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 UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
 
 FORM
10-K
 
 S ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE
FISCAL YEAR ENDED   DECEMBER 31,
2007.
 
 £ 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
 
  Delaware
                
                95-4302784(State
      or other jurisdiction of incorporation or organization)
                
                (I.R.S.
      Employer Identification No.)1229
      Oak Valley Drive, Ann Arbor, Michigan
                
                48108(Address
      of principal executive offices)
                
                (Zip
      Code)
 
 (800)
      281-0356(Registrant’s
      telephone number, including area
code)
 
 Securities
registered pursuant to Section 12(b) of the Act:
 
 Title
      of each class
                
                Name
      of each exchange on which registeredCommon
      Stock, $0.01 par value
                
                The
      Nasdaq Stock Market LLC
  Securities
      registered pursuant to Section 12(g) of the Act:
                Common Stock, $0.01 par
      value
  Indicate by check markif the registrant is a well-known seasoned issuer, as defined in Rule 405
of the Securities Act.
 Yes
£    No
S
 
 Indicate by check markif the registrant is not required to file reports pursuant to Section 13
or Section 15(d) of the Act.
 Yes
£    No
S
 
 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
S    No
£
 
 Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not
be contained, to the best of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K.  £
 
 Indicate
by check mark whether the registrant is large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definition of “accelerated filer and
large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
one):
 
 Large
      accelerated filer: £
                Accelerated
      filer: £
                Non-accelerated
      filer: £
                Smaller
      reporting company: S
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act).
 Yes
£    No
x
 
 The
aggregate market value of the registrant’s voting stock held by non-affiliates
of the registrant as of June 30, 2007 was approximately $40,382,408 (based on
the last sale price of such stock on such date as reported by The Nasdaq Global
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:
 13,599,197
as of 3/31/08
 
 Documents
      incorporated by reference:
                
                None





PRELIMINARY
NOTE




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




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










PART
I




ITEM
      1.
            BUSINESS




General




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




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




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




·
            We
      provide specialized “use of force” training for police, security personnel
      and the military through our subsidiary IES Interactive Training, located
      in Ann Arbor, Michigan, which we merged into our FAAC subsidiary in
      October of 2007 (“IES”).




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




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




·
            We
      provide ballistic armor kits for rotary and fixed wing aircraft and marine
      armor through our subsidiary Armour of America, located in Auburn, Alabama
      (“AoA”).




Ø
            We
      manufacture and sell lithium and Zinc-Air batteries for defense and
      security products and other military applications through our Battery and
      Power Systems Division:




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




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




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




Background




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




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




Facilities




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




The
offices and facilities of three of our principal subsidiaries, EFL, MDT and
Epsilor, are located in Israel (in Beit Shemesh, Lod and Dimona, respectively,
all of which are within Israel’s pre-1967 borders). Most of the members of our
senior management work extensively out of EFL’s facilities; our financial
operations are conducted primarily from our principal executive offices in Ann
Arbor. IES’s and FAAC’s home offices and facilities are located in Ann Arbor,
Michigan, and the offices and facilities of EFB, MDT Armor and AoA are located
in Auburn, Alabama.




Training
and Simulation Division




We
develop, manufacture and market advanced high-tech multimedia and interactive
digital solutions for use-of-force training and driver training of military, law
enforcement, security and other personnel through our Training and Simulation
Division, the largest of our three divisions.




- 2
-





During
2007 and 2006, revenues from our Training and Simulation Division were
approximately $27.8 million and $22.0 million, respectively.




The
Training and Simulation Division concentrates on three different product
areas:




Ø
            Our
      Vehicle
      Simulation group provides high fidelity vehicle simulators for use
      in operator training and is marketed under our FAAC
    nameplate;




Ø
            Our
      Military
      Operations group provides weapon simulations used to train military
      pilots in the effective use of air launched weapons and is also marketed
      under our FAAC nameplate; and




Ø
            Our
      Use of Force
      group provides training products focused on the proper employment of hand
      carried weapons and is marketed under our IES Interactive Training
      nameplate.




Vehicle
Simulation




We
provide simulators, systems engineering and software products focused on
training vehicle operators for cars and trucks. We provide these products to the
United States military, government, municipalities, and private industry through
our FAAC nameplate. Our fully interactive driver-training systems feature
state-of-the-art vehicle simulator technology enabling training in situation
awareness, risk analysis and decision making, emergency reaction and avoidance
procedures, and proper equipment operation techniques. Our simulators have
successfully trained hundreds of thousands of drivers.




Our
Vehicle Simulation group focuses on the development and delivery of complete
driving simulations for a wide range of vehicle types – such as trucks,
automobiles, subway trains, buses, fire trucks, police cars, ambulances, airport
ground vehicles, and military vehicles. In 2007, our Vehicle Simulations group
accounted for approximately 55% of our Training and Simulation Division’s
revenues.




We
believe that we have held near a 100% market share in U.S. military wheeled
vehicle operator driver training simulators since 1999 and that we are currently
one of three significant participants in the U.S. municipal wheeled vehicle
simulators market.




Military
Operations




In the
area of Military Operations, we believe we are a premier developer of validated,
high fidelity analytical models and simulations of tactical air and land warfare
systems for all branches of the Department of Defense and its related industrial
contractors. Our simulations are found in systems ranging from instrumented air
combat and maneuver training ranges (such as Top Gun), full task training
devices such as the F-18 Weapon Tactics Trainer, and in the on-board computer of
many fighter jet aircraft. In 2007, our Military Operations group accounted for
20% of our Training and Simulation Division’s revenues.




FAAC is
the sole provider of validated weapon simulations used in US air-combat
training. We supply on-board software to support weapon launch decisions for the
F-15, F-16, F-18, and Joint Strike Fighter (JSF) fighter aircraft. We also
provide an instructor operator station,




- 3
-





mission
operator station and real-time, database driven electronic combat environment
for the special operational forces aircrew training system.




Use-of-Force




We are a
leading provider of interactive, multimedia, fully digital training simulators
for law enforcement, security, military and similar applications. With a large
customer base spread over twenty countries around the world, we are a leader in
the supply of simulation training products to law enforcement, governmental, and
commercial clients. We conduct our interactive training activities using our IES
Interactive Training nameplate. In 2007, our Use of Force group accounted for
25% of our Training and Simulation Division’s revenues.




Marketing
and Customers




We market
our Simulation Division products to all branches of the U.S. military, federal
and local government, municipal transportation departments, and public safety
groups. Municipalities throughout the U.S. are using our vehicle simulators and
use-of-force products, and our penetration in Asia, Europe and the Americas
continues through the use of commissioned sales agents and regional
distributors.




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




Competition




Our
technical excellence, superior product reliability, and high customer
satisfaction have enabled us to develop market leadership and attractive
competitive positions in each of our product areas.




Vehicle
Simulators




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




Military
Operations




Currently
no significant competitors participate in the markets we serve around our weapon
simulation niche. Our 30-year history in this space provides a library of
resources that would require a competitor to invest heavily in to offer a
comparable product. The companies that could logically compete with us if they
chose would be the companies that now subcontract this work to us: Boeing,
Raytheon and Cubic.




- 4
-


Use
of Force




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




Armor
Division




We armor
vehicles and manufacture aviation and other armor through our Armor Division.
During 2007 and 2006, revenues from our Armor Division were approximately $18.7
million and $12.6 million, respectively.




Introduction




We
specialize in armoring vehicles and manufacturing armor kits for aircraft and
vessels by using state-of-the-art lightweight ballistic materials, special
ballistic glass and advanced engineering processes. We fully armor vehicles,
vans, SUVs and small buses. We also provide ballistic armor kits for rotary and
fixed wing aircraft, marine armor, personnel armor, and armor for architectural
applications.




We
operate through three business units: MDT Protective Industries Ltd., located in
Lod, Israel (in which we acquired a majority stake in 2002), MDT Armor
Corporation, which we established in 2003 in Auburn, Alabama and Armour of
America, which we acquired in 2004 and relocated to Auburn,
Alabama.




We are a
leading supplier to the Israeli military, Israeli Special Forces and special
services. We provide products to the US Army, and to military and defense and
paramilitary customers worldwide.




Our
products have been proven in intensive battlefield situations and under actual
terrorist attack conditions, and are designed to meet the demanding requirements
of governmental and private sector customers worldwide. We have acquired many
years of battlefield experience in Israel. Our vehicles have provided proven
life-saving protection for their passengers in incidents of rock throwing,
handgun and assault rifle attack at point-blank range, roadside bombings and
suicide bombings.




During
2006 and 2007, we received over $26 million in orders from the Israel Defense
Forces for the U.S.-built David, a patrol, combat command and reconnaissance
armored vehicle that is specifically designed as an urban combat
vehicle.




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




Sales,
Marketing and Customers




Most of
our vehicle armoring business has historically come from Israel, although we
have armored vehicles under contracts for companies operating in Iraq. Our
principal customer at present is the Israeli Ministry of Defense. Other
customers include Israeli and American government


- 5
-


ministries
and agencies, private companies, medical services and private clients. In the
United States, we have armored vehicles for U.S. operations in
Iraq.




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




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




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




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




Manufacturing




Our
manufacturing facilities are located in Lod, Israel, and in Auburn, Alabama. In
Israel we manufacture armored vehicles only, and in the US we manufacture
vehicle armoring, and hard and soft armor.




Our
facilities have been awarded ISO 9001:2000 quality standards
certification.




Competition




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




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




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


- 6
-


Battery
and Power Systems Division




We
manufacture and sell lithium and Zinc-Air batteries for defense and security
products and other military applications through our Battery and Power Systems
Division. During 2007 and 2006, revenues from our Battery and Power Systems
Division were approximately $11.2 million and $8.6 million,
respectively.




Lithium
Batteries and Charging Systems for the Military




Introduction




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




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




We have
added lithium-ion battery production capabilities at EFB’s facility in Auburn.
The goal is to enable U.S.-produced lithium-ion batteries and chargers to be
sold using funding from Foreign Military Funding (FMF) program to countries such
as Israel and Turkey. These products are marketed and designed by Epsilor and
manufactured by EFB.




Competition




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




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




Marketing




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


- 7
-


Manufacturing




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




Zinc-Air
Batteries and Chargers for the Military




Introduction




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




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




Our
Zinc-Air batteries, rechargeable batteries and battery chargers for the military
are manufactured through EFB. In 2003, EFB’s facilities were granted ISO 9001
“Top Quality Standard” certification.




Markets/Applications




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




Customers




The
principal customers for our Zinc-Air batteries during 2007 were the U.S. Army’s
Communications-Electronics Command (CECOM) and the Defense Logistics Agency
(DLA). In addition, we continue to further penetrate Special Forces and other
specific U.S. military units with direct sales.




Competition




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




Zinc-Air
batteries are inherently safer than primary lithium battery packs in storage,
transportation, use, and disposal, and are more cost-effective. They are
lightweight, with up to twice the energy density of primary lithium battery
packs. Zinc-Air batteries for the military are also under development by Rayovac
Corporation. Rayovac’s military Zinc-Air batteries utilize


- 8
-


cylindrical
cells, rather than the prismatic cells that we developed. While cylindrical
cells may provide higher specific power than our prismatic cells, we believe
they will generally have lower energy densities and be more difficult to
manufacture.




The most
popular competing primary battery in use by the US Armed Forces is the
BA-5590/U, which uses lithium-sulfur dioxide (LiSO2) cells.
The largest suppliers of LiSO2 batteries
to the US military are believed to be Saft America Inc. and Eagle Picher
Technologies LLC. The battery compartment of most military communications
equipment, as well as other military equipment, is designed for the XX90 family
of batteries, of which the BA-5590/U battery is the most commonly deployed.
Another primary battery in this family is the BA-5390/U, which uses
lithium-manganese dioxide (LiMnO2) cells.
Suppliers of LiMnO2 batteries
include Ultralife Batteries Inc., Saft and Eagle Picher.




Rechargeable
batteries in the XX90 family include lithium-ion (BB-2590/U) and nickel-metal
hydride (BB-390/U) batteries which may be used in training missions in order to
save the higher costs associated with primary batteries. These rechargeable
batteries are also become more prevalent in combat use as their energy densities
improve, their availability expands and their State-of-Charge Indicator (SOCI)
technologies become more reliable.




Our
BA-8180/U does not fit inside the XX90 battery compartment of any military
equipment, and therefore is connected externally using an interface adapter that
we also sell to the Army. Our battery offers greatly extended mission time,
along with lower total mission cost, and these significant advantages often
greatly outweigh the slight inconvenience of fielding an external
battery.




Manufacturing




EFB
maintains a battery and electronics development and manufacturing facility in
Auburn, Alabama, housed in a 30,000-square-foot light industrial space leased
from the city of Auburn. We also have production capabilities for some battery
components at EFL’s facility in Beit Shemesh, Israel. Both of these facilities
have received ISO 9001 “Top Quality Standard” certification.




Lifejacket
Lights




Products




We have a
product line consisting of seven lifejacket light models, five for use with
marine life jackets and two for use with aviation life vests, all of which work
in both freshwater and seawater. Each of our lifejacket lights is certified for
use by relevant governmental agencies under various U.S. and international
regulations. We manufacture, assemble and package all our lifejacket lights
through EFL in our factory in Beit Shemesh, Israel.




Marketing




We market
our marine safety products through our own network of distributors in Europe,
the United States, Asia and Oceania. We market our lights to the commercial
aviation industry through an independent company that receives a commission on
sales.


- 9
-


Competition




The
largest manufacturer of aviation and marine safety products, including TSO and
SOLAS-approved lifejacket lights, is ACR Electronics Inc. of Hollywood, Florida.
Other significant competitors in the marine market include Daniamant Aps of
Denmark and England, and SIC of Italy.




Backlog




We
generally sell our products under standard purchase orders. Orders constituting
our backlog are subject to changes in delivery schedules and are typically
cancelable by our customers until a specified time prior to the scheduled
delivery date. Accordingly, our backlog is not necessarily an accurate
indication of future sales. As of December 31, 2007 and 2006, our backlog for
the following years was approximately $48.7 million and $41.3 million,
respectively, divided among our divisions as follows:




Division
            
            2007
            
            
            2006Training
      and Simulation Division
            
            $
            21,670,000
            
            
            $
            11,518,000Battery
      and Power Systems Division
            
            
            12,861,000
            
            
            
            9,213,000Armor
      Division
            
            
            14,164,000
            
            
            
            20,582,000TOTAL:
            
            $
            48,695,000
            
            
            $
            41,313,000




Major
Customers




During
2007 and 2006, including all of our divisions, various branches of the United
States military accounted for approximately 52% and 58% of our revenues. See
“Item 1A. Risk Factors – Risks Related to Government Contracts,”
below.




Patents
and Trade Secrets




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




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


- 10
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Research
and Development




During
the years ended December 31, 2007 and 2006, our gross research and product
development expenditures were approximately $1.9 million and $1.6 million,
respectively.




EFL has
certain contingent royalty obligations to the Office of the Chief Scientist of
the Israel Ministry of Industry and Trade and the Israel-U.S. Binational
Industrial Research and Development Foundation (BIRD-F), which apply (in respect
of continuing operations) only to our inactive Electric Vehicle program. As of
December 31, 2007, our total outstanding contingent liability in this connection
was approximately $10.4 million.




Employees




As of
February 29, 2008, we had 407 employees worldwide, most of whom were full-time
employees. Our success will depend in large part on our ability to attract and
retain skilled and experienced employees.




With
respect to those of our employees who are Israeli residents, Israeli law
generally requires severance pay upon the retirement or death of an employee or
termination of employment without due cause; additionally, some of our senior
employees have special severance arrangements, certain of which are described
under “Item 11. Executive Compensation – Employment Contracts,” below. We
currently fund our ongoing severance obligations by making monthly payments to
approved severance funds or insurance policies.




ITEM
      1A.
            RISK
      FACTORS




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




Business-Related
Risks




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




We were
incorporated in 1990 and began our operations in 1991. We have funded our
operations principally from funds raised in each of the initial public offering
of our common stock in February 1994; through subsequent public and private
offerings of our common stock and equity and debt securities convertible or
exercisable into shares of our common stock; research contracts and supply
contracts; funds received under research and development grants from the
Government of Israel; and sales of products that we and our subsidiaries
manufacture. We have incurred significant net losses since our inception.
Additionally, as of December 31, 2007, we had an accumulated deficit of
approximately $161.5 million. In an effort to reduce operating expenses and
maximize available resources, we have consolidated certain of our subsidiaries,
shifted personnel and reassigned responsibilities. We have also taken a variety
of other measures to limit spending and will continue to assess our internal
processes to seek additional cost-structure improvements. Although we believe
that such steps will help to reduce our operating expenses and maximize our
available resources, there can be no assurance that we will ever be able to
achieve or maintain profitability consistently or that our business will
continue to exist.


- 11
-


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




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




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




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




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




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.


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-


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




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




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 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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-


Various
battery technologies are being considered for use in 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, 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.




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


- 14
-


our trade
secrets will not otherwise become known or be independently developed by
competitors.




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




We are
highly dependent on the president of our FAAC subsidiary and the general
managers of our MDT and Epsilor subsidiaries, and the loss of the services of
one or more of these persons could adversely affect us. We are especially
dependent on the services of our Chairman and Chief Executive Officer, Robert S.
Ehrlich, and our President and Chief Operating Officer, Steven Esses. The loss
of either Mr. Ehrlich or Mr. Esses could have a material adverse effect on us.
We are party to an employment agreement with Mr. Ehrlich, which agreement
expires at the end of 2009, and an employment agreement with Mr. Esses, which
agreement expires at the end of 2010. We do not have key-man life insurance on
either Mr. Ehrlich or Mr. Esses.




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 2007 and 2006, 22% and 25%, 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.See also “Israel-Related
Risks,” below.




We do not anticipate paying 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.




Risks
Related to Government Contracts




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




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




Sales to
public sector customers are subject to a multiplicity of detailed regulatory
requirements and public policies as well as to changes in training and
purchasing priorities. Contracts with public sector customers may be conditioned
upon the continuing availability of public funds, which in turn depends upon
lengthy and complex budgetary procedures, and may be subject


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-


to
certain pricing constraints. Moreover, U.S. government contracts and those of
many international government customers may generally be terminated for a
variety of factors when it is in the best interests of the government and
contractors may be suspended or debarred for misconduct at the discretion of the
government. There can be no assurance that these factors or others unique to
government contracts or the loss or suspension of necessary regulatory licenses
will not reduce our revenues and have a material adverse effect on our future
results of operations and financial condition.




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




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




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




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.




We may not be able to receive or retain
the necessary licenses or authorizations required for us to export or re-export
our products, technical data or services, or to transfer technology from foreign
sources (including our own subsidiaries) and to work collaboratively with
them. Denials of such
licenses and authorizations could have a material adverse effect on our business
and results of operations.




U.S. regulations concerning export
controls require us to screen potential customers, destinations, and technology
to ensure that sensitive equipment, technology and services are not exported in
violation of U.S. policy or diverted to improper uses or
users.




In order
for us to export certain products, technical data or services, we are required
to obtain licenses from the U.S. government, often on a
transaction-by-transaction basis. These licenses are generally required for the
export of the military versions of our products and technical data and for
defense services. We cannot be sure of our ability to obtain the U.S. government
licenses or other approvals required to export our products, technical data and
services for sales to foreign governments, foreign commercial customers or
foreign destinations.




In
addition, in order for us to obtain certain technical know-how from foreign
vendors and to collaborate on improvements on such technology with foreign
vendors, including at times our own foreign subsidiaries, we may need to obtain
U.S. government approval for such collaboration through manufacturing license or
technical assistance agreements approved by U.S. government export control
agencies.




The U.S.
government has the right, without notice, to revoke or suspend export licenses
and authorizations for reasons of foreign policy, issues over which we have no
control.




Failure to receive required licenses or
authorizations would hinder our ability to export our products, data and
services and to use some advanced technology from foreign sources. This could
have a material adverse effect on our business, results of operations and
financial condition.




Our
failure to comply with export control rules could have a material adverse effect
on our business.




Our
failure to comply with these rules could expose us to significant criminal or
civil enforcement action by the U.S. government, and a conviction could result
in denial of export privileges, as well as contractual suspension or debarment
under U.S. government contracts, either of


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-


which
could have a material adverse effect on our business, results of operations and
financial condition.




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




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




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




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




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




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




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




Since the
invasion of Iraq by the U.S. and other forces in March 2003, we have received
orders from the U.S. military for armoring of vehicles and military batteries.
These orders are the result, in substantial part, of the particular combat
situations encountered by the U.S. military in


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Iraq. We
cannot be certain to what degree the U.S. military would continue placing orders
for our products if the U.S. military were to reduce its force levels or
withdraw completely from Iraq. A significant reduction in orders from the U.S.
military could have a material adverse effect on our business, financial
condition, results of operations and liquidity.




Market-Related
Risks




The
price of our common stock is volatile.




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




·
            announcements
      by us, our competitors or our
customers;




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




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




·
            rumors
      relating to our competitors or us;




·
            actual
      or anticipated fluctuations in our operating
  results;




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




·
            general
      market or economic conditions.




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




One of
the continued listing standards for our stock on the Nasdaq Stock Market (both
the Nasdaq Global Market, on which our stock is currently listed, and the Nasdaq
Capital Market) is the maintenance of a $1.00 bid price. Our stock price was
below $1.00 between August 15, 2005 and June 20, 2006; however, on June 21,
2006, we effected a one-for-fourteen reverse stock split, which brought the bid
price of our common stock back over $1.00. 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 Global
Market. In addition, we may be unable to satisfy the other continued listing
requirements.




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


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-


willing
to engage in transactions, thereby making it more difficult for our stockholders
to dispose of their shares.




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




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




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




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




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




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


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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. Israel withdrew
unilaterally from the Gaza Strip and certain areas in northern Samaria in 2005.
It is unclear what the long-term effects of such disengagement plan will be. The
election of representatives of the Hamas movement to a majority of seats in the
Palestinian Legislative Council has created additional unrest and
uncertainty.




In July
and August of 2006, Israel was involved in a full-scale armed conflict with
Hezbollah, a Lebanese Islamist Shiite militia group and political party, in
southern Lebanon, which involved missile strikes against civilian targets in
northern Israel that resulted in economic losses. On August 14, 2006, a
ceasefire was declared relating to that armed conflict, although it is uncertain
whether or not the ceasefire will continue to hold.




Continued
hostilities between Israel and its neighbors and any failure to settle the
conflict could 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.




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 29% 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 2007, the inflation adjusted NIS appreciated against
the dollar.


- 21
-


ITEM
      1B.
            UNRESOLVED
      STAFF COMMENTS




None.




ITEM
      2.
            PROPERTIES




Our
primary executive offices are located in FAAC’s offices, consisting of
approximately 17,300 square feet of office and warehouse space in Ann Arbor,
Michigan, pursuant to a lease expiring in January 2013. FAAC has also leased
approximately 17,200 square feet of office and warehouse space in Ann Arbor,
Michigan pursuant to a lease beginning in June 2006 and expiring in April 2013,
which includes a new addition of approximately 6,300 square feet that is
currently under construction. Additionally, FAAC is renting approximately 6,600
square feet in a separate building, on a month to month basis, until
construction on the addition is completed, and FAAC, through its subsidiary
Realtime Technologies, Inc., acquired at the beginning of 2008, rents
approximately 800 square feet in Lafayette, Colorado pursuant to a lease
terminating at the end of November 2008, and approximately 3,900 square feet in
Royal Oak, Michigan pursuant to a lease terminating at the end of April
2009.




EFB, MDT
Armor and AoA all operate out of our Auburn, Alabama facilities, constituting
approximately 30,000 square feet, which is leased from the City of Auburn
through December 2008. Additionally, we have purchased 16,700 square feet of
space in Auburn for approximately $1.1 million pursuant to a seller-financed
secured purchase money mortgage. Half the mortgage is payable over ten years in
equal monthly installments based on a 20-year amortization of the full principal
amount, and the remaining half is payable at the end of ten years in a balloon
payment.




Our
management and administrative facilities and research, development and
production facilities for the manufacture and assembly of our Survivor Locator
Lights, constituting approximately 18,300 square feet, are located in Beit
Shemesh, Israel, located between Jerusalem and Tel-Aviv (within Israel’s
pre-1967 borders). The lease for these facilities in Israel expires on December
31, 2017; we have the ability to terminate the lease upon three months’ written
notice at the end of November 2009 and 2013. Most of the members of our senior
management, including our Chief Executive Officer and our Chief Operating
Officer, work extensively out of our Beit Shemesh facility. Our Chief Financial
Officer works out of our Ann Arbor, Michigan facility.




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




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




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


- 22
-


ITEM
      3.
            LEGAL
      PROCEEDINGS




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




NAVAIR
Litigation




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




Class
Action Litigation




In May
2007, two purported class action complaints (the “Complaint”) were filed in the
United States District Court for the Eastern District of New York against us and
certain of our officers and directors. These two cases were consolidated in June
2007. A similar case filed in the United States District Court for the Eastern
District of Michigan in March 2007 was withdrawn by the plaintiff in June 2007.
The Complaint seeks class status on behalf of all persons who purchased our
securities between November 9, 2004 and November 14, 2005 (the “Period”) and
alleges violations by us and certain of our officers and directors of Sections
10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5
thereunder, primarily related to our acquisition of Armour of America in 2005
and certain public statements made by us with respect to our business and
prospects during the Period. The Complaint also alleges that we did not have
adequate systems of internal operational or financial controls, and that our
financial statements and reports were not prepared in accordance with GAAP and
SEC rules. The Complaint seeks an unspecified amount of damages. A lead
plaintiff has been named, and the plaintiff’s consolidated amended complaint was
filed in September 2007. Our motion to dismiss was filed in November 2007, but a
decision on our motion is not expected until mid-2008.




Although
the ultimate outcome of this matter cannot be determined with certainty, we
believe that the allegations stated in the Complaint are without merit and we
and our officers and directors named in the Complaint intend to defend ourselves
vigorously against such allegations.




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




None.


- 23
-




PART
II




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




Our
common stock is traded on the Nasdaq Global Market (formerly known as the Nasdaq
National Market) and, since September 2007, on the Tel-Aviv Stock Exchange (the
“TASE”). Our Nasdaq and TASE ticker symbol is “ARTX.” The following table sets
forth, for the periods indicated, the range of high and low sales prices of our
common stock on the Nasdaq Global/National Market System; such prices have been
adjusted to reflect the one-for-fourteen reverse stock split effected on June
21, 2006:




Year Ended December 31,
2007
            
            High
            
            
            LowFourth
      Quarter
            
            $
            3.63
            
            
            $
            1.94Third
      Quarter
            
            $
            3.70
            
            
            $
            2.52Second
      Quarter
            
            $
            3.73
            
            
            $
            2.15First
      Quarter
            
            $
            4.87
            
            
            $
            3.03Year Ended December 31,
2006
            
            High
            
            
            LowFourth
      Quarter
            
            $
            3.69
            
            
            $
            1.43Third
      Quarter
            
            $
            3.92
            
            
            $
            1.88Second
      Quarter
            
            $
            8.12
            
            
            $
            2.25First
      Quarter
            
            $
            8.96
            
            
            $
            5.18




As of
February 29, 2008 we had approximately 327 holders of record of our common
stock.




Dividends




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




ITEM
      6.
            SELECTED
      FINANCIAL DATA




Not
applicable.




