UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549





FORM
10-K





Annual
Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934









Commission
file number: 001-31972





TELKONET,
INC.


(Exact
name of registrant as specified in its charter)





Utah
            87-0627421(State
      or other jurisdiction of
            (IRS
      Employee Identification No.)incorporation
      or organization)





20374
Seneca Meadows Parkway


Germantown,
MD 20876


(Address
of principal executive offices)





(240)
912-1800


(Issuer’s
telephone number)





Securities Registered pursuant to
section 12(g) of the Act: None





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





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





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 and 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. XYes __ No





Check if
disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not
contained in this form, and no disclosure will 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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See the definition of
“accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange
Act.




___
      Large Accelerated Filer
            XAccelerated Filer
            ___
      Non-Accelerated Filer





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





Aggregate
market value of the voting stock held by non-affiliates of the registrant as of
March 1, 2008: $51,800,422.


Number of
outstanding shares of the registrant’s par value $0.001 common stock as of March
1, 2008: 72,039,455.









TELKONET,
INC.


FORM
10-K


INDEX





PagePart
      IItem
      1.
            Description
      of Business
            1Item
      1A.
            Risk
      Factors
            11Item
      1B.
            Unresolved
      Staff Comments
            18Item
      2.
            Description
      of Property
            18Item
      3.
            Legal
      Proceedings
            19Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            19Part
      IIItem
      5.
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and
      Registrant’s Purchases of Securities
            19Item
      6.
            Selected
      Financial Data
            20Item
      7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            21Item
      7A.
            Quantitative
      and Qualitative Disclosures About Market Risk.
            33Item
      8.
            Financial
      Statements
            34Item
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
            34Item
      9A.
            Controls
      and Procedures
            34Item
      9B.
            Other
      Information
            37Part
      IIIItem
      10.
            Directors
      and Executive Officers of the Registrant
            37Item
      11.
            Executive
      Compensation
            40Item
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
            49Item
      13.
            Certain
      Relationships and Related Transactions
            51Item
      14.
            Principal
      Accounting Fees and Services
            51Part
      IVItem
      15.
            Exhibits
      and Financial Statement Schedules
            52







PART
I





ITEM
1.DESCRIPTION OF
BUSINESS.





GENERAL





Business





Telkonet,
Inc., formed in 1999 and incorporated under the laws of the State of Utah, is a
leading provider of innovative, centrally managed solutions for integrated
energy management, networking, building automation and proactive support
services.





Through
the revolutionary Telkonet iWire SystemTM and newly released Series 5 platform,
Telkonet utilizes proven PLC technology to deliver commercial high-speed
Broadband access from an IP “platform” that is easy to deploy, reliable and
cost-effective by leveraging a building’s existing electrical infrastructure.
The building’s existing electrical wiring becomes the backbone of a local area
network (LAN), which converts virtually every electrical outlet into a
high-speed data port without the costly installation of additional wiring or
major disruption of business activity.





Through
the Company’s majority-owned subsidiary MSTI Holdings, Inc. (MSTI), the Company
is able to offer quadruple play (“Quad-Play”) services to multi-tenant unit
(“MTU”) and multi-dwelling unit (“MDU”) residential, hospitality and commercial
properties. These Quad- Play services include video, voice, high-speed internet
and wireless fidelity (“Wi-Fi”) access.





The
Company’s acquisition of EthoStream, LLC, a leading high-speed wireless
internet  technology and services provider for the
hospitality industry (as described in greater detail below under
“Segment Reporting”), has enabled Telkonet to provide installation and support
for PLC and HSIA products and third party applications to customers across North
America. The Company’s new operating division represented by the assets
acquired from Smart Systems International, a leading provider of energy
management products and solutions  (as described in greater detail below
under “Segment Reporting”), permits the Company to offer new energy management
products and solutions to its customers in the United States and
Canada.





As a
result of Telkonet's acquisition of Smart Systems International and
EthoStream, the Company can now provide hospitality owners with a
greater return on investment on technology investments. Hotel owners
can leverage the Telkonet platform to support wired and wireless Internet
access, digital video surveillance, digital displays and the
forthcoming  networked energy management system. With the synergy of
EthoStream’s centralized remote monitoring and management platform extending
over HSIA, digital video surveillance and energy management, hospitality owners
will have a complete technology offering based on Telkonet’s core PLC system as
the infrastructure backbone, demonstrating true technology
convergence.





The
Company’s headquarters are located at 20374 Seneca Meadows Parkway, Germantown,
Maryland 20876. The reports that the Company files pursuant to the Securities
Exchange Act of 1934 can be found at the Company’s web site at www.telkonet.com.





The
highlights and business developments for the twelve months ended December 31,
2007 include the following:





·
            Consolidated
      revenue growth of 173% driven by acquisitions, as well as an increase
      in sales of the Telkonet iWire SystemTM·
            The
      acquisition of 1,800 hotel customers through the addition of EthoStream to
      the Telkonet segment in March 2007. As of March 1, 2008, the Company has
      over 2,300 hotels under management.·
            The
      acquisition of exclusive and patented technology from Smart Systems
      International·
            The
      raising of $10 million through a private placement of 4 million shares of
      common stock


·
            Completion
      of a merger by 90%-owned Microwave Satellite Technologies, Inc. (MST) with
      a wholly-owned subsidiary of a  public shell corporation and a
      subsequent raise by the public shell corporation of $9.1 million
      through sales of convertible debentures and a private placement of common
      stock of the newly formed corporation.·
            The
      acquisition of approximately 1,900 internet and telephone subscribers from
      Newport Telecommunications Co. by the MST segment in July
      2007.·
            A
      strategic investment in Geeks on Call America, Inc., the nation's premier
      provider of on-site computer services·
            The
      sale of the Company’s  investment in BPL Global for $2,000,000,
      yielding a gross profit of $1,868,956·
            The
      award of a $3.8M Contract with InTown Suites for the installation of the
      Telkonet SmartEnergyTM (TSE) energy management system in 125 properties
      across the U.S.





1





Segment
Reporting





We
classify our operations in two reportable segments: the Telkonet Segment and the
MST Segment.





Telkonet
Segment (“Telkonet”)





The
Telkonet Segment consists of the Telkonet iWire SystemTM and Series 5 platform,
energy management products, and centrally managed high-speed internet network
platforms integrated to form a complete SAAS technology platform. This segment
employs both direct and indirect sales models to distribute and support its
products on a worldwide basis and serves five major markets: hospitality,
commercial, industrial, government (including defense and education) and
retail.





The
Telkonet iWire SystemTM and Series 5 platform offer a viable and cost-effective
alternative to the challenges of hardwiring and wireless local area networks
(LANs). Telkonet’s products are designed for use in residential, commercial and
industrial applications, including multi-dwelling  hospitality,
government and utility  markets. Applications supported by the
Telkonet “platform” include, but are not limited to, VoIP telephones, internet
connectivity, local area networking, video conferencing, closed circuit security
surveillance, point of sale, digital signage and a host of other information
services.





Telkonet
has been shipping PLC products since 2003, initially targeting the hospitality
market followed by the multi-dwelling unit (MDU) market as well as the
government and other commercial markets.





The
Company released its Series 5 product on March 1, 2008.  The Series 5
product provides enhancements to the Telkonet iWire SystemTM which include, but
are not limited to, the following:





·
            more
      than 14 times faster than the legacy
product,


·
            more
      robust security and data
encryption,


·
            enhanced
      quality of service, or QOS,


·
            uses
      both alternating current and direct current which makes it highly
      compatible within utility and industrial
space,


·
            increased
      survivability in harsh environments,
and


·
            additional
      physical interfaces.





On March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $7,000,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. 1,090,909 of these shares were held in an escrow account for a period of
one year following the closing from which certain potential indemnification
obligations under the purchase agreement could be satisfied. The aggregate
number of shares held in escrow was subject to adjustment upward or downward
depending upon the trading price of the Company’s common stock during the one
year period following the closing date.  On March 12, 2008, the
Company released these shares from escrow and plans to issue an additional
1,909,091 shares pursuant to the adjustment provision in the SSI asset purchase
agreement.





Many of
the largest initiatives within Telkonet center on the sale of energy management
products and services. The Telkonet SmartEnergy system uses a combination of
occupancy sensors along with intelligent programmable thermostats or controllers
to adjust and maintain room temperature according to occupancy, time of day, and
environmental factors, for a preset configuration eliminating wasteful heating
and cooling of unoccupied rooms, and limiting the damaging impact of improper
temperature fluctuations.  On average, the installation of these
devices can save 30% or more per year on heating and cooling energy
consumption.





Thus far
the hospitality, MDU, educational, and government industries have been highly
interested in energy management devices and Telkonet has increased sales in
these markets consistently during the past three quarters.  In
addition, Telkonet continues to recognize increased interest and significant
wins internationally with its SmartEnergy offering.  Telkonet intends
to expand these efforts to facilitate growth acceleration in the installation of
our Telkonet SmartEnergy product line.  This effort is supported by
the enforcement of new energy conservation legislation such as the Energy
Independence and Security Act signed into law by President Bush on December 19,
2007 which contains provisions to improve energy efficiency in appliances and
commercial products and reduce federal government energy
usage.  Telkonet continues to support these initiatives and will
remain at the forefront of green technology solutions throughout 2008 with
upcoming introductions such as our networked Telkonet SmartEnergy product
line.




2




Additionally,
the integration of the Series Five product line with the energy management
products will allow Telkonet to use the electrical grid of commercial buildings
as a backbone for the networked Telkonet SmartEnergy solution making it easier,
quicker, less intrusive, and less expensive to install and operate the system
within a commercial environment.  The benefits of this are
twofold.  First, reduced costs provide the possibility of increased
margins on Telkonet’s sales.  Second, Telkonet has increased price
flexibility in order to respond to competitive market pressures.





On March
15, 2007, the Company acquired 100% of the outstanding membership units of
EthoStream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The EthoStream, LLC
acquisition enables Telkonet to provide installation and support for PLC
products and third party applications to customers across North America. The
purchase price of $11,756,097 was comprised of $2.0 million in cash and
3,459,609 shares of the Company’s common stock. The entire stock portion of the
purchase price is being held in escrow to satisfy certain potential
indemnification obligations of the sellers under the purchase agreement. The
shares held in escrow are distributable over the three years following the
closing.





One of
Telkonet’s largest recurring revenue streams is the Milwaukee-based technical
support center that was acquired in the EthoStream acquisition.  This
support center is one of the only internally-operated hospitality HSIA support
centers and the key driver in the quality and customer satisfaction that
EthoStream is credited with.  Telkonet’s support center is
a  fully operating 24/7, 365 day full-service customer support center
that provides e-mail, phone, and technical support not only to hospitality
internet access customers but to the third party vendors as well.





This has
been a growth market for the past several years due to business travel demand
for high quality internet access in a hotel room.  Additionally, over
the past year, the demands for high speed wireless internet access have extended
beyond the traditional business traveler with a significant number of leisure
travelers also demanding that the service be available.  Over the past
few quarters, we partnered with several large hotel chains allowing us to
service more than 2,300 total properties and providing connectivity to more than
a million travelers monthly.  We continue these efforts and Telkonet’s
hospitality market expansion through working with additional franchisors through
approved or preferred affiliations and franchise upgrades or
rollouts.





