tax on the above amount at the U.S. statutory tax
                rate
            
            $
            (2,859,914
            )
            $
            (3,096,971
            )
            $
            (1,558,149
            )Deferred
                taxes on losses for which valuation allowance was provided
            
            
            556,692
            
            
            1,146,754
            
            
            1,558,149Non-deductible
                expenses
            
            
            1,629,874
            
            
            1,873,129
            
            
            -State
                taxes
            
            
            168,081
            
            
            33,020
            
            
            -Accrual
                for deferred taxes on undistributed earnings
            
            
            49,416
            
            
            -
            
            
            -Foreign
                income in tax rates other then U.S rate
            
            
            919,895
            
            
            86,954
            
            
            -Taxes
                in respect of prior years
            
            
            84,292
            
            
            352,091
            
            
            -Others
            
            
            37,773
            
            
            1,216
            
            
            -Actual
                tax expense
            
            $
            586,109
            
            $
            396,193
            
            $
            -


Restated
      (see Note 1.b.).




**NOTE
      16:-**  **SELECTED
      STATEMENTS OF OPERATIONS DATA**




Financial
      income (expenses), net:




**Year
                ended December 31,****2004**
            
            **2003***
            
            **2002**Financial
                expenses:Interest,
                bank charges and fees
            
            $
            (622,638
            )
            $
            (355,111
            )
            $
            (89,271
            )Amortization
                of compensation related to warrants issued to the holders of convertible
                debentures and beneficial conversion feature
            
            
            (4,142,109
            )
            
            (3,928,237
            )
            
            -Bonds
                premium amortization
            
            
            (202,467
            )
            
            -
            
            
            -Foreign
                currency translation differences
            
            
            (71,891
            )
            
            115,538
            
            
            15,202(5,039,105
            )
            
            (4,167,810
            )
            
            (74,069
            )Financial
                income:Interest
            
            
            443,182
            
            
            129,101
            
            
            174,520Realized
                gain from marketable securities sale
            
            
            40,119
            
            
            -
            
            
            -Financial
                income in connection with warrants granted (note 14.f.4)
            
            
            326,839
            
            
            -
            
            
            -Total
            
            $
            (4,228,965
            )
            $
            (4,038,709
            )
            $
            100,451


Restated
      (see Note 1.b.).


F-65
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**


**NOTE
      17:-**  **RELATED
      PARTY DISCLOSURES**




**Year
                ended December 31,****2004**
            
            **2003**
            
            **2002**Transactions:Reimbursement
                of general and administrative expenses
            
            
            -
            
            
            -
            
            $
            36,000Financial
                income (expenses), net from notes receivable and loan
                holders
            
            $
            18,251
            
            
            -
            
            $
            (7,309
            )





**NOTE
      18:-**  **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 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.




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




**Simulation
                    and Security**
                
                **Armor**
                
                **Battery
                    and**
                  **Power
                    Systems**
                
                **All
                    Others(4)**
                
                **Total****2004**Revenues
                    from outside customers
                
                $
                21,464,406
                
                $
                17,988,687
                
                $
                10,500,753
                
                $
                -
                
                $
                49,953,846Depreciation
                    expenses and amortization(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


F-66
 **AROTECH
                    CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                    U.S. dollars**


**NOTE
            18:-**  **SEGMENT
            INFORMATION (Cont.)**
  **Simulation
                    and Security**
                
                **Armor**
                
                **Battery
                    and**
                  **Power
                    Systems**
                
                **All
                    Others(4)**
                
                **Total****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**2002**Revenues
                    from outside customers
                
                $
                1,980,061
                
                $
                2,744,382
                
                $
                1,682,296
                
                $
                -
                
                $
                6,406,739Depreciation
                    expenses and amortization(1)
                
                
                (569,832
                )
                
                (106,921
                )
                
                (252,514
                )
                
                (194,014
                )
                
                (1,123,281
                )Direct
                    expenses(1)
                
                
                (2,037,775
                )
                
                (2,315,995
                )
                
                (3,062,548
                )
                
                (2,905,743
                )
                