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




The
following Management’s Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that involve inherent
risks and uncertainties. When used in this discussion, the words “believes,”
“anticipated,” “expects,” “estimates” and similar expressions are intended to
identify such forward-looking statements. Such statements are subject to certain
risks and uncertainties that could cause actual results to differ materially
from those projected. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date hereof. We undertake
no obligation to publicly release the result of any revisions to these
forward-looking statements that may be made to reflect events or circumstances
after the date hereof or to reflect the occurrence of un


- 24
-





anticipated
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,” above, and in our other filings with the Securities and Exchange
Commission.




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




General




We are a
defense and security products and services company, engaged in three business
areas: interactive simulation for military, law enforcement and commercial
markets; batteries and charging systems for the military; and high-level
armoring for military, paramilitary and commercial vehicles. We operate in three
business units:




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




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




Ø
            we
      develop, manufacture and market primary Zinc-Air batteries, rechargeable
      batteries and battery chargers for defense and security products and other
      military applications (our Battery and
      Power Systems Division).




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.


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-


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.




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.


- 26
-


Stock
Based Compensation




We
account for stock options and awards issued to employees in accordance with the
fair value recognition provisions of Financial Accounting Standards Board
(“FASB”) Statement No. 123(R) (“SFAS No. 123(R)”), “Share-Based Payment,” using
the modified prospective transition method. Under SFAS No. 123(R), stock-based
awards to employees are required to be recognized as compensation expense, based
on the calculated fair value on the date of grant. We determine the fair value
using the Black Scholes option pricing model. This model requires subjective
assumptions, including future stock price volatility and expected term, which
affect the calculated values.




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. We 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. We do not provide for
U.S. federal income taxes on the undistributed earnings of our foreign
subsidiaries because such earnings are re-invested and, in the opinion of
management, will continue to be re-invested indefinitely.


- 27
-


On
January 1, 2007, we adopted the provisions of the Financial Accounting Standards
Board Interpretation No.48, Accounting for Uncertainty in Income Taxes (“FIN
48”), an interpretation of Statement 109. FIN 48 prescribes a recognition
threshold and measurement attribute for the financial statement recognition and
measurement of a tax position taken in a tax return. We must determine whether
it is “more-likely-than-not” that a tax position will be sustained upon
examination, including resolution of any related appeals or litigation
processes, based on the technical merits of the position. Once it is determined
that a position meets the more-likely-than-not recognition threshold, the
position is measured to determine the amount of benefit to recognize in the
financial statements. FIN 48 applies to all tax positions related to income
taxes subject to Statement 109. Uncertain tax positions require determinations
and estimated liabilities to be made based on provisions of the tax law which
may be subject to change or varying interpretation.  If our determinations
and estimates prove to be inaccurate, the resulting adjustments could be
material to its future financial results.  Based on the analysis
performed, we did not record any unrecognized tax positions as of
December 31, 2007.




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 2007, 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.




We
determine fair value using a 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


- 28
-


expectations.
In assessing the recoverability of our goodwill, we may be required to make
assumptions regarding estimated future cash flows and other factors to determine
the fair value of the respective assets. This process is subjective and requires
judgment at many points throughout the analysis. If our estimates or their
related assumptions change in subsequent periods or if actual cash flows are
below our estimates, we may be required to record impairment charges for these
assets not previously recorded.




Other
Intangible Assets




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




The
determination of the value of such intangible assets requires us to make
assumptions regarding future business conditions and operating results in order
to estimate future cash flows and other factors to determine the fair value of
the respective assets. If these estimates or the related assumptions change in
the future, we could be required to record additional impairment
charges.




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


- 29
-


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 stockholders’
equity.




Recent
Developments




Purchase
of the Minority Interest in MDT Israel and MDT Armor




In
January 2008, we purchased the minority shareholder’s 24.5% interest in MDT
Israel and the 12.0% interest in MDT Armor, as well as settling all outstanding
disputes regarding severance payments, in exchange for a total of $1.0 million.
We are currently evaluating the impact of this transaction on our first quarter
2008 financial statements.




Purchase
of Realtime Technologies, Inc.




In
February 2008 our FAAC subsidiary acquired Realtime Technologies, Inc. (RTI), a
privately-owned corporation headquartered in Royal Oak, Michigan, close to the
headquarters of the rest of our Training and Simulation Division, for a total of
$1,350,000 ($1,250,000 in cash and $100,000 in stock) with a 2008 earn-out
(maximum of $250,000) based on 2008 net profit. Since its founding in 1998, RTI
has specialized in multi-body vehicle dynamics modeling and graphical simulation
solutions. RTI offers simulation software applications, consulting services,
custom engineering solutions, and software and hardware
development.




AoA
Arbitration




In
connection with our acquisition of AoA, we had a contingent earnout obligation
in an amount equal to the revenues AoA realized from certain specific programs
that were identified by us and the seller of AoA (“Seller”) as appropriate
targets for revenue increases. As of December 31, 2006, we had reduced the $3.0
million escrow held by the Seller by $1,520,174 for a putative claim against
such escrow in respect of such earn-out obligation.




On March
20, 2007, we filed a Demand for Arbitration with the American Arbitration
Association against the Seller. In our demand, we sought the return of $3.0
million, plus interest, held in escrow by the Seller in connection with his sale
of AoA to us in 2004. The Seller asserted counterclaims against us in the
arbitration, alleging (i) that he is entitled to keep the $3.0 million, (ii)
that he is entitled to an additional $3.0 million in post-sale earnouts, and
(iii) that he is entitled to $70,000 in compensation (plus interest and
statutory penalties) wrongfully withheld by us when we constructively terminated
his employment.




In
February 2008, the arbitration panel issued a decision denying the Seller’s
counterclaims (i) and (ii) above, granting the Seller’s counterclaim for $70,000
in compensation, awarding us the entire $3.0 million escrow (less the $70,000 in
compensation (with simple interest but


- 30
-


without
statutory penalties)), and awarding us $135,000 in attorneys’ fees. The time for
the Seller to move to vacate or modify this award has not yet
expired.




Executive
Summary




Overview
of Results of Operations




We
incurred significant operating losses for the years ended December 31, 2007 and
2006. 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.




A portion
of our operating loss during 2007 and 2006 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. To the extent that
we continue certain of these activities during 2008, we would expect to continue
to incur such non-cash charges in the future.




Acquisitions




In
acquisition of subsidiaries, part of the purchase price is allocated to
intangible assets and goodwill. Amortization of intangible assets related to
acquisition of subsidiaries is recorded based on the estimated expected life of
the assets. Accordingly, for a period of time following an acquisition, we incur
a non-cash charge related to amortization of intangible assets in the amount of
a fraction (based on the useful life of the intangible assets) of the amount
recorded as intangible assets. Such amortization charges continued during 2007.
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 in 2007 and 2006 in the amount of
$1.4 million and $1.9 million, respectively.




Financings
and Issuances of Restricted Shares, Options and Warrants




The
non-cash charges that relate to our financings occurred in connection with our
issuance of convertible securities with warrants, and in connection with our
repricing of certain warrants and grants of new warrants. When we issue
convertible securities, 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
securities, we record debt discount for financial expenses that is amortized
ratably over the term of the convertible securities; when the


- 31
-


convertible
securities are converted, the entire remaining unamortized debt discount is
immediately recognized in the quarter in which the convertible securities are
converted.




During
2007 and 2006, we issued restricted shares to certain of our employees. These
shares were issued as stock bonuses, and are restricted for a period of up to
three years from the date of issuance. Relevant accounting rules provide that
the aggregate amount of the difference between the purchase price of the
restricted shares (in this case, generally zero) and the market price of the
shares on the date of grant is taken as a general and administrative expense,
amortized over the life of the period of the restriction.




As a
result of the application of the above accounting rules, we incurred non-cash
charges related to stock-based compensation in 2007 and 2006 in the amount of
$1,332,000 and $360,000, respectively.




As a
result of options granted to employeesand the adoption of
Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based
Payments,” we incurred non-cash charges related to stock-based compensation in
2007 and 2006 in the amount of $86,000 and $141,000, respectively.




As part
of the repricings and exercises of warrants described in Note 13 of the Notes to
Consolidated Financial Statements, we issued warrants to purchase up to 298,221
shares of common stock. Since the terms of these warrants provided that the
warrants were exercisable subject to our obtaining stockholder 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,” the fair value of the warrants was recorded as a liability at the
closing date. Such fair value was remeasured at each subsequent cut-off date
until we obtained stockholder approval. The fair value of these warrants was
remeasured as at June 19, 2006 (the date of the stockholder approval) using the
Black-Scholes pricing model assuming a risk free interest rate of 5.00%, a
volatility factor of 72%, dividend yields of 0% and a contractual life of
approximately 1.78 years. The change in the fair value of the warrants between
the date of the grant and June 19, 2006 in the amount of $700,000 has been
recorded as finance income.




Under the
terms of our convertible notes, which have been paid in full, we had the option
in respect of scheduled principal repayments to force conversion of the payment
amount at a conversion price based upon the weighted average trading price of
our common stock during the 20 trading days prior to the conversion, less a
discount of 8%.




On April
7, 2006, we and each holder of our convertible notes agreed that we would force
immediate conversion of an aggregate of $6,148,904 principal amount of the
convertible notes into 1,098,019 shares of our common stock. The amount
converted eliminated our obligation to make the installment payments under the
convertible notes on each of March 31, 2008, January 31, 2008, November 30, 2007
and September 30, 2007 (aggregating a total of $5,833,333). In addition, as a
result of the conversion an additional $315,570 was applied against part of the
installment payment due July 31, 2007. After giving effect to the conversion,
$8,434,430 of principal remained outstanding under the convertible
notes.


- 32
-


During
the remainder of 2006, we converted $1,458,333 of principal remaining
outstanding under our convertible notes by forcing conversion of this principal
amount into 526,444 shares of or common stock. During 2007, we converted the
remaining $6,976,097 of principal remaining outstanding under our convertible
notes by forcing conversion of this principal amount into 930,125 shares of our
common stock.




Additionally,
in an effort to improve our cash situation and our shareholders’ equity, we have
periodically induced holders of certain of our warrants to exercise their
warrants by lowering the exercise price of the warrants in exchange for
immediate exercise of such warrants, and by issuing to such investors new
warrants. Under such circumstances, we record a deemed dividend in an amount
determined based upon the fair value of the new warrants (using the
Black-Scholes pricing model). As and to the extent that we engage in similar
warrant repricings and issuances in the future, we would incur similar non-cash
charges.




During
2007 and 2006, the Company recorded expenses of $19,000 and $1.5 million,
respectively, attributable to amortization related to warrants issued to the
holders of convertible debentures and the beneficial conversion feature. During
2007 and 2006, the Company also recorded expenses of $280,000 and $5.4 million,
respectively, attributable to financial expenses in connection with convertible
debenture principle repayment. Additionally, during 2007 and 2006, the Company
recorded expenses of $44,000 and $781,000, respectively, attributable to
amortization of deferred charges related to convertible debentures issuance that
were recorded as a general and administrative expense.




Overview
of Operating Performance and Backlog




Overall,
our net loss before minority interest earnings, earnings from an affiliated
company and tax expenses for 2007 was $2.8 million on revenues of $57.7 million,
compared to a net loss of $15.7 million on revenues of $43.1 million during
2006. As of December 31, 2007, our overall backlog totaled $48.7
million.




In our
Training and Simulation Division, revenues increased from approximately $22.0
million in 2006 to $27.8 million in 2007. As of December 31, 2007, our backlog
for our Training and Simulation Division totaled $21.7 million.




In our
Battery and Power Systems Division, revenues increased from approximately $8.6
million in 2006 to approximately $11.2 million in 2007. As of December 31, 2007,
our backlog for our Battery and Power Systems Division totaled $12.9
million.




In
our Armor Division, revenues increased from approximately $12.6 million in 2006
to approximately $18.7 million in 2007. As of December 31, 2007, our backlog for
our Armor Division totaled $14.1 million.




Results
of Operations




Preliminary
Note




Summary




Following
is a table summarizing our results of operations for the years ended December
31, 2007 and 2006, after which we present a narrative discussion and
analysis:


- 33
-




Year
      Ended December 31,2007
            
            
            2006Revenues:Training
      and Simulation Division
            
            $
            27,760,858
            
            
            $
            21,951,337Armor
      Division
            
            
            18,724,107
            
            
            
            12,571,779Battery
      and Power Systems Division
            
            
            11,234,596
            
            
            
            8,597,623$
            57,719,561
            
            
            $
            43,120,739Cost
      of revenues:Training
      and Simulation Division
            
            $
            15,528,023
            
            
            $
            14,196,298Armor
      Division
            
            
            15,906,071
            
            
            
            12,299,756Battery
      and Power Systems Division
            
            
            8,205,718
            
            
            
            5,997,592$
            39,639,812
            
            
            $
            32,493,646Research
      and development expenses:Training
      and Simulation Division
            
            $
            629,430
            
            
            $
            308,738Armor
      Division
            
            
            115,500
            
            
            
            20,546Battery
      and Power Systems Division
            
            
            1,132,233
            
            
            
            1,272,170$
            1,877,163
            
            
            $
            1,601,454Sales
      and marketing expenses:Training
      and Simulation Division
            
            $
            2,956,995
            
            
            $
            2,514,981Armor
      Division
            
            
            634,237
            
            
            
            366,923Battery
      and Power Systems Division
            
            
            570,768
            
            
            
            656,604All
      Other
            
            
            2,464
            
            
            
            175,814$
            4,164,464
            
            
            $
            3,714,322General
      and administrative expenses:Training
      and Simulation Division
            
            $
            3,400,013
            
            
            $
            2,562,868Armor
      Division
            
            
            1,295,079
            
            
            
            1,031,333Battery
      and Power Systems Division
            
            
            1,658,968
            
            
            
            994,136All
      Other
            
            
            6,804,237
            
            
            
            7,104,479$
            13,158,297
            
            
            $
            11,692,816Other
      income:Training
      and Simulation Division
            
            $
            122,934
            
            
            $
            361,560Armor
      Division
            
            
            152,206
            
            
            
            –All
      Other
            
            
            342,812
            
            
            
            –$
            617,952
            
            
            $
            361,560Financial
      expense (income):Training
      and Simulation Division
            
            $
            14,610
            
            
            $
            (129,908
            )Armor
      Division
            
            
            93,292
            
            
            
            54,476Battery
      and Power Systems Division
            
            
            176,834
            
            
            
            (50,590
            )All
      Other
            
            
            621,152
            
            
            
            7,645,922$
            905,888
            
            
            $
            7,519,900Tax
      expenses (credits):Training
      and Simulation Division
            
            $
            69,930
            
            
            $
            49,383Armor
      Division
            
            
            2,639
            
            
            
            –Battery
      and Power Systems Division
            
            
            (120,000
            )
            
            
            182,776All
      Other
            
            $
            163,916
            
            
            $
            232,159Amortization
      of intangible assets:Training
      and Simulation Division
            
            $
            776,736
            
            
            $
            1,049,136Armor
      Division
            
            
            95,907
            
            
            
            295,067Battery
      and Power Systems Division
            
            
            509,239
            
            
            
            509,239$
            1,381,882
            
            
            $
            1,853,442Impairment
      of goodwill and other intangible assets:Armor
      Division
            
            
            –
            
            
            
            316,024$
            –
            
            
            $
            316,024Gain  (loss)
      from affiliated company:Training
      and Simulation Division
            
            $
            (40,230
            )
            
            $
            354,898$
            (40,230
            )
            
            $
            354,898Minority
      interest in loss (profit) of subsidiaries:Armor
      Division
            
            
            (62,296
            )
            
            
            17,407$
            (62,296
            )
            
            $
            17,407Net
      income (loss):Training
      and Simulation Division
            
            $
            4,467,825
            
            
            $
            2,116,299Armor
      Division
            
            
            671,292
            
            
            
            (1,794,939
            )Battery
      and Power Systems Division
            
            
            (990,511
            )
            
            
            (964,304
            )All
      Other
            
            
            (7,205,041
            )
            
            
            (14,926,215
            )$
            (3,056,435
            )
            
            $
            (15,569,159
            )


- 34
-




Fiscal
Year 2007 compared to Fiscal Year 2006




Revenues.During 2007, we (through our
subsidiaries) recognized revenues as follows:




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




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




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




Ø
            EFL
      recognized revenues from the sale of water-activated battery (WAB)
      lifejacket lights.




Revenues
for 2007 totaled $57.7 million, compared to $43.1 million in 2006, an increase
of $14.6 million, or 33.9%. This increase was primarily attributable to the
following factors:




Ø
            Increased
      revenues from our Training and Simulation Division ($5.8 million more in
      2007 versus 2006).




Ø
            Increased
      revenues from our Battery and Power Systems Division ($2.6 million more in
      2007 versus 2006).




Ø
            Increased
      revenues from our Armor Division ($6.2 million more in 2007 versus
      2006).




In 2007,
revenues were $27.8 million for the Training and Simulation Division (compared
to $22.0 million in 2006,an increase of $5.8
million, or 26.5%,due primarily to
increased sales of military vehicle simulators and use of force simulators);
$11.2 million for the Battery and Power Systems Division (compared to $8.6
million in 2006,an
increase of $2.6 million, or 30.7%, due primarily to increased sales of our
battery products at Epsilor and EFB); and $18.7 million for the Armor Division
(compared to $12.6 million in 2006,an increase of $6.2
million, or 48.9%,due primarily to
increased revenues from MDT and MDT Armor, mostly in respect of orders for the
“David” Armored Vehicle).


- 35
-


Cost of
revenues.Cost of revenues totaled
$39.6 million during 2007, compared to $32.5 million in 2006,an increase of $7.1
million, or 22.0%,due primarily to
increased sales in all divisions, particularly in the production of the “David”
Armored Vehicle in our Armor Division, which accounted for over $2.0 million of
the increase. Total cost of revenues and cost of revenues as a percentage of
revenue also increased in the Battery and Power Systems Division due to several
factors, primarily the production of new products.




Cost of
revenues for our three divisions during 2007 were $15.5 million for the Training
and Simulation Division (compared to $14.2 million in 2006,an increase of $1.3
million, or 9.4%, due primarily to increased revenues); $8.2 million for the
Battery and Power Systems Division (compared to $6.0 million in 2006,an increase of $2.1
million, or 36.8%, due primarily to increased revenues); and $15.9 million for
the Armor Division (compared to $12.3 million in 2006,an increase of $3.6
million, or 29.3%,due primarily to
production of the “David” Armored Vehicle).




Amortization of
intangible assets. Amortization of intangible
assets totaled $1.4 million in 2007, compared to $1.9 million in 2006, a
decrease of $472,000, or 25.4%, due primarily to completion of the amortization
of certain intangible assets at our FAAC and AoA subsidiaries.




Research and
development expenses. Research and development
expenses for 2007 were $1.9 million, compared to $1.6 million during 2006, an
increase of $276,000, or 17.2%, due primarily to an increase in expenses at FAAC
for expenses associated with the improvements to our simulator
products.




Selling and
marketing expenses. Selling and marketing
expenses for 2007 were $4.2 million, compared to $3.7 million 2006, an increase
of $450,000, or 12.1%. This increase was primarily attributable to the overall
increase in revenues and their associated sales and marketing expenses in our
Training and Simulation Division and Armor Division, partially offset by a
reduction in expense in our Battery and Power Systems Division.




General and
administrative expenses. General and administrative
expenses for 2007 were $13.2 million, compared to $11.7 million in 2006, an
increase of $1.5 million, or 12.5%. This increase was primarily attributable to
additional expenses in all three operating divisions, partially offset by a
reduction in corporate expenses.




Financial
expenses, net.
Financial expenses totaled approximately $900,000 in 2007 compared to $7.5
million in 2006, a decrease of $6.6 million, or 88.0%. The difference was due
primarily to decreased interest related to our convertible notes that were
issued in September 30, 2006 as a result of payments of principal during 2006,
and financial expenses in 2006 related to repayment by forced conversion of our
convertible notes at an 8% discount to average market price as provided under
the terms of the convertible notes that did not occur to the same extent in
2007.




Income
taxes.We
and certain of our subsidiaries incurred net operating losses during 2007 and,
accordingly, no provision for income taxes was for these losses recorded. With
respect to some of our subsidiaries that operated at a net profit during 2007,
we were able to offset federal taxes against our accumulated loss carry forward.
We recorded a total of $164,000 in tax expenses in 2007, compared to $232,000 in
tax expenses in 2006, mainly due to state taxes. We also
set up a tax liability for the impact of the deductions taken for good will
amounted to $120,000 in 2007.  We also adjusted the 2006 accumulated
deficit in the amount of $900,000 to correct the balances in prior
years.


- 36
-


Impairment of
goodwill and other intangible assets. Current accounting standards
require us to test goodwill for impairment at least annually, and between annual
tests in certain circumstances; when we determine goodwill is impaired, it must
be written down, rather than being amortized as previous accounting standards
required. Goodwill is tested for impairment by comparing the fair value of our
reportable units with their carrying value. Fair value is determined using
discounted cash flows. Significant estimates used in the methodologies include
estimates of future cash flows, future short-term and long-term growth rates,
weighted average cost of capital and estimates of market multiples for the
reportable units. We performed the required annual impairment test of goodwill,
based on our management’s projections and using expected future discounted
operating cash flows. We did not identify any impairment of goodwill during
2007. In the corresponding period of 2006, we identified in AoA an impairment of
goodwill in the amount of $316,000.




Net loss.
Due to the factors cited above, net loss from operations decreased from $15.6
million in 2006 to $3.1 million in 2007, an improvement of $12.7 million, or
81.1%. (Net loss attributable to common stockholders was $16.0 million in 2006,
due to a deemed dividend that was recorded in the amount of $434,000 in 2006 due
to the repricing of existing warrants and the issuance of new
warrants.)




Liquidity
and Capital Resources




As of
December 31, 2007, we had $3.4 million in cash, $320,000 in restricted
collateral securities, $1.5 million in an escrow receivable and $47,000 in
available-for-sale marketable securities, as compared to at December 31, 2006,
when we had $2.4 million in cash, $649,000 in restricted collateral securities,
$1.4 million in an escrow receivable and $41,000 in available-for-sale
marketable securities. We also had $2.9 million available in unused bank lines
of credit, including funds drawn under a $7.5 million line of credit in favor of
our FAAC subsidiary, which line of credit is secured by our assets and the
assets of our other subsidiaries and guaranteed by us and our other
subsidiaries.




We used
available funds in 2007 primarily for sales and marketing, continued research
and development expenditures, and other working capital needs. We increased our
investment in fixed assets (including the purchase of two buildings in Alabama)
by $2.8 million during the year ended December 31, 2007. Our net fixed assets
amounted to $5.1 million as at year end.




Net cash
provided by (used in) operating activities for 2007 and 2006 was $1.4 million
and $(3.6) million, respectively, an increase of $5.0 million, due primarily to
the reduction of our net loss in 2007, offset in part by an increase in our
accounts receivable.




Net cash
used in investing activities for 2007 and 2006 was $1.6 million and $487,000,
respectively. This increase was primarily the result of the purchase of fixed
assets along with the payment of promissory notes in respect of an arbitration
settlement related to the acquisition of FAAC.




Net cash
provided by financing activities for 2007 and 2006 was $1.1 million and
$452,000, respectively, an increase of $1.9 million. This increase was primarily
due to an increase in long term debt.


- 37
-


As of
December 31, 2007, we had (based on the contractual amount of the debt and not
on the accounting valuation of the debt, not taking into consideration trade
payables, other accounts payables and accrued severance pay) approximately $4.6
million in bank debt outstanding.




Subject
to all of the reservations regarding “forward-looking statements” set forth
above, we believe that our present cash position, anticipated cash flows from
operations and lines of credit should be sufficient to satisfy our current
estimated cash requirements through the remainder of the year. In this
connection, we note that from time to time our working capital needs are
partially dependent on our subsidiaries’ lines of credit. In the event that we
are unable to continue to make use of our subsidiaries’ lines of credit for
working capital on economically feasible terms, our business, operating results
and financial condition could be adversely affected.




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, 2007 and 2006, 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 2007, we were able to offset federal taxes against our net
operating loss carryforward, which amounted to approximately $7.2 million as of
December 31, 2007. 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 2007,
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
29% in 2007 (less, in the case of companies that have “approved enterprise”
status as discussed in Note 14.b. to the Notes to Financial Statements). We also
set up a tax liability for the impact of the deductions taken for
goodwill.




As of
December 31, 2007, we had a U.S. net operating loss carryforward of
approximately $7.2 million that is available to offset future taxable income
under certain circumstances, expiring primarily from 2009 through 2026, and
foreign net operating and capital loss carryforwards of approximately $106
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, 2007, not including trade payables and other accounts payable:




- 38
-




Payment
      Due by PeriodContractual
      Obligations
              
              Total
              
              
              Less
      Than 1 Year
              
              
              1-3
      Years
              
              
              3-5
      Years
              
              
              More
      than 5 YearsLong-term
      debt
              
              $
              1,192,342
              
              
              $
              103,844
              
              
              $
              72,182
              
              
              $
              66,215
              
              
              $
              950,101Short-term
      debt*
              
              $
              4,557,890
              
              
              $
              4,557,890
              
              
              $
              –
              
              
              $
              –
              
              
              $
              –Promissory
      note due to purchase of subsidiaries
              
              $
              151,450
              
              
              $
              151,450
              
              
              $
              –
              
              
              $
              –
              
              
              $
              –Operating
      lease obligations**
              
              $
              4,302,191
              
              
              $
              637,760
              
              
              $
              997,535
              
              
              $
              1,021,224
              
              
              $
              1,645,672Capital
      lease obligations
              
              $
              154,532
              
              
              $
              67,543
              
              
              $
              72,411
              
              
              $
              14,578
              
              
              $
              –Severance
      obligations***
              
              $
              4,853,231
              
              
              $
              –
              
              
              $
              4,853,231
              
              
              $
              –
              
              
              $
              –







*
            Primarily
      in short-term bank debt.


**
            Includes
      operating lease obligations related to
rent.


***
            Includes
      obligations related to special severance pay arrangements in addition to
      the severance amounts due to certain employees pursuant to Israeli
      severance pay law (the amount shown in the table above with payment due
      during the next 1-3 years might not be paid in the period stated in the
      event the employment agreements to which such severance obligations relate
      are extended).





ITEM
      8.
            FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA


Index
to Financial Statements




PageConsolidated Financial
      StatementsReport
      of Independent Registered Public Accounting Firm
            F-1Consolidated
      Balance Sheets
            F-2Consolidated
      Statements of Operations
            F-4Statements
      of Changes in Stockholders’ Equity
            F-5Consolidated
      Statements of Cash Flows
            F-7Notes
      to Consolidated Financial Statements
            F-9Financial Statement
      ScheduleSchedule
      II – Valuation and Qualifying Accounts
            F-45




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




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




Effective
as of June 20, 2006, BDO Seidman, LLP replaced Kost, Forer, Gabbay and Kasierer,
a member of Ernst & Young Global, as our independent registered public
accounting firm. This change was reported in a Current Report on Form 8-K filed
on June 26, 2006. There have been no disagreements with accountants on any
matter of accounting principles or financial disclosure required to be reported
under this Item.




ITEM
      9A.
            CONTROLS
      AND PROCEDURES




Evaluation
of Disclosure Controls and Procedures




As of
December 31, 2007, 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


- 39
-


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




Based on
their evaluation as of December 31, 2007, our principal executive officer and
principal financial officer were able to conclude that our disclosure controls
and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934) were 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.