Competition





Telkonet
is a member of the HomePlug(TM) Powerline Alliance, an industry trade group that
engages in marketing and educational initiatives and sets standards and
specifications for products in the powerline communications
industry.





The
HomePlug(TM)
Powerline Alliance has grown over the past year and now includes many well
recognized brands in the networking and communications industries. These include
Linksys (a Cisco company), Intel, GE, Motorola, Netgear, Sony and Samsung. With
the exception of Motorola, which recently introduced a commercial product, these
companies do not presently represent a direct competitive threat to Telkonet
since they only market and sell their products in the residential
sector.





There can
be no assurance that other companies will not develop PLC products that compete
with Telkonet’s products in the future. Many have longer operating histories,
greater name recognition and substantially greater financial, technical, sales,
marketing and other resources than Telkonet. These potential competitors may,
among other things, undertake more extensive marketing campaigns, adopt more
aggressive pricing policies, obtain more favorable pricing from suppliers and
manufacturers and exert more influence on the sales channel than Telkonet can.
As a result, Telkonet may not be able to compete successfully with these
potential competitors and these potential competitors may develop or market
technologies and products that are more widely accepted than those being
developed by Telkonet or that would render Telkonet’s products obsolete or
noncompetitive.





Management
has focused its sales and marketing efforts primarily on the commercial and
industrial sector, which includes office buildings, hotels, schools, shopping
malls, commercial buildings, multi-dwelling units, government facilities,
utilities, substations, and any other commercial facilities that have a need for
Internet access and network connectivity. Telkonet has also focused on
establishing relationships with value added resellers. Telkonet continues to
examine, select and approach entities with existing distribution channels that
will be enhanced by Telkonet’s offerings.




3




Raw
Materials





Telkonet
has not experienced any significant or unusual problems in the purchase of raw
materials or commodities. While Telkonet is dependent, in certain situations, on
a limited number of vendors to provide certain raw materials and components, it
has not experienced significant problems or issues purchasing any essential
materials, parts or components. Telkonet obtains the majority of its raw
materials from the following suppliers: Arrow Electronics, Avnet Electronics
Marketing, Digi-Key Corporation, Intellon Corporation, and Versa Technology. In
addition, Superior Manufacturing Services, a U.S. based company, provides
substantially all the manufacturing and assembly requirements for Telkonet iWire
SystemTM and ATR Manufacturing, a Chinese based company, provides substantially
all the manufacturing requirements for the Telkonet SmartEnergy
products.





Customers





Telkonet
is neither limited to, nor reliant upon, a single or narrowly segmented consumer
base from which it derives its revenues. Presently, Telkonet is not dependent on
any particular customer under contract.  Telkonet’s primary focus is
in the hospitality, commercial, industrial and government markets.





Revenue
from one (1) major customer approximated $1,436,838 or 10% of total revenues for
the year ending December 31, 2007. Total sales of rental contract agreements
(Note F) and the related capitalized equipment to Hospitality Leasing
Corporation approximated $705,000 and $252,000 in the year ending December 31,
2006, and $439,000 and $0 in the year ending 2005, which constituted
approximately 18% and approximately 18% of total revenue, respectively, and
represented the only major customer for years then ended.




Intellectual
Property





Telkonet
has applied for patents that cover the unique technology integrated into the
Telkonet iWire SystemTM and
Series 5 product suite. Telkonet also continues to identify, design and develop
enhancements to its core technologies that will provide additional
functionality, diversification of application and desirability for current and
future users of the Telkonet iWire SystemTMand
Series 5 product suite.





In
December 2005, the United States Patent and Trademark Office issued Patent
No: 6,975,212 titled “Method and Apparatus for Attaching Power Line
Communications to Customer Premises”. The patent covers the method and apparatus
for modifying a three-phase power distribution network in a building in order to
provide data communications by using a PLC signal to an electrical central
location point of the power distribution system. Telkonet’s Coupler technology
enables the conversion of electrical outlets into high-speed data ports without
costly installation, additional wiring, or significant disruption of business
activity. The Coupler is an integral component of the Telkonet iWire SystemTMandSeries
5 product suites.




In August
2006, the United States Patent and Trademark Office issued Patent No: 7,091,831,
titled "Method and Apparatus for Attaching Power Line Communications to Customer
Premises". The patented technology incorporates a safety disconnect circuit
breaker into the Telkonet Coupler, creating a single streamlined unit. In doing
so, installation of the Telkonet iWire System(TM) is faster, more efficient, and
more economical than with separate disconnect switches, delivering optimal
signal quality. The Telkonet Integrated Coupler Breaker patent covers the unique
technique used for interfacing and coupling its communication devices onto the
three-phase electrical systems that are predominant in commercial
buildings.





In
January 2007, the United States Patent and Trademark Office issued Patent No:
7,170,395 titled “Methods and Apparatus for Attaching Power Line Communications
to Customer Premises” for Delta phase power distribution system applications,
which are prevalent in the maritime industry, shipboard systems, along with that
of heavy industrial plants and facilities.





The
Company acquired certain intellectual property in the SSI acquisition, including
Patent No: 5,395,042, titled “Apparatus and Method for automatic climate
control,” which was issued by the United States Patent Trademark Office in March
1995.  This invention calculates and records the amount of time needed
for the thermostat to return the room temperature to the occupant’s set point
once a person re-enters the room





In
addition to the foregoing, Telkonet currently has multiple patent applications
under examination, and intends to file additional patent applications covering a
wide range of technologies including that of improved network topologies and
techniques for imposing LANs over existing wired infrastructure.




4




Telkonet
has also filed multiple Patent Cooperation Treaty (PCT) patent applications,
which have been used to file national patent applications in foreign countries
including the European Union, Japan, China, Russia, India and
others.





Notwithstanding
the issuance of these patents, there can be no assurance that any of Telkonet’s
current or future patent applications will be granted, or, if granted, that such
patents will provide necessary protection for the Company’s technology or its
product offerings, or be of commercial benefit to the Company.





Government
Regulation





We are
subject to regulation in the United States by the FCC. FCC rules permit the
operation of unlicensed digital devices that radiate radio frequency (RF)
emissions if the manufacturer complies with certain equipment authorization
procedures, technical requirements, marketing restrictions and product labeling
requirements.





In
January 2003, Telkonet received Federal Communications Commission
(FCC) approval to market the Telkonet iWire SystemTM product
suite. FCC rules permit the operation of unlicensed digital devices that radiate
radio frequency emissions if the manufacturer complies with certain equipment
authorization procedures, technical requirements, marketing restrictions and
product labeling requirements. An independent, FCC-certified testing lab has
verified the Company’s Gateway complies with the FCC technical requirements for
Class A digital devices. No further testing of this device is required and
the device may be manufactured and marketed for commercial use.





In
December 2003, Telkonet received approval from the U.S. Patent and Trademark
Office for its “Method and Apparatus for Providing Telephonic Communication
Services” Patent No.: 6,668,058. This invention covers the utilization of an
electrical power grid, for a concentration of electrical power consumers, and
use of existing consumer power lines to provide for a worldwide voice and data
telephony exchange





In
March 2005, Telkonet received final certification of its Telkonet iWire
SystemTMproduct
suite from European Union (EU) authorities, which certification was
required before Telkonet could sell and permanently install the Telkonet iWire
SystemTM in
EU countries. As a result of the certification, the Telkonet iWire SystemTM
that will be sold and installed in EU countries will bear the Conformite
Europeene (CE) mark, a symbol that demonstrates that the product has met the
EU’s regulatory standards and is approved for sale within the EU. Telkonet now
has satisfied the governmental requirements for product safety and certification
in the EU and is free to sell and install the Telkonet iWire SystemTMproduct
suite in the EU.





In
June 2005, Telkonet received the National Institute of Standards and
Technology (NIST) Federal Information Processing Standard (FIPS) 140-2
validation for the Gateway. In July 2005, Telkonet received FIPS 140-2
validation for the eXtender and iBridge. The U.S. federal government requires,
as a condition to purchasing certain information processing applications, that
such applications receive FIPS 140-2 validation. U.S. federal agencies use FIPS
140-2 compliant products for the protection of sensitive information. As a
result of the foregoing validations, as of July 2005, all of Telkonet’s
powerline carrier products have satisfied all governmental requirements for
security certification and are eligible for purchase by the U.S. federal
government. In addition to the foregoing, Canadian provincial authorities use
FIPS 140-2 compliant products for the protection of sensitive designate
information. The Communications-Electronics Security Group (CESG) also has
stated that FIPS 140-2 compliant products meet its security criteria for use in
data traffic categorized as “Private.” CESG is part of the United Kingdom’s
National Technical Authority for Information Assurance, which is a government
agency responsible for validating the security of information processing
applications for the government of the United Kingdom, financial institutions,
healthcare organizations, and international governments, among
others.





In
November 2005, Telkonet received the Norma Official Mexicana
(NOM) certification, enabling Telkonet to sell the iWire SystemTMproduct
suite in Mexico. NOM certification is required for Telkonet’s products to be
sold in Mexico, and no further certifications are required to sell the Telkonet
iWire SystemTMproduct
suite in Mexico.





Future
products designed by the Company will require testing for compliance with FCC
and CE regulations. Moreover, if in the future, the FCC or EU changes its
technical requirements, further testing and/or modifications may be
necessary.





Research
and Development





During the years ended December 31,
2007, 2006 and 2005, Telkonet spent $2,349,690, $1,925,746 and $2,096,104,
respectively, on research and development activities. In 2007 and 2006, research
and development activities were focused on the development of Telkonet’s next
generation product. In 2005, research and development activities included (a)
QoS for VoIP service for both commercial and FIPS 140-2 product applications,
(b) design of the next generation high-speed development platform, (c) design,
prototype & release of the Integrated Coupler Breaker product line, (d)
design & development of the second generation automated test equipment for
manufacturing, (e) automated SQA regression testing.




5




Long
Term Investments





Amperion,
Inc.




On
November 30, 2004, Telkonet entered into a Stock Purchase Agreement
(“Agreement”) with Amperion, Inc. ("Amperion"), a privately held company.
Amperion is engaged in the business of developing networking hardware and
software that enables the delivery of high-speed broadband data over
medium-voltage power lines. Pursuant to the Agreement, the Company invested
$500,000 in Amperion in exchange for 11,013,215 shares of Series A Preferred
Stock for an equity interest of approximately 4.7%. Telkonet accounted for this
investment under the cost method, as the Company does not have the ability to
exercise significant influence over operating and financial policies of the
investee.