                (10,322,061
                )Segment
                    net income (loss)
                
                $
                (627,546
                )
                $
                321,466
                
                $
                (1,632,766
                )
                $
                (3,099,757
                )
                
                (5,038,603
                )Financial
                    income (after deduction of minority interest)
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                100,451Net
                    income from continuing operations
                
                
                
                
                
                
                
                
                
                
                
                
                
                $
                (4,938,152
                )Segment
                    assets(3)
                
                $
                655,143
                
                $
                1,028,682
                
                $
                2,007,291
                
                $
                575,612
                
                $
                4,266,728
 Restated
          (see Note 1.b.).


(1)  Including
      property and equipment depreciation, intangible assets amortization and
      amortization of adjustment of one of the Company’s subsidiaries’ inventory to
      market values as of the purchase date.


(2)  Including
      sales and marketing, general and administrative expenses.


(3)  Including
      property and equipment and inventory.


(4)  Including
      unallocated costs.




The
      Company allocates its goodwill among its three divisions as follows:




**Year
                ended December 31,****2004**
            
            **2003**
            
            **2002**Simulation
                and Security Division
            
            $
            22,845,372
            
            $
            4,032,726
            
            $
            4,068,726Armor
                Division
            
            $
            11,591,228
            
            $
            1,031,829
            
            $
            886,255Battery
                and Power Systems Division
            
            $
            5,308,916
            
            $
            -
            
            $
            -


c.  Summary
      information about geographic areas:


F-67
 **AROTECH
                      CORPORATION AND ITS SUBSIDIARIES**
 NOTES
                      TO CONSOLIDATED FINANCIAL STATEMENTS
 **In
                      U.S. dollars**
 **NOTE
              18:-**  **SEGMENT
              INFORMATION (Cont.)**


The
      following presents total revenues according to end customers location for the
      years ended December 31, 2004, 2003 and 2002, and long-lived assets as of
      December 31, 2004, 2003 and 2002:




**2004**
            
            **2003**
            
            **2002****Total**
              **revenues**
            
            **Long-lived
                assets**
            
            **Total**
              **revenues**
            
            **Long-lived
                assets**
            
            **Total**
              **revenues**
            
            **Long-lived
                assets**U.S.
                dollarsU.S.A.
            
            $
            40,656,729
            
            $
            45,154,086
            
            $
            10,099,652
            
            $
            6,778,050
            
            $
            2,787,250
            
            $
            6,710,367Germany
            
            
            319,110
            
            
            -
            
            
            2,836,725
            
            
            -
            
            
            38,160
            
            
            -England
            
            
            344,261
            
            
            -
            
            
            29,095
            
            
            -
            
            
            47,696
            
            
            -Thailand
            
            
            -
            
            
            -
            
            
            95,434
            
            
            -
            
            
            291,200
            
            
            -India
            
            
            3,061,705
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Israel
            
            
            4,212,408
            
            
            13,560,822
            
            
            3,576,139
            
            
            2,954,441
            
            
            2,799,365
            
            
            3,367,320Other
            
            
            1,359,633
            
            
            -
            
            
            689,596
            
            
            -
            
            
            443,068
            
            
            -$
            49,953,846
            
            $
            58,714,908
            
            $
            17,326,641
            
            $
            9,732,491
            
            $
            6,406,739
            
            $
            10,077,687







d.  Revenues
      from major customers:




**Year
                ended December 31,****2004**
            
            **2003**
            
            **2002****%**Batteries
                and power systems:Customer
                A
            8%
            
            27%
            
            8%Armor:Customer
                B
            4%
            
            17%
            
            43%Customer
                C
            24%
            
            -
            
            -Simulation
                and security:Customer
                D
            13%
            
            -
            
            -Customer
                E
            1%
            
            16%
            
            -





e.  Revenues
      from major products:




**Year
                ended December 31,****2004**
            
            **2003**
            
            **2002**Electric
                - vehicle
            
            $
            232,394
            
            $
            408,161
            
            $
            460,562Water
                activated batteries
            
            
            921,533
            
            
            703,084
            
            
            647,896Military
                batteries
            
            
            9,324,247
            
            
            4,757,116
            
            
            573,839Car
                armoring
            
            
            17,988,686
            
            
            3,435,715
            
            
            2,744,382Simulators
            
            
            21,414,968
            
            
            7,961,302
            
            
            1,980,060Other
            
            
            72,018
            
            
            61,263
            
            
            -Total
            
            $
            49,953,846
            
            $
            17,326,641
            
            $
            6,406,739







F-68





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




**Quarterly
      Financial Data (unaudited) for the two years ended December 31,
      2004**




**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


**Quarter
                  Ended****2003***
              
              **March
                  31**
              
              **June
                  30**
              
              **September
                  30**
              
              **December
                  31**Net
                  revenue
              
              $
              4,033,453
              
              $
              3,493,135
              
              $
              5,705,898
              
              $
              4,094,155Gross
                  profit
              
              $
              1,399,734
              
              $
              1,013,965
              
              $
              2,453,575
              
              $
              1,371,527Net
                  loss from continuing operations
              
              $
              (1,291,122
              )
              $
              (2,788,348
              )
              $
              218,606
              
              $
              (5,487,167
              )Net
                  income (loss) from discontinued operations
              
              $
              (95,962
              )
              $
              179,127
              
              $
              (2,285
              )
              $
              29,529Net
                  income (loss) for the period
              
              $
              (1,387,083
              )
              $
              (2,609,221
              )
              $
              216,321
              
              $
              (5,457,638
              )Deemed
                  dividend to certain stockholders of common stock
              
              $
              -
              
              $
              (172,350
              )
              $
              (94,676
              )
              $
              (82,974
              )Net
                  income (loss) attributable to common stockholders
              
              $
              (1,387,083
              )
              $
              (2,781,571
              )
              $
              121,645
              
              $
              (5,540,612
              )Net
                  loss per share - basic and diluted
              
              $
              (0.04
              )
              $
              (0.08
              )
              $
              0.00
              
              $
              (0.13
              )Shares
                  used in per share calculation
              
              
              34,758,960
              
              
              36,209,872
              
              
              40,371,940
              
              
              43,604,830


Restated
      (see Note 1.b. of Notes to Consolidated Financial Statements).










F-69






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




**Arotech
      Corporation and Subsidiaries**









**Schedule
      II - Valuation and Qualifying Accounts**




For
      the
      Years Ended December 31, 2004, 2003 and 2002




**Description**
            
            **Balance
                at**
              **beginning**
              **of
                period**
            
            **Additions**
              **charged
                to**
              **costs
                and**
              **expenses**
            
            **Balance
                at**
              **end
                of**
              **period****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**Year
                ended December 31, 2002**Allowance
                for doubtful accounts
            
            $
            39,153
            
            $
            1,483
            
            $
            40,636Valuation
                allowance for deferred taxes
            
            
            12,640,103
            
            
            16,920,219
            
            
            29,560,322**Totals**
            
            $
            12,679,256
            
            $
            16,921,702
            
            $
            29,600,958













F-70




**Exhibit
      Index**




**Exhibit****Number**
            
            **Description**23.1
            
            Consent
                of Kost, Forer, Gabbay & Kassierer, a member of Ernst & Young
                Global23.2
            
            Consent
                of Stark Winter Schenkein & Co., LLP31.1
            
            Certification
                of Principal Executive Officer pursuant to Section 302 of
                the
                Sarbanes-Oxley Act of 200231.2
            
            Certification
                of Principal Financial Officer pursuant to Section 302 of
                the
                Sarbanes-Oxley Act of 200232.1
            
            Certification
                of Principal Executive Officer pursuant to 18 U.S.C. Section 1350,
                as
                adopted pursuant to Section 906 of the Sarbanes-Oxley Act
                of
                200232.2
            
            Certification
                of Principal Financial Officer pursuant to 18 U.S.C. Section 1350,
                as
                adopted pursuant to Section 906 of the Sarbanes-Oxley Act
                of
                2002