We will
continue to review and evaluate the design and effectiveness of our disclosure
controls and procedures on an ongoing basis and to improve our controls and
procedures over time and correct any deficiencies that we may discover in the
future. Our goal is to ensure that our senior management has timely access to
all material financial and non-financial information concerning our business.
While we believe the present design of our disclosure controls and procedures is
effective to achieve our goal, future events affecting our business may cause us
to modify our disclosure controls and procedures.




Management’s
Report on Internal Control Over Financial Reporting




Our
management, including our principal executive and financial officers, is
responsible for establishing and maintaining adequate internal control over our
financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our
management has evaluated the effectiveness of our internal controls as of the
end of the period covered by this Annual Report on Form 10-K for the year ended
December 31, 2007. 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.




Based on
management’s assessment and these criteria, our management concluded that our
internal control over financial reporting was effective as of December 31,
2007.




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


- 40
-


Changes
in Internal Controls Over Financial Reporting




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




ITEM
      9B.
            OTHER
      INFORMATION




None.


- 41
-


PART
III




ITEM
      10.
            DIRECTORS
      AND EXECUTIVE OFFICERS OF THE
REGISTRANT




Executive
Officers, Directors and Significant Employees




Executive
Officers and Directors




Our
executive officers and directors and their ages as of February 29, 2008 were as
follows:




Name
            
            Age
            
            PositionRobert
      S. Ehrlich
            
            69
            
            Chairman
      of the Board and Chief Executive OfficerSteven
      Esses
            
            44
            
            President,
      Chief Operating Officer and DirectorThomas
      J. Paup
            
            59
            
            Vice
      President – Finance and Chief Financial OfficerDr.
      Jay M. Eastman
            
            59
            
            DirectorJack
      E. Rosenfeld
            
            69
            
            DirectorLawrence M. Miller
            
            61
            
            DirectorEdward
      J. Borey
            
            57
            
            DirectorSeymour
      Jones
            
            76
            
            DirectorElliot
      Sloyer
            
            43
            
            DirectorMichael
      E. Marrus
            
            44
            
            Director




Our
by-laws provide for a board of directors of one or more directors. There are
currently nine directors. Under the terms of our certificate of incorporation,
the board of directors is composed of three classes of similar size, each
elected in a different year, so that only one-third of the board of directors is
elected in any single year. Dr. Eastman and Messrs. Esses and Marrus are
designated Class I directors and have been elected for a term expiring in 2009
and until their successors are elected and qualified; Messrs. Rosenfeld and
Miller and Prof. Jones are designated Class II directors elected for a term
expiring in 2008 and until their successors are elected and qualified; and
Messrs. Ehrlich, Borey and Sloyer are designated Class III directors elected for
a term that expires in 2010 and until their successors are elected and
qualified. A majority of the Board is “independent” under relevant SEC and
Nasdaq regulations.




Robert S. Ehrlichhas been our
Chairman of the Board since January 1993 and our President and Chief Executive
Officer since October 2002. In December 2005, Mr. Ehrlich ceased to hold the
title of President. From May 1991 until January 1993, Mr. Ehrlich was our Vice
Chairman of the Board, from May 1991 until October 2002, he was our Chief
Financial Officer, and from October 2002 until December 2005, Mr. Ehrlich also
held the title of President. Mr. Ehrlich was a director of Eldat, Ltd., an
Israeli manufacturer of electronic shelf labels, from June 1999 to August 2003.
From 1987 to June 2003, Mr. Ehrlich served as a director of PSC Inc. (“PSCX”), a
manufacturer and marketer of laser diode bar code scanners, and, between April
1997 and June 2003, Mr. Ehrlich was the chairman of the board of PSCX. Mr.
Ehrlich received a B.S. and J.D. from Columbia University in New York, New
York.


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-


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




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




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




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




Lawrence M. Millerhas served
as a director since November 1996. Mr. Miller has been a senior partner in the
Washington D.C. law firm of Schwartz, Woods and Miller since 1990.
He


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-


served
from August 1993 through May 1996 as a member of the board of directors of The
Phoenix Resource Companies, Inc., a publicly traded energy exploration and
production company, and as a member of the Audit and Compensation Committee of
that board. That company was merged into Apache Corporation in May 1996. Mr.
Miller holds a B.A. from Dickinson College in Carlisle, Pennsylvania and a J.D.
with honors from George Washington University in Washington, D.C. He is a member
of the District of Columbia bar.




Edward J. Borey has served as
a director since December 2003. From July 2004 until October 2006, Mr. Borey
served as Chairman and Chief Executive Officer of WatchGuard Technologies, Inc.,
a leading provider of network security solutions (NasdaqGM: WGRD). From December
2000 to September 2003, Mr. Borey served as President, Chief Executive Officer
and a director of PSCX. Prior to joining PSCX, Mr. Borey was President and
CEO of TranSenda (May 2000 to December 2000). Previously,
Mr. Borey held senior positions in the automated data collection industry.
At Intermec Technologies Corporation (1995-1999), he was Executive Vice
President and Chief Operating Officer and also Senior Vice President/General
Manager of the Intermec Media subsidiary. Mr. Borey holds a B.S. in
Economics from the State University of New York, College of Oswego; an M.A. in
Public Administration from the University of Oklahoma; and an M.B.A. in Finance
from Santa Clara University.




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




Elliot Sloyer has served as a
director since October 2007. Mr. Sloyer is a Managing Member of WestLane Capital
Management LLC, which he founded in 2005. From 1992 until 2005, Mr. Sloyer was a
founder and Managing Director of Harbor Capital Management LLC, which managed
convertible arbitrage portfolios. Mr. Sloyer is active in community
organizations and currently serves on the investment committee of a charitable
organization. Mr. Sloyer has a B.A. from New York University.




Michael E. Marrus has served
as a director since October 2007. Mr. Marrus is a Managing Director of C. E.
Unterberg, Towbin, an investment banking firm that was recently acquired by
Collins Stewart plc, a London based corporate broker traded on the London Stock
Exchange. Prior to joining Unterberg, Towbin in 1998, Mr. Marrus was a Principal
and founding member of Fieldstone Private Capital Group, an investment banking
firm specializing in corporate, project and structured finance. Previously, he
was employed at Bankers Trust Company, initially in the Private Equity and
Merchant Banking Groups and subsequently in BT Securities, the
securities


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-


affiliate
of Bankers Trust. Mr. Marrus has an A.B. from Brown University and an M.B.A.
from the Graduate School of Business, University of Chicago.




Committees
of the Board of Directors




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




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




The
Compensation Committee, also created in December 1993, recommends annual
compensation arrangements for the Chief Executive Officer and Chief Financial
Officer and reviews annual compensation arrangements for all officers and
significant employees. The Compensation Committee operates pursuant to a
charter, available through a hyperlink located on the investor relations page of
our website, at http://www.arotech.com/compro/investor.html.
The Compensation Committee consists of Dr. Eastman (Chair) and Messrs. Marrus
and Sloyer, all of whom are independent non-employee directors.




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




The
Nominating Committee, created in March 2003, identifies and proposes
candidates to serve as members of the Board of Directors. Proposed nominees for
membership on the Board of Directors submitted in writing by stockholders to the
Secretary of the Companywill be brought to the attention of the
Nominating Committee. The Nominating Committee consists of Mr. Marrus (Chair),
Mr. Borey and Prof. Jones, all of whom are “independent,” as independence is
defined in Rule 4200(a)(15) of the National Association of Securities Dealers’
listing standards and under Item 7(d)(3)(iv) of Schedule 14A of the proxy rules
under the Exchange Act. The Nominating Committee operates under a formal charter
that governs its duties. The Nominating Committee’s


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-


charter
is publicly available through a hyperlink located on the investor relations page
of our website, at http://www.arotech.com/compro/investor.html.




Code
of Ethics




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




Code
of Conduct




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




Whistleblower
Policy




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




Director
Compensation




Non-employee
members of our Board of Directors are paid a cash retainer of $7,000 (plus
expenses) per quarter, plus $500 per quarter for each committee on which such
outside directors serve. The Chairman of the Audit Committee receives an
additional retainer of $1,500 per quarter, and the Chairman of the Compensation
Committee receives an additional retainer of $1,000 per quarter. No per-meeting
fees are paid. In addition, we have adopted a Non-Employee Director Equity
Compensation Plan, pursuant to which non-employee directors receive an initial
grant of a number of restricted shares having a fair market value on the date of
grant equal to $25,000 upon their election as a director, and an annual grant on
March 31 of each year (beginning with March 31, 2008) of a number of restricted
shares having a fair market value on the date of grant equal to $15,000. Each
grant of restricted stock shall become free of restrictions in three equal
installments on each of the first, second and third anniversaries of the grant,
unless


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the
director resigns from the Board prior to such vesting. Restrictions lapse
automatically in the event of a director being removed for service other than
for cause, or being nominated as a director but failing to be elected, or death,
disability or mandatory retirement. Furthermore, all restrictions lapse prior to
the consummation of a merger or consolidation involving us, our liquidation or
dissolution, any sale of substantially all of our assets or any other
transaction or series of related transactions as a result of which a single
person or several persons acting in concert own a majority of our
then-outstanding common stock.




The
following table shows the compensation earned or received by each of our
non-officer directors for the year ended December 31, 2007:




DIRECTOR
COMPENSATION




Name
            
            Fees
      Earned or Paid in Cash
              ($)
            
            
            Stock
      Awards(1)
              ($)
            
            
            Total
              ($)Dr.
      Jay M. Eastman
            
            $
            29,250
            
            
            $
            15,000
            (2)
            
            $
            44,250Jack
      E. Rosenfeld
            
            $
            30,250
            
            
            $
            15,000
            (3)
            
            $
            45,250Lawrence
      M. Miller
            
            $
            27,750
            
            
            $
            15,000
            (4)
            
            $
            42,750Edward
      J. Borey
            
            $
            28,250
            
            
            $
            15,000
            (5)
            
            $
            43,250Seymour
      Jones
            
            $
            31,250
            
            
            $
            15,000
            (6)
            
            $
            46,250Elliot
      Sloyer
            
            $
            8,000
            
            
            $
            25,000
            (7)
            
            $
            33,000Michael
      E. Marrus
            
            $
            8,000
            
            
            $
            25,000
            (8)
            
            $
            33,000





(1)
            This
      column reflects the compensation cost for the year ended December 31,
      2007 of each director’s restricted stock, calculated in accordance with
      SFAS 123R.


(2)
            As
      of December 31, 2007, Dr. Eastman held 4,934 restricted
      shares of our common stock.


(3)
            As
      of December 31, 2007, Mr. Rosenfeld held 4,934 restricted
      shares of our common stock.


(4)
            As
      of December 31, 2007, Mr. Miller held 4,934 restricted
      shares of our common stock.


(5)
            As
      of December 31, 2007, Mr. Borey held 4,934 restricted
      shares of our common stock.


(6)
            As
      of December 31, 2007, Prof. Jones held 4,934 restricted shares
      of our common stock.


(7)
            As
      of December 31, 2007, Mr. Sloyer held 8,224 restricted shares of
      our common stock.


(8)
            As
      of December 31, 2007, Mr. Marrus held 8,224 restricted shares of
      our common stock.




Significant
Employees




Our
significant employees as of February 29, 2008, and their ages as of December 31,
2007, are as follows:




Name
            
            Age
            
            PositionJonathan
      Whartman
            
            53
            
            President,
      Armor DivisionYaakov
      Har-Oz
            
            50
            
            Senior
      Vice President, General Counsel and SecretaryWilliam
      Graham
            
            48
            
            Vice
      President of Government AffairsNorman
      Johnson
            
            55
            
            ControllerDean
      Krutty
            
            42
            
            President,
      Simulation DivisionRonen
      Badichi
            
            42
            
            President,
      Battery Division




Jonathan Whartman has been
Senior Vice President since December 2000 and President of our Armor Division
since January 2008. Mr. Whartman was Vice President of
Marketing


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-




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




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




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




Norman Johnson has served as
our Controller and as our chief accounting officer since August 2006. Prior to
joining Arotech, Mr. Johnson was the Corporate Controller with Catuity Inc., a
Nasdaq-listed provider of loyalty and gift card solutions. Prior to Catuity, he
was with the McCoig Group, a Detroit based holding company, and from March 2000
to August 2004 he was the Corporate Controller of Learning Care Group Inc., a
$250 million Nasdaq-listed provider of child care and educational services. Mr.
Johnson holds a B.S. in Accounting from Central Michigan University in Mt.
Pleasant, Michigan.




Dean Krutty became President
of the Simulation Division in January 2005, after having spent the prior
thirteen years as a member of the FAAC management team. He began his career at
FAAC as an electrical engineer in FAAC’s part task trainer division and most
recently served as FAAC’s Director of Military Operations,. He also has
significant experience managing programs in the training and simulation
industry. Mr. Krutty holds a B.S. in electrical engineering from the Michigan
State University.




Ronen Badichi became the
General Manager of Epsilor Electronic Industries in May 2005 and the President
of our Battery Division in December 2007. Prior to joining Epsilor, Mr. Badichi
served since 1999 as the General Manager of Maoz Industries, a high
end supplier of displays to the aviation industry. Prior thereto, Mr.
Badichi was a project manager at BAE Systems and served as the F-16 Avionics
Integration manager in the Israeli Air Force, with the rank


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of
Captain. Mr. Badichi holds a B.Sc. in Physics and Electro-Optic Engineering from
the Lev Institute of Technology in Jerusalem.




Section
16(a) Beneficial Ownership Reporting Compliance




Under the
securities laws of the United States, our directors, certain of our officers and
any persons holding more than ten percent of our common stock are required to
report their ownership of our common stock and any changes in that ownership to
the Securities and Exchange Commission. Specific due dates for these reports
have been established and we are required to report any failure to file by these
dates during 2007. We are not aware of any instances during 2007, not previously
disclosed by us, where such “reporting persons” failed to file the required
reports on or before the specified dates, except as follows:




(i)
            Mr.
      Esses was required to file a Form 4 on or prior to January 2, 2008 in
      connection with his receipt of 200,000 shares of restricted stock. He
      reported these transactions in a Form 5 filed on February 14,
      2008.




(ii)
            Mr.
      Paup was required to file a Form 4 on or prior to January 2, 2008 in
      connection with his receipt of 65,000 shares of restricted stock. He
      reported these transactions in a Form 5 filed on February 14,
      2008.




ITEM
      11.
            EXECUTIVE
      COMPENSATION




Cash
and Other Compensation




Summary
Compensation Table




The
following table, which should be read in conjunction with the explanations
provided above, shows the compensation that we paid (or accrued) to our
executive officers during the fiscal years ended December 31, 2007 and
2006:




SUMMARY
COMPENSATION TABLE(1)




Name
      and Principal Position
              
              Year
              
              Salary
                ($)
              
              
              Bonus
                ($)
              
              
              Stock
                Awards(2)
                ($)
              
              
              Option
                Awards
                ($)
              
              
              Non-Equity
                Incentive
      Plan
                Compensation
                ($)
              
              
              All
      Other
                Compensation
                ($)
              
              
              Total
                ($)Robert
      S. Ehrlich
              
              2007
              
              $
              420,110
              
              
              $
              180,000
              
              
              $
              753,783
              
              
              $
              –
              
              
              $
              –
              
              
              $
              221,301
              (3)
              
              $
              1,575,194Chairman,
      Chief Executive Officer and a director
              
              2006
              
              $
              312,173
              
              
              $
              105,000
              
              
              $
              11,467
              
              
              $
              –
              
              
              $
              –
              
              
              $
              483,331
              (4)
              
              $
              911,971Thomas
      J. Paup
              
              2007
              
              $
              143,100
              
              
              $
              71,550
              
              
              $
              138,067
              
              
              $
              –
              
              
              $
              –
              
              
              $
              2,908
              (5)
              
              $
              355,625Vice
      President – Finance and Chief Financial Officer
              
              2006
              
              $
              135,000
              
              
              $
              20,000
              
              
              $
              –
              
              
              $
              –
              
              
              $
              –
              
              
              $
              2,596
              (6)
              
              $
              157,956Steven
      Esses
              
              2007
              
              $
              81,146
              (7)
              
              $
              29,612
              (8)
              
              $
              259,891
              
              
              $
              –
              
              
              $
              –
              
              
              $
              99,012
              (9)
              
              $
              469,661President,
      Chief Operating Officer and a director
              
              2006
              
              $
              62,211
              (10)
              
              $
              116,000
              (11)
              
              $
              5,733
              
              
              $
              –
              
              
              $
              –
              
              
              $
              252,929
              (12)
              
              $
              436,873


(1)
            We
      paid the amounts reported for each named executive officer in U.S. dollars
      and/or New Israeli Shekels (NIS). We have translated amounts paid in NIS
      into U.S. dollars at the exchange rate of NIS into U.S. dollars at the
      time of payment or accrual.


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-


(2)
            Reflects
      the value of restricted stock awards granted to our executive officers
      based on the compensation cost of the award computed in accordance with
      Financial Accounting Standards Board Statement of Financial Accounting
      Standards No. 123 (revised 2004), Share-Based Payment, which we refer
      to as SFAS 123R, but excluding any impact of assumed forfeiture rates. See
      Note 2.p. of the Notes to Consolidated Financial Statements. The
      number of shares of restricted stock received by our executive officers
      pursuant to such awards in 2007, vesting in equal amounts over three years
      (one-half based on tenure and performance criteria and one-half based only
      on tenure), was as follows: Mr. Ehrlich, 240,000; Mr. Paup,
      43,125; Mr. Esses, 120,000. The number of shares of restricted stock
      received by our executive officers pursuant to such awards in 2006,
      vesting one-quarter immediately and the remaining three-quarters in equal
      amounts over three years (one-half based on tenure and performance
      criteria and one-half based only on tenure), was as follows:
      Mr. Ehrlich, 200,000; Mr. Paup, 53,125; Mr. Esses,
      100,000.


(3)
            Of
      this amount, $69,137 represents payments to Israeli pension and education
      funds; $13,289 represents our accrual for severance pay that will be
      payable to Mr. Ehrlich upon his leaving our employ other than if he is
      terminated for cause, such as a breach of trust; $44,047 represents the
      increase of the accrual for vacation days redeemable by Mr. Ehrlich; and
      $29,859 represents the increase of our accrual for severance pay that
      would be payable to Mr. Ehrlich under the laws of the State of Israel if
      we were to terminate his
employment.


(4)
            Of
      this amount, $151,760 represents payments to Israeli pension and education
      funds; $218,907 represents our accrual for severance pay that will be
      payable to Mr. Ehrlich upon his leaving our employ other than if he is
      terminated for cause, such as a breach of trust; $26,689 represents the
      increase of the accrual for vacation days redeemable by Mr. Ehrlich; and
      $21,217 represents the increase of our accrual for severance pay that
      would be payable to Mr. Ehrlich under the laws of the State of Israel if
      we were to terminate his
employment.


(5)
            Represents
      the increase in our accrual for Mr. Paup for accrued but unused vacation
      days.


(6)
            Represents
      the increase in our accrual for Mr. Paup for accrued but unused vacation
      days.


(7)
            Does
      not include $188,634 that we paid in consulting fees to Sampen
      Corporation, a New York corporation owned by members of Steven Esses’s
      immediate family, from which Mr. Esses receives a salary. See “Item 13.
      Certain Relationships and Related Transactions – Consulting Agreement with
      Sampen Corporation,” below.


(8)
            Does
      not include $30,720 that we paid as a bonus to Sampen Corporation, a New
      York corporation owned by members of Steven Esses’s immediate family, from
      which Mr. Esses receives a salary. See “Item 13. Certain Relationships and
      Related Transactions – Consulting Agreement with Sampen Corporation,”
      below.


(9)
            Of
      this amount, $15,744 represents payments to Israeli pension and education
      funds; and $4,177 represents the increase of our accrual for severance pay
      that would be payable to Mr. Esses if we were to terminate his
      employment.


(10)
            Does
      not include $178,176 that we paid in consulting fees to Sampen
      Corporation, a New York corporation owned by members of Steven Esses’s
      immediate family, from which Mr. Esses receives a salary. See “Item 13.
      Certain Relationships and Related Transactions – Consulting Agreement with
      Sampen Corporation,” below.


(11)
            Does
      not include $30,720 that we paid as a bonus to Sampen Corporation, a New
      York corporation owned by members of Steven Esses’s immediate family, from
      which Mr. Esses receives a salary. See “Item 13. Certain Relationships and
      Related Transactions – Consulting Agreement with Sampen Corporation,”
      below.


(12)
            Of
      this amount, $112,627 represents payments to Israeli pension and education
      funds; and $86,707 represents the increase of our accrual for severance
      pay that would be payable to Mr. Esses if we were to terminate his
      employment.




Executive
Loans




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




Name
      of Borrower
            
            Date
      of Loan
            
            Original
              Principal
              Amount
      of Loan
            
            
            Amount
              Outstanding
              as
      of 12/31/07
            
            Terms
      of LoanRobert
      S. Ehrlich
            
            12/28/99
            
            $
            167,975
            
            
            $
            201,570
            
            Ten-year
      non-recourse loan to purchase our stock, secured by the shares of stock
      purchased.Robert
      S. Ehrlich
            
            02/09/00
            
            $
            789,991
            
            
            $
            820,809
            
            Twenty-five-year
      non-recourse loan to purchase our stock, secured by the shares of stock
      purchased.Robert
      S. Ehrlich
            
            06/10/02
            
            $
            36,500
            
            
            $
            45,388
            
            Twenty-five-year
      non-recourse loan to purchase our stock, secured by the shares of stock
      purchased.


- 50
-


Plan-Based
Awards




Grants
of Stock Options




We did
not grant any stock options to our executive officers during 2007.




Grants
of Restricted Stock




During
2007, the Compensation Committee approved the grant of a total of
465,000 shares of restricted stock to our executive officers. Pursuant to the
terms of the grant, the stock vested in equal amounts over three years (one-half
based on tenure and performance criteria and one-half based only on tenure). The
exact performance criteria have not yet been determined, but will be related to
our revenues and EBITDA, which is determined by taking net profit and adding
back in interest expense (income), net (after deduction of minority interest),
depreciation of fixed assets, taxes (after deduction of minority interest), and
amortization of inventory adjustments and of intangible assets, capitalized
software costs and technology impairment), in such years.




The table
below sets forth each performance-based equity award granted to our executive
officers during the year ended December 31, 2007.




GRANTS
OF PLAN-BASED AWARDS





Performance
      Period
            
            Estimate
      Future Payouts Under Equity Incentive Plan Awards(1)Grant
            
            Determining
      Release
            
            Threshold
            
            Target
      1
            
            Target
      2
            
            MaximumName
            
            Date
            
            of
      Restrictions
            
            (#)
            
            (#)
            
            (#)
            
            (#)Robert
      S. Ehrlich
            
            10/22/07
            
            10/22/07
      to 12/31/07
            
            66,667
            
            –
            
            –
            
            66,66710/22/07
            
            01/01/08
      to 12/31/08
            
            66,667
            
            –
            
            –
            
            66,66710/22/07
            
            01/01/09
      to 12/31/09
            
            66,666
            
            –
            
            –
            
            66,666Thomas
      J. Paup
            
            12/28/07
            
            01/01/08
      to 12/31/08
            
            10,834
            
            (2)
            
            (2)
            
            21,66712/28/07
            
            01/01/09
      to 12/31/09
            
            10,833
            
            (2)
            
            (2)
            
            21,66712/28/07
            
            01/01/10
      to 12/31/10
            
            10,833
            
            (2)
            
            (2)
            
            21,666Steven
      Esses
            
            12/28/07
            
            01/01/08
      to 12/31/08
            
            33,334
            
            (2)
            
            (2)
            
            66,66712/28/07
            
            01/01/09
      to 12/31/09
            
            33,333
            
            (2)
            
            (2)
            
            66,66712/28/07
            
            01/01/10
      to 12/31/10
            
            33,333
            
            (2)
            
            (2)
            
            66,666





(1)
            The
      threshold number of restricted shares vests based solely based on
      continued employment during the performance period. If 90% of the EBITDA
      performance goal is met for the applicable performance period, the first
      target number of shares of restricted stock will be freed of their
      restrictions. If 90% of the revenue performance goal is met for the
      applicable performance period, the second target number of shares of
      restricted stock will be freed of their restrictions. If 90% of both the
      EBITDA and the revenue performance goals are met for the applicable
      performance period, the maximum number of shares of restricted stock will
      be freed of their restrictions. Performance-based shares that do not vest
      in one year roll over to the following year and become part of the
      following year’s performance-based
pool.


(2)
            Performance
      criteria for these shares have not yet been set; hence, there are no
      threshold or target levels
listed.


- 51
-




Stock
Option Exercises and Vesting of Restricted Stock Awards




Our
executive officers did not exercise any stock options during 2007. The following
table presents awards of restricted stock that vested during the year ended
December 31, 2007.




STOCK
VESTED




Name
            
            Number
      of Shares
              Acquired
      on Vesting
              (#)
            
            
            Value
      Realized
              on
      Vesting(1)
              ($)Robert
      S. Ehrlich
            
            
            226,667
            
            
            $
            478,267Thomas
      J. Paup
            
            
            42,500
            
            
            $
            89,675Steven
      Esses
            
            
            80,000
            
            
            $
            168,800(1)        Reflects the aggregate market
      value of the shares of restricted stock determined based on a per share
      price of $2.11, the closing price of our common stock on the Nasdaq Global
      Market on December 31, 2007, which was the last trading day of
      2007.






Outstanding
Equity Awards at Fiscal Year-End




The table
below sets forth information for our executive officers with respect to option
and restricted stock values at the end of the fiscal year ended December 31,
2007.




OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END




Option
      Awards
            
            
            Stock
      AwardsEquity
      Incentive Plan AwardsMarketMarket
            
            
            Number
      of
            
            
            Value
      ofNumber
      of
            
            
            
            
            
            
            
            
            Number
      of
            
            
            Value
      of
            
            
            Unearned
            
            
            UnearnedSecurities
      Underlying
            
            
            Option
            
            
            
            
            
            Shares
      that
            
            
            Shares
      that
            
            
            Shares
      that
            
            
            Shares
      thatUnexercised
      Options(1)
            
            
            Exercise
            
            
            Option
            
            
            Have
      Not
            
            
            Have
      Not
            
            
            Have
      Not
            
            
            Have
      Not(#)
            
            
            Price
            
            
            Expiration
            
            
            Vested
            
            
            Vested(2)
            
            
            Vested
            
            
            Vested(2)Name
            
            Exercisable
            
            
            Unexercisable
            
            
            ($)
            
            
            Date
            
            
            (#)
            
            
            ($)
            
            
            (#)
            
            
            ($)Robert
      S. Ehrlich
            
            
            5,178
            
            
            
            0
            
            
            $
            5.46
            
            
            12/31/11
            
            
            
            213,334
            
            
            $
            450,135
            
            
            
            293,334
            
            
            $
            618,9354,687
            
            
            
            0
            
            
            $
            5.46
            
            
            04/01/121,116
            
            
            
            0
            
            
            $
            5.46
            
            
            07/01/124,687
            
            
            
            0
            
            
            $
            5.46
            
            
            10/01/126,294
            
            
            
            0
            
            
            $
            5.46
            
            
            01/01/13Thomas
      J. Paup
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            53,750
            
            
            $
            113,413
            
            
            
            75,000
            
            
            $
            158,250Steven
      Esses
            
            
            714
            
            
            
            0
            
            
            $
            8.54
            
            
            12/31/12
            
            
            
            140,000
            
            
            $
            295,400
            
            
            
            180,000
            
            
            $
            379,8001,785
            
            
            
            0
            
            
            $
            11.62
            
            
            07/22/12


(1)
            All
      options in the table are vested.