It is the
policy of Telkonet to regularly review the assumptions underlying the operating
performance and cash flow forecasts in assessing the carrying values of the
investment. Telkonet identifies and records impairment losses on investments
when events and circumstances indicate that such decline in fair value is other
than temporary. Such indicators include, but are not limited to, limited capital
resources, limited prospects of receiving additional financing, and limited
prospects for liquidity of the related securities. Telkonet determined that its
investment in Amperion was impaired based upon forecasted discounted cash flow.
Accordingly, Telkonet wrote-off $92,000 and $400,000 of the carrying value of
its investment through a charge to operations during the year-ended December 31,
2006 and 2005, respectively. The remaining value of Telkonet’s investment in
Amperion is $8,000 at December 31, 2007 and 2006 and the amount at December 31,
2007, represents the current fair value.





BPL Global,
Ltd.




On
February 4, 2005, the Company’s Board of Directors approved an investment in BPL
Global, Ltd. (“BPL Global”), a privately held company. The Company funded an
aggregate of $131,000 as of December 31, 2005 and additional $44 during the year
of 2006.. BPL Global is engaged in the business of developing broadband services
via power lines through joint ventures in the United States, Asia, Eastern
Europe and the Middle East. The Company accounted for this investment under the
cost method, as the Company did not have the ability to exercise significant
influence over operating and financial policies of the investee. The Company
reviewed the assumptions underlying the operating performance and cash flow
forecasts in assessing the carrying values of the investment. The fair value of
the Company's investment in BPL Global, Ltd. amounted $131,044 as of December
31, 2006.  On November 7, 2007, the Company completed the sale of its
investment in BPL Global, Ltd for $2,000,000 in cash to certain existing
stockholders of BPL Global.





Geeks on Call America,
Inc.





On
October 19, 2007, the Company completed the acquisition of approximately 30.0%
of the issued and outstanding shares of common stock of Geeks on Call America,
Inc. (“GOCA”), the nation's premier provider of on-site computer services. 
Under the terms of the stock purchase agreement, the Company acquired
approximately 1,160,043 shares of GOCA common stock from several GOCA
stockholders in exchange for 2,940,200 shares of the Company’s common stock for
total consideration valued at approximately $4.5 million. The number of shares
issued in connection with this transaction was determined using a per share
price equal to the average closing price of the Company’s common stock on the
American Stock Exchange (AMEX) during the ten trading days immediately preceding
the closing date. The number of shares is subject to adjustment on the date the
Company files a registration statement for the shares issued in this
transaction, which must occur no later than the 180th day
following the closing date. The increase or decrease to the number of shares
issued will be determined using a per share price equal to the average closing
price of the Company’s common stock on the AMEX during the ten trading days
immediately preceding the date the registration statement is
filed.  The Company accounted for this investment under the cost
method, as the Company does not have the ability to exercise significant
influence over operating and financial policies of the investee.





On
February 8 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned
subsidiary of Geeks On Call Holdings, Inc., (formerly Lightview, Inc.) merged
with Geeks on Call America, Inc (“GOCA”). As a result of the merger, the
Company’s common stock in GOCA was exchanged for shares of common stock of Geeks
on Call Holdings Inc.  Immediately following the merger, Geeks on Call
Holdings Inc. completed a private placement of its common stock for aggregate
gross proceeds of $3,000,000. As a result of this transaction, the Company’s 30%
interest in GOCA became an 18% interest in Geeks on Call Holdings
Inc.




6




Multiband
Corporation





In
connection with a payment of $75,000 of accounts receivable, the company
received 30,000 shares of common stock of Multiband Corporation, a
Minnesota-based communication services provider to multiple dwelling
units.  The Company accounted for this investment under the cost
method as the Company does not have the ability to exercise significant
influence over operating and financial policies of the investee, and the shares
are not eligible for sale by the Company under Rule 144 of the Securities Act of
1933.  The value of this investment amounted to $75,000 as of December
31, 2007.





Backlog





The
Telkonet Segment maintains contracts and monthly services for more than 2,300
hotels which are expected to generate approximately $3,600,000 annual recurring
support and internet advertising revenue.





The
Telkonet Segment has maintained certain purchase orders relating to a major
utilities energy management initiative provided through the two selected
providers. The current order backlog amounts to approximately $1,100,000 and the
estimated remaining program value amounts to $4,500,000 for products and
services to be provided through March 2010. In addition, the Company recently
contracted a similar energy efficiency program in Wisconsin estimated to achieve
5,000 rooms and establish offerings within utility programs
nationally.





The
Company has contracted with a national hotel operator to install energy
management devices in approximately 16,000 rooms for an approximate value of
$3,800,000. The implementation is anticipated to be completed by the third
quarter of 2008.




MST
Segment (“MSTI”)





MSTI is a
communications service provider offering quadruple play (“Quad-Play”) services
to multi-tenant unit (“MTU”) and multi-dwelling unit (“MDU”) residential,
hospitality and commercial properties. These Quad-Play services include video,
voice, high-speed internet and wireless fidelity (“Wi-Fi”) access. In addition,
MSTI currently offers or plans to offer a variety of next-generation
telecommunications solutions and services including satellite installation,
video conferencing, surveillance/security and energy management, and other
complementary professional services.




NuVisionsTM




MSTI
currently offers digital television service through DISH Network, a national
satellite television provider, under its private label NuVisionsTM brand of
services. The NuVisions TV offering currently includes over 500 channels of
video and audio programming, with a large high definition (more than 40
channels) and ethnic offering (over 100 channels from 17 countries) available in
the market today. MSTI also offers its NuVisions Broadband high speed internet
service and NuVisions Digital Voice telephone service to multi-family residences
and commercial properties. MSTI delivers its broadband based services using
terrestrial fiber optic links and in February 2005, began deployment in New York
City of a proprietary wireless gigabit network that connects properties served
in a redundant gigabit ring - a virtual fiber optic network in the
air.





Wi-Fi
Network





MSTI has
constructed a large NuVisions Wi-Fi footprint in New York City intended to
create a ubiquitous citywide Wi-Fi network. NuVisions Wi-Fi offers Internet
access in the southern-half of Central Park, Riverside Park from 60th to 79th
Streets, Dag Hammarskjold Plaza, and the United Nations Plaza. In addition, MSTI
provides NuVisions Wi-Fi service in and around Trump Tower on Fifth Avenue,
Trump World Tower on First Avenue, the Trump Place properties located on
Riverside Boulevard, Trump Palace, Trump Parc, Trump Parc East as well as
portions of Roosevelt Island surrounding the Octagon residential community. MSTI
currently has plans to deploy additional Wi-Fi “Hot Zones” throughout New York
City and continue to enlarge its Wi-Fi footprint as new properties are
served.





Internet
Protocol Television (“IPTV”)





In fourth
quarter of 2006, MSTI invested in an IPTV platform to deploy in 2008. IPTV is a
method of distributing television content over IP that enables a more
user-defined, on-demand and interactive experience than traditional cable or
satellite television. The IPTV service delivers traditional cable TV programming
and enables subscribers to surf the Internet, receive on-demand content, and
perform a host of Internet-based functions via their TV sets.




7




Competition




The home
entertainment and video programming industry is competitive, and MSTI expects
competition to intensify in the future. MSTI faces its most significant
competition from the franchised cable operators. In addition, MSTI’s competition
includes other satellite providers, telecom providers and off-air
broadcasters.





Hardwired
Franchised Cable System





Cable
companies currently dominate the market in terms of subscriber penetration, the
number of programming services available, audience ratings and expenditures on
programming. However, satellite services are gaining market share which MSTI
believes will provide it with the opportunity to acquire and consolidate a
subscriber base by providing a high quality signal at a comparable or reduced
price to many cable operators' current service.





Other
Operators





MSTI’s
next largest competitors are other operators who build and operate
communications systems such as satellite master antenna television systems,
commonly known as SMATV, or private cable headend systems, which generally serve
condominiums, apartment and office complexes and residential developments. MSTI
also competes with other national DBS operators such as EchoStar.





Off-Air
Broadcasters





A
majority of U.S. households that are not serviced by cable operators are
serviced only by broadcast networks and local television stations (“off-air
broadcasters”). Off-air broadcasters send signals through the air, which are
received by traditional television antennas. Signals are accessible to anyone
with an antenna and programming is funded by advertisers. Audio and video
quality is limited and service can be adversely affected by weather or by
buildings blocking a signal.





Traditional
Telephone Companies




Traditional
telephone companies such as Verizon and AT&T have recently diversified their
service offerings to compete with traditional franchised cable companies in a
triple-play market. Although their subscriber growth is currently smaller than
franchise cable companies, these traditional phone companies are developing
video offerings such as Verizon's FIOS product. These phone companies have in
the past also been resellers of DIRECTV and EchoStar video programming, however,
rarely in the multi-dwelling unit market. In the future, video offerings from
traditional phone companies may become a significant competitor in the MDU
market.




Customers/Strategy





MSTI’s
customer base and strategy is to target and cultivate a subscriber base that
will demand high margin products, including, video, IPTV, VoIP, high-speed
Internet and Wi-Fi services.




MSTI
currently maintains service agreements with approximately 22 MDU and MTU
properties. Generally, under the terms of a service agreement, MSTI provides
either (i) “bulk services,” which may include one or all of a bundle of products
and services, at a fixed price per month to the owner of the MDU or MTU
property, and contract with individual residents for enhanced services, such as
premium cable channels, for a monthly fee or (ii) contract with individual
residents of the MDU property for one or more basic or enhanced services for a
monthly fee. These agreements typically include a revenue sharing arrangement
with property owners, whereby the property owner is entitled to a share of the
revenues derived from subscribers who reside at the MDU/MTU property.Theserevenue sharing
arrangements are either based upon a fix amount per subscriber or based on a
percentage, typically between 7-10%, of the monthly fees MSTI charges residents
for its services. MSTI believes that its complementary products and services
allows for future growth and as such are designed and integrated with
scalability in mind.




8




Governmental
Regulation





Federal
Regulation




MSTI’s
systems do not use or traverse public rights-of-way and thus are exempt
from the comprehensive regulation of cable systems under the Federal
Communications Act of 1934, as amended (the “Communications Act”). Because its
systems are subject to minimal federal regulation, MSTI has greater pricing
freedom and is not required to serve any customer whom it does not choose to
serve, and management believes that MSTI has significantly more competitive
flexibility than do the franchised cable systems. Management believes that these
regulatory advantages help to make MSTIs’ private systems competitive with
larger franchised cable systems.





On
October 5, 1992, Congress enacted the Cable Consumer Protection and Competition
Act of 1992 (the “1992 Cable Act”), which imposed additional regulation on
traditional franchised cable operators and permits regulation of rates in
markets in which there is no “effective competition”, as defined in the 1992
Cable Act, and directed the FCC to adopt comprehensive new federal standards for
local regulation of certain rates charged by traditional franchised cable
operators. Conversely, the legislation also provides for deregulation of
traditional hardwire cable in a given market where effective competition is
shown to exist. Rates charged by private cable operators, typically already
lower than traditional franchise cable rates, are not subject to regulation
under the 1992 Cable Act.





In
February 1996, Congress passed the Telecommunications Act of 1996 (the “1996
Act”), which substantially amended the Communications Act. The 1996 Act contains
provisions intended to increase competition in the telephone, radio, broadcast
television, and hardwire and wireless cable television businesses. This
legislation has altered, and management believes will continue to alter,
federal, state, and local laws and regulations affecting the communications
industry, including certain of the services MSTI provides.