(2)
            Reflects
      the aggregate market value of the shares of restricted stock
      determined based on a per share price of $2.11, the closing price of
      our common stock on the Nasdaq Global Market on December 31, 2007,
      which was the last trading day of
2007.




Employment
Contracts




Robert
S. Ehrlich




Mr.
Ehrlich is party to an employment agreement with us executed in April 2007. The
term of this employment agreement expires on December 31, 2009.




The
employment agreement provides for a base salary of $33,333 per month, as
adjusted annually for Israeli inflation and devaluation of the Israeli shekel
against the U.S. dollar, if any. Additionally, the board may at its discretion
raise Mr. Ehrlich’s base salary. The employment


- 52
-


agreement
also grants Mr. Ehrlich a retention bonus in the amount of 200,000 shares of
restricted stock, vesting one-third on each of December 31, 2007, 2008 and
2009.




The
employment agreement provides that we will pay an annual bonus, on a sliding
scale, in an amount equal to 35% of Mr. Ehrlich’s annual base salary then in
effect if the results we actually attain for the year in question are 90% or
more of the amount we budgeted at the beginning of the year, up to a maximum of
75% of his annual base salary then in effect if the results we actually attain
for the year in question are 120% or more of the amount we budgeted at the
beginning of the year. For 2007, the Compensation Committee choose financial
targets for determining eligibility for the above-referenced cash incentive
bonus that are determined 50% on the achievement of set budgetary forecast
targets for revenue growth and 50% on the achievement of set budgetary forecast
targets for EBITDA, which is determined by taking net profit and adding back in
interest expense (income), net (after deduction of minority interest),
depreciation of fixed assets, taxes (after deduction of minority interest), and
amortization of inventory adjustments and of intangible assets, capitalized
software costs and technology impairment. New targets will be chosen for 2008
and 2009 based upon future budgetary forecasts.




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




We can
terminate Mr. Ehrlich’s employment agreement in the event of death or disability
or for “Cause” (defined as conviction of certain crimes, willful failure to
carry out directives of our board of directors or gross negligence or willful
misconduct). Mr. Ehrlich has the right to terminate his employment upon a change
in our control or for “Good Reason,” which is defined to include adverse changes
in employment status or compensation, our insolvency, material breaches and
certain other events. Additionally, Mr. Ehrlich may terminate his agreement for
any reason upon 120 days’ notice.




Upon
termination of employment, the employment agreement provides for payment of all
accrued and unpaid compensation and benefits (including under most circumstances
Israeli statutory severance, described above), and (unless we have terminated
the agreement for Cause or Mr. Ehrlich has terminated the agreement without Good
Reason and without giving us 120 days’ notice of termination) bonuses (to the
extent earned) due for the year in which employment is terminated and severance
pay in the amount of up to $1,625,400, except that in the event of termination
by Mr. Ehrlich on 120 days’ prior notice, the severance pay will be only that
amount that has vested (meaning that it had been scheduled to have been
deposited in trust as described in the next paragraph). Furthermore, in respect
of any termination by us other than termination for Cause or termination of the
agreement due to Mr. Ehrlich’s death or disability, or by Mr. Ehrlich for Good
Reason, all outstanding options, all vested restricted shares, and any of the
restricted shares that have performance criteria that have not yet vested
(80,000 shares as of February 29, 2008) will be fully vested. Restricted shares
that have vested prior to the date of termination are not forfeited under any
circumstances, including termination for Cause.


- 53
-


A table
describing the payments that would have been due to Mr. Ehrlich under his
employment agreement had Mr. Ehrlich’s employment with us been terminated at the
end of 2007 under various circumstances (pursuant to the terms of his
then-current employment agreement) appears under “Potential Payments and
Benefits upon Termination of Employment – Robert S. Ehrlich,”
below.




Pursuant
to the terms of our employment agreement Mr. Ehrlich, funds to secure payment of
Mr. Ehrlich’s contractual severance are to be deposited into accounts for his
benefit, with payments to be made pursuant to an agreed-upon schedule. As of
December 31, 2007, a total of $618,097 had been deposited into accounts with two
capital management funds. These accounts are in our name and continue to be
owned by us, and we benefit from all gains and bear the risk of all losses
resulting from deposits of these funds.




Steven
Esses




Mr. Esses
is party to an employment agreement with us executed in April 2008, effective as
of January 1, 2008. The term of this employment agreement expires on December
31, 2010, and is extended automatically for additional terms of two years each
unless either Mr. Esses or we terminate the agreement sooner.




The
employment agreement provides for a base salary of NIS 53,023.50 per month
(approximately $13,787 at the rate of exchange in effect on January 1, 2008),
with an automatic annual 6% increase to adjust for inflation. Additionally, the
board may at its discretion raise Mr. Esses’s base salary. The agreement also
provides for a stock retention bonus of 200,000 shares of restricted stock,
vesting (i) 25,000 shares on December 31, 2008, 25,000 shares on December 31,
2009, and 25,000 shares on December 31, 2010, with each such vesting being
contingent solely on Mr. Esses being employed by us on the scheduled vesting
date, (ii) 25,000 shares on December 31, 2008, 25,000 shares on December 31,
2009, and 25,000 shares on December 31, 2010, with each such vesting being
contingent on Mr. Esses being employed by us on the scheduled vesting date and
on performance criteria to be established by the Compensation Committee of our
Board of Directors, and (iii) 50,000 shares on January 1, 2011, with such
vesting being contingent upon Mr. Esses succeeding to the position of Chief
Executive Officer by such date. The agreement further provides for a cash
retention bonus of NIS 900,000 (approximately $234,000 at the rate of exchange
in effect on January 1, 2008).




The
employment agreement provides that if the results we actually attain in a given
year are at least 90% of the amount we budgeted at the beginning of the year, we
will pay a bonus, on a sliding scale, in an amount equal to a minimum of 20% of
Mr. Esses’s annual base salary then in effect, up to a maximum of 75% of his
annual base salary then in effect if the results we actually attain for the year
in question are 120% or more of the amount we budgeted at the beginning of the
year. For 2007, the Compensation Committee choose financial targets for
determining eligibility for the above-referenced cash incentive bonus that are
determined 50% on the achievement of set budgetary forecast targets for revenue
growth and 50% on the achievement of set budgetary forecast targets for EBITDA,
which is determined by taking net profit and adding back in interest expense
(income), net (after deduction of minority interest), depreciation of fixed
assets, taxes (after deduction of minority interest), and amortization of
inventory adjustments and of intangible assets, capitalized software costs and
technology impairment. New targets will be chosen for 2008 based upon future
budgetary forecasts.


- 54
-


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




We can
terminate Mr. Esses’s employment agreement in the event of death or disability
or for “Cause” (defined as conviction of certain crimes, willful failure to
carry out directives of our board of directors or gross negligence or willful
misconduct). Mr. Esses has the right to terminate his employment upon a change
in our control or for “Good Reason,” which is defined to include adverse changes
in employment status or compensation, our insolvency, material breaches and
certain other events. Additionally, Mr. Esses may retire (after age 65), retire
early (after age 55) or terminate his agreement for any reason upon 150 days’
notice.




Upon
termination of employment, the employment agreement provides for payment of all
accrued and unpaid compensation, and (unless we have terminated the agreement
for Cause or Mr. Esses has terminated the agreement without Good Reason and
without giving us 150 days’ notice of termination) bonuses (to the extent
earned) due for the year in which employment is terminated (in an amount of not
less than 20% of base salary) and severance pay, as follows: (A) before the end
of the first year of the agreement, a total of (i) $30,400 plus (ii) eighteen
(18) times monthly salary; (B) before the end of the second year of the
agreement, a total of (i) $56,000 plus (ii) twenty (20) times monthly salary;
(C) before the end of the third year of the agreement, a total of (i) $81,600
plus (ii) twenty-two (22) times monthly salary; or (D) at or after the end of
the third year of the agreement, a total of (i) $107,200 plus (ii) twenty-four
(24) times monthly salary. Furthermore, Mr. Esses will receive, in respect of
all benefits, an additional sum in the amount of (i) $75,000, in the case of
termination due to disability, Good Reason, death, or non-renewal, or (ii)
$150,000, in the case of termination due to early retirement, retirement, change
of control or change of location.




A table
describing the payments that would have been due to Mr. Esses under his
employment agreement had Mr. Esses’s employment with us been terminated at the
end of 2007 under various circumstances (pursuant to his prior employment
agreement) appears under “Potential Payments and Benefits upon Termination of
Employment – Steven Esses,” below.




Pursuant
to the terms of our employment agreement Mr. Esses, funds to secure payment of
Mr. Esses’s contractual severance are to be deposited into accounts for his
benefit, with payments to be made pursuant to an agreed-upon schedule. As of
December 31, 2007, a total of $100,000 had been deposited into accounts with two
capital management funds. These accounts are in our name and continue to be
owned by us, and we benefit from all gains and bear the risk of all losses
resulting from deposits of these funds.




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




Thomas
J. Paup




Mr. Paup
is party to an amended and restated employment agreement with us executed in
April 2008, effective as of January 1, 2008, having a term running until
December 31, 2010 and automatically renewing for additional terms of two years
each unless otherwise terminated by either


- 55
-


party.
Under the terms of his employment agreement, Mr. Paup is entitled to receive a
base salary of $160,000 per annum, with increases of 6% per year thereafter to
take account of inflation, and will be eligible for a bonus with a target equal
to between 20% and 50% of the base salary. The actual bonus payout shall be
determined based upon the Company’s achievement level against financial and
performance objectives determined by the Compensation Committee of our Board of
Directors. Mr. Paup’s employment agreement provides that if we terminate his
agreement other than for cause (defined as conviction of certain crimes, willful
failure to carry out directives of our board of directors or gross negligence or
willful misconduct), we must pay Mr. Paup severance in an amount of four times
his monthly salary plus an additional two months’ salary for every year worked
during the term of his agreement, with the maximum severance payable of one
year’s salary; these payments are doubled in the event of termination by reason
of a change of control.




Others




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




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




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




Potential
Payments and Benefits upon Termination of Employment




This
section sets forth in tabular form quantitative disclosure regarding estimated
payments and other benefits that would have been received by certain of our
executive officers if their employment had terminated on December 31, 2007
(the last business day of the fiscal year).


- 56
-


Mr.
Paup’s prior employment agreement contained no provision with respect to
payments or benefits upon termination of employment, and hence there is no
tabular disclosure with respect to him below.




For a
narrative description of the severance and change in control arrangements in the
employment contracts of Messrs. Ehrlich and Esses, see “– Employment Contracts,”
above. Each of Messrs. Ehrlich and Esses will be eligible to receive severance
payments in excess of accrued but unpaid items only if he signs a general
release of claims.




Robert
S. Ehrlich




The
following table describes the potential payments and benefits upon employment
termination for Robert S. Ehrlich, our Chairman and Chief Executive Officer,
pursuant to applicable law and the terms of his employment agreement with us, as
if his employment had terminated on December 31, 2007 (the last business day of
the fiscal year) under the various scenarios described in the column headings as
explained in the footnotes below.




ROBERT
      S. EHRLICHPayments
      and Benefits
              
              Death
      or
                Disability(1)
              
              
              Cause(2)
              
              
              Good
                Reason(3)
              
              
              Change
      of
                Control(4)
              
              
              Termination
                at
      Will(5)
              
              
              Other
      Employee
                Termination(6)Accrued
      but unpaid:Base
      salary
              
              $
              33,333
              
              
              $
              33,333
              
              
              $
              33,333
              
              
              $
              33,333
              
              
              $
              33,333
              
              
              $
              33,333Bonus
              
              
              6,960
              
              
              
              6,960
              
              
              
              6,960
              
              
              
              6,960
              
              
              
              6,960
              
              
              
              6,960Vacation
              
              
              76,400
              
              
              
              76,400
              
              
              
              76,400
              
              
              
              76,400
              
              
              
              76,400
              
              
              
              76,400Recuperation
      pay(7)
              
              
              345
              
              
              
              345
              
              
              
              345
              
              
              
              345
              
              
              
              345
              
              
              
              345Benefits:Manager’s
      insurance(8)
              
              
              5,277
              
              
              
              5,277
              
              
              
              5,277
              
              
              
              5,277
              
              
              
              5,277
              
              
              
              5,277Continuing
      education fund(9)
              
              
              2,500
              
              
              
              2,500
              
              
              
              2,500
              
              
              
              2,500
              
              
              
              2,500
              
              
              
              2,500Tax
      gross-up on automobile
              
              
              1,952
              
              
              
              –
              
              
              
              1,952
              
              
              
              1,952
              
              
              
              1,952
              
              
              
              –Contractual
      severance
              
              
              1,625,400
              
              
              
              –
              
              
              
              1,625,400
              
              
              
              1,625,400
              
              
              
              1,625,400
              
              
              
              –Statutory
      severance(10)
              
              
              643,998
              
              
              
              –
              
              
              
              643,998
              
              
              
              643,998
              
              
              
              643,998
              
              
              
              –Accelerated
      vesting of restricted stock
              
              
              168,800
              
              
              
              –
              
              
              
              168,800
              
              
              
              168,800
              
              
              
              –
              
              
              
              –TOTAL:
              
              $
              2,564,965
              
              
              $
              124,815
              
              
              $
              2,564,965
              
              
              $
              2,564,965
              
              
              $
              2,396,165
              
              
              $
              124,815





(1)
            “Disability”
      is defined in Mr. Ehrlich’s employment agreement as a physical or mental
      infirmity which impairs the Mr. Ehrlich’s ability to substantially perform
      his duties and which continues for a period of at least 180 consecutive
      days.


(2)
            “Cause”
      is defined in Mr. Ehrlich’s employment agreement as (i) conviction
      for fraud, crimes of moral turpitude or other conduct which reflects on us
      in a material and adverse manner; (ii) a willful failure to carry out a
      material directive of our Board of Directors, provided that such
      directive concerned matters within the scope of Mr. Ehrlich’s duties,
      would not give Mr. Ehrlich “Good Reason” to terminate his agreement (see
      footnote 4 below) and was capable of being reasonably and lawfully
      performed; (iii) conviction in a court of competent jurisdiction for
      embezzlement of our funds; and (iv) reckless or willful misconduct that is
      materially harmful to us.


(3)
            “Good
      Reason” is defined in Mr. Ehrlich’s employment agreement as (i) a change
      in Mr. Ehrlich’s status, title, position or responsibilities which, in Mr.
      Ehrlich’s reasonable judgment, represents a reduction or demotion in his
      status, title, position or responsibilities as in effect immediately prior
      thereto; (ii) a reduction in Mr. Ehrlich’s base salary; (iii) the failure
      by us to continue in effect any material compensation or benefit plan in
      which Mr. Ehrlich is participating; (iv) the insolvency or the filing (by
      any party, including us) of a petition for the winding-up of us; (v) any
      material breach by us of any provision of Mr. Ehrlich’s employment
      agreement; (vi) any purported termination of Mr. Ehrlich’s employment for
      cause by us which does not comply with the terms of Mr. Ehrlich’s
      employment agreement; and (vii) any movement of the location where Mr.
      Ehrlich is generally to render his services to us from the Jerusalem/Tel
      Aviv area of Israel.


(4)
            “Change
      of Control” is defined in Mr. Ehrlich’s employment agreement as (i) the
      acquisition (other than from us in any public offering or private
      placement of equity securities) by any person or entity of beneficial
      ownership of 20% or more of the combined voting power of our
      then-outstanding voting securities; or (ii) individuals who, as of January
      1, 2000, were members of our Board of Directors (the “Original Board”),
      together with individuals approved by a vote of at least 2⁄3 of the
      individuals who were members of the Original Board and are then still
      members of our Board, cease for any reason to constitute at least 1⁄3 of our
      Board of us; or (iii) approval by our shareholders of a complete
      winding-up or an agreement for the sale or other disposition of all or
      substantially all of our assets.


(5)
            “Termination
      at Will” is defined in Mr. Ehrlich’s employment agreement as Mr. Ehrlich
      terminating his employment with us on written notice of at least 120 days
      in advance of the effective date of such
  termination.


(6)
            “Other
      Employee Termination” means a termination by Mr. Ehrlich of his employment
      without giving us the advance notice of 120 days needed to make such a
      termination qualify as a “Termination at
Will.”


- 57
-


(7)
            Pursuant
      to Israeli law and our customary practice, we pay Mr. Ehrlich in July of
      each year the equivalent of ten days’ “recuperation pay” at the statutory
      rate of NIS 318 (approximately $86) per
day.


(8)
            Payments
      to managers’ insurance, a benefit customarily given to senior executives
      in Israel, come to a total of 15.83% of base salary, consisting of 8.33%
      for payments to a fund to secure payment of statutory severance
      obligations, 5% for pension and 2.5% for disability. The managers’
      insurance funds reflected in the table do not include the 8.33% payments
      to a fund to secure payment of statutory severance obligations with
      respect to amounts paid prior to December 31, 2007, which funds are
      reflected in the table under the “Statutory severance”
      heading.


(9)
            Pursuant
      to Israeli law, we must contribute an amount equal to 7.5% of Mr.
      Ehrlich’s base salary to a continuing education fund, up to the
      permissible tax-exempt salary ceiling according to the income tax
      regulations in effect from time to time. At December 31, 2007, the ceiling
      then in effect was NIS 15,712 (approximately $4,250). In Mr. Ehrlich’s
      case, we have customarily contributed to his continuing education fund in
      excess of the tax-exempt ceiling, and then reimbursed Mr. Ehrlich for the
      tax. The sums in the table reflect this additional contribution and the
      resultant tax reimbursement.


(10)
            Under
      Israeli law, employees terminated other than for cause receive severance
      in the amount of one month’s base salary for each year of work, at their
      salary rate at the date of
termination.




Steven
Esses




The
following table describes the potential payments and benefits upon employment
termination for Steven Esses, our President and Chief Operating Officer,
pursuant to applicable law and the terms of his employment agreement with us, as
if his employment had terminated on December 31, 2007 (the last business day of
the fiscal year) under the various scenarios described in the column headings as
explained in the footnotes below.




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




STEVEN
      ESSESPayments
      and Benefits
            
            Non-
              Renewal(1)
            
            
            Death
      or
              Disability(2)
            
            
            Cause(3)
            
            
            Good
              Reason(4)
            
            
            Change
      of
              Control(5)
            
            
            Change
      of
              Location(6)
            
            
            Retirement(7)
            
            
            Early
              Retirement(8)
            
            
            Other
              Employee
              Termination(9)Accrued
      but unpaid(10):Base
      salary
            
            $
            6,068
            
            
            $
            6,068
            
            
            $
            6,068
            
            
            $
            6,068
            
            
            $
            6,068
            
            
            $
            6,068
            
            
            $
            6,068
            
            
            $
            6,068
            
            
            $
            6,068Vacation
            
            
            45,393
            
            
            
            45,393
            
            
            
            45,393
            
            
            
            45,393
            
            
            
            45,393
            
            
            
            45,393
            
            
            
            45,393
            
            
            
            45,393
            
            
            
            45,393Sick leave(11)
            
            
            17,455
            
            
            
            17,455
            
            
            
            –
            
            
            
            17,455
            
            
            
            17,455
            
            
            
            17,455
            
            
            
            17,455
            
            
            
            17,455
            
            
            
            –Recuperation pay(12)
            
            
            241
            
            
            
            241
            
            
            
            241
            
            
            
            241
            
            
            
            241
            
            
            
            241
            
            
            
            241
            
            
            
            241
            
            
            
            241Benefits:Manager’s
      insurance(13)
            
            
            961
            
            
            
            961
            
            
            
            961
            
            
            
            961
            
            
            
            961
            
            
            
            961
            
            
            
            961
            
            
            
            961
            
            
            
            961Continuing education
      fund(14)
            
            
            1,415
            
            
            
            1,415
            
            
            
            1,415
            
            
            
            1,415
            
            
            
            1,415
            
            
            
            1,415
            
            
            
            1,415
            
            
            
            1,415
            
            
            
            1,415Tax
      gross-up on automobile
            
            
            2,317
            
            
            
            2,317
            
            
            
            –
            
            
            
            2,317
            
            
            
            2,317
            
            
            
            2,317
            
            
            
            2,317
            
            
            
            2,317
            
            
            
            –Contractual
      severance
            
            
            330,000
            
            
            
            330,000
            
            
            
            –
            
            
            
            330,000
            
            
            
            330,000
            
            
            
            330,000
            
            
            
            330,000
            
            
            
            330,000
            
            
            
            –Statutory
      severance(15)
            
            
            28,794
            
            
            
            28,794
            
            
            
            –
            
            
            
            28,794
            
            
            
            28,794
            
            
            
            28,794
            
            
            
            28,794
            
            
            
            28,794
            
            
            
            –Benefits:Manager’s
      insurance(13)
            
            
            11,527
            
            
            
            11,527
            
            
            
            –
            
            
            
            11,527
            
            
            
            11,527
            
            
            
            11,527
            
            
            
            11,527
            
            
            
            11,527
            
            
            
            –Vacation
            
            
            6,545
            
            
            
            6,545
            
            
            
            –
            
            
            
            6,545
            
            
            
            6,545
            
            
            
            6,545
            
            
            
            6,545
            
            
            
            6,545
            
            
            
            –Continuing education
      fund(14)
            
            
            29,647
            
            
            
            29,647
            
            
            
            –
            
            
            
            29,647
            
            
            
            29,647
            
            
            
            29,647
            
            
            
            29,647
            
            
            
            29,647
            
            
            
            –Automobile(16)
            
            
            11,126
            
            
            
            11,126
            
            
            
            –
            
            
            
            11,126
            
            
            
            11,126
            
            
            
            11,126
            
            
            
            11,126
            
            
            
            11,126
            
            
            
            –Tax gross-up(16)
            
            
            13,666
            
            
            
            13,666
            
            
            
            –
            
            
            
            13,666
            
            
            
            13,666
            
            
            
            13,666
            
            
            
            13,666
            
            
            
            13,666
            
            
            
            –TOTAL:
            
            $
            505,155
            
            
            $
            505,155
            
            
            $
            54,078
            
            
            $
            505,155
            
            
            $
            505,155
            
            
            $
            505,155
            
            
            $
            505,155
            
            
            $
            505,155
            
            
            $
            54,078





(1)
            “Non-renewal”
      is defined in Mr. Esses’s employment agreement as a decision, made with
      written notice of at least 90 days in advance of the effective date of
      such decision, by either us or Mr. Esses not to renew Mr. Esses’s
      employment for an additional two-year term. Pursuant to the terms of Mr.
      Esses’s employment agreement, in the absence of such notice, Mr. Esses’s
      employment agreement automatically
renews.


(2)
            “Disability”
      is defined in Mr. Esses’s employment agreement as a physical or mental
      infirmity which impairs the Mr. Esses’s ability to substantially perform
      his duties and which continues for a period of at least 180 consecutive
      days.


(3)
            “Cause”
      is defined in Mr. Esses’s employment agreement as (i) conviction for
      fraud, crimes of moral turpitude or other conduct which reflects on us in
      a material and adverse manner; (ii) a willful failure to carry out a
      material directive of our Chief Executive Officer, provided that such
      directive concerned matters within the scope of Mr. Esses’s duties, would
      not give Mr. Esses “Good Reason” to terminate his agreement (see footnote
      4 below) and was capable of being reasonably and lawfully performed; (iii)
      conviction in a court of competent jurisdiction for embezzlement of our
      funds; and (iv) reckless or willful misconduct that is materially harmful
      to us.


- 58
-


(4)
            “Good
      Reason” is defined in Mr. Esses’s employment agreement as (i) a change in
      (a) Mr. Esses’s status, title, position or responsibilities which, in Mr.
      Esses’s reasonable judgment, represents a reduction or demotion in his
      status, title, position or responsibilities as in effect immediately prior
      thereto, or (b) in the primary location from which Mr. Esses shall have
      conducted his business activities during the 60 days prior to such change;
      or (ii) a reduction in Mr. Esses’s base salary; (iii) the failure by us to
      continue in effect any material compensation or benefit plan in which Mr.
      Esses is participating; (iv) the insolvency or the filing (by any party,
      including us) of a petition for the winding-up of us; (v) any material
      breach by us of any provision of Mr. Esses’s employment agreement; and
      (vi) any purported termination of Mr. Esses’s employment for cause by us
      which does not comply with the terms of Mr. Esses’s employment
      agreement.


(5)
            “Change
      of Control” is defined in Mr. Esses’s employment agreement as (i) the
      acquisition (other than from us in any public offering or private
      placement of equity securities) by any person or entity of beneficial
      ownership of 30% or more of the combined voting power of our
      then-outstanding voting securities; or (ii) individuals who, as of January
      1, 2000, were members of our Board of Directors (the “Original Board”),
      together with individuals approved by a vote of at least 2⁄3 of the
      individuals who were members of the Original Board and are then still
      members of our Board, cease for any reason to constitute at least 1⁄3 of our
      Board of us; or (iii) approval by our shareholders of a complete
      winding-up or an agreement for the sale or other disposition of all or
      substantially all of our assets.


(6)
            “Change
      of location” is defined in Mr. Esses’s employment agreement as a change in
      the primary location from which Mr. Esses shall have conducted his
      business activities during the 60 days prior to such
    change.


(7)
            “Retirement”
      is defined as Mr. Esses terminating his employment with us at age 65 or
      older on at least 150 days’ prior
notice.


(8)
            “Early
      Retirement” is defined as Mr. Esses terminating his employment with us at
      age 55 or older (up to age 65) on at least 150 days’ prior
      notice.


(9)
            Any
      termination by Mr. Esses of his employment with us that does not fit into
      any of the prior categories, including but not limited to Mr. Esses
      terminating his employment with us, with or without notice, other than at
      the end of an employment term or renewal thereof, in circumstances that do
      not fit into any of the prior
categories.


(10)
            Does
      not include a total of $12,800 in accrued but unpaid consulting fees due
      at December 31, 2007 to Sampen Corporation, a New York corporation owned
      by members of Steven Esses’s immediate family, from which Mr. Esses
      receives a salary. See “Item 13. Certain Relationships and Related
      Transactions – Consulting Agreement with Sampen Corporation,”
      below.


(11)
            Limited
      to an aggregate of 30 days.


(12)
            Pursuant
      to Israeli law and our customary practice, we pay Mr. Esses in July of
      each year the equivalent of six days’ “recuperation pay” at the statutory
      rate of NIS 318 (approximately $86) per
day.


(13)
            Payments
      to managers’ insurance, a benefit customarily given to senior executives
      in Israel, come to a total of 15.83% of base salary, consisting of 8.33%
      for payments to a fund to secure payment of statutory severance
      obligations, 5% for pension and 2.5% for disability. The managers’
      insurance funds reflected in the table do not include the 8.33% payments
      to a fund to secure payment of statutory severance obligations with
      respect to amounts paid prior to December 31, 2007, which funds are
      reflected in the table under the “Statutory severance”
      heading.


(14)
            Pursuant
      to Israeli law, we must contribute an amount equal to 7.5% of Mr. Esses’s
      base salary to a continuing education fund, up to the permissible
      tax-exempt salary ceiling according to the income tax regulations in
      effect from time to time. At December 31, 2007, the ceiling then in effect
      was NIS 15,712 (approximately $4,350). In Mr. Esses’s case, we have
      customarily contributed to his continuing education fund in excess of the
      tax-exempt ceiling, and then reimbursed Mr. Esses for the tax. The sums in
      the table reflect this additional contribution and the resultant tax
      reimbursement.