Under the
federal copyright laws, permission from the copyright holder generally must be
secured before a video program may be retransmitted. Section 111 of the
Copyright Act establishes the cable compulsory license pursuant to which certain
“cable systems” are entitled to engage in the secondary transmission of
broadcast programming without the prior permission of the holders of copyrights
in the programming. In order to do so, a cable system must secure a compulsory
copyright license. Such a license may be obtained upon the filing of certain
reports with and the payment of certain licensing fees to the U.S. Copyright
Office. Private cable operators, such as MSTI, may rely on the cable compulsory
license with respect to the secondary transmission of broadcast programming.
Management does not expect the licensing fees to have a material adverse effect
on MSTI’s business.





Under the
retransmission consent provisions of the 1992 Cable Act, multichannel video
programming distributors, including, but not limited to, franchised and private
cable operators, seeking to retransmit certain commercial television broadcast
signals, notwithstanding the cable compulsory license, must first obtain the
permission of the broadcast station in order to retransmit the station’s signal.
However, private cable systems, unlike franchised cable systems, are not
required under the FCC’s “must carry” rules to retransmit local television
signals. Although there can be no assurances that MSTI will be able to obtain
requisite broadcaster consents, management believes, in most cases, MSTI will be
able to do so for little or no additional cost.





On
November 29, 1999, Congress enacted the Satellite Home Viewer Improvement Act of
1999 (“SHVIA”), which amended the Satellite Home Viewer Act. SHVIA permits DBS
operators to transmit local television signals into local markets. SHVIA
generally seeks to place satellite operators on an equal footing with cable
television operators in regards to the availability of television broadcast
programming. SHVIA amends the Copyright Act and other applicable laws and
regulations in order to clarify the terms and conditions under which a DBS
operator may retransmit local and distant broadcast television stations to
subscribers. The law was intended to promote the ability of satellite services
to compete with cable television systems and to resolve disputes that had arisen
between broadcasters and satellite carriers regarding the delivery of broadcast
television station programming to satellite service subscribers. As a result of
SHVIA, television stations are generally entitled to seek carriage on any DBS
operator's system providing local service in their respective markets. SHVIA
creates a statutory copyright license applicable to the retransmission of
broadcast television stations to DBS subscribers located in their markets.
Although there is no royalty payment obligation associated with this license,
eligibility for the license is conditioned on the satellite carrier's compliance
with applicable laws, regulations and FCC rules governing the retransmission of
such “local” broadcast television stations to satellite service subscribers.
Noncompliance with such laws, regulations and/or FCC requirements could subject
a satellite carrier to liability for copyright infringement. SHVIA was extended
and re-enacted by the Satellite Home Viewer Extension and Reauthorization Act
(“SHVERA”) in December of 2004.





MSTI is
not directly subject to rate regulation or certification requirements by the FCC
or state public utility commissions because its equipment installation and sales
agent activities do not constitute the provision of common carrier or cable
television services. As a private cable operator, MSTI is not subject to
regulation as a DBS provider, but primarily relies upon its third-party
programming aggregators to procure all necessary re-transmission consents and
other programming rights under the Communications Act and the Copyright
Act.




9




State
and Local Cable System Regulation




MSTI does
not anticipate that its deployment of video programming services will be subject
to state or local franchise laws primarily due to the fact that its facilities
do not use or traverse public rights-of-way. Although MSTI may be required to
comply with state and local property tax, environmental laws and local zoning
laws, management does not anticipate that compliance with these laws will have
any material adverse impact on MSTI’s business.




State
Mandatory Access Laws
  A number
of states have enacted mandatory access laws that generally require, in exchange
for just compensation, the owners of rental apartments (and, in some instances,
the owners of condominiums) to allow the local franchise cable television
operator to have access to the property to install its equipment and provide
cable service to residents of the MDU. Such state mandatory access laws
effectively eliminate the ability of the property owner to enter into an
exclusive right of entry with a provider of cable or other broadcast services.
In addition, some states have anti-compensation statutes forbidding an owner of
an MDU from accepting compensation from whomever the owner permits to provide
cable or other broadcast services to the property. These statutes have been and
are being challenged on constitutional grounds in various
states.  These state access laws may provide both benefits and
detriments to our business plan should we expand significantly in any of these
states.




Preferential
Access Right




MSTI
generally negotiates exclusive rights to provide satellite services singularly
or in competition with competing cable providers, and also negotiates, where
possible, “rights-of-first-refusal” to match price and terms of third-party
offers to provide other communication services in buildings where it has
negotiated broadcast access rights. Management believes that these preferential
rights of entry are generally enforceable under applicable law. However, current
trends at the state and federal level suggest that the future enforceability of
these provisions may be uncertain. In 2001, the FCC issued an order prohibiting
telecommunications service providers from negotiating exclusive contracts with
owners of commercial MDU properties. The FCC recently extended this prior action
to prohibit carriers from entering into contracts with residential MDU owners
that grant carriers exclusive access for the provision of telecommunications
services to residents in those MDUs.  The ban applies retrospectively to
existing contracts as well as to any future agreements.  The FCC has also
banned agreements that provide exclusive access for video services to
MDUs.  The ban applies retrospectively to existing contracts as well as to
any future agreements.  The ban on exclusive video agreements does not
currently apply to non-franchised entities such as MSTI however the FCC is
currently considering extending the ban to such entities.  While
limitations on exclusivity may undermine the exclusivity provisions of MSTI’s
rights of entry on the one hand, they may also open up many other properties to
which MSTI may provide a competing service. There can be no assurance that
future state or federal laws or regulations will not restrict MSTI’s ability to
offer access payments, limit MDU owners' ability to receive access payments or e
enter into exclusive agreements, any of which could have a material adverse
effect on MSTI’s business.




Regulation
of the High-Speed lnternet and Wi-Fi Business




ISPs,
including Internet access providers, are largely unregulated by the FCC or state
public utility commissions at this time (apart from federal, state and local
laws and regulations applicable to business in general). However, there can be
no assurance that this business will not become subject to regulatory
restraints. Also, although the FCC has rejected proposals to impose additional
costs and regulations on ISPs to the extent they use local exchange telephone
network facilities, such change may affect demand for Internet related services.
No assurance can be given that changes in current or future regulations adopted
by the FCC or state regulators or other legislative or judicial initiatives
relating to Internet services would not have a material adverse effect on MSTI’s
business.




Regulation
of the VoIP Business




IP-based
voice services are currently exempt from the reporting and pricing restrictions
placed on common carriers by the FCC. However, there are several state and
federal regulatory proceedings further defining what specific service offerings
qualify for this exemption. Due to the growing acceptance and deployment of VoIP
services, the FCC and a number of state public service commissions are
conducting regulatory proceedings that could affect the regulatory duties and
rights of entities that provide IP-based voice applications. There is regulatory
uncertainty as to the imposition of traditional retail, common carrier
regulation on VoIP products and services.





Long
Term Investments





MSTI
maintains an investment in Interactivewifi.com, LLC a privately held company.
This investment represents an equity interest of approximately 50% at December
31, 2007. Interactivewifi.com is engaged in providing internet and related
services to customers throughout metropolitan New York, including the Nuvision's
internet services. MSTI accounted for this investment under the cost method, as
MSTI does not have the ability to exercise significant influence over operating
and financial policies of the investee. Telkonet reviewed the assumptions
underlying the operating performance and cash flow forecasts in assessing the
carrying values of the investment. The fair value of MSTI’s investment in
Interactivewifi.com amounted to approximately $55,000 as of December 31,
2007.




10


Backlog





The MSTI
subscriber portfolio includes approximately 22 MDU properties with bulk service
agreements and/or access licenses to service the individual subscribers in
metropolitan New York. The remaining terms of the access agreements provide MSTI
access rights from 7 to 15 years with the final agreement expiring in 2016 and
the revenues to be recognized under non-cancelable bulk agreements provide a
minimum of $2,100,000 in revenue through 2013.





Other
information





Employees





As of
March 1, 2008, the Company had 172 full time employees comprised of 141 full
time employees of Telkonet and 31 employees of MSTI. The Company intends to hire
additional personnel to meet future operating requirements.  The
Company anticipates that it may need to hire additional staff in the areas of
customer support, engineering, sales and marketing, and
administration.





Environmental
Matters





The
Company does not anticipate any material effect on its capital expenditures,
earnings or competitive position due to compliance with government regulations
involving environmental matters.





Financial
Information About Geographic Areas





To date,
the majority of the Company’s revenue has been derived in the United States,
although the Company continues to derive a growing portion of our revenue from
international sales. International sales as a percentage of total revenue
represented 2%, 19% and 25% in 2007, 2006 and 2005, respectively. Our
international sales are concentrated in Canada, Latin America and Western Europe
and we continue to expand into other markets worldwide. The table below sets
forth our net revenue by major geographic region.





Year
      Ended December 31,2007
            
            Percentage
              Change
            
            2006
            
            Percentage
              Change
            
            2005United
      States
            
            $
            13,851,021
            
            207%
            
            $
            4,508,478
            
            141%
            
            $
            1,871,241Worldwide
            
            
            301,712
            
            -55%
            
            
            672,850
            
            9%
            
            
            617,082Total
            
            $
            14,152,733
            
            173%
            
            $
            5,181,328
            
            108%
            
            $
            2,488,323




ITEM
1A.RISK
FACTORS.





The
Company’s results of operations, financial condition and cash flows can be
adversely affected by various risks. These risks include, but are not limited
to, the principal factors listed below and the other matters set forth in this
annual report on Form 10-K. You should carefully consider all of these
risks.





The
Company has a history of operating losses and an accumulated deficit and expects
to continue to incur losses for the foreseeable future.




Since
inception through December 31, 2007, the Company has incurred cumulative losses
of $90,815,779 and has never generated enough funds through operations to
support its business. Additional capital may be required in order to provide
working capital requirements for the next twelve months. The Company’s losses to
date have resulted principally from:





·
            research
      and development costs relating to the development of the Telkonet iWire
      SystemTM
      product suite;





·
            costs
      and expenses associated with manufacturing, distribution and marketing of
      the Company’s products;





·
            general
      and administrative costs relating to the Company’s operations;
      and





·
            interest
      expense related to the Company’s
indebtedness.




11




The
Company is currently unprofitable and may never become profitable. Since
inception, the Company has funded its research and development activities
primarily from private placements of equity and debt securities, a bank loan and
short term loans from certain of its executive officers. As a result of its
substantial research and development expenditures and limited product revenues,
the Company has incurred substantial net losses. The Company’s ability to
achieve profitability will depend primarily on its ability to successfully
commercialize the Telkonet iWire SystemTM product suite. If the Company is not
successful in generating sufficient liquidity from operations or in raising
sufficient capital resources on terms acceptable to the Company, this could have
a material adverse effect on the Company’s business, results of operations,
liquidity and financial condition.





Our
independent auditors have added an explanatory paragraph to their report of our
financial statements for the year ended December 31, 2007 stating that our net
losses, lack of revenues and dependence on our ability to raise additional
capital to continue our existence, raise substantial doubt about our ability to
continue as a going concern. If we are not successful in raising sufficient
additional capital, we may we may not be able to continue as a going concern,
our stockholders may lose their entire investment in us.





Potential
fluctuations in operating results could have a negative effect on the price of
the Company’s common stock.




The
Company’s operating results may fluctuate significantly in the future as a
result of a variety of factors, most of which are outside the Company’s control,
including:





·
            the
      level of use of the Internet;





·
            the
      demand for high-tech goods;





·
            the
      amount and timing of capital expenditures and other costs relating to the
      expansion of the Company’s
operations;





·
            price
      competition or pricing changes in the
industry;





·
            technical
      difficulties or system downtime;





·
            economic
      conditions specific to the internet and communications industry;
      and





·
            general
      economic conditions.




The
Company’s quarterly results may also be significantly impacted by certain
accounting treatment of acquisitions, financing transactions or other matters.
Such accounting treatment could have a material impact on the Company’s results
of operations and have a negative impact on the price of the Company’s common
stock.





The
Company’s directors and executive officers own a substantial percentage of the
Company’s issued and outstanding common stock. Their ownership could allow them
to exercise significant control over corporate decisions.




As of
March 1, 2008, the Company’s officers and directors owned 11.2% of the Company’s
issued and outstanding common stock. This means that the Company’s officers and
directors, as a group, exercise significant control over matters upon which the
Company’s stockholders may vote, including the selection of the Board of
Directors, mergers, acquisitions and other significant corporate
transactions.




Further
issuances of equity securities may be dilutive to current
stockholders.




Although
the funds that were raised in the Company’s debenture offerings, the note
offerings and the private placement of common stock are being used for general
working capital purposes, it is likely that the Company will be required to seek
additional capital in the future. This capital funding could involve one or more
types of equity securities, including convertible debt, common or convertible
preferred stock and warrants to acquire common or preferred stock. Such equity
securities could be issued at or below the then-prevailing market price for the
Company’s common stock. Any issuance of additional shares of the Company’s
common stock will be dilutive to existing stockholders and could adversely
affect the market price of the Company’s common stock.




12




The
exercise of options and warrants outstanding and available for issuance may
adversely affect the market price of the Company’s common stock.





As of
December 31, 2007, the Company had outstanding employee options to purchase a
total of 8,105,429 shares of common stock at exercise prices ranging from $1.00
to $5.97 per share, with a weighted average exercise price of $1.98. As of
December 31, 2007, the Company had outstanding non-employee options to purchase
a total of 1,815,937 shares of common stock at an exercise price of $1.00 per
share. As of December 31, 2007, the Company had warrants outstanding to purchase
a total of 7,673,627 shares of common stock at exercise prices ranging from
$2.59 to $4.70 per share, with a weighted average exercise price of $4.15. The
exercise of outstanding options and warrants and the sale in the public market
of the shares purchased upon such exercise will be dilutive to existing
stockholders and could adversely affect the market price of the Company’s common
stock.





The
powerline communications industry is intensely competitive and rapidly
evolving.




The
Company operates in a highly competitive, quickly changing environment, and the
Company’s future success will depend on its ability to develop and introduce new
products and product enhancements that achieve broad market acceptance in
commercial and governmental sectors. The Company will also need to respond
effectively to new product announcements by its competitors by quickly
introducing competitive products.




Delays in
product development and introduction could result in:





·
            loss
      of or delay in revenue and loss of market
share;





·
            negative
      publicity and damage to the Company’s reputation and brand;
      and





·
            decline
      in the average selling price of the Company’s
  products.




The
communication industry is intensely competitive and rapidly
evolving.





The
Company operates in a highly competitive, quickly changing environment, and our
future success will depend on our ability to develop and introduce new services
and service enhancements that achieve broad market acceptance in MDU and
commercial sectors. The Company will also need to respond effectively to new
product announcements by our competitors by quickly introducing competitive
products.




Delays in
product development and introduction could result in:





·
            loss
      of or delay in revenue and loss of market
share;





·
            negative
      publicity and damage to our reputation and brand;
  and





·
            decline
      in the selling price of our products and
  services.





Additionally,
new companies are constantly entering the market, thus increasing the
competition. This could also have a negative impact on our ability to obtain
additional capital from investors. Larger companies who have been engaged in our
business for substantially longer periods of time may have access to greater
resources. These companies may have greater success in the recruitment and
retention of qualified employees, as well as in conducting their operations,
which may give them a competitive advantage. In addition, actual or potential
competitors may be strengthened through the acquisition of additional assets and
interests. If the Company is unable to compete effectively or adequately respond
to competitive pressures, this may materially adversely affect our results of
operation and financial condition. Large companies including Direct TV,
EchoStar, Time Warner, Cablevision and Verizon are active in our markets in the
provision and distribution of communications services and we will have to
compete with such companies.




13


The
Company is not large enough to negotiate cable television programming contracts
as favorable as some of our larger competitors.




Programming
costs are generally directly related to the number of subscribers to which the
programming is provided, with discounts available to large traditional cable
operators and direct broadcast satellite (DBS) providers based on their high
subscriber levels. As a result, larger cable and DBS systems generally pay lower
per subscriber programming costs. The Company has attempted to obtain volume
discounts from our suppliers. Despite these efforts, we believe that our per
subscriber programming costs are significantly higher than large cable operators
and DBS providers with which we compete in some of our markets. This may put us
at a competitive disadvantage in terms of maintaining our operating results
while remaining competitive with prices offered by these providers. In addition,
as programming agreements come up for renewal, the Company cannot assure you
that we will be able to renew these agreements on comparable or favorable terms.
To the extent that we are unable to reach agreement with a programmer on terms
that we believe are reasonable, we may be forced to remove programming from our
line-up, which could result in a loss of customers.





Programming
costs have risen in past years and are expected to continue to rise, which may
adversely affect our financial results.




The cost
of acquiring programming is a significant portion of the operating costs for our
cable television business. These costs have increased each year and we expect
them to continue to increase, especially the costs associated with sports
programming. Many of our programming contracts cover multiple years and provide
for future increases in the fees we must pay. Historically, we have absorbed
increased programming costs in large part through increased prices to our
customers. However, competitive and other marketplace factors may not permit us
to continue to pass these costs through to customers. In order to minimize the
negative impact that increased programming costs may have on our margins, we may
pursue a variety of strategies, including offering some programming at premium
prices or moving some programming from our analog service to our premium digital
services. Despite our efforts to manage programming expenses and pricing, the
rising cost of programming may adversely affect our results of
operations.





Government
regulation of the Company’s products could impair the Company’s ability to sell
such products in certain markets.




FCC rules
permit the operation of unlicensed digital devices that radiate radio frequency
emissions if the manufacturer complies with certain equipment authorization
procedures, technical requirements, marketing restrictions and product labeling
requirements. Differing technical requirements apply to “Class A” devices
intended for use in commercial settings, and “Class B” devices intended for
residential use to which more stringent standards apply. An independent,
FCC-certified testing lab has verified that the Company’s iWire SystemTM product
suite complies with the FCC technical requirements for Class A and Class B
digital devices. No further testing of these devices is required and the devices
may be manufactured and marketed for commercial and residential use. Additional
devices designed by the Company for commercial and residential use will be
subject to the FCC rules for unlicensed digital devices. Moreover, if in the
future, the FCC changes its technical requirements for unlicensed digital
devices, further testing and/or modifications of devices may be necessary.
Failure to comply with any FCC technical requirements could impair the Company’s
ability to sell its products in certain markets and could have a negative impact
on its business and results of operations.




Products
sold by the Company’s competitors could become more popular than the Company’s
products or render the Company’s products obsolete.




The
market for powerline communications products is highly competitive. The
HomePlug(TM) Powerline Alliance has grown over the past year and now includes
many well recognized brands in the networking and communications industries.
These include Linksys (a Cisco company), Intel, GE, Motorola, Netgear, Sony and
Samsung. With the exception of Motorola, who recently introduced a commercial
product, these companies do not presently represent a direct competitive threat
to the Company since they only market and sell their products in the residential
sector. There can be no assurance that other companies will not develop PLC
products that compete with the Company’s products in the future. Some of these
potential competitors have longer operating histories, greater name recognition
and substantially greater financial, technical, sales, marketing and other
resources. These potential competitors may, among other things, undertake more
extensive marketing campaigns, adopt more aggressive pricing policies, obtain
more favorable pricing from suppliers and manufacturers and exert more influence
on the sales channel than the Company can. As a result, the Company may not be
able to compete successfully with these potential competitors and these
potential competitors may develop or market technologies and products that are
more widely accepted than those being developed by the Company or that would
render the Company’s products obsolete or noncompetitive. The Company
anticipates that potential competitors will also intensify their efforts to
penetrate the Company’s target markets. These potential competitors may have
more advanced technology, more extensive distribution channels, stronger brand
names, bigger promotional budgets and larger customer bases than the Company
does. These companies could devote more capital resources to develop,
manufacture and market competing products than the Company could. If any of
these companies are successful in competing against the Company, its sales could
decline, its margins could be negatively impacted, and the Company could lose
market share, any of which could seriously harm the Company’s business and
results of operations.




14




The
failure of the internet to continue as an accepted medium for business commerce
could have a negative impact on the Company’s results of
operations.




The
Company’s long-term viability is substantially dependent upon the continued
widespread acceptance and use of the Internet as a medium for business commerce.
The Internet has experienced, and is expected to continue to experience,
significant growth in the number of users. There can be no assurance that the
Internet infrastructure will continue to be able to support the demands placed
on it by this continued growth. In addition, delays in the development or
adoption of new standards and protocols to handle increased levels of Internet
activity or increased governmental regulation could slow or stop the growth of
the Internet as a viable medium for business commerce. Moreover, critical issues
concerning the commercial use of the Internet (including security, reliability,
accessibility and quality of service) remain unresolved and may adversely affect
the growth of Internet use or the attractiveness of its use for business
commerce. The failure of the necessary infrastructure to further develop in a
timely manner or the failure of the Internet to continue to develop rapidly as a
valid medium for business would have a negative impact on the Company’s results
of operations.




The
Company may not be able to obtain patents, which could have a material adverse
effect on its business.




The
Company’s ability to compete effectively in the powerline technology industry
will depend on its success in acquiring suitable patent protection. The Company
currently has several patents pending. The Company also intends to file
additional patent applications that it deems to be economically beneficial. If
the Company is not successful in obtaining patents, it will have limited
protection against those who might copy its technology. As a result, the failure
to obtain patents could negatively impact the Company’s business and results of
operations.




Infringement
by third parties on the Company’s proprietary technology and development of
substantially equivalent proprietary technology by the Company’s competitors
could negatively impact the Company’s business.