(15)
            Under
      Israeli law, employees terminated other than for cause receive severance
      in the amount of one month’s base salary for each year of work, at their
      salary rate at the date of
termination.


(16)
            Under
      the terms of Mr. Esses’s employment agreement, we must under certain
      circumstances provide him with the use of the company car that he was
      driving at the time of termination for a period of time after termination
      and pay the tax on the benefit thereon. The taxable value of this use is
      reflected in the table.





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




Security
Ownership of Certain Beneficial Owners and Management




The
following table sets forth information regarding the security ownership, as of
February 29, 2008, of those persons owning of record or known by us to own
beneficially more than 5% of our common stock (of which there were none) and of
each of our Named Executive Officers and directors, and the shares of common
stock held by all of our directors and executive officers as a
group.




Name and Address of Beneficial Owner(1)
            
            Shares Beneficially Owned(2)(3)
            
            Percentage
      of Total Shares Outstanding(3)Robert
      S. Ehrlich
            
            
            596,393
            (4)
            
            
            4.4
            %Steven
      Esses
            
            
            374,284
            (5)
            
            
            2.8
            %Thomas
      J. Paup
            
            
            150,000
            (6)
            
            
            1.1
            %Dr.
      Jay M. Eastman
            
            
            4,934
            (7)
            
            
            *Jack
      E. Rosenfeld
            
            
            5,076
            (8)
            
            
            *Lawrence
      M. Miller
            
            
            29,056
            (9)
            
            
            *Edward
      J. Borey
            
            
            6,076
            (10)
            
            
            *Prof.
      Seymour Jones
            
            
            4,934
            (11)
            
            
            *Elliot
      Sloyer
            
            
            8,224
            (12)
            
            
            *Michael
      E. Marrus
            
            
            8,224
            (13)
            
            
            *All
      of our directors and executive officers as a group (10
      persons)
            
            
            1,187,201
            (14)
            
            
            8.7
            %


- 59
-







*
            Less
      than one percent.


(1)
            The
      address of each named beneficial owner is in care of Arotech Corporation,
      1229 Oak Valley Drive, Ann Arbor, Michigan
  48108.


(2)
            Unless
      otherwise indicated in these footnotes, each of the persons or entities
      named in the table has sole voting and sole investment power with respect
      to all shares shown as beneficially owned by that person, subject to
      applicable community property laws.


(3)
            Based
      on 13,599,197 shares of common stock outstanding as of February 29, 2008.
      For purposes of determining beneficial ownership of our common stock,
      owners of options exercisable within sixty days are considered to be the
      beneficial owners of the shares of common stock for which such securities
      are exercisable. The percentage ownership of the outstanding common stock
      reported herein is based on the assumption (expressly required by the
      applicable rules of the Securities and Exchange Commission) that only the
      person whose ownership is being reported has exercised his options for
      shares of common stock.


(4)
            Consists
      of 266,000 shares held directly by Mr. Ehrlich, 293,333 shares of unvested
      restricted stock, 3,571 shares held by Mr. Ehrlich’s wife (in which shares
      Mr. Ehrlich disclaims beneficial ownership), 11,527 shares held in Mr.
      Ehrlich’s pension plan, and 21,962 shares issuable upon exercise of
      options exercisable within 60 days of February 29,
  2008.


(5)
            Consists
      of 91,785 shares held directly by Mr. Esses, 280,000 shares of unvested
      restricted stock, and 2,499 shares issuable upon exercise of options
      exercisable within 60 days of February 29,
2008.


(6)
            Consists
      of 42,500 shares held directly by Mr. Paup and 107,500 shares of unvested
      restricted stock.


(7)
            Consists
      of 4,934 shares of unvested restricted
stock.


(8)
            Consists
      of 142 shares held directly by Mr. Rosenfeld and 4,934 shares of unvested
      restricted stock.


(9)
            Consists
      of 23,271 shares held by Mr. Miller as trustee of the Rose Gross
      Charitable Foundation, in which shares Mr. Miller disclaims beneficial
      ownership, 851 shares held directly by Mr. Miller, and 4,934 shares of
      unvested restricted stock.


(10)
            Consists
      of 1,142 shares owned directly by Mr. Borey and 4,934 shares of unvested
      restricted stock.


(11)
            Consists
      of 4,934 shares of unvested restricted
stock.


(12)
            Consists
      of 8,224 shares of unvested restricted
stock.


(13)
            Consists
      of 8,224 shares of unvested restricted
stock.


(14)
            Includes
      24,461 shares issuable upon exercise of options exercisable within 60 days
      of February 29, 2008 and 727,951 shares of unvested restricted
      stock.




Securities
Authorized for Issuance Under Equity Compensation Plans




The
following table sets forth certain information, as of December 31, 2007, with
respect to our 1998, 2004 and 2007 stock option plans, as well as any other
stock options and warrants previously issued by us (including individual
compensation arrangements) as compensation for goods and
services:


- 60
-


EQUITY
COMPENSATION PLAN INFORMATION




Plan
      Category
            
            Number
      of securities to be issued upon exercise of outstanding options, warrants
      and rights
              (a)
            
            Weighted-average
      exercise price of outstanding options, warrants and rights
              (b)
            
            Number
      of securities remaining available for future issuance under equity
      compensation plans (excluding securities reflected in column
      (a))
              (c)Equity
      compensation plans approved by security holders(1)
            
            291,381
            
            $2.34
            
            434,974





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







ITEM
      13.
            CERTAIN
      RELATIONSHIPS AND RELATED
TRANSACTIONS




Officer
Loans




On
December 3, 1999, Robert S. Ehrlich purchased 8,928 shares of our common stock
out of our treasury at the closing price of the common stock on December 2,
1999. Payment was rendered by Mr. Ehrlich in the form of non-recourse promissory
notes due in 2009 in the amount of $167,975, bearing simple annual interest at a
rate of 2%, secured by the shares of common stock purchased and other shares of
common stock previously held by him. As of December 31, 2007, the aggregate
amount outstanding pursuant to this promissory note was $201,570.




On
February 9, 2000, Mr. Ehrlich exercised 9,404 stock options. Mr. Ehrlich paid
the exercise price of the stock options and certain taxes that we paid on his
behalf by giving us a non-recourse promissory note due in 2025 in the amount of
$789,991, bearing annual interest (i) as to $329,163, at 1% over the
then-current federal funds rate announced from time to time by the Wall Street Journal, and (ii)
as to $460,828, at 4% over the then-current percentage increase in the Israeli
consumer price index between the date of the loan and the date of the annual
interest calculation, secured by the shares of our common stock acquired through
the exercise of the options and certain compensation due to Mr. Ehrlich upon
termination. As of December 31, 2007, the aggregate amount outstanding pursuant
to this promissory note was $820,809.




On June
10, 2002, Mr. Ehrlich exercised 3,571 stock options. Mr. Ehrlich paid the
exercise price of the stock options by giving us a non-recourse promissory note
due in 2012 in the amount of $36,500, bearing simple annual interest at a rate
equal to the lesser of (i) 5.75%, and (ii) 1% over the then-current federal
funds rate announced from time to time, secured by the shares of our common
stock acquired through the exercise of the options. As of December 31, 2007, the
aggregate amount outstanding pursuant to this promissory note was
$45,388.




Consulting
Agreement with Sampen Corporation




We have a
consulting agreement with Sampen Corporation that we executed in March 2005,
effective as of January 1, 2005. Sampen is a New York corporation owned by
members of Steven Esses’s immediate family, and Mr. Esses is an employee of both
the Company and of Sampen. The term of this consulting agreement as extended
expires on December 31, 2008, and


- 61
-


is
extended automatically for additional terms of two years each unless either
Sampen or we terminate the agreement sooner.




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




ITEM
      14.
            PRINCIPAL
      ACCOUNTING FEES AND SERVICES




In
accordance with the requirements of the Sarbanes-Oxley Act of 2002 and the Audit
Committee’s charter, all audit and audit-related work and all non-audit work
performed by our independent accountants, BDO Seidman, LLP (“BDO”), is approved
in advance by the Audit Committee, including the proposed fees for such work.
The Audit Committee is informed of each service actually rendered.




Ø
            Audit Fees.Audit fees
      billed or expected to be billed to us by BDO for the audit of the
      financial statements included in our Annual Report on Form 10-K, and
      reviews of the financial statements included in our Quarterly Reports on
      Form 10-Q, for the years ended December 31, 2007 and 2006 totaled
      approximately $408,000 and $456,000,
  respectively.




Ø
            Audit-Related
      Fees.  BDO billed us $16,000 and $15,000 for the fiscal
      years ended December 31, 2007 and 2006, respectively, for assurance and
      related services that are reasonably related to the performance of the
      audit or review of our financial
statements.




Ø
            Tax
      Fees.  BDO billed us $0 and $9,000 for the fiscal years
      ended December 31, 2007 and 2006, respectively, for tax
      services.




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




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


- 62
-


PART
IV




ITEM
      15.
            EXHIBITS,
      FINANCIAL STATEMENT SCHEDULES




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




(1)
            Financial
      Statements – See Index to Financial Statements on page 39 above and
      the financial pages following page 66
below.




(2)
            Financial Statements
      Schedules – Schedule II - Valuation and Qualifying Accounts. All
      schedules other than those listed above are omittedbecause
      of the absence of conditions under which they are required or because the
      required information is presented in the financial statements or related
      notes thereto.




(3)
            Exhibits
      – The following Exhibits are either filed herewith or have previously been
      filed with the Securities and Exchange Commission and are referred to and
      incorporated herein by reference to such
  filings:






Exhibit
      No.
            
            Description(1)
            
            3.1
            
            Amended
      and Restated Certificate of Incorporation(3)
            
            3.1.1
            
            Amendment
      to our Amended and Restated Certificate of
Incorporation(8)
            
            3.1.2
            
            Amendment
      to our Amended and Restated Certificate of
Incorporation(9)
            
            3.1.3
            
            Amendment
      to our Amended and Restated Certificate of
Incorporation(18)
            
            3.1.4
            
            Amendment
      to our Amended and Restated Certificate of
Incorporation(2)
            
            3.2
            
            Amended
      and Restated By-Laws(9)
            
            4.1
            
            Specimen
      Certificate for shares of common stock, $.01 par value(14)
            
            10.1
            
            Promissory
      Note dated December 3, 1999, from Robert S. Ehrlich to
  us(14)
            
            10.2
            
            Promissory
      Note dated February 9, 2000, from Robert S. Ehrlich to
  us(14)
            
            10.3
            
            Promissory
      Note dated January 12, 2001, from Robert S. Ehrlich to
  us(4)
            
            10.4
            
            Agreement
      of Lease dated December 6, 2000 between Janet Nissim et al. and M.D.T.
      Protection (2000) Ltd. [English summary of Hebrew
  original](4)
            
            10.5
            
            Agreement
      of Lease dated August 22, 2001 between Aviod Building and Earthworks
      Company Ltd. et
      al. and M.D.T. Protective Industries Ltd. [English summary of
      Hebrew original](5)
            
            10.6
            
            Form
      of Warrant dated September 30, 2003(6)
            
            10.7
            
            Form
      of Warrant dated January __, 2004(7)
            
            10.8
            
            Promissory
      Note dated July 1, 2002 from Robert S. Ehrlich to us(7)
            
            10.9
            
            Lease
      dated April 8, 1997, between AMR Holdings, L.L.C. and FAAC
      Incorporated†(9)
            
            10.10
            
            Consulting
      Agreement, effective as of January 1, 2005, between us and Sampen
      Corporation†
      (19)
            
            10.11
            
            Fourth
      Amended and Restated Employment Agreement, dated April 16, 2007, between
      us, EFL and Robert S. Ehrlich†(10)
            
            10.12
            
            Employment
      Agreement, effective as of January 1, 2005, between EFL and Steven
      Esses




- 63
-




Exhibit
      No.
            
            Description†  **
            
            10.12.1
            
            Amended
      and Restated Employment Agreement, dated April 14, 2008 and effective as
      of January 1, 2008, between EFL and Steven Esses(16)
            
            10.13
            
            Conversion
      Agreement dated April 7, 2006 between us and the Investors named
      therein(11)
            
            10.14
            
            Form
      of Warrant dated September 29, 2005†
      (12)
            
            10.15
            
            Employment
      Agreement between the Company and Thomas J. Paup dated December 30,
      2005†  **
            
            10.15.1
            
            Amended
      and Restated Employment Agreement between the Company and Thomas J. Paup
      dated April 14, 2008 and effective as of January 1,
2008†
      (12)
            
            10.16
            
            Separation
      Agreement and Release of Claims among the Company, EFL and Avihai Shen
      dated January 5, 2006(13)
            
            10.17
            
            Form
      of Warrant dated February 15, 2006(14)
            
            10.18
            
            Lease
      dated February 10, 2006 between Arbor Development Company LLC and FAAC
      Incorporated(15)
            
            10.19
            
            Form
      of Warrant dated March 27, 2006(17)
            
            10.20
            
            Form
      of Warrant dated April 11, 2006(20)
            
            10.21
            
            Loan
      Agreement between FAAC Incorporated and Keybank National Association dated
      December 27, 2007(20)
            
            10.22
            
            Security
      Agreement between us and Keybank National Association dated December 27,
      2007(20)
            
            10.23
            
            Guaranty
      from us to Keybank National Association dated December 27,
      2007*  **
            
            10.24
            
            Agreement
      with Yossi Bar in respect of our purchase of the minority interest of
      M.D.T. Protective Industries Ltd. and MDT Armor Corporation dated January
      15, 2008**
            
            10.25
            
            Stock
      Purchase Agreement among FAAC Incorporated, Realtime Technologies Ltd. and
      Richard Romano dated February 4, 2008(9)
            
            21.1
            
            List
      of Subsidiaries of the Registrant**
            
            23.1
            
            Consent
      of BDO Seidman, LLP**
            
            31.1
            
            Certification
      of Principal Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002**
            
            31.2
            
            Certification
      of Principal Financial Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002**
            
            32.1
            
            Certification
      of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002**
            
            32.2
            
            Certification
      of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002










*
            English
      translation or summary from original
Hebrew


**
            Filed
      herewith


†
            Includes
      management contracts and compensation plans and
    arrangements


(1)
            Incorporated
      by reference to our Registration Statement on Form S-1 (Registration No.
      33-73256), which became effective on February 23,
  1994


(2)
            Incorporated
      by reference to our Registration Statement on Form S-1 (Registration No.
      33-97944), which became effective on February 5,
  1996




- 64
-




(3)
            Incorporated
      by reference to our Current Report on Form 8-K filed January 6,
      2003


(4)
            Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2002


(5)
            Incorporated
      by reference to our Current Report on Form 8-K filed October 3,
      2003


(6)
            Incorporated
      by reference to our Current Report on Form 8-K filed January 9,
      2004


(7)
            Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2003


(8)
            Incorporated
      by reference to our Current Report on Form 8-K filed July 15,
      2004


(9)
            Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2004


(10)
            Incorporated
      by reference to our Quarterly Report on Form 10-Q for the quarter ended
      June 30, 2004


(11)
            Incorporated
      by reference to our Current Report on Form 8-K filed September 30,
      2005


(12)
            Incorporated
      by reference to our Current Report on Form 8-K filed January 5,
      2006


(13)
            Incorporated
      by reference to our Current Report on Form 8-K filed February 16,
      2006


(14)
            Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2005


(15)
            Incorporated
      by reference to our Current Report on Form 8-K filed March 30,
      2006


(16)
            Incorporated
      by reference to our Current Report on Form 8-K filed April 7,
      2006


(17)
            Incorporated
      by reference to our Current Report on Form 8-K filed April 12,
      2006


(18)
            Incorporated
      by reference to our Quarterly Report on Form 10-Q for the quarter ended
      June 30, 2006


(19)
            Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2006


(20)
            Incorporated
      by reference to our Current Report on Form 8-K filed January 3,
      2008


- 65
-


SIGNATURES




Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized, on April 14, 2008.




AROTECH
      CORPORATIONBy:
            /s/  Robert S.
      EhrlichName:
            Robert
      S. EhrlichTitle:
            Chairman
      and Chief Executive Officer





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




Signature
            Title
            Date/s/  Robert
      S. Ehrlich
              Robert
      S. Ehrlich
            Chairman
      Chief Executive Officer and Director
              (Principal
      Executive Officer)
            April
      14, 2008/s/  Thomas
      J. Paup
              Thomas J.
      Paup
            Vice
      President – Finance
              (Principal
      Financial Officer)
            April
      14, 2008/s/  Norman
      Johnson
              Norman
      Johnson
            Controller
              (Principal
      Accounting Officer)
            April
      14, 2008/s/  Steven
      Esses
              Steven
      Esses
            President,
      Chief Operating Officer and Director
            April
      14, 2008/s/  Jay
      M. Eastman
              Dr. Jay M.
      Eastman
            Director
            April
      14, 2008/s/  Lawrence
      M. Miller
              Lawrence M.
      Miller
            Director
            April
      14, 2008/s/  Jack
      E. Rosenfeld
              Jack E.
      Rosenfeld
            Director
            April
      14, 2008/s/  Edward
      J. Borey
              Edward J.
      Borey
            Director
            April
      14, 2008/s/  Seymour
      Jones
              Seymour
      Jones
            Director
            April
      14, 2008/s/  Elliot
      Sloyer
              Elliot
      Sloyer
            Director
            April
      14, 2008/s/  Michael
      E. Marrus
              
              Michael E.
      Marrus
            Director
            April
      14, 2008





- 66
-


Report
of Independent Registered Public Accounting Firm








To the
Board of Directors and Shareholders of Arotech Corporation:





We have
audited the accompanying consolidated balance sheets of Arotech Corporation and
subsidiaries as of December 31, 2007 and 2006 and the related consolidated
statements of operations, changes in stockholders’ equity and cash flows for the
years then ended. In connection with our audits of the financial statements, we
have also audited the financial statement schedule listed in the accompanying
index.  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 schedules based on our
audits.





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





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Arotech Corporation and
subsidiaries as of December 31, 2007 and 2006, and the results of their
operations and their cash flows for the years then ended, in conformity with
accounting principles generally accepted in the United States of
America.





Also, in
our opinion, the financial statement schedule, when considered in relation to
the basic consolidated financial statements taken as a whole, presents fairly,
in all material respects, the information set forth therein.











Grand
      Rapids, Michigan
            /s/ BDO Seidman, LLPApril
      14, 2008
            BDO
      Seidman, LLP







AROTECH
CORPORATION AND ITS SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS


In
U.S. dollars




December 31,2007
            
            
            2006ASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
            
            $
            3,447,671
            
            
            $
            2,368,872Restricted
      collateral deposits
            
            
            320,454
            
            
            
            648,975Escrow
      receivable
            
            
            1,479,826
            
            
            
            1,479,826Available
      for sale marketable securities
            
            
            47,005
            
            
            
            41,166Trade
      receivables (net of allowance for doubtful accounts in the amounts of
      $25,000 and $159,000 as of December 31, 2007 and 2006,
      respectively)
            
            
            14,583,213
            
            
            
            7,780,965Unbilled
      receivables
            
            
            3,271,594
            
            
            
            6,902,533Other
      accounts receivable and prepaid expenses
            
            
            1,614,614
            
            
            
            1,134,622Inventories
            
            
            7,887,820
            
            
            
            7,851,820Total
      current assets
            
            
            32,652,197
            
            
            
            28,208,779SEVERANCE
      PAY FUND
            
            
            2,815,040
            
            
            
            2,246,457OTHER
      LONG-TERM RECEIVABLES
            
            
            386,899
            
            
            
            262,608PROPERTY
      AND EQUIPMENT, NET
            
            
            5,079,796
            
            
            
            3,740,593INVESTMENT
      IN AFFILIATED COMPANY
            
            
            352,168
            
            
            
            392,398OTHER
      INTANGIBLE ASSETS, NET
            
            
            7,837,076
            
            
            
            9,502,214GOODWILL
            
            
            31,358,131
            
            
            
            30,715,225Total
      long term assets
            
            
            47,829,110
            
            
            
            46,859,495$
            80,481,307
            
            
            $
            75,068,274








F-2





AROTECH
CORPORATION AND ITS SUBSIDIARIES
 CONSOLIDATED
BALANCE SHEETS
 In
U.S. dollars


December 31,2007
            
            
            2006LIABILITIES
      AND STOCKHOLDERS’ EQUITYCURRENT
      LIABILITIES:Trade
      payables
            
            $
            4,233,288
            
            
            $
            2,808,131Other
      accounts payable and accrued expenses
            
            
            4,889,729
            
            
            
            5,171,055Current
      portion of capitalized leases
            
            
            67,543
            
            
            
            55,263Current
      portion of promissory notes due to purchase of
subsidiaries
            
            
            151,450
            
            
            
            302,900Current
      portion of long term debt
            
            
            103,844
            
            
            
            –Short
      term bank credit
            
            
            4,557,890
            
            
            
            3,496,008Deferred
      revenues
            
            
            2,903,166
            
            
            
            1,321,311Convertible
      debenture
            
            
            –
            
            
            
            2,583,629Total
      current liabilities
            
            
            16,906,910
            
            
            
            15,738,297LONG
      TERM LIABILITIESAccrued
      severance pay
            
            
            4,853,231
            
            
            
            4,039,049Long
      term portion of promissory notes due to purchase of
      subsidiaries
            
            
            –
            
            
            
            151,450Long
      term portion of capitalized leases
            
            
            86,989
            
            
            
            158,120Long
      term portion of long term debt
            
            
            1,088,498
            
            
            
            –Other
      long term liabilities
            
            
            1,020,000
            
            
            
            900,000Deferred
      TaxesTotal
      long-term liabilities
            
            
            7,158,973
            
            
            
            5,248,619COMMITMENTS
      AND CONTINGENT LIABILITIES (Note 11)MINORITY
      INTEREST
            
            
            83,816
            
            
            
            21,520STOCKHOLDERS’
      EQUITY:Share
      capital –Common
      stock – $0.01 par value each;Authorized:
      250,000,000 shares as of December 31, 2007 and 2006; Issued: 13,544,819
      shares and 12,023,242 shares as of December 31, 2007 and 2006,
      respectively; Outstanding – 13,544,819 shares and 11,983,575 shares as of
      December 31, 2007 and 2006, respectively
            
            
            135,448
            
            
            
            120,232Preferred
      shares – $0.01 par value each;Authorized:
      1,000,000 shares as of December 31, 2007 and 2006; No shares issued and
      outstanding as of December 31, 2007 and 2006
            
            
            –
            
            
            
            –Additional
      paid-in capital
            
            
            218,551,110
            
            
            
            217,735,860Accumulated
      deficit
            
            
            (162,522,558
            )
            
            
            (159,466,123
            )Treasury
      stock, at cost (common stock – none as of December 31, 2007 and 39,667
      shares as of December 31, 2006)
            
            
            –
            
            
            
            (3,537,106
            )Notes
      receivable from shareholders
            
            
            (1,333,833
            )
            
            
            (1,304,179
            )Accumulated
      other comprehensive income
            
            
            1,501,441
            
            
            
            511,154Total
      stockholders’ equity
            
            
            56,331,608
            
            
            
            54,059,838$
            80,481,307
            
            
            $
            75,068,274









F-3


AROTECH
CORPORATION AND ITS SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF OPERATIONS





In
U.S. dollars





2007
            
            
            2006Revenues
            
            $
            57,719,561
            
            
            $
            43,120,739Cost
      of revenues, exclusive of amortization of intangibles
            
            
            39,639,812
            
            
            
            32,493,646Research
      and development
            
            
            1,877,163
            
            
            
            1,601,454Selling
      and marketing expenses
            
            
            4,164,464
            
            
            
            3,714,322General
      and administrative expenses
            
            
            13,158,297
            
            
            
            11,692,816Amortization
      of intangible assets
            
            
            1,381,882
            
            
            
            1,853,442Impairment
      of goodwill and other intangible assets
            
            
            –
            
            
            
            316,024Total
      operating costs and expenses
            
            
            60,221,618
            
            
            
            51,671,704Operating
      loss
            
            
            (2,502,057
            )
            
            
            (8,550,965
            )Other
      income
            
            
            617,952
            
            
            
            361,560Financial
      expenses, net
            
            
            (905,888
            )
            
            
            (7,519,900
            )Loss
      before minority interest in earnings of a subsidiaries, earnings from
      affiliated company, and income tax expenses
            
            
            (2,789,993
            )
            
            
            (15,709,305
            )Income
      taxes
            
            
            (163,916
            )
            
            
            (232,159
            )Gain
      (loss) from affiliated company
            
            
            (40,230
            )
            
            
            354,898Minority
      interest in loss (earnings) of subsidiaries
            
            
            (62,296
            )
            
            
            17,407Net
      loss
            
            $
            (3,056,435
            )
            
            $
            (15,569,159
            )Deemed
      dividend to certain stockholders
            
            $
            –
            
            
            $
            (434,185
            )Net
      loss attributable to common stockholders
            
            $
            (3,056,435
            )
            
            $
            (16,003,344
            )Basic
      and diluted net loss per share
            
            $
            (0.27
            )
            
            $
            (1.87
            )Weighted
      average number of shares used in computing basic and diluted net loss per
      share
            
            
            11,274,387
            
            
            
            8,569,191




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




F-4


AROTECH
CORPORATION AND ITS SUBSIDIARIES


STATEMENTS
OF CHANGES IN STOCKHOLDERS’ EQUITY


In U.S. dollars




AccumulatedNotes
            
            
            other
            
            
            TotalAdditional
            
            
            
            
            
            Deferred
            
            
            
            
            
            receivable
            
            
            comprehensive
            
            
            comprehensive
            
            
            TotalCommon
      stock
            
            
            paid-in
            
            
            Accumulated
            
            
            stock
            
            
            Treasury
            
            
            from
            
            
            income
            
            
            income
            
            
            stockholders’Shares
            
            
            Amount
            
            
            capital
            
            
            deficit
            
            
            compensation
            
            
            stock
            
            
            stockholders
            
            
            (loss)
            
            
            (loss)
            
            
            equityBalance
      as of January 1, 2006, as previously reported
            
            
            6,221,194
            
            
            $
            870,969
            
            
            $
            193,949,882
            
            
            $
            (142,996,964
            )
            
            $
            (389,303
            )
            
            $
            (3,537,106
            )
            
            $
            (1,256,777
            )
            
            $
            (375,445
            )
            
            $
            –
            
            
            $
            46,265,256Prior
      Period Adjustment
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            (900,000
            )
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            (900,000
            )Blanace
      of January 1, 2006, as adjusted
            
            
            6,221,194
            
            
            $
            870,969
            
            
            $
            193,949,882
            
            
            $
            (143,869,964
            )
            
            $
            (389,303
            )
            
            $
            (3,537,106
            )
            
            $
            (1,256,777
            )
            
            $
            (375,445
            )
            
            
            –
            
            
            $
            45,365,256Adjustment
      of fractional shares due to reverse split
            
            
            (142
            )
            
            
            (808,757
            )
            
            
            808,757
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –FAS
      123R reclassification
            
            
            –
            
            
            
            –
            
            
            
            (389,303
            )
            
            
            –
            
            
            
            389,303
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –Principal
      installment of convertible debenture payment in shares
            
            
            4,184,855
            
            
            