The
Company’s success depends partly on its ability to maintain patent and trade
secret protection, to obtain future patents and licenses, and to operate without
infringing on the proprietary rights of third parties. There can be no assurance
that the measures the Company has taken to protect its intellectual property,
including those integrated to its Telkonet iWire SystemTM product
suite, will prevent misappropriation or circumvention. In addition, there can be
no assurance that any patent application, when filed, will result in an issued
patent, or that the Company’s existing patents, or any patents that may be
issued in the future, will provide the Company with significant protection
against competitors. Moreover, there can be no assurance that any patents issued
to, or licensed by, the Company will not be infringed upon or circumvented by
others. Infringement by third parties on the Company’s proprietary technology
could negatively impact its business. Moreover, litigation to establish the
validity of patents, to assert infringement claims against others, and to defend
against patent infringement claims can be expensive and time-consuming, even if
the outcome is in the Company’s favor. The Company also relies to a lesser
extent on unpatented proprietary technology, and no assurance can be given that
others will not independently develop substantially equivalent proprietary
information, techniques or processes or that the Company can meaningfully
protect its rights to such unpatented proprietary technology. Development of
substantially equivalent technology by the Company’s competitors could
negatively impact its business.




The
Company depends on a small team of senior management, and it may have difficulty
attracting and retaining additional personnel.




The
Company’s future success will depend in large part upon the continued services
and performance of senior management and other key personnel. If the Company
loses the services of any member of its senior management team, its overall
operations could be materially and adversely affected. In addition, the
Company’s future success will depend on its ability to identify, attract, hire,
train, retain and motivate other highly skilled technical, managerial,
marketing, purchasing and customer service personnel when they are needed.
Competition for these individuals is intense. The Company cannot ensure that it
will be able to successfully attract, integrate or retain sufficiently qualified
personnel when the need arises. Any failure to attract and retain the necessary
technical, managerial, marketing, purchasing and customer service personnel
could have a negative effect on the Company’s financial condition and results of
operations.




15




Any
acquisitions we make could result in difficulties in successfully managing our
business and consequently harm our financial condition.




We may
seek to expand by acquiring competing businesses in our current or other
geographic markets, including as a means to acquire spectrum. We cannot
accurately predict the timing, size and success of our acquisition efforts and
the associated capital commitments that might be required. We expect to face
competition for acquisition candidates, which may limit the number of
acquisition opportunities available to us and may lead to higher acquisition
prices. There can be no assurance that we will be able to identify, acquire or
profitably manage additional businesses or successfully integrate acquired
businesses, if any, without substantial costs, delays or other operational or
financial difficulties. In addition, acquisitions involve a number of other
risks, including:




·
            failure
      of the acquired businesses to achieve expected
  results;





·
            diversion
      of management’s attention and resources to
  acquisitions;





·
            failure
      to retain key customers or personnel of the acquired
      businesses;





·
            disappointing
      quality or functionality of acquired equipment and people:
    and





·
            risks
      associated with unanticipated events, liabilities or
      contingencies.





Client
dissatisfaction or performance problems at a single acquired business could
negatively affect our reputation. The inability to acquire businesses on
reasonable terms or successfully integrate and manage acquired companies, or the
occurrence of performance problems at acquired companies, could result in
dilution, unfavorable accounting treatment or one-time charges and difficulties
in successfully managing our business.




Our
inability to obtain capital, use internally generated cash or debt, or use
shares of our common stock to finance future acquisitions could impair the
growth and expansion of our business.




Reliance
on internally generated cash or debt to finance our operations or complete
acquisitions could substantially limit our operational and financial
flexibility. The extent to which we will be able or willing to use shares of our
common stock to consummate acquisitions will depend on our market value which
will vary, and liquidity. Using shares of our common stock for this purpose also
may result in significant dilution to our then existing stockholders. To the
extent that we are unable to use our common stock to make future acquisitions,
our ability to grow through acquisitions may be limited by the extent to which
we are able to raise capital through debt or additional equity financings. No
assurance can be given that we will be able to obtain the necessary capital to
finance any acquisitions or our other cash needs. If we are unable to obtain
additional capital on acceptable terms, we may be required to reduce the scope
of any expansion or redirect resources committed to internal purposes. In
addition to requiring funding for acquisitions, we may need additional funds to
implement our internal growth and operating strategies or to finance other
aspects of our operations. Our failure to: (i) obtain additional capital on
acceptable terms; (ii) use internally generated cash or debt to complete
acquisitions because it significantly limits our operational or financial
flexibility; or (iii) use shares of our common stock to make future
acquisitions, may hinder our ability to actively pursue our acquisition
program.




We
rely on a limited number of third party suppliers. If these companies fail to
perform or experience delays, shortages, or increased demand for their products
or services, we may face shortages, increased costs, and may be required to
suspend deployment of our products and services.





We depend
on a limited number of third party suppliers to provide the components and the
equipment required to deliver our solutions. If these providers fail to perform
their obligations under our agreements with them or we are unable to renew these
agreements, we may be forced to suspend the sale and deployment of our products
and services and enrollment of new customers, which would have an adverse effect
on our business, prospects, financial condition and operating
results.





Our
management and operational systems might be inadequate to handle our potential
growth.





We may
experience growth that could place a significant strain upon our management and
operational systems and resources. Failure to manage our growth effectively
could have a material adverse effect upon our business, results of operations
and financial condition. Our ability to compete effectively as a provider of PLC
technology and a provider of digital satellite television and high-speed
Internet products and services and to manage future growth will require us to
continue to improve our operational systems, organization and financial and
management controls, reporting systems and procedures. We may fail to make these
improvements effectively. Additionally, our efforts to make these improvements
may divert the focus of our personnel. We must integrate our key executives into
a cohesive management team to expand our business. If new hires perform poorly,
or if we are unsuccessful in hiring, training and integrating these new
employees, or if we are not successful in retaining our existing employees, our
business may be harmed. To manage the growth we will need to increase our
operational and financial systems, procedures and controls. Our current and
planned personnel, systems, procedures and controls may not be adequate to
support our future operations. We may not be able to effectively manage such
growth, and failure to do so could have a material adverse effect on our
business, financial condition and results of operations.




16





We
may be affected if the United States participates in wars or military or other
action or by international terrorism.




Involvement
in a war or other military action or acts of terrorism may cause significant
disruption to commerce throughout the world. To the extent that such disruptions
result in (i) delays or cancellations of customer orders, (ii) a general
decrease in consumer spending on information technology, (iii) our inability to
effectively market and distribute our services or products or (iv) our inability
to access capital markets, our business and results of operations could be
materially and adversely affected. We are unable to predict whether the
involvement in a war or other military action will result in any long-term
commercial disruptions or if such involvement or responses will have any
long-term material adverse effect on our business, results of operations, or
financial condition.





A
significant portion of our total assets consists of goodwill, which is subject
to a periodic impairment analysis and a significant impairment determination in
any future period could have an adverse effect on our results of operations even
without a significant loss of revenue or increase in cash expenses attributable
to such period.




We have
goodwill totaling approximately $14.7 million at December 31, 2007 resulting
from recent and past acquisitions. We evaluate this goodwill for impairment
based on the fair value of the operating business units to which this goodwill
relates at least once a year. This estimated fair value could change if we are
unable to achieve operating results at the levels that have been forecasted, the
market valuation of those business units decreases based on transactions
involving similar companies, or there is a permanent, negative change in the
market demand for the services offered by the business units. These changes
could result in an impairment of the existing goodwill balance that could
require a material non-cash charge to our results of operations.





At
December 31, 2007, the Company performed an impairment test on the goodwill and
intangibles acquired, it was determined that there were no changes in the
carrying value of the intangibles acquired.  However, based upon
managements assessment of operating results and forecasted discounted cash flow
the carrying value of MSTI goodwill was determined to be impaired and therefore
the entire value of $1,977,768 was written off during the year ended December
31, 2007.





MSTI
may be unable to register for resale all of the common stock included within the
units sold in its Private Placement, which would cause a default under the
Registration Rights Agreement executed in connection with such Private
Placement.





MSTI is
obligated to file a “resale” registration statement with the SEC that covers all
of the common stock included within the units sold in the private placement and
issuable upon conversion of its debentures and the exercise of the warrants
thereto and to use its best efforts to have such “resale” registration statement
declared effective by the SEC as set forth therein. Nevertheless, it is possible
that the SEC may not permit MSTI to register all of such shares of common stock
for resale. In certain circumstances, the SEC may take the view that the private
placement requires MSTI to register the issuance of the securities as a primary
offering. Without sufficient disclosure of this risk, rescission of the private
placement could be sought by investors or an offer of rescission may be mandated
by the SEC, which would result in a material adverse affect to MSTI and us since
we consolidate the financial statements of MSTI.





MSTI has
agreed to file a registration statement with the SEC within 60 days of the final
closing of the Private Placement and the issuance of the Debentures and to use
its best efforts to have the registration statement declared effective by the
SEC within 120 days after the final closing of the private placement and the
original issuance of the debentures. There are many reasons, including those
over which MSTI has no control, which could delay the filing or effectiveness of
the registration statement, including delays resulting from the SEC review
process and comments raised by the SEC during that process. Failure to file or
cause a registration statement to become effective in a timely manner or
maintain its effectiveness could materially adversely affect MSTI and require
MSTI to pay substantial penalties to the holders of those securities pursuant to
the terms of the registration rights agreement.  Since we consolidate
the financial statements of MSTI, the incurrence of a significant penalty by
MSTI under the Registration Rights Agreement could materially adversely affect
our results of operations.




17


Obligations
to the holders of MSTI’s debentures are secured by all of MSTI’s assets, so if
we default on those obligations, the debenture holders could foreclose on MSTI’s
assets.




The
holders of MSTI’s debentures have a security interest in all of MSTI’s assets
and those of its subsidiary. As a result, if we default under our obligations to
the debenture holders, the debenture holders could foreclose their security
interests and liquidate some or all of these assets, which may cause MSTI to
cease operations.





MSTI’s  indebtedness
and restrictive debt covenants could limit MSTI’s  financing options
and liquidity position, which would limit MSTI’s ability to grow our
business.




The terms
of MSTI’s outstanding debentures could have negative consequences, such
as:




·
            MSTI
      may be unable to obtain additional financing to fund working capital,
      operating losses, capital expenditures or acquisitions on terms acceptable
      to MSTI, or at all;


·
            MSTI
      may be unable to refinance its indebtedness on terms acceptable to MSTI,
      or at all; and


·
            MSTI
      may be more vulnerable to economic downturns and limit MSTI’s ability to
      withstand competitive
pressures.





Additionally,
covenants in the securities purchase agreement governing the debentures impose
operating and financial restrictions on MSTI. These restrictions prohibit or
limit MSTI’s ability, and the ability of our subsidiaries, to, among other
things:





·
            pay
      cash dividends to our stockholders;


·
            incur
      additional indebtedness;


·
            permit
      liens on assets or conduct sales of assets;
and


·
            engage
      in transactions with affiliates.