            41,848
            
            
            
            18,477,301
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            18,519,149Warrants
      exercise
            
            
            745,549
            
            
            
            7,455
            
            
            
            4,343,180
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            4,350,635Stock
      based compensation
            
            
            –
            
            
            
            –
            
            
            
            500,545
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            500,545Stock
      options and restricted stock
            
            
            871,786
            
            
            
            8,717
            
            
            
            (1,904
            )
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            6,813Interest
      accrued on notes receivable from shareholders
            
            
            –
            
            
            
            –
            
            
            
            47,402
            
            
            
            –
            
            
            
            –
            
            
            
            
            
            
            
            (47,402
            )
            
            
            –
            
            
            
            –
            
            
            
            –Other
      comprehensive loss – foreign currency translation
    adjustment
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            885,733
            
            
            
            885,733
            
            
            
            885,733Other
      comprehensive loss – unrealized gain on available for sale marketable
      securities
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            866
            
            
            
            866
            
            
            
            866Net
      loss
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            (15,569,159
            )
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            (15,569,159
            )
            
            
            (15,569,159
            )Total
      comprehensive loss
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            (14,682,560
            )
            
            
            –Balance
      as of December 31, 2006
            
            
            12,023,242
            
            
            $
            120,232
            
            
            $
            217,735,860
            
            
            $
            (159,466,123
            )
            
            $
            0
            
            
            $
            (3,537,106
            )
            
            $
            (1,304,179
            )
            
            $
            511,154
            
            
            
            
            
            
            $
            54,059,838







F-5





AROTECH
CORPORATION AND ITS SUBSIDIARIES
 STATEMENTS OF CHANGES IN STOCKHOLDERS’
EQUITY


In U.S. dollars





AccumulatedNotes
                
                
                other
                
                
                TotalAdditional
                
                
                
                
                
                
                
                
                receivable
                
                
                comprehensive
                
                
                comprehensive
                
                
                TotalCommon
      stock
                
                
                paid-in
                
                
                Accumulated
                
                
                Treasury
                
                
                from
                
                
                income
                
                
                income
                
                
                stockholders’Shares
                
                
                Amount
                
                
                capital
                
                
                deficit
                
                
                stock
                
                
                stockholders
                
                
                (loss)
                
                
                (loss)
                
                
                equityBalance
      as of January 1, 2007
                
                
                12,023,242
                
                
                $
                120,232
                
                
                $
                217,735,860
                
                
                $
                (159,466,123
                )
                
                $
                (3,537,106
                )
                
                $
                (1,304,179
                )
                
                $
                511,154
                
                
                $
                –
                
                
                $
                54,059,838Principal
      installment of convertible debenture payment in shares
                
                
                930,125
                
                
                
                9,301
                
                
                
                2,873,454
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                2,882,755Treasury
      shares cancellation
                
                
                (39,666
                )
                
                
                (396
                )
                
                
                (3,536,710
                )
                
                
                –
                
                
                
                3,537,106
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –Stock
      based compensation
                
                
                –
                
                
                
                –
                
                
                
                1,417,521
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                1,417,521Stock
      options and restricted stock
                
                
                631,118
                
                
                
                6,311
                
                
                
                31,331
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                37,642Interest
      accrued on notes receivable from shareholders
                
                
                –
                
                
                
                –
                
                
                
                29,654
                
                
                
                –
                
                
                
                
                
                
                
                (29,654
                )
                
                
                –
                
                
                
                –
                
                
                
                –Other
      comprehensive loss – foreign currency translation
    adjustment
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                988,740
                
                
                
                988,740
                
                
                
                988,740Other
      comprehensive loss – unrealized gain on available for sale marketable
      securities
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                1,547
                
                
                
                1,547
                
                
                
                1,547Net
      loss
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (3,056,435
                )
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (3,056,435
                )
                
                
                (3,056,435
                )Total
      comprehensive loss
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (2,066,148
                )
                
                
                –Balance
      as of December 31, 2007
                
                
                13,544,819
                
                
                $
                135,448
                
                
                $
                218,551,110
                
                
                $
                (162,522,558
                )
                
                $
                0
                
                
                $
                (1,333,833
                )
                
                $
                1,501,441
                
                
                
                
                
                
                $
                56,331,608







F-6





AROTECH
CORPORATION AND ITS SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS


In U.S. dollars





2007
            
            
            2006Cash
      flows from operating activities:Net
      loss
            
            $
            (3,056,435
            )
            
            $
            (15,569,159
            )Adjustments
      required to reconcile net loss to net cash used in operating
      activities:Minorities
      interests in loss (earnings) of subsidiary
            
            
            62,296
            
            
            
            (17,407
            )Loss
      (gain) from affiliated company
            
            
            40,230
            
            
            
            (354,898
            )Depreciation
            
            
            1,376,749
            
            
            
            1,966,748Amortization
      of intangible assets, capitalized software costs and impairment of
      intangible assets
            
            
            1,953,164
            
            
            
            2,857,891Remeasurement
      of liability in connection to warrants granted
            
            
            –
            
            
            
            (700,113
            )Accrued
      severance pay, net
            
            
            245,599
            
            
            
            194,810Compensation
      related to shares issued to employees, consultants and
      directors
            
            
            1,417,521
            
            
            
            507,081Impairment
      of property and equipment
            
            
            –
            
            
            
            32,485Financial
      expenses in connection with convertible debenture principle
      repayment
            
            
            280,382
            
            
            
            5,395,338Amortization
      related to warrants issued to the holders of convertible debentures and
      beneficial conversion feature
            
            
            18,745
            
            
            
            1,485,015Amortization
      of deferred charges related to convertible debentures
    issuance
            
            
            44,253
            
            
            
            780,719Capital
      loss (gain) from sale of property and equipment
            
            
            56,224
            
            
            
            (1,842
            )Decrease
      (increase) in trade receivables
            
            
            (6,802,248
            )
            
            
            3,631,978Decrease
      (increase) in other accounts receivable and prepaid
    expenses
            
            
            (706,569
            )
            
            
            605,610Decrease
      in deferred taxes
            
            
            (100,323
            )
            
            
            6,788Decrease
      (increase) in inventories
            
            
            (36,000
            )
            
            
            83,926Increase
      (decrease) in unbilled revenues
            
            
            3,630,939
            
            
            
            (1,674,029
            )Increase
      in deferred revenues
            
            
            1,581,854
            
            
            
            718,290Increase
      (decrease) in trade payables
            
            
            1,425,156
            
            
            
            (3,156,665
            )Decrease
      in other accounts payable and accrued expenses
            
            
            (137,834
            )
            
            
            (296,866
            )Net
      cash provided by (used in) operating activities from continuing
      operations
            
            
            1,494,349
            
            
            
            (3,504,300
            )Net
      cash used in operating activities from discontinued
    operations
            
            
            –
            
            
            
            (120,000
            )Net
      cash provided by (used in) operating activities
            
            $
            1,494,349
            
            
            $
            (3,624,300
            )Cash
      flows from investing activities:Purchase
      of property and equipment
            
            
            (1,594,426
            )
            
            
            (1,412,383
            )Increase
      in capitalized software costs
            
            
            (15,750
            )
            
            
            (688,443
            )Payment
      of additional required payout for FAAC acquisition
            
            
            –
            
            
            
            (630,350
            )Repayment
      of promissory notes related to acquisition of subsidiaries
            
            
            (302,900
            )
            
            
            –Proceeds
      from sale of property and equipment
            
            
            36,061
            
            
            
            –Increase
      in escrow receivable
            
            
            –
            
            
            
            (1,479,826
            )Decrease
      in restricted cash
            
            
            322,682
            
            
            
            3,723,611Net
      cash used in investing activities
            
            $
            (1,554,333
            )
            
            $
            (487,391
            )








F-7





AROTECH
CORPORATION AND ITS SUBSIDIARIES
 CONSOLIDATED STATEMENTS OF CASH
FLOWS


In U.S. dollars





2007
            
            
            2006Forward
            
            
            (59,985
            )
            
            
            (4,111,691
            )Cash
      flows from financing activities:Proceeds
      from exercise of options
            
            
            37,642
            
            
            
            250Proceeds
      from exercise of warrants
            
            
            –
            
            
            
            4,350,635Repayment
      of convertible debentures
            
            
            –
            
            
            
            (5,204,167
            )Repayment
      of long term loan
            
            
            (21,468
            )
            
            
            (149,414
            )Increase
      in short term bank credit
            
            
            1,061,883
            
            
            
            1,455,309Net
      cash provided by financing activities
            
            
            1,078,057
            
            
            
            452,613Increase
      (decrease) in cash and cash equivalents
            
            
            1,018,073
            
            
            
            (3,659,078
            )Cash
      accretion (erosion) due to exchange rate differences
            
            
            60,726
            
            
            
            (122,702
            )Cash
      and cash equivalents at the beginning of the year
            
            
            2,368,872
            
            
            
            6,150,652Cash
      and cash equivalents at the end of the year
            
            $
            3,447,671
            
            
            $
            2,368,872Supplementary
      information on non-cash transactions:Payment
      of principle installment of convertible debenture in
shares
            
            $
            2,882,753
            
            
            $
            18,519,149Mortgage
      note payable (seller financed) issued for purchase of
    building
            
            $
            1,115,000
            
            
            $
            –Interest
      paid during the period
            
            $
            662,789
            
            
            $
            2,018,061








F-8




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




NOTE
1:–   GENERAL





a.                 Corporate
structure:





Arotech
Corporation (“Arotech” or the “Company”) and its subsidiaries are engaged in the
development, manufacture and marketing of defense and security products,
including advanced high-tech multimedia and interactive digital solutions for
training of military, law enforcement and security personnel and sophisticated
lightweight materials and advanced engineering processes to armor vehicles, and
in the design, development and commercialization of its proprietary zinc-air
battery technology for electric vehicles and defense applications. The Company
is primarily operating through FAAC Corporation, a wholly-owned subsidiary based
in Ann Arbor, Michigan; 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; M.D.T. Protective Industries,
Ltd. (“MDT”), a majority-owned (now wholly-owned; see Note 18.b.) subsidiary
based in Lod, Israel; MDT Armor Corporation, a majority-owned (now wholly-owned;
see Note 18.b.) subsidiary based in Auburn, Alabama; and Armour of America,
Incorporated, a wholly-owned subsidiary based in Auburn, Alabama.





Revenues
derived from the Company’s largest customers in 2007 and 2006 are described in
Note 16.d.





b.                 Acquisition
of FAAC:





The
Company had a contingent earnout obligation in an amount equal to the net income
realized by the Company from certain specific programs that were identified by
the Company and the former shareholders of FAAC as appropriate targets for
revenue increases in 2005. During 2005 and 2006, the Company accrued an amount
of $603,764 and $630,000, respectively, in respect of such earnout obligation to
increase FAAC’s goodwill. The $151,450 shown as promissory notes in the balance
sheet is the portion of the 2006 earnout that is paid in equal installments that
started in January 2007 and will be paid in full in June 2008 .The promissory
note is non-interest bearing.





c.                 Acquisition
of AoA:





The total
purchase price consisted of $19,000,000 in cash, with additional possible
earn-outs if AoA was awarded certain material contracts. An additional
$3,000,000 was to be paid into an escrow account pursuant to the terms of an
escrow agreement, to secure a portion of the Earnout Consideration. These funds
are currently being held by the seller of AoA. As of December 31, 2007, the
Company had reduced the $3.0 million escrow held by the seller of AoA by
$1,520,174 for a putative claim against such escrow in respect of such earn-out
obligation.  When the contingency on the earn-out provision is
resolved, the additional consideration, if any, will be recorded as additional
purchase price.  Any recovery of the previously expensed escrow amount
will be recorded as income in the period received.





In March
2007, the Company filed a Demand for Arbitration with the American Arbitration
Association against the seller of AoA. The Company sought the return of the $3.0
million escrow, plus interest. The seller of AoA asserted counterclaims against
the Company in the arbitration, alleging (i) that he is entitled to keep the
$3.0 million, (ii) that he is entitled to an additional $3.0 million
in





F-9


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


post-sale
earnouts, and (iii) that he is entitled to $70,000 in compensation (plus
interest and statutory penalties) wrongfully withheld by the Company when it
constructively terminated his employment.





In
December 2007, the matter was brought before an arbitration panel and in
February 2008, the arbitration panel issued a decision, granting the seller’s
counterclaim for $70,000 in compensation, awarding the Company the entire $3.0
million escrow (less the $70,000 in compensation (with simple interest but
without statutory penalties)), and awarding the Company $135,000 in attorneys’
fees. The federal district court for the Southern District of New York has not
yet ruled upon the Company’s petition to confirm the arbitration
award.





d.                 Impairment
of goodwill and other intangible assets:





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





In 2007,
the Company evaluated all goodwill and it was determined that there was no
impairment.





In 2006,
the Company identified an additional $316,024 in potential earn-out obligations
in an amount equal to the revenues realized by the Company from certain specific
programs at AoA.  This expense is shown as impairment expense since
the full amount of AoA goodwill had been previously written off in
2005.





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.





e.                 Reverse
stock split:





On June
20, 2006, the Company filed a Certificate of Amendment with the Delaware
Secretary of State which served to effect, as of 7:00 a.m. e.d.t. on June 21,
2006, a one-for-fourteen reverse split of the Company’s common stock. As a
result of the reverse stock split, every fourteen shares of the Company’s common
stock were combined into one share of common stock; any fractional shares
created by the reverse stock split were eliminated. The par value of the shares
remained unchanged. The reverse stock split affected all of the Company’s common
stock, stock options, warrants





F-10


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


and
convertible debt outstanding immediately prior to the effective date of the
reverse stock split. The reverse split reduced the number of shares of the
Company’s common stock outstanding at June 21, 2006 from 118,587,361 shares to
8,468,957 shares. All references to common share and per common share amounts
for all periods presented have been retroactively restated to reflect this
reverse split.





f.                 Related
parties





The
Company has a consulting agreement with Sampen Corporation that it executed in
March 2005, effective as of January 1, 2005. Sampen is a New York corporation
owned by members of the immediate family of one of the Company’s executive
officers, and this executive officer is an employee of both the Company and of
Sampen. The term of this consulting agreement as extended expires on December
31, 2008, and is extended automatically for additional terms of two years each
unless either Sampen or the Company terminate the agreement sooner.





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





During
the years ended December 31, 2007 and 2006 the Company paid Sampen a total of
$219,354 and $208,896, respectively.





On
December 3, 1999, Robert S. Ehrlich purchased 8,928 shares of the Company’s
common stock out of the Company’s treasury at the closing price of the Company’s
common stock on December 2, 1999. Payment was rendered by Mr. Ehrlich in the
form of non-recourse promissory notes due in 2009 in the amount of $167,975,
bearing simple annual interest at a rate of 2%, secured by the shares of common
stock purchased and other shares of common stock previously held by him. As of
December 31, 2007, the aggregate amount outstanding pursuant to this promissory
note was $201,570.





On
February 9, 2000, Mr. Ehrlich exercised 9,404 stock options. Mr. Ehrlich paid
the exercise price of the stock options and certain taxes that the Company paid
on his behalf by giving the Company a non-recourse promissory note due in 2025
in the amount of $789,991, bearing annual interest (i) as to $329,163, at 1%
over the then-current federal funds rate announced from time to time by the
Wall Street Journal,
and (ii) as to $460,828, at 4% over the then-current percentage increase in the
Israeli consumer price index between the date of the loan and the date of the
annual interest calculation, secured by the shares of the Company’s common stock
acquired through the exercise of the options and certain compensation due to Mr.
Ehrlich upon termination. As of





F-11


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


December
31, 2007, the aggregate amount outstanding pursuant to this promissory note was
$820,809.





On June
10, 2002, Mr. Ehrlich exercised 3,571 stock options. Mr. Ehrlich paid the
exercise price of the stock options by giving the Company a non-recourse
promissory note due in 2012 in the amount of $36,500, bearing simple annual
interest at a rate equal to the lesser of (i) 5.75%, and (ii) 1% over the
then-current federal funds rate announced from time to time, secured by the
shares of the Company’s common stock acquired through the exercise of the
options. As of December 31, 2007, the aggregate amount outstanding pursuant to
this promissory note was $45,388.





NOTE
2:–   SIGNIFICANT ACCOUNTING POLICIES





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





a.                 Use
of estimates:





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





b.                 Financial
statements in U.S. dollars:





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





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





F-12


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


c.                 Principles
of consolidation:





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





d.                 Cash
equivalents:





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





e.                 Restricted
collateral deposits





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





f.                 Marketable
securities





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





At
December 31, 2007 the Company and its subsidiaries classified its investment in
marketable securities as available-for-sale.





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





g.                 Inventories:





Inventories
are stated at the lower of cost or market value. Inventory write-offs and
write-down provisions are provided to cover risks arising from slow-moving items
or technological obsolescence and for market prices lower than cost. The Company
periodically evaluates the quantities on hand relative to current and historical
selling prices and historical and projected sales volume. Based on this
evaluation, provisions are made to write inventory down to its market value. In
2007 and 2006, the Company wrote off $150,681 and $292,864, 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 or FIFO.





F-13


AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE 2:–   SIGNIFICANT
ACCOUNTING POLICIES (Cont.)
 Work in
progress – represents the cost of manufacturing with additions of allocable
indirect manufacturing cost.





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





h.                 Property
and equipment:





Property
and equipment are stated at cost net of accumulated depreciation and investment
grants received from the State of Israel for investments in fixed assets under
the Investment Law (no investment grants were received during 2007 and
2006).





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 or the life of the
    asset





i.                 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
2007 and 2006, 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 (Training and Simulation
Division); (ii) from revenues under armor contracts and for service and repair
of armored vehicles (Armor Division); (iii) from the sale of batteries, chargers
and adapters to the military, and under certain development contracts with the
U.S. Army (Battery and Power Systems Division); and (iv) from the sale of
lifejacket lights (Battery and Power Systems Division).





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





Revenues
from contracts that involve customization of FAAC’s simulation system to
customer specific specifications are recognized in accordance with Statement Of
Position 81-1, “Accounting for Performance of Construction-Type and Certain
Production-Type Contracts,” using contract accounting on a percentage of
completion method, in accordance with the “Input Method.” The amount of revenue
recognized is based on the percentage to completion achieved. The percentage to
completion is measured by monitoring progress using records of actual time
incurred





F-14


AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE 2:–   SIGNIFICANT
ACCOUNTING POLICIES (Cont.)
  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. During 2006 $741,165 in
estimated losses were identified and expensed.





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





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





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





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





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





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





F-15


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




j.                 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.





k.                 Warranty:





The
Company offers up to one year warranty for most of its products. The specific
terms and conditions of those warranties vary depending upon the product sold
and country in which the Company does business. The Company estimates the costs
that may be incurred under its basic limited warranty, including parts and
labor. The Company estimates the costs that may be incurred under its basic
limited warranty and records a liability in the amount of such costs as the time
product revenue is recognized. Factors that affect the Company’s warranty
liability include the number of installed units, historical and anticipated
rates of warranty claims, and cost per claim. The Company periodically assesses
the adequacy of its recorded warranty liabilities and adjusts the amounts as
necessary. See Note 18.





l.                 Research
and development cost:





SFAS No.
86, “Accounting for the Costs of Computer Software to be Sold, Leased or
Otherwise Marketed,” requires capitalization of certain software development
costs, subsequent to the establishment of technological feasibility. Based on
the Company’s product development process, technological feasibility is
established upon the completion of a working model or a detailed program design.
Research and development costs incurred in the process of developing product
improvements or new products, are generally charged to expenses as incurred,
when applicable. Significant costs incurred by the Company between completion of
the working model or a detailed program design and the point at which the
product is ready for general release, have been capitalized. Capitalized
software costs will be amortized by the greater of the amount computed using
the: (i) ratio that current gross revenues from sales of the software bears to
the total of current and anticipated future gross revenues from sales of that
software, or (ii) the straight-line method over the estimated useful life of the
product (two to five years). The Company assesses the net realizable value of
this intangible asset on a regular basis by determining whether the amortization
of the asset over its remaining life can be recovered through undiscounted
future operating cash flows from the specific software product sold. Based on
its most recent analyses, management believes that no impairment of capitalized
software development costs exists as of December 31, 2007.





m.                 Income
taxes:





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





F-16


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


n.                 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 deposits, trade receivables and available for sale
marketable securities. Cash and cash equivalents are invested mainly in U.S.
dollar deposits with major Israeli and U.S. banks. Such deposits in the U.S. may
be in excess of insured limits and are not insured in other jurisdictions.
Management believes that the financial institutions that hold the Company’s
investments are financially sound and, accordingly, minimal credit risk exists
with respect to these investments.





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





The
Company’s available for sale marketable securities 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.





o.                 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, non vested restricted stock 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
1,791,562 and 1,781,984, for the years ended December 31, 2007 and 2006,
respectively.





p.                 Accounting
for stock-based compensation





Effective
January 1, 2006, the Company started to account for stock options and awards
issued to employees in accordance with the fair value recognition provisions of
Financial Accounting Standards Board (“FASB”) Statement No. 123(R) (“SFAS No.
123(R)”), “Share-Based Payment,” using the modified prospective transition
method. Under SFAS No. 123(R), stock-based





F-17


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


awards to
employees are required to be recognized as compensation expense, based on the
calculated fair value on the date of grant. The Company determines the fair
value using the Black Scholes option pricing model. This model requires
subjective assumptions, including future stock price volatility and expected
term, which affect the calculated values. The adoption of SFAS No. 123(R)
resulted in a reduction in income of $500,445 in 2006, which reduced basic and
diluted EPS for the year by $0.06.





The fair
value for the 2006 options granted to employees was estimated at the date of
grant, using the Black-Scholes Option Valuation Model, with the following
weighted-average assumptions: risk-free interest rates of 4.64% (based on
three-year U.S. Treasury bonds); a dividend yield of 0.0%, a volatility factor
of the expected market price of the common stock of 1.33 (based on historical
volatility of the stock over the previous three years); and a weighted-average
expected life of the option of three years. The Company did not grant any
options in 2007.  The Company assumed a 20% forfeiture rate for
options for both years.  The Company uses a 10% forfeiture rate for
restricted stock.





q.                 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 deposits,
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.





r.                 Severance
pay:





The
Company’s liability for severance pay for its Israeli employees 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
Israeli 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 EITF 88-1:
“Determination of Vested Benefit Obligation for a Defined Benefit





F-18


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


Pension
Plan” As of December 31, 2007 and 2006, the accumulated severance pay in that
regard amounted to $2,081,587 and $2,163,264, respectively.





Pursuant
to the terms of the employment agreement between the Company and its Chief
Executive Officer, funds to secure payment of the Chief Executive Officer’s
contractual severance are to be deposited for the benefit of the Chief Executive
Officer, with payments to be made pursuant to an agreed-upon schedule. As of
December 31, 2007, a total of $618,097 had been deposited. These funds continue
to be owned by the Company, which benefits from all gains and bears the risk of
all losses resulting from investments of these funds.





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





Severance
expenses for the years ended December 31, 2007 and 2006 amounted to $334,749 and
$563,302, respectively.





s.                 Advertising
costs:





The
Company and its subsidiaries expense advertising costs as incurred. Advertising
expense for the years ended December 31, 2007 and 2006 was approximately $92,775
and $21,000, respectively.





t.                 New
accounting pronouncements:





In
December 2007, the Financial Accounting Standards Board (FASB)
issued Statement of Financial Accounting Standards (SFAS) No. 141(R), Business Combinations, to
further enhance the accounting and financial reporting related to business
combinations.  SFAS No. 141(R) establishes principles
and requirements for how the acquirer in a business combination (1)
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree, (2) recognizes and measures the goodwill acquired in the business
combination or a gain from a bargain purchase, and (3) determines what
information to disclose to enable users of the financial statements to
evaluate the nature and financial effects of the business combination.
 SFAS No. 141(R) applies prospectively to business combinations for
which the acquisition date is on or after the beginning of the first annual
reporting period beginning on or after December 15, 2008. Therefore, the
effects of the Corporation’s adoption of SFAS No. 141(R) will depend upon
the extent and magnitude of acquisitions after December 31, 2008.





In
September 2006, the FASB issued SFAS No. 157,Fair Value
Measurements.  This Statement defines fair value, establishes a
framework for measuring fair value and expands disclosures about fair value
measurements.  SFAS No. 157 applies to other accounting pronouncements
that require or permit fair value measurements, the Board having previously
concluded in those accounting pronouncements that fair value is the relevant
measurement attribute.  The Statement does not require any new fair
value measurements and was initially effective for the Corporation





F-19


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


beginning
January 1, 2008.  In February 2008, the FASB approved the issuance of
FASB Staff Position (FSP) FAS 157-2. FSP FAS 157-2 defers the
effective date of SFAS No. 157 until January 1, 2009 for nonfinancial assets and
nonfinancial liabilities except those items recognized or disclosed at fair
value on an annual or more frequently recurring basis.  Management has
not completed its review of the new guidance; however, the effect of the
Statement’s implementation is not expected to be material to the Corporation’s
results of operations or financial position.





In
February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial
Assets and Financial Liabilities.  This
Statement permits entities to choose to measure eligible items at fair value at
specified election dates.  For items for which the fair value option has
been elected, unrealized gains and losses are to be reported in earnings at each
subsequent reporting date.  The fair value option is irrevocable unless a
new election date occurs, may be applied instrument by instrument, with a few
exceptions, and applies only to entire instruments and not to portions of
instruments.  SFAS No. 159 provides an opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge
accounting.  SFAS No. 159 is effective for the Corporation beginning
January 1, 2008.  Management has not completed its review of the new
guidance; however, the effect of the Statement’s implementation is not expected
to be material to the Corporation’s results of operations or financial
position.





In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements–an amendment of ARB No. 51,
to create accounting and reporting standards for the noncontrolling
interest in a subsidiary and for the deconsolidation of a subsidiary.
 SFAS No. 160 establishes accounting and reporting standards that
require (1) the ownership interest in subsidiaries held by parties other
than the parent to be clearly identified and presented in the consolidated
balance sheet within equity, but separate from the parent’s equity, (2) the
amount of consolidated net income attributable to the parent and
the noncontrolling interest to be clearly identified and presented on the
face of the consolidated statement of income, (3) changes in a parent’s
ownership interest while the parent retains its controlling financial
interest in its subsidiary to be accounted for consistently, (4) when a
subsidiary is deconsolidated, any retained noncontrolling equity investment
in the former subsidiary to be initially measured at fair value, and (5)
entities to provide sufficient disclosures that clearly identify and
distinguish between the interests of the parent and the interests of the
noncontrolling owners.  SFAS No. 160 applies to fiscal years, and
interim periods within those fiscal years, beginning on or after December
15, 2008, and prohibits early adoption.  Management has not completed
its review of the new guidance; however, the effect of the Statement’s
implementation is not expected to be material to the Corporation’s results of
operations or financial position.





u.                 Reclassification:





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





F-20


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


NOTE
3:–   RESTRICTED COLLATERAL DEPOSITS





December 31,2007
            
            
            2006Short-term:Deposits
      in connection with MDT Israel projects
            
            $
            254,668
            
            
            $
            –Deposits
      in connection with FAAC projects
            
            
            –
            
            
            
            535,151Restricted
      cash in connection with interest payment to convertible debenture
      holders.
            