These
restrictions may limit MSTI’s ability to obtain additional financing, withstand
downturns in MSTI’s business or take advantage of business opportunities.
Moreover, additional debt financing MSTI may seek may contain terms that include
more restrictive covenants, may require repayment on an accelerated schedule or
may impose other obligations that limit the ability to grow MSTI’s business,
acquire needed assets, or take other actions MSTI might otherwise consider
appropriate or desirable.




MSTI's
restrictive debt covenant requires Frank Matarazzo, Chief Executive Officer of
MSTI, to be in his current position through term of the Debenture
agreement.
 
 On
January 31, 2008, the Company amended the Convertible Debenture agreement
requiring indicating that if Frank T. Matarazzo shall cease to serve as Chief
Executive Officer of the MSTI it may constitute an event of
default.
 
 Our
independent auditors have expressed substantial doubt about our ability to
continue as a going concern, which may hinder our ability to obtain future
financing.
 
 In their
report dated March 31, 2008, our independent auditors stated that our financial
statements for the year ended December 31, 2007 were prepared assuming that we
would continue as a going concern, and that they have substantial doubt about
our ability to continue as a going concern.  Our auditors’ doubts are
based on our incurring net losses and deficits in cash flows from
operations.  We continue to experience net operating
losses.  Our ability to continue as a going concern is subject to our
ability to generate a profit and/or obtain necessary funding from outside
sources, including by the sale of our securities, or obtaining loans from
financial institutions, where possible.  Our continued net operating
losses and our auditors’ doubts increase the difficulty of our meeting such
goals and our efforts to continue as a going concern may not prove
successful.





ITEM
1B.UNRESOLVED STAFF
COMMENTS.





None.





ITEM
2.PROPERTIES.





The
Company presently leases 11,600 square feet of commercial office space in
Germantown, Maryland for its corporate headquarters. The Germantown lease
expires in November 2010. The Company spent approximately $61,000 in buildout
costs to increase the office space of its Germantown headquarters by
approximately 6,000 square feet in April 2007.  The lease on the
additional office space expires in December 2015.





In March
2005, the Company entered into a lease agreement for 6,742 square feet of
commercial office space in Crystal City, Virginia. The Crystal City lease
expires in March 2008. In February 2007, the Company executed a sublease for
this space commencing in April 2007 through the expiration of the lease in March
2008.





The
Company presently leases 12,600 square feet of commercial office space in
Hawthorne, New Jersey for its office and warehouse spaces. This lease expires in
April 2010 with an option to extend the lease an additional five
years.





Following
the acquisitions of SSI and Ethostream the Company assumed leases on 9,000
square feet of office space in Las Vegas, NV for the SSI office and warehouse
space on a month to month basis and 8,200 square feet of office space in
Milwaukee, WI for Ethostream.  The Milwaukee lease expires in May
2011.  The Las Vegas, NV office lease will terminate effective April
30, 2008.




18




ITEM
3.LEGAL
PROCEEDINGS.





None.





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





On
December 21, 2007, the Company held its annual meeting of stockholders at which
the Company’s stockholders elected seven (7) directors to serve on the Company’s
Board of Directors and ratified the appointment of the Company’s independent
accountants for 2006. The following directors were elected at the annual meeting
based on the number of votes indicated below. Each director was elected to serve
until the next annual meeting of stockholders or until his successor is elected
and qualified.





Director
      Name
            For
            Against
            Abstain
            Broker
      Non-votesWarren
      V. Musser
            48,456,921
            0
            5,154,563
            0Ronald
      W. Pickett
            44,644,974
            0
            8,966,510
            0Thomas
      C. Lynch
            50,274,675
            0
            3,336,809
            0James
      L. Peeler
            50,114,855
            0
            3,496,629
            0Thomas
      M. Hall
            50,188,670
            0
            3,422,814
            0Anthony
      J. Paoni
            50,253,005
            0
            3,358,479
            0Seth
      D. Blumenfeld
            49,285,144
            0
            4,326,340
            0





The other
matters presented at the meeting were approved by the Company’s stockholders as
follows:





Matter
      Voted Upon
            For
            Against
            Abstain
            Broker
      Non-votesRatification
      of Independent Accountants
            51,337,882
            1,111,186
            1,162,414
            0




PART
II





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





On
January 24, 2004, the Company’s common stock was listed for trading on the
American Stock Exchange (AMEX) under the ticker symbol “TKO.” Prior to January
24, 2004, the Company’s common stock was quoted on the OTC Bulletin Board under
the symbol “TLKO.OB.” As of March 1, 2008, the Company had 241 stockholders of
record and 72,039,455 shares of its common stock issued and
outstanding.




The
following table documents the high and low sales prices for the Company’s common
stock on the AMEX for the period beginning January 1, 2006 through December 31,
2007. The information provided for the periods listed below was obtained from
the Yahoo! Finance web site.





High
            
            
            LowYear
      Ended December 31, 2007First
      Quarter
            
            $
            4.00
            
            
            $
            2.50Second
      Quarter
            
            $
            2.77
            
            
            $
            1.60Third
      Quarter
            
            $
            2.01
            
            
            $
            1.20Fourth
      Quarter
            
            $
            1.84
            
            
            $
            0.75Year
      Ended December 31, 2006First
      Quarter
            
            $
            4.51
            
            
            $
            3.35Second
      Quarter
            
            $
            4.49
            
            
            $
            2.46Third
      Quarter
            
            $
            3.50
            
            
            $
            1.65Fourth
      Quarter
            
            $
            3.27
            
            
            $
            2.32




19


The
Company has never paid dividends on its common stock and does not anticipate
paying dividends in the foreseeable future.




Performance
Graph





Set forth
below is a line graph comparing the cumulative total return on Telkonet’s common
stock against the cumulative total return of the Market Index for the American
Stock Exchange (U.S.) (“AMEX”) and for the peer group “Communications Services,
within the Standard Industrial Classification Code category, (SIC) Code 4899”,
for the period beginning December 31, 2002 and each fiscal year ending December
31 thereafter through the fiscal year ended December 31, 2007. The total returns
assume $100 invested on December 31, 2002 with reinvestment of
dividends.









ITEM
6.SELECTED
FINANCIAL DATA




The
following table sets forth selected financial data for the last 5 years. This
selected financial data should be read in conjunction with the consolidated
financial statements and related notes included in Item 15 of this Form
10-K.




Year
      Ended December 31,(in
      thousands, except per share amounts)
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Total
      revenues
            
            $
            14,153
            
            
            $
            5,181
            
            
            $
            2,488
            
            
            $
            698
            
            
            $
            94Operating
      loss
            
            
            (23,458
            )
            
            
            (17,563
            )
            
            
            (15,307
            )
            
            
            (13,112
            )
            
            
            (6,564
            )Net
      loss
            
            
            (20,391
            )
            
            
            (27,437
            )
            
            
            (15,778
            )
            
            
            (13,093
            )
            
            
            (7,657
            )Loss
      per share - basic
            
            
            (0.31
            )
            
            
            (0.54
            )
            
            
            (0.35
            )
            
            
            (0.32
            )
            
            
            (0.37
            )Loss
      per share - diluted
            
            
            (0.31
            )
            
            
            (0.54
            )
            
            
            (0.35
            )
            
            
            (0.32
            )
            
            
            (0.37
            )Basic
      and diluted weighted average common shares outstanding
            
            
            65,415
            
            
            
            50,824
            
            
            
            44,743
            
            
            
            41,384
            
            
            
            20,702Working
      capital
            
            
            (2,991
            )
            
            
            (531
            )
            
            
            12,061
            
            
            
            12,672
            
            
            
            5,296Total
      assets
            
            
            38,741
            
            
            
            12,517
            
            
            
            23,291
            
            
            
            15,493
            
            
            
            6,176Short-term
      borrowings and current portion of long-term debt
            
            
            1,471
            
            
            
            —
            
            
            
            6,350
            
            
            
            —
            
            
            
            15Long-term
      debt, net of current portion
            
            
            4,432
            
            
            
            —
            
            
            
            9,617
            
            
            
            588
            
            
            
            3,132Stockholders’
      equity (deficiency)
            
            
            21,268
            
            
            
            8,135
            
            
            
            5,315
            
            
            
            13,646
            
            
            
            2,388




20


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





The
following discussion and analysis of the Company’s financial condition and
results of operations should be read in conjunction with the accompanying
financial statements and related notes thereto.





The
Company reports financial results for the following operating business
segments:





Telkonet
Segment





Through
the revolutionary Telkonet iWire SystemTM , Telkonet utilizes proven PLC
technology to deliver commercial high-speed Broadband access from an IP
“platform” that is easy to deploy, reliable and cost-effective by leveraging a
building’s existing electrical infrastructure. The building’s existing
electrical wiring becomes the backbone of the local area network, which converts
virtually every electrical outlet into a high-speed data port, without the
costly installation of additional wiring or major disruption of business
activity. The segment’s net sales in 2007 were $11,476,983, representing 81% of
the Company’s consolidated net sales.




MST
Segment





MSTI is a
communications service provider offering Quad-Play services to MTU and MDU
residential, hospitality and commercial properties. These Quad-Play services
include video, voice, high-speed internet and Wi-Fi access. In addition, MST
currently offers or plans to offer a variety of next-generation
telecommunications solutions and services, including satellite installation,
video conferencing, surveillance/security and energy management, and other
complementary professional services. The segments’ net sales in 2007 were
$2,675,750, representing 19% of the Company’s consolidated net
sales.





Critical
Accounting Policies and Estimates





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires us to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. On an ongoing basis, we evaluate significant
estimates used in preparing our financial statements, including those related to
revenue recognition, guarantees and product warranties and stock based
compensation. We base our estimates on historical experience, underlying run
rates and various other assumptions that we believe to be reasonable, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities. Actual results could differ from these estimates. The
following are critical judgments, assumptions, and estimates used in the
preparation of the consolidated financial statements.





Revenue
Recognition





For
revenue from product sales, the Company recognizes revenue in accordance with
Staff Accounting Bulletin No. 104, Revenue Recognition
(“SAB104”), which superseded Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
Statements (“SAB101”). SAB 101 requires that four basic criteria must be
met before revenue can be recognized: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred; (3) the selling price is fixed and
determinable; and (4) collectibility is reasonably assured. Determination of
criteria (3) and (4) are based on management’s judgments regarding the fixed
nature of the selling prices of the products delivered and the collectibility of
those amounts. Provisions for discounts and rebates to customers, estimated
returns and allowances, and other adjustments are provided for in the same
period the related sales are recorded. The Company defers any revenue for which
the product has not been delivered or is subject to refund until such time that
the Company and the customer jointly determine that the product has been
delivered or no refund will be required. SAB 104 incorporates Emerging Issues
Task Force 00-21 (“EITF 00-21”), Multiple-Deliverable Revenue
Arrangements.EITF 00-21 addresses accounting for arrangements that may
involve the delivery or performance of multiple products, services and/or rights
to use assets.




21




For
equipment under lease, revenue is recognized over the lease term for operating
lease and rental contracts. All of the Company’s leases are accounted for as
operating leases. At the inception of the lease, no lease revenue is recognized
and the leased equipment and installation costs are capitalized and appear on
the balance sheet as “Equipment Under Operating Leases.” The capitalized cost of
this equipment is depreciated from two to three years, on a straight-line basis
down to the Company’s original estimate of the projected value of the equipment
at the end of the scheduled lease term. Monthly lease payments are recognized as
rental income.