            
            
            
            
            
            113,824Deposits
      in connection with EFL projects
            
            
            65,786
            
            
            
            –Total
      Restricted Collateral
            
            $
            320,454
            
            
            $
            648,975





NOTE
4: –   AVAILABLE FOR SALE MARKETABLE SECURITIES





The
following is a summary of investments in marketable securities as of December
31, 2007 and 2006:





Cost
            
            
            Unrealized gains
            
            
            Estimated fair value2007
            
            
            2006
            
            
            2007
            
            
            2006
            
            
            2007
            
            
            2006Available
      for sale marketable securities
            
            $
            41,166
            
            
            $
            36,708
            
            
            $
            5,839
            
            
            $
            4,458
            
            
            $
            47,005
            
            
            $
            41,166





NOTE
5:–   OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES





December 31,2007
              
              
              2006Government
      authorities
              
              $
              259,036
              
              
              $
              213,362Employees
              
              
              60,950
              
              
              
              77,836Prepaid
      expenses
              
              
              790,157
              
              
              
              292,496Deferred
      taxes
              
              
              –
              
              
              
              58,032Other
              
              
              504,471
              
              
              
              492,896$
              1,614,614
              
              
              $
              1,134,622




NOTE
6:–   INVENTORIES





December 31,2007
            
            
            2006Raw
      and packaging materials
            
            $
            6,043,170
            
            
            $
            4,556,250Work
      in progress
            
            
            1,583,790
            
            
            
            3,186,843Finished
      products
            
            
            260,860
            
            
            
            108,727$
            7,887,820
            
            
            $
            7,851,820





F-21


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


NOTE
7:–   PROPERTY AND EQUIPMENT, NET





a.                 Composition
of property and equipment is as follows:





December 31,2007
            
            
            2006Cost:Computers
      and related equipment
            
            $
            2,494,370
            
            
            $
            2,080,462Motor
      vehicles
            
            
            561,737
            
            
            
            674,737Office
      furniture and equipment
            
            
            1,194,132
            
            
            
            1,015,054Machinery,
      equipment and  installations
            
            
            4,485,959
            
            
            
            4,108,763Buildings
            
            
            1,172,072
            
            
            
            –Land
            
            
            115,538
            
            
            
            –Leasehold
      improvements
            
            
            846,271
            
            
            
            887,311Demo
      inventory
            
            
            1,150,129
            
            
            
            643,458$
            12,020,208
            
            
            $
            9,409,785Accumulated
      depreciation:Computers
      and related equipment
            
            
            2,061,044
            
            
            
            1,626,066Motor
      vehicles
            
            
            249,627
            
            
            
            234,023Office
      furniture and equipment
            
            
            536,472
            
            
            
            585,069Machinery,
      equipment and installations
            
            
            3,132,202
            
            
            
            2,466,598Buildings
            
            
            25,045
            
            
            
            –Leasehold
      improvements
            
            
            407,030
            
            
            
            385,196Demo
      inventory
            
            
            528,992
            
            
            
            372,2406,940,412
            
            
            
            5,669,192Depreciated
      cost
            
            $
            5,079,796
            
            
            $
            3,740,593





b.                 Depreciation
expense amounted to $1,376,749 and $1,966,748 for the years ended December 31,
2007 and 2006, respectively.





c.                 In
March 2007, the Company purchased 16,700 square feet of space in Auburn, Alabama
for approximately $1.1 million pursuant to a seller-financed secured purchase
money mortgage. Half the mortgage is payable over ten years in equal monthly
installments based on a 20-year amortization of the full principal amount, and
the remaining half is payable at the end of ten years in a balloon
payment.





As for
liens, see Note 11.d.




NOTE
8:–   GOODWILL AND OTHER INTANGIBLE ASSETS, NET





a.           Goodwill





A summary
of the goodwill by business segment is as follows:





12/31/06
            
            
            Additions
            
            
            Adjustments (currency)
            
            
            12/31/07Simulation
            
            $
            24,235,419
            
            
            $
            –
            
            
            $
            –
            
            
            $
            24,235,419Battery
            
            
            5,413,210
            
            
            
            –
            
            
            
            533,439
            
            
            
            5,946,649Armor
            
            
            1,066,596
            
            
            
            –
            
            
            
            109,467
            
            
            
            1,176,063Total
            
            $
            30,715,225
            
            
            $
            –
            
            
            $
            642,906
            
            
            $
            31,358,131




F-22


AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE 8:–   GOODWILL AND
OTHER INTANGIBLE ASSETS, NET (Cont.)
  b.           Other
intangible assets





December 31,2007
            
            
            2006Cost
            
            
            Net Book Value
            
            
            Cost
            
            
            Net Book ValueTechnology
            
            $
            6,405,000
            
            
            $
            2,305,000
            
            
            $
            6,405,000
            
            
            $
            2,898,750Capitalized
      software costs
            
            
            1,720,991
            
            
            
            442,816
            
            
            
            1,701,150
            
            
            
            975,664Backlog
            
            
            682,000
            
            
            
            –
            
            
            
            682,000
            
            
            
            –Covenants
      not to compete
            
            
            99,000
            
            
            
            –
            
            
            
            99,000
            
            
            
            9,900Customer
      list
            
            
            7,548,645
            
            
            
            3,846,117
            
            
            
            7,548,645
            
            
            
            4,591,065Certification
            
            
            246,969
            
            
            
            –
            
            
            
            246,969
            
            
            
            51,87716,702,605
            
            
            
            6,593,933
            
            
            
            16,682,764
            
            
            
            8,527,256Exchange
      differences
            
            
            444,143
            
            
            
            
            
            
            
            175,958Less
      - accumulated amortization
            
            
            (10,108,672
            )
            
            
            
            
            
            
            (8,155,508
            )Amortized
      cost
            
            
            7,038,076
            
            
            
            
            
            
            
            8,703,214Trademarks
            
            
            799,000
            
            
            
            
            
            
            
            799,000Net
      book value
            
            $
            7,837,076
            
            
            
            
            
            
            $
            9,502,214





Amortization
expense amounted to $1,953,164 and $2,857,891 for the years ended December 31,
2007 and 2006, respectively, including amortization of capitalized software
costs of $552,689 and $285,467, respectively.





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




Year ended December 31,2008
            
            $
            1,276,0752009
            
            
            1,235,6322010
            
            
            1,197,9902011
            
            
            1,197,9902012
            
            
            621,7402013
      and forward
            
            
            621,691Total
            
            $
            6,151,117





Goodwill
and other intangible assets are adjusted on a quarterly basis for any change due
to currency fluctuations and any variation is included in the accumulated other
comprehensive loss on the Balance Sheet.





NOTE
9:–   SHORT-TERM BANK CREDIT AND LOANS




The
Company and/or certain of its subsidiaries have $8.0 million authorized in
credit lines from certain banks, of which $475,000 is denominated in NIS and
carries various approximate interest rates of prime rate + 2.6 to 4.2% and $7.5
million is denominated in U.S. dollars (the Company’s primary line) and carries
an interest rate of lender’s prime rate + 0.25%, the interest rate charged by
the bank for this line was 7.5% at December 31, 2007. As of December 31, 2007,
$5.1 million was utilized from the Company’s primary line, out of which $530,000
is related to two letters of credit issued to customers of two of the Company’s
subsidiaries.





F-23


AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
 NOTE
9:–   SHORT-TERM BANK CREDIT AND LOANS
(Cont.)


These
lines of credit are secured by the accounts receivable, inventory and marketable
securities of the relevant subsidiary of the Company.





NOTE
10:–  OTHER ACCOUNTS PAYABLE AND ACCRUED EXPENSES





December 31,2007
            
            
            2006Employees
      and payroll accruals
            
            $
            1,531,157
            
            
            $
            1,288,601Accrual
      for expected loss
            
            
            –
            
            
            
            829,973Accrued
      vacation pay
            
            
            530,850
            
            
            
            442,068Accrued
      expenses
            
            
            1,813,947
            
            
            
            1,380,150Government
      authorities
            
            
            401,826
            
            
            
            815,374Advances
      from customers
            
            
            611,948
            
            
            
            414,889$
            4,889,728
            
            
            $
            5,171,055





NOTE
11:–   COMMITMENTS AND CONTINGENT LIABILITIES





a.                 Royalty
commitments:





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





Royalties
paid or accrued for the years ended December 31, 2007 and 2006 to the OCS
amounted to $15,063 and $30,402, respectively.





As of
December 31, 2007, the total contingent liability to the OCS was approximately
$10,356,671. 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.





F-24




AROTECH
CORPORATION AND ITS SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





In
U.S. dollars




NOTE
11:–   COMMITMENTS AND CONTINGENT LIABILITIES
(Cont.)




No
royalties were paid or accrued to the BIRD-F in each of the three years in the
period ended December 31, 2007.





As of
December 31, 2007, 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 minimum rental payments under
non-cancelable operating leases are as follows:





December 312008
            
            $
            637,7602009
            
            
            495,5042010
            
            
            502,0312011
            
            
            507,3492012
            
            
            513,875Thereafter
            
            
            1,645,672Total
            
            $
            4,302,191





Total
rent expenses for the years ended December 31, 2007 and 2006 were $890,406 and
$878,908, respectively.





The
existing leases have terms from 3 to 5 years and are for equipment
purchases.  The equipment is classified under machinery and equipment
in fixed assets.





The table
below details the original value, depreciation and net book value of the leased
assets. The net book value is included the property and equipment totals in the
balance sheet.





Leased Assets
            
            December 31,2007
            
            
            2006Equipment
            
            $
            249,532
            
            
            $
            249,532Less:
      Accumulated Depreciation
            
            
            (97,789
            )
            
            
            (20,130
            )Net
      book value
            
            $
            151,743
            
            
            $
            229,402





The table
below details the remaining liability of the capital lease
obligations.





Liabilities
            
            December 31, 2007Obligations
      under capital leases:Current
            
            $
            67,543Non-current
            
            
            86,989Total
            
            $
            154,532





The table
below details the minimum future lease payments due along with the present value
of the net minimum lease payments as of December 31, 2007.





F-25


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





Future Minimum Lease
    Payments
            
            December 312008
            
            $
            67,5432009
            
            
            42,3942010
            
            
            30,0172011
            
            
            14,5782012
      and forward
            
            
            –Total
      minimum lease payments
            
            
            154,532





c.                 Guarantees:





The
Company obtained bank guarantees in the amount of $235,000 in connection (i)
obligations of two of the Company’s subsidiaries to the Israeli customs
authorities, (ii) the obligation of one of the Company’s subsidiaries to secure
the return of products loaned to the Company from one of its customers, and
(iii) the obligation of one of the Company’s subsidiaries to secure a required
letter of credit required under a long term contract. In addition, the Company
has two outstanding letters of credit in the amounts of $334,000 and $196,210 to
two of its subsidiaries’ customers.





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 (that is, liens
that apply not only to assets owned at the time but also to after-acquired
assets) on all of its assets, in favor of the State of Israel.





FAAC has
a $7.5 million line of credit secured by the assets of the Company and its
active United States subsidiaries and guaranteed by the Company and its active
subsidiaries.





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.





e.                 Litigation
and other claims:





As of
December 31, 2007, there were no pending material legal proceedings to which the
Company was a party, other than ordinary routine litigation incidental to its
business, except as follows:





1.                 In
December 2004, AoA filed an action against a U.S. government defense agency,
seeking approximately $2.2 million in damages for alleged improper termination
of a contract. In its answer, the government agency counterclaimed, seeking
approximately $2.1 million in reprocurement and administrative costs. Trial in
this matter is in progress. At this stage in the proceedings, the Company and
its legal advisors cannot determine with any certainty whether AoA will have any
liability and, if so, the extent of that liability.





2.                 In
May 2007, two purported class action complaints (the “Complaint”) were filed in
the United States District Court for the Eastern District of New York against
the Company and certain of its officers and directors. These two cases were
consolidated in June 2007. A similar case filed





F-26


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


in the
United States District Court for the Eastern District of Michigan in March 2007
was withdrawn by the plaintiff in June 2007. The Complaint seeks class status on
behalf of all persons who purchased the Company’s securities between November 9,
2004 and November 14, 2005 (the “Period”) and alleges violations by the Company
and certain of its officers and directors of Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934 and Rule 10b-5 thereunder, primarily related to
the Company’s acquisition of AoA in 2005 and certain public statements made by
the Company with respect to its business and prospects during the Period. The
Complaint also alleges that the Company did not have adequate systems of
internal operational or financial controls, and that the Company’s financial
statements and reports were not prepared in accordance with GAAP and SEC rules.
The Complaint seeks an unspecified amount of damages. A lead plaintiff has been
named, and the plaintiff’s consolidated amended complaint was filed in September
2007. The Company’s motion to dismiss the complaint was filed in November 2007,
but a decision on its motion is not expected until mid-2008.  Although
the ultimate outcome of this matter cannot be determined with certainty, the
Company believes that the allegations stated in the Complaint are without merit
and the Company and its officers and directors named in the
Complaint intend to defend themselves vigorously against such
allegations.





NOTE
      12:–
            CONVERTIBLE
      DEBT, DETACHABLE WARRANTS AND OTHER LONG TERM
      DEBT





As of
July 31, 2007, all convertible notes had been repaid in full





a.                 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 were convertible at any time
prior to September 30, 2006 at a conversion price of $16.10 per share, or a
maximum aggregate of 310,559 shares of common stock.





As part
of the securities purchase agreement on September 30, 2003, the Company issued
to the purchasers of its 8% secured convertible debentures due September 30,
2006, warrants to purchase an aggregate of 89,286 shares of common stock at any
time prior to September 30, 2006 at a price of $20.125 per share. In March 2006,
8,929 of these warrants were repriced to an exercise price of $5.60 per share
and exercised. In connection with this repricing, the holder of these warrants
received a new warrant to purchase 3,571 shares at an exercise price of $8.316.
As a result of this repricing of the existing warrants and the issuance of these
new warrants, the Company recorded in 2006 a deemed dividend in the amount of
$24,531.





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-27


AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
 NOTE
      12:–
              CONVERTIBLE
      DEBT, DETACHABLE WARRANTS AND OTHER LONG TERM
      DEBT (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
2006, the Company recorded an expense of $22,142 which was attributable to
amortization of debt discount and beneficial conversion feature related to the
convertible debenture over its term. These expenses were included in the
financial expenses.





During
2006, the Company paid the remaining principal amount of $150,000 in respect of
these secured convertible debentures.





b.                 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 were convertible at any time
prior to September 30, 2006 at a conversion price of $20.30 per share, or a
maximum aggregate of 295,567 shares of common stock.





As a
further part of the securities purchase agreement on September 30, 2003, the
Company issued to the purchasers of its 8% secured convertible debentures due
September 30, 2006, warrants to purchase an aggregate of 107,143 shares of
common stock at any time prior to December 18, 2006 at a price of $25.375 per
share. Additionally, the Company issued to the investors supplemental warrants
to purchase an aggregate of 74,143 shares of common stock at any time prior to
December 31, 2006 at a price of $30.80 per share. In February and March 2006, an
aggregate of 55,607 of these warrants were repriced to an exercise price of
$5.60 per share and exercised. In connection with this repricing, the holders of
these warrants received new warrants to purchase an aggregate of 22,244 shares
at an exercise price of $8.316. In April 2006, 11,121 of these warrants were
repriced to an exercise price of $5.60 per share and exercised. In connection
with this repricing, the holder of these warrants received a new warrant to
purchase 4,449 shares at an exercise price of $8.316. As a result of these
repricings of the existing warrants and the issuance of these new warrants, the
Company recorded in 2006 a deemed dividend in the amount of
$39,221.





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





F-28


AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
      12:–
              CONVERTIBLE
      DEBT, DETACHABLE WARRANTS AND OTHER LONG TERM
      DEBT (Cont.)


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
2006, the Company recorded an expense of $1,168,573 which was attributable to
amortization of the beneficial conversion feature of the convertible debenture
over its term. These expenses were included in the financial
expenses.





During
2006, the Company paid in cash the remaining principal amount of $4,387,500 in
respect of these secured convertible debentures.





c.                 Senior
Secured Convertible Notes due March 31, 2008





Pursuant
to the terms of a Securities Purchase Agreement dated September 29, 2005 (the
“Purchase Agreement”) by and between the Company and certain institutional
investors, the Company issued and sold to the investors an aggregate of $17.5
million principal amount of senior secured convertible notes (“Notes”) having a
final maturity date of March 31, 2008.





Under the
terms of the Purchase Agreement, as amended, the Company granted the investors
(i) a second position security interest in the assets and receivables of FAAC
Incorporated, and in the receivables of MDT Armor Corporation related to MDT’s
David order with the U.S. Army (junior to the security interest of a bank that
had, at that time, extended to FAAC Corporation a $6.0 million line of credit)
and (ii) a first position security interest in the assets of all of the
Company’s other active United States subsidiaries and in the stock of all of the
Company’s active United States subsidiaries, as well as in any stock that the
Company acquires in future Acquisitions (as defined in the securities purchase
agreement). The Company’s active United States subsidiaries are also acting as
guarantors of the Company’s obligations under the Notes.  Since the
senior notes were paid in full during 2007, these security interests no longer
apply.





The Notes
are convertible at the investors’ option at a fixed conversion price of $14.00.
The Notes bear interest at a rate equal to six month LIBOR plus 6% per annum,
subject to a floor of 10% and a cap of 12.5%. The Company was obligated to repay
the principal amount of the Notes over a period of two and one-half years, with
the principal amount being amortized in twelve payments payable in cash and/or,
at the Company’s option, in stock by forcing conversion of the Notes, provided
certain conditions are met. In the event of an election by the Company to make
such payments in stock by forcing conversion of the notes, the price used to
determine the number of shares to be issued was calculated using an 8% discount
to the average trading price of the Company’s common stock during 17 of the 20
consecutive trading days ending two days before the payment date.





As a
further part of the Securities Purchase Agreement dated September 29, 2005, the
Company issued warrants, which were not exercisable for the six month period
following closing, to purchase up to 375,000 shares of common stock (30% warrant
coverage) at an exercise price of $15.40 per share. These warrants were
exercisable until March 29, 2007.





F-29


AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
      12:–
              CONVERTIBLE
      DEBT, DETACHABLE WARRANTS AND OTHER LONG TERM
      DEBT (Cont.)


This
transaction was accounted according to APB No. 14, “Accounting for Convertible
Debt and Debt Issued with Stock Purchase Warrants” and Emerging Issue Task Force
No. 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments”
(“EITF 00-27”). The fair value of the warrants granted in respect of convertible
debentures was determined using Black-Scholes pricing model, assuming a
risk-free interest rate of 3.87%, a volatility factor 53%, divi­dend yields
of 0% and a contractual life of one year.





In
connection with these Notes, the Company recorded a deferred debt discount of
$422,034 with respect to the discount arising from fair value allocation of the
warrants according to APB No. 14, which was amortized from the date of issuance
to the stated redemption date – March 31, 2008 – or the actual conversion date,
if earlier, as financial expenses





The
Company has also considered EITF No. 05-2, “The Meaning of Conventional
Convertible Debt Instrument” in EITF Issue No. 00-19, “Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock.” Accordingly, the Company has concluded that these convertible notes
would be considered as conventional convertible debt.





As to
EITF No. 00-19, since the terms of the warrants referred to above provided that
upon exercise of a warrant the Company could issue only stock that had been
registered with the SEC (which occurred in December 2005) and therefore freely
tradable, in accordance with Emerging Issues Task Force No 00-19 “Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company’s Own Stock,” their fair value was recorded as a liability at the
closing date. Such fair value was remeasured at each subsequent cut-off
date.  The fair value of these warrants was remeasured as at December
31, 2005 using the Black-Scholes pricing model assuming a risk free interest
rate of 3.87%, a volatility factor of 64%, dividend yields of 0% and a
contractual life of approximately nine months





The Notes
provide for repayment in twelve equal installments. Installments may be paid in
cash or, at the Company’s option (subject to certain conditions), in stock. If
the Company elects to make a payment in stock, it must give notice 24 trading
days prior to the date the installment is due, and issue shares of its stock to
the holders of the Note based on a conversion price of $14.00. Thereafter, based
on a price of 92% of the average price of the stock during 17 of the trading
days between the notice date and the installment payment date, the Company
issues additional shares based on the amount, if any, by which the average price
of the stock was less than $14.00.





As a
result of a prepayment conversion in April 2006, the Company made the final
payment in respect of the Notes in July 2007.





During
2007 and 2006, the Company recorded expenses of $18,745 and $1,485,015,
respectively, attributable to amortization related to warrants issued to the
holders of the Notes and the beneficial conversion feature.  During
2007 and 2006, the Company also recorded expenses of $280,382 and $5,395,338,
respectively, attributable to financial expenses in connection with convertible
debenture principle repayment of the Notes.  Additionally, during 2007
and 2006, the





F-30


AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
      12:–
              CONVERTIBLE
      DEBT, DETACHABLE WARRANTS AND OTHER LONG TERM
      DEBT (Cont.)


Company
recorded expenses of $44,253 and $780,719, respectively, attributable toamortization
of deferred charges related to issuance of the Notes.





During
2007 and 2006, the Company issued a total of 930,125 and 4,184,855 shares,
respectively, in payment of the debentures.





d.                 Other
Long Term  Debt:





1.                 Mortgage
Note, Auburn, Alabama:





In March
2007, the Company purchased 16,700 square feet of space in Auburn, Alabama for
approximately $1.1 million pursuant to a seller-financed secured purchase money
mortgage. Half the mortgage is payable over ten years in equal monthly
installments based on a 20-year amortization of the full principal amount, and
the remaining half is payable at the end of ten years in a balloon payment. The
note requires a payment (principal and interest) of approximately $9,300 per
month at an interest rate of 8% per annum. The balance of this note is shown in
the short and long term sections of the balance sheet.





Mortgage Future Payments2008
            
            $
            25,0212009
            
            
            27,1052010
            
            
            29,3552011
            
            
            31,7922012
            
            
            34,423Thereafter
            
            
            950,101$
            1,097,797





The
Company has additional long term debt outstanding of approximately $95,000,
primarily vehicle loans. This amount is payable $79,000 in 2008 and $15,000 in
2009.





NOTE
13:– STOCKHOLDERS’
EQUITY





a.                 Stockholders’
rights:





The
Company’s shares confer upon the holders the right to receive notice to
participate and vote in the general meetings of the Company and right to receive
dividends, if and when declared.





b.                 Warrants:





1.                 In
March 2006, 19,625 of the Company’s warrants were repriced to an exercise price
of $5.60 per share and exercised. In connection with this repricing, the holder
of these warrants received new warrants to purchase 7,850 shares at an exercise
price of $8.316. As a result of this repricing of the existing warrants and the
issuance of these new warrants, the Company recorded during 2006 a deemed
dividend in the amount of $28,369.





F-31


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




2.                  In
January 2004, in connection with a purchase of the Company’s securities by
certain investors, the Company granted three-year warrants to purchase up to an
aggregate of 702,888 shares of the Company’s common stock at any time beginning
six months after closing at an exercise price per share of $26.32.





In July
2004 an aggregate of 531,915 shares were issued pursuant to exercise of these
warrants. In connection with the exercise of the warrants, the Company granted
to the same investors five-year warrants to purchase up to an aggregate of
531,915 shares of the Company’s common stock at an exercise price per share of
$19.32. The fair value of these warrants was determined using Black Scholes
pricing model, assuming a risk-free interest rate of 3.5%, a volatility factor
of 79%, dividend yields of 0% and a contractual life of five years.





In March
2006, 56,991 of these warrants were repriced to an exercise price of $5.60 per
share and exercised. In connection with this repricing, the holder of these
warrants received a new warrant to purchase an aggregate of 22,796 shares at an
exercise price of $8.316. In April 2006, an additional 75,988 of these warrants
were repriced to an exercise price of $5.60 per share and exercised. In
connection with this repricing, the holder of these warrants received a new
warrant to purchase 30,395 shares at an exercise price of $8.316. As a result of
these repricings of the existing warrants and the issuance of these new
warrants, the Company recorded in 2006 a deemed dividend in the amount of
$270,336.





3.                  On
July 14, 2004, warrants to purchase 629,588 shares of common stock, having an
aggregate exercise price of $16,494,194, net of issuance expenses, were
exercised. Out of the shares issued in conjunction with the exercise of these
warrants, 80,357 shares were issued upon exercise of warrants issued in
connection with the Company’s former 8% Secured Convertible Debentures due
September 30, 2006 and 531,915 shares were issued upon exercise of warrants
issued in the transaction referred to in the Note 13.b.2. above; the remaining
17,316 shares were issued upon exercise of a warrant that the Company issued to
an investor in May 2001. In connection with this transaction, the Company issued
to the holders of those exercising warrants an aggregate of 622,662 new
five-year warrants to purchase shares of common stock at an exercise price of
$19.32 per share





In
February and March 2006, an aggregate of 501,216 of these warrants were repriced
to an exercise price of $5.60 per share and exercised. In connection with this
repricing, the holders of these warrants received new warrants to purchase an
aggregate of 200,487 shares at an exercise price of $8.316. In April 2006, an
additional 16,071 of these warrants were repriced to an exercise price of $5.60
per share and exercised. In connection with this repricing, the holder of these
warrants received a new warrant to purchase 6,429 shares at an exercise price of
$8.316. As a result of these repricings of the existing warrants and the
issuance of these new warrants, the Company recorded in 2006 deemed dividend in
the amount of $71,728.





As to
EITF 00-19, since the terms of the new warrants referred to above provided
thatthe warrants were
exercisable subject to the Company obtaining shareholder 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





F-32


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




a
liability at the closing date. Such fair value was remeasured at each subsequent
cut-off date until obtaining shareholder approval.  The fair value of
these warrants was remeasured as at June 19, 2006 (the date of the shareholder
approval), using the Black-Scholes pricing model assuming a risk free interest
rate of 5.00%, a volatility factor of 72%, dividend yields of 0% and a
contractual life of approximately 1.78 years. The change in the fair value of
the warrants between the date of the grant and June 19, 2006 in the amount of
$700,113 has been recorded as finance income.





4.                 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 $3.0 million. Pursuant to the
terms of the settlement agreement, in addition to agreeing to dismiss their
lawsuit with prejudice, IES Electronics agreed (i) to cancel the Company’s
$450,000 debt to them that had been due on December 31, 2003, and (ii) to
transfer to the Company title to certain certificates of deposit in the
approximate principal amount of $112,000. The parties also agreed to exchange
mutual releases. In consideration of the foregoing, the Company issued to IES
Electronics (i) 32,143 shares of common stock, and (ii) five-year warrants to
purchase up to an additional 32,143 shares of common stock at a purchase price
of $26.74 per share. The fair value of the warrants was determined using
Black-Scholes pricing model, assuming a risk-free interest rate of 3.5%, a
volatility factor 79%, dividend yields of 0% and a contractual life of five
years. The fair value of warrants was calculated as $483,828 and fair value of
shares as $765,000.





5.                 As
of December 31, 2007, the Company’s outstanding warrants totaled 493,851with
expiration dates through July 2009 with exercise prices ranging from $8.32 to
$31.50.





c.                 The
Company has adopted the following stock option plans, whereby options and
restricted shares may be granted for purchase of shares of the Company’s common
stock. Under the terms of the employee plans, the Board of Directors or the
designated committee grants options and determines the vesting period and the
exercise terms.





1.                 1998
Employee Option Plan – as amended, 339,286 shares reserved for issuance, of
which 86,194 were available for future grants to employees and consultants as of
December 31, 2007.





2.                 1995
Non-Employee Director Plan – 71,429 shares reserved for issuance, of which
71,429 stock options were issued and outstanding as of December 31, 2007.
Pursuant to the terms of this Plan, no new options were issuable under this Plan
after September 28, 2005.





3.                 2004
Employee Option Plan – 535,714 shares reserved for issuance, of which 277,351
were available for future grants to employees and consultants as of December 31,
2007.





4.                 2007
Non-Employee Director Equity Compensation Plan – 750,000 shares reserved for
issuance, of which 708,882 were available for future grants to outside directors
as of December 31, 2007.





F-33


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


5.                 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 also generally
vest after three years or pursuant to defined performance criteria; in the event
that employment is terminated within that period, unvested restricted shares
revert back to the Company.




Restricted
stock generally vests over three years. Half of these shares are subject only to
service requirements and half vest subject to service and performance
requirements. The performance requirements are determined annually by the Board.
These performance requirements were met in 2007 but have not been determined for
future years. Shares subject to performance requirements carryover to subsequent
years if the performance requirements are not met in a particular year. Vesting
will not occur if the performance requirements are never met. In the event that
employment is terminated prior to vesting, all unvested restricted shares revert
back to the Company.




6.                 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, 2007 and 2006, and changes during the years ended on those dates,
is presented below:





Stock
Options:





2007
            
            
            2006Amount
            
            
            Weighted average exercise
    price
            
            
            Amount
            
            
            Weighted average exercise
    price$
            
            
            
            
            
            $Options
      outstanding at be­ginning of year
            
            
            623,686
            
            
            $
            8.20
            
            
            
            606,068
            
            
            $
            10.23Changes
      during year:Granted
      (1) (2)
            
            
            –
            
            
            $
            –
            
            
            
            124,000
            
            
            $
            2.86Exercised
            
            
            –
            
            
            $
            –
            
            
            
            (1,786
            )
            
            $
            0.14Forfeited
            
            
            (332,305
            )
            
            $
            13.34
            
            
            
            (104,596
            )
            
            $
            13.75Options
      outstanding at end of year
            
            
            291,381
            
            
            $
            2.34
            
            
            
            623,686
            
            
            $
            8.20Options
      vested at end of year
            
            
            222,260
            
            
            $
            2.47
            
            
            
            486,526
            
            
            $
            9.22Options
      expected to vest
            
            
            55,296
            
            
            $
            2.34
            
            
            
            109,728
            
            
            $
            8.20




(1)            Includes
0 and 12,500 options granted to directors and executive officers in 2007 and
2006, respectively.


(2)            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 2007 and 2006 was $1,417,521 and $500,545,
respectively.





The table
below summarizes the intrinsic value of options for each year.





Vested
            
            
            Unvested2007(1)
            
            $
            –
            
            
            $
            –2006
            
            $
            1,039
            
            
            $
            31,220(1)Calculated intrinsic value is
      less than zero.




F-34




AROTECH
CORPORATION AND ITS SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





In
U.S. dollars




NOTE
13:–   STOCKHOLDERS’
EQUITY (Cont.)




Restricted
Shares:





2007
            
            
            2006Shares
            
            
            Weightedaverage fair value at grant
      date
            
            
            Shares
            
            
            Weightedaverage fair value at grant
      dateNonvested
      at the beginning of the year
            
            
            863,572
            
            
            $
            2.51
            
            
            
            54,286
            
            
            $
            1.41Changes
      during year:Granted
            
            
            436,118
            
            
            $
            2.51
            
            
            
            860,000
            
            
            $
            2.58Vested
            
            
            (500,238
            )
            
            $
            2.62
            
            
            
            (48,571
            )
            
            $
            1.42Forfeited
            
            
            –
            
            
            $
            –
            
            
            
            (2,143
            )
            
            $
            1.73Nonvested
      at the end of the year
            
            
            799,452
            
            
            $
            2.38
            
            
            
            863,572
            
            
            $
            2.51Restricted
      shares vested at end of year
            
            
            548,809
            
            
            $
            2.51
            
            
            
            48,571
            
            
            $
            1.42





7.                 
The options outstanding as of December 31, 2007 have been separated into ranges
of exercise price, as follows:




Total options outstanding
              
              
              Vested options outstandingRange of
                exercise
                prices
              
              
              Amount
                outstandingat
                December 31,
                2007
              
              
              Weighted
                average
                remaining
                contractual life
              
              
              Weighted
                average
                exercise price
              
              
              Amount
                exercisable at
                December 31, 2007
              
              
              Weighted
                average
                exercise price$
              
              
              
              
              
              Years
              
              
              $
              
              
              
              
              
              $0.00-28.00
              
              
              
              
              289,483
              
              
              
              3.71
              
              
              
              2.14
              
              
              
              220,362
              
              
              
              2.2028.01-56.00
              
              
              
              
              1,898
              
              
              
              1.96
              
              
              
              34.24
              
              
              
              1,898
              
              
              
              34.24Total
              
              
              
              291,381
              
              
              
              3.70
              
              
              
              2.35
              
              
              
              222,260
              
              
              
              2.47




8.                 
Weighted-average fair values and exercise prices of options on dates of grant
are as follows:





Equals market price
            
            
            Less than market priceYear ended December 31,
            
            
            Year ended December 31,2007
            
            
            2006
            
            
            2007
            
            
            2006Weighted
      average exercise prices
            
            $
            –
            
            
            $
            2.86
            
            
            $
            –
            
            
            $
            –Weighted
      average fair value on grant date
            
            $
            –
            
            
            $
            2.11
            
            
            $
            –
            
            
            $
            –





9.                 Options
issued to consultants:





The
Company’s outstanding options to consultants are as follows:





2007
            
            
            2006Amount
            
            
            Weighted average exercise
    price
            
            
            Amount
            
            
            Weighted average exercise
    priceOptions
      outstanding at beginning of year
            
            
            11,878
            
            
            $
            53.20
            
            
            
            11,878
            
            
            $
            53.20Changes
      during year:Granted
            
            
            –
            
            
            $
            –
            
            
            
            10,000
            
            
            $
            1.90Exercised
            
            
            –
            
            
            $
            –
            
            
            
            (10,000
            )
            
            $
            1.90Forfeited
      or cancelled
            
            
            –
            
            
            $
            –
            
            
            
            –
            
            
            $
            –Options
      outstanding at end of year
            
            
            11,878
            
            
            $
            53.20
            
            
            
            11,878
            
            
            $
            53.20Options
      vested at end of year
            
            
            11,878
            
            
            $
            53.20
            
            
            
            11,878
            
            
            $
            53.20




F-35


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


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:





2006Dividend
      yield
            
            
            0%Expected
      volatility
            
            
            84.8%Risk-free
      interest
            
            
            4.58%Contractual
      life of up to
            
            1 year





In
connection with the grant of stock options to consultants, the Company recorded
stock compensation expenses totaling $0 and $6,563 for the years ended December
31, 2007 and 2006, respectively, and included these amounts in general and
administrative expenses.





10.           The
remaining total compensation cost related to non-vested stock options and
restricted share awards not yet recognized (before applying a forfeiture rate)
in the income statement as of December 31, 2007 was $2,294,727, of which $90,457
was for stock options and $2,204,271 was for restricted shares. The weighted
average period over which this compensation cost is expected to be recognized is
approximately 2 years.





d.           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.





e.           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
14:– INCOME
TAXES





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




As of
December 31, 2007, Arotech has operating loss carryforwards for U.S. federal
income tax purposes of approximately $21.2million, which are available to
offset future taxable income, if any, expiring in 2009 through
2027. 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 adopted the provisions of FIN 48 on January 1, 2007. As a result of the
implementation of FIN 48, the Company did not record a liability for
unrecognized tax positions. The adoption of FIN 48 did not impact the Company’s
financial condition, results of operations or cash flows. At December 31, 2007,
the Company had net deferred tax assets of $36.8 million. The deferred tax
assets are primarily composed of federal, state and foreign tax net operating
loss (“NOL”) carryforwards. Due to uncertainties surrounding the Company’s
ability to generate





F-36


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


future
taxable income to realize these assets, a full valuation has been established to
offset its net deferred tax asset. Additionally, the future utilization of the
Company’s NOL carryforwards to offset future taxable income is subject to a
substantial annual limitation as a result of ownership changes that that has
occurred. The Company has completed a Section 382 analysis regarding the
limitation of the net operating losses and has determined that the maximum
amount of U.S. federal NOL available as of January 1, 2007 was $18,851,605,
compared to the amount shown on the tax return of $31,161,945. The related DTA
and corresponding valuation allowance were reduced by $4,185,516 for the U.S.
federal NOLs and by $3,555,231 for the state NOLs. The Company has also
reevaluated the unrecognized tax benefits under FIN 48 after the completion of
the Section 382 analysis. The Company does not believe that the unrecognized tax
benefits will change within 12 months of this reporting date. Any carryforwards
that will expire prior to utilization as a result of such limitations will be
removed from deferred tax assets with a corresponding reduction of the valuation
allowance. Due to the existence of the valuation allowance, future changes in
our unrecognized tax benefits will not impact the Company’s effective tax
rate.





At least
three years of the Company’s federal returns are still open for examination, so
it is possible that the amount of this liability could change in future
accounting periods.





The
Company files income tax returns, including returns for its subsidiaries, with
federal, state, local and foreign jurisdictions. The Company is no longer
subject to IRS examination for periods prior to 2003, although carryforward
losses that were generated prior to 2002 may still be adjusted by the IRS if
they are used in a future period. Additionally, the Company is no longer subject
to examination in Israel for periods prior to 2002.





On July
12, 2007, the Governor of Michigan signed into law the Michigan Business Tax
(MBT), which will be effective January 1, 2008. This is a combined income tax
and modified gross receipts tax and replaces the Michigan Single Business
Tax.  The Company does not believe that the impact of the MBT on the
Company’s financial position will be material.





The
Company files consolidated tax returns with its U.S. 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 two 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.





F-37


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


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.





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 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 reduced tax rates.





3.                 As
stated above for each specific program





Epsilor
is entitled to claim accelerated depreciation in respect of machinery and
equipment used by the “Approved Enterprise” for the first five years of
operation of these assets.





Income
from sources other than the “Approved Enterprise” during the benefit period will
be subject to tax at the regular corporate tax rate of 31%.





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, 2007 there are no tax exempt profits earned by Epsilor’s “approved
enterprises” by Israel law that will be distributed as a dividend and
accordingly no deferred tax





F-38


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


liability
was recorded as of December 31, 2007. Furthermore, management has indicated that
it has no intention of declaring any dividend.





On April
1, 2005, an amendment to the Investment Law came into effect (“the Amendment”)
and has significantly changed the provisions of the Investment Law. The
Amendment limits the scope of enterprises which may be approved by the
Investment Center by setting criteria for the approval of a facility as a
Privileged Enterprise, such as provisions generally requiring that at least 25%
of the Privileged Enterprise’s income will be derived from export. Additionally,
the Amendment enacted major changes in the manner in which tax benefits are
awarded under the Investment Law so that companies no longer require Investment
Center approval in order to qualify for tax benefits.





However,
the Investment Law provides that terms and benefits included in any certificate
of approval already granted will remain subject to the provisions of the law as
they were on the date of such approval. Therefore, the existing Approved
Enterprise of the Israeli subsidiaries will generally not be subject to the
provisions of the Amendment. As a result of the Amendment, tax-exempt income
generated under the provisions of the Amended Investment Law, will subject the
Company to taxes upon distribution or liquidation and the Company may be
required to record deferred tax liability with respect to such tax-exempt
income. As of December 31, 2007, the Company did not generate income under the
provision of the amended Investment Law.





c.                 Other
tax information about the Israeli subsidiaries:





1.                 Measurement
of results for tax purposes under the Income Tax Law (Inflationary Adjustments),
1985





Results
for tax purposes are measured in real terms of earnings in NIS after certain
adjustments for increases in the Consumer Price Index. As explained in Note
2.b., the financial statements are presented in U.S. dollars. The difference
between the annual change in the Israeli consumer price index and in the
NIS/dollar exchange rate causes a difference between taxable income and the
income before taxes shown in the financial statements. In accordance with
paragraph 9(f) of SFAS No. 109, EFL, Epsilor and MDT have not provided deferred
income taxes on this difference between the reporting currency and the tax bases
of assets and liabilities.





2.                 Tax
benefits under the Law for the Encouragement of Industry (Taxation),
1969:





EFL and
Epsilor are “industrial companies,” as defined by this law and, as such, are
entitled to certain tax benefits, mainly accelerated depreciation, as prescribed
by regulations published under the inflationary adjustments law, the right to
claim amortization of know-how, patents and certain other intangible property
rights as deductions for tax purposes.





3.                 Tax
rates applicable to income from other sources:





Income
from sources other than the “Approved Enterprise,” is taxed at the regular rate
of 34%. See also Note 14.e.





F-39


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


4.                 Tax
loss carryforwards:





As of
December 31, 2007, EFL has operating and capital loss carryforwards for Israeli
tax purposes of approximately $106 million, which are available, indefinitely,
to offset future taxable income.





d.                 Tax
rates applicable to the income of the Group companies:





Until
December 31, 2003, the regular tax rate applicable to income of companies (which
are not entitled to benefits due to “approved enterprise”, as described above)
was 36%. In June 2004, an amendment to the Income Tax Ordinance (No. 140 and
Temporary Provision), 2004 was passed by the Knesset (Israeli parliament) and on
July 25, 2005, another law was passed, the amendment to the Income Tax Ordinance
(No. 147) 2005, according to which the corporate tax rate is to be progressively
reduced to the following tax rates: 2006 - 31%, 2007 - 29%, 2008 - 27%, 2009 -
26%, 2010 and thereafter - 25%.





e.                 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 31,2007
            
            
            2006Operating
      loss carryforward (1)
            
            $
            33,741,900
            
            
            $
            33,222,692Other
      temporary differences
            
            
            4,088,598
            
            
            
            7,192,079Net
      deferred tax asset before valuation allowance
            
            
            37,830,498
            
            
            
            40,414,771Valuation
      allowance
            
            
            (37,752,789
            )
            
            
            (40,356,739
            )Total
      deferred tax asset
            
            $
            77,709
            
            
            $
            58,032Deferred
      tax liability
            
            $
            1,020,000
            
            
            $
            900,000





(1)
            
            
            December 31,2007
            
            
            2006Domestic
            
            
            $
            7,216,709
            
            
            $
            11,627,401Foreign
            
            
            
            26,525,191
            
            
            
            21,595,291$
            33,741,900
            
            
            $
            33,222,692





We have
not recorded any deferred taxes on the cumulative undistributed earnings of
other non-U.S. subsidiaries because the earnings are intended to be
indefinitely re-invested in those operations and we are unable, at this time, to
estimate the amount. Accrued income taxes on the undistributed earnings of
domestic subsidiaries and affiliates are not provided because dividends received
from domestic companies are expected to be non-taxable.





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





F-40


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


and other
temporary differences will not be realized. The change in the valuation
allowance as of December 31, 2007 was $(2,723,950).





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





Year ended December 312007
              
              
              2006Domestic
              
              $
              2,464,512
              
              
              $
              13,014,325Foreign
              
              
              365,711
              
              
              
              2,340,082$
              2,830,223
              
              
              $
              15,354,407





g.                 Taxes
on income were comprised of the following:





Year ended December 312007
              
              
              2006Current
      state and local taxes
              
              $
              111,162
              
              
              $
              225,371Deferred
      taxes
              
              
              (100,323
              )
              
              
              6,788Taxes
      in respect of prior years
              
              
              (47,569
              )
              
              
              –$
              163,916
              
              
              $
              232,159Domestic
              
              $
              189,930
              
              
              $
              49,383Foreign
              
              
              (26,014
              )
              
              
              182,776$
              163,916
              
              
              $
              232,159





h.           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-41


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




Year ended December 31,2007
            
            
            2006Loss
      from continuing operations before taxes, as reported in the consolidated
      statements of income
            
            $
            (2,830,223
            )
            
            $
            (15,354,407
            )Statutory
      tax rate
            
            
            34
            %
            
            
            34
            %Theoretical
      income tax on the above amount at the U.S. statutory tax
    rate
            
            $
            (962,276
            )
            
            $
            (5,220,498
            )Deferred
      taxes on losses for which valuation allowance was provided
            
            
            955,412
            
            
            
            2,745,964Non-deductible
      expenses
            
            
            126,864
            
            
            
            2,793,214Foreign
      non-deductible expenses
            
            
            27,748
            
            
            
            –State
      taxes
            
            
            69,930
            
            
            
            49,383Foreign
      income in tax rates other then U.S rate
            
            
            (5,969
            )
            
            
            (141,822
            )Taxes
      in respect of prior years
            
            
            (47,569
            )
            
            
            –Others
            
            
            (224
            )
            
            
            5,918Actual
      tax expense
            
            $
            163,916
            
            
            $
            232,159








NOTE
15:– SELECTED
STATEMENTS OF OPERATIONS DATA





Financial
income (expenses), net:





Year ended December 31,2007
            
            
            2006Financial
      expenses:Interest,
      bank charges and fees
            
            $
            (662,789
            )
            
            $
            (2,018,061
            )Amortization  related
      to warrants issued to the holders of convertible debentures and beneficial
      conversion feature
            
            
            (18,745
            )
            
            
            (1,485,015
            )Expenses
      in connection with convertible debenture principle
    repayment
            
            
            (280,382
            )
            
            
            (5,395,338
            )Bonds
      premium amortization
            
            
            –
            
            
            
            –Other
            
            
            (91,625
            )
            
            
            (35,332
            )Foreign
      currency translation differences
            
            
            –
            
            
            
            –(1,053,540
            )
            
            
            (8,933,746
            )Financial
      income:Interest
            
            
            53,298
            
            
            
            646,583Foreign
      currency translation differences
            
            
            94,354
            
            
            
            67,150Financial
      income in connection with warrants granted (Note 12.c. and
      13.b.3.)
            
            
            –
            
            
            
            700,113Total
            
            $
            (905,888
            )
            
            $
            (7,519,900
            )






NOTE
16:– SEGMENT
INFORMATION





a.                 General:





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





F-42




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


NOTE
16:– SEGMENT
INFORMATION (Cont.)


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: Training
and Simulation (formerly known as Simulation and Security); Armor; and Battery
and Power Systems. As a result the Company restated information previously
reported in order to comply with new segment reporting.





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





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





Training and Simulation
            
            
            Armor
            
            
            Battery and
              Power Systems
            
            
            All Others
            
            
            Total2007Revenues
      from outside customers
            
            $
            27,760,858
            
            
            $
            18,724,107
            
            
            $
            11,234,596
            
            
            $
            –
            
            
            $
            57,719,561Depreciation
      , amortization and impairment expenses (1)
            
            
            (1,667,703
            )
            
            
            (469,093
            )
            
            
            (1,024,434
            )
            
            
            (227,980
            )
            
            
            (3,389,210
            )Direct
      expenses (2)
            
            
            (21,610,720
            )
            
            
            (17,490,430
            )
            
            
            (11,023,839
            )
            
            
            (6,335,909
            )
            
            
            (56,480,898
            )Segment
      net income (loss)
            
            $
            4,482,435
            
            
            $
            764,584
            
            
            $
            (813,677
            )
            
            $
            (6,583,889
            )
            
            
            (2,150,547
            )Financial
      expenses
            
            
            (14,610
            )
            
            
            (93,292
            )
            
            
            (176,834
            )
            
            
            (621,152
            )
            
            
            (905,888
            )Net
      income (loss)
            
            $
            4,467,825
            
            
            $
            671,292
            
            
            $
            (990,511
            )
            
            $
            (7,205,041
            )
            
            $
            (3,056,435
            )Segment
      assets (3)
      (4)
            
            $
            43,810,684
            
            
            $
            11,235,386
            
            
            $
            21,191,545
            
            
            $
            4,243,692
            
            
            $
            80,481,3072006Revenues
      from outside customers
            
            $
            21,951,337
            
            
            $
            12,571,779
            
            
            $
            8,597,623
            
            
            $
            –
            
            
            $
            43,120,739Depreciation
      , amortization and impairment expenses (1)
            
            
            (1,708,012
            )
            
            
            (1,077,416
            )
            
            
            (844,431
            )
            
            
            (350,308
            )
            
            
            (3,980,167
            )Direct
      expenses (2)
            
            
            (18,256,934
            )
            
            
            (13,234,826
            )
            
            
            (8,768,086
            )
            
            
            (6,929,985
            )
            
            
            (47,189,831
            )Segment
      net income (loss)
            
            $
            1,986,391
            
            
            $
            (1,740,463
            )
            
            $
            (1,014,894
            )
            
            $
            (7,280,293
            )
            
            $
            (8,049,259
            )Financial
      expenses
            
            
            129,908
            
            
            
            (54,476
            )
            
            
            50,590
            
            
            
            (7,645,922
            )
            
            
            (7,519,900
            )Net
      income (loss)
            
            $
            2,116,299
            
            
            $
            (1,794,939
            )
            
            $
            (964,304
            )
            
            $
            (14,926,215
            )
            
            $
            (15,569,159
            )Segment
      assets (3)
      (4)
            
            $
            43,753,369
            
            
            $
            9,523,126
            
            
            $
            18,184,133
            
            
            $
            3,607,646
            
            
            $
            75,068,274


_______________________


(1)
            Includes
      depreciation of property and equipment, amortization expenses of
      intangible assets and impairment of goodwill and other intangible
      assets.


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


(3)
            Consisting
      of all assets.


(4)
            Out
      of those amounts, goodwill in the Company’s Training and Simulation,
      Battery and Power Systems and Armor Divisions stood at $24,235,419,
      $5,946,649 and $1,176,063 as of December 31, 2007, and $24,235,419,
      $5,413,210 and $1,066,596 as of December 31, 2006,
      respectively.





c.                 Summary
information about geographic areas:





The
following presents total revenues according to the location of the end customer
for the years ended December 31, 2007 and 2006, and long-lived assets as of
December 31, 2007 and 2006:





F-43




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


NOTE
16:–   SEGMENT
INFORMATION (Cont.)




2007
            
            
            2006Total
              revenues
            
            
            Long-lived
              assets
            
            
            Total
              revenues
            
            
            Long-lived
              assetsU.S. dollarsU.S.A.
            
            $
            45,198,904
            
            
            $
            3,141,428
            
            
            $
            32,945,951
            
            
            $
            1,916,964Germany
            
            
            230,571
            
            
            
            –
            
            
            
            387,612
            
            
            
            –England
            
            
            273,239
            
            
            
            –
            
            
            
            240,712
            
            
            
            –Thailand
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –India
            
            
            1,153,521
            
            
            
            –
            
            
            
            1,388,401
            
            
            
            –Israel
            
            
            8,239,135
            
            
            
            1,938,368
            
            
            
            5,658,986
            
            
            
            1,823,629Other
            
            
            2,624,191
            
            
            
            –
            
            
            
            2,499,077
            
            
            
            –$
            57,719,561
            
            
            $
            5,079,796
            
            
            $
            43,120,739
            
            
            $
            3,740,593








d.                 Revenues
from major customers:





Year
      ended December 31,2007
            
            
            2006Batteries
      and power systems:Customer
      A
            
            
            6
            %
            
            
            6
            %Armor:Customer
      B
            
            
            6
            %
            
            
            5
            %Customer
      C
            
            
            19
            %
            
            
            18
            %Training
      and Simulation:Customer
      D
            
            
            27
            %
            
            
            34
            %Customer
      E
            
            
            6
            %
            
            
            –





e.                 Revenues
from major products:





Year ended December 31,2007
            
            
            2006Water
      activated batteries
            
            
            1,629,014
            
            
            
            1,660,521Military
      batteries
            
            
            9,605,582
            
            
            
            6,937,101Car
      and aircraft armoring
            
            
            18,724,107
            
            
            
            12,571,779Simulators
            
            
            27,760,858
            
            
            
            21,951,338Total
            
            $
            57,719,561
            
            
            $
            43,120,739








NOTE
17:– ACCUMULATED
OTHER COMPREHENSIVE INCOME





Accumulated
other comprehensive income consists of currency translation adjustments of
$1,495,000 and $508,000 and unrealized gains on marketable securities of $6,000
and $4,000 at December 31, 2007 and 2006, respectively.








NOTE
18:– WARRANTY





The
Company provides or sells a warranty on certain of our simulators and armored
vehicles.  The Company allocates a percentage of each covered system
or a dollar amount per covered vehicle to our warranty reserve.  The
amount reserved, either percentage or fixed dollar amount is determined using
historical repair costs.  These calculations along with the amounts
allocated are reviewed semi-annually by management.





Accrued liability
              beginning of
              year
            
            
            New accruals
              during year
            
            
            Charges for
              the year
            
            
            Accrued liability
              end of year2006
            
            
            (666,541
            )
            
            
            (1,513,513
            )
            
            
            1,037,053
            
            
            
            (1,143,001
            )2007
            
            
            (1,143,001
            )
            
            
            (1,310,845
            )
            
            
            936,777
            
            
            
            (1,517,069
            )





F-44




AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
19:– PRIOR PERIOD
ADJUSTMENT
 
 The
accumulated deficit for January 1, 2006 was increased by $900,000 to
$143,869,964 to reflect a deferred tax liability that was created when the
Company deducted goodwill on previously filed tax returns.  This did
not have a material impact on the Company’s Consolidated Statement of
Operations.


NOTE
20:– SUBSEQUENT
EVENTS





a.                 In
February 2008 the Company’s FAAC subsidiary acquired Realtime Technologies, Inc.
(RTI), a privately-owned corporation headquartered in Royal Oak, Michigan, for a
total of $1,350,000 ($1,250,000 in cash and $100,000 in stock) with a 2008
earn-out (maximum of $250,000) based on 2008 net profit.





b.                 In
January 2008, the Company purchased the minority shareholder’s in 24.5% interest
in MDT Israel and his 12.0% interest in MDT Armor, as well as settling all
outstanding disputes regarding severance payments, in exchange for a total of
$1.0 million.





- - - - -
- - -





F-45





FINANCIAL
STATEMENT SCHEDULE





Arotech
Corporation and Subsidiaries





Schedule
II – Valuation and Qualifying Accounts





For the
Years Ended December 31, 2007 and 2006





Description
            
            Balance at
              beginning
              of period
            
            
            Additions
              charged to
              costs and
              expenses*
            
            
            Balance at
              end of
              periodYear
      ended December 31, 2007Allowance
      for doubtful accounts
            
            $
            159,000
            
            
            $
            (134,000
            )
            
            $
            25,000Allowance
      for slow moving inventory
            
            
            1,573,000
            
            
            
            151,000
            
            
            
            1,724,000Valuation
      allowance for deferred taxes
            
            
            39,457,000
            
            
            
            (2,724,000
            )
            
            
            36,733,000Totals
            
            $
            41,189,000
            
            
            $
            (2,707,000
            )
            
            $
            38,482,000Year
      ended December 31, 2006Allowance
      for doubtful accounts
            
            $
            176,000
            
            
            $
            (17,000
            )
            
            $
            159,000Allowance
      for slow moving inventory
            
            
            1,280,000
            
            
            
            293,000
            
            
            
            1,573,000Valuation
      allowance for deferred taxes
            
            
            34,484,000
            
            
            
            4,973,000
            
            
            
            39,457,000Totals
            
            $
            35,940,000
            
            
            $
            5,224,000
            
            
            $
            41,189,000





*The 2007
and 2006 valuation allowance includes an adjustment to the prior year provision
calculation due to changes recognized in the preparation of the actual
returns.




F-46