Revenue
from sales-typeleases for
Ethostream products is recognized at the time of lessee acceptance, which
follows installation.The Company recognizes revenue
fromsales-typeleases at the
net present value of future lease payments. Revenue from operating leases is
recognized ratably over the lease period





MSTI
accounts for the revenue, costs and expense related to residential cable
services as the related services are performed in accordance with SFAS
No. 51, Financial Reporting by Cable Television Companies. Installation
revenue for residential cable services is recognized to the extent of direct
selling costs incurred. Direct selling costs have exceeded installation revenue
in all reported periods. Generally, credit risk is managed by disconnecting
services to customers who are delinquent.





Management
identifies a delinquent customer based upon the delinquent payment status of an
outstanding invoice, generally greater than 30 days past due
date.  The delinquent account designation does not trigger an
accounting transaction until such time the account is deemed uncollectible.
Accounts are deemed uncollectible on a case-by-case basis, at management’s
discretion based upon an examination of the communication with the delinquent
customer and payment history.  Typically, accounts are only escalated
to “uncollectible” status after multiple attempts have been made to communicate
with the customer.





Guarantees
and Product Warranties





FASB
Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”),
requires that upon issuance of a guarantee, the guarantor must disclose and
recognize a liability for the fair value of the obligation it assumes under that
guarantee.





The
Company’s guarantees issued subject to the recognition and disclosure
requirements of FIN 45 as of December 31, 2007 and 2006 were not material. The
Company records a liability for potential warranty claims. The amount of the
liability is based on the trend in the historical ratio of claims to sales, the
historical length of time between the sale and resulting warranty claim, new
product introductions and other factors. The products sold are generally covered
by a warranty for a period of one year. In the event the Company determines that
its current or future product repair and replacement costs exceed its estimates,
an adjustment to these reserves would be charged to earnings in the period such
determination is made. During the year ended December 31, 2007, the Company
experienced approximately 3% percent of units returned. Using this experience
factor a reserve of $102,534 was accrued.





Stock
Based Compensation





On
January 1, 2006, the Company adopted Statement of Financial Accounting Standards
No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which
requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors including employee
stock options based on estimated fair values. SFAS 123(R) supersedes the
Company’s previous accounting under Accounting Principles Board Opinion
No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods
beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission
issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS
123(R). The Company has applied the provisions of SAB 107 in its adoption of
SFAS 123(R).




22




The
Company adopted SFAS 123(R) using the modified prospective transition method,
which requires the application of the accounting standard as of January 1, 2006,
the first day of the Company’s fiscal year 2006. The Company’s Consolidated
Financial Statements as of and for the year ended December 31, 2007 and 2006
reflect the impact of SFAS 123(R). In accordance with the modified prospective
transition method, the Company’s Consolidated Financial Statements for prior
periods have not been restated to reflect, and do not include, the impact of
SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for
the year ended December 31, 2007 and 2006, was $1,534,260 and $1,080,895,
respectively, net of tax effect.




SFAS
123(R) requires companies to estimate the fair value of share-based payment
awards on the date of grant using an option-pricing model. The value of the
portion of the award that is ultimately expected to vest is recognized as
expense over the requisite service periods in the Company’s Consolidated
Statement of Operations. Prior to the adoption of SFAS 123(R), the Company
accounted for stock-based awards to employees and directors using the intrinsic
value method in accordance with APB 25 as allowed under Statement of Financial
Accounting Standards No. 123, “Accounting for Stock-Based Compensation”
(“SFAS 123”). Under the intrinsic value method, no stock-based compensation
expense had been recognized in the Company’s Consolidated Statement of
Operations because the exercise price of the Company’s stock options granted to
employees and directors approximated or exceeded the fair market value of the
underlying stock at the date of grant.




Stock-based
compensation expense recognized during the period is based on the value of the
portion of share-based payment awards that is ultimately expected to vest during
the period. Stock-based compensation expense recognized in the Company’s
Consolidated Statement of Operations for the year ended December 31, 2006
included compensation expense for share-based payment awards granted prior to,
but not yet vested as of prior to January 1, 2006 based on the grant date fair
value estimated in accordance with the pro forma provisions of SFAS 123 and
compensation expense for the share-based payment awards granted subsequent to
December 31, 2005 based on the grant date fair value estimated in accordance
with the provisions of SFAS 123(R). SFAS 123(R) requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates. In the Company’s pro forma
information required under SFAS 123 for the periods prior to fiscal 2006, the
Company accounted for forfeitures as they occurred.




Upon
adoption of SFAS 123(R), the Company is using the Black-Scholes option-pricing
model as its method of valuation for share-based awards granted beginning in
fiscal 2006, which was also previously used for the Company’s pro forma
information required under SFAS 123. The Company’s determination of fair value
of share-based payment awards on the date of grant using an option-pricing model
is affected by the Company’s stock price as well as assumptions regarding a
number of highly complex and subjective variables. These variables include, but
are not limited to the Company’s expected stock price volatility over the term
of the awards, and certain other market variables such as the risk free interest
rate.




Goodwill and Other
Intangibles
 
 Goodwill
represents the excess of the cost of businesses acquired over fair value or net
identifiable assets at the date of acquisition. Goodwill is subject to a
periodic impairment assessment by applying a fair value test based upon a
two-step method. The first step of the process compares the fair value of the
reporting unit with the carrying value of the reporting unit, including any
goodwill. The Company utilizes a discounted cash flow valuation methodology to
determine the fair value of the reporting unit. If the fair value of the
reporting unit exceeds the carrying amount of the reporting unit, goodwill is
deemed not to be impaired in which case the second step in the process is
unnecessary. If the carrying amount exceeds fair value, the Company performs the
second step to measure the amount of impairment loss. Any impairment loss is
measured by comparing the implied fair value of goodwill, calculated per SFAS
No. 142, with the carrying amount of goodwill at the reporting unit, with
the excess of the carrying amount over the fair value recognized as an
impairment loss.
 
 Long-Lived
Assets
 
 The
Company has adopted Statement of Financial Accounting Standards No. 144 (SFAS
144). The Statement requires that long-lived assets and certain identifiable
intangibles held and used by the Company be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Events relating to recoverability may include
significant unfavorable changes in business conditions, recurring losses, or a
forecasted inability to achieve break-even operating results over an extended
period. The Company evaluates the recoverability of long-lived assets based upon
forecasted discounted cash flows. Should impairment in value be indicated, the
carrying value of intangible assets will be adjusted, based on estimates of
future discounted cash flows resulting from the use and ultimate disposition of
the asset. SFAS No. 144 also requires assets to be disposed of be reported at
the lower of the carrying amount or the fair value less costs to
sell.




Year
Ended December 31, 2007 Compared to Year Ended December 31,
2006





The
Company’s revenue consists of product sales and a recurring (lease) model in the
commercial, government and international markets of the Telkonet Segment
including activity for SSI and Ethostream from the date of acquisition through
December 31, 2007. The MST Segment revenue consists of Quad-Play services
provided to a subscriber portfolio of MDU properties with bulk service
agreements and/or access licenses to service the individual subscribers in
metropolitan New York. The MST Segment is included in revenue since the
acquisition of MST on January 31, 2006.





The table
below outlines product versus recurring (lease) revenues for comparable
periods:





Year
      ended December 31,Revenue:
            
            2007
            
            2006
            
            VarianceProduct
            
            $
            9,168,077
            
            65%
            
            $
            3,092,967
            
            60%
            
            $
            6,075,110
            
            196%Rental
      (lease)
            
            
            4,984,656
            
            35%
            
            
            2,088,361
            
            40%
            
            
            2,896,295
            
            139%Total
            
            
            14,152,733
            
            100%
            
            $
            5,181,328
            
            100%
            
            
            8,971,405
            
            173%




23


Product
revenue
 
 The
Telkonet Segment product revenue principally arises from the sale and
installation of broadband networking and energy management equipment, including
the Telkonet iWire SystemTM to commercial resellers, and directly to customers in
the hospitality, government and international markets. The Telkonet iWire
SystemTM
consists of the Telkonet Gateway, the Telkonet Extender, the patented Telkonet
Coupler, and the Telkonet iBridge, which “bridges” the connection from a
computer to the data port. The Telkonet SmartEnergy energy management solution
consists of thermostats, sensors and controllers.  Product revenue in
the Telkonet Segment increased by approximately $5,961,000 for the year ended
December 31, 2007, including approximately $3,316,000 attributed to the sale of
energy management products since the acquisition of SSI in March 2007 , and
approximately $1,905,000 of additional products and services to the hospitality
market from the acquisition of Ethostream in March
2007.  Additionally, revenues generated in the government market were
approximately $1,540,000 for the year ended December 31, 2007, and were related
to site evaluations and deployments of certain government installations. We
anticipate a continued upward trend of quarterly growth in the hospitality,
energy management utility and government markets of the Telkonet
segment.


The MST
Segment product revenue consists of equipment, installations and ancillary
services provided to customers independent of the subscriber model. Product
revenue in this segment for the year ended December 31, 2007 was approximately
$279,000.





Recurring
(lease) Revenue





The
increase in recurring revenue in the Telkonet Segment for the year ended
December 31, 2007, reflects the addition of Ethostream’s hospitality portfolio
in March 2007. During the year ended December 31, 2007, we added approximately
2,100 hotels to our broadband network portfolio, and currently support over
190,000 HSIA rooms, resulting in additional recurring revenue of $2,090,000 for
the year ended December 31, 2007. The Telkonet Segment monthly recurring revenue
is approximately $300,000 and we anticipate growth to our subscriber base as we
deploy additional sites upon installation of Telkonet products.




The
recurring revenue for the MST Segment subscriber base increased by approximately
$806,000 for the year ended December 31, 2007. The MST Segment subscriber
portfolio includes approximately 22 MDU properties with bulk service agreements
and/or access licenses to service the individual subscribers in metropolitan New
York. Additionally, the MST Segment added approximately 1,900 internet and
telephone subscribers through the acquisition of Newport Telecommunications Co.
in July 2007.





Cost
of Sales





Year
      ended December 31,Cost
      of Sales:
            
            2007
            
            2006
            
            VarianceProduct
            
            $
            7,165,120
            
            78%
            
            $
            2,062,399
            
            67%
            
            $
            5,102,721
            
            247%Rental
      (lease)
            
            
            4,505,476
            
            90%
            
            
            2,418,260
            
            116%
            
            
            2,087,216
            
            86%Total
            
            
            11,670,596
            
            82%
            
            $
            4,480,659
            
            86%
            
            
            7,189,937
            
            160%





Product
Costs




The
Telkonet Segment product costs include equipment and installation labor related
to the Telkonet iWire SystemTM product
suite, as well as wireless networking and energy management
products.  During the year ended December 31, 2007, product costs
increased by approximately $5,103,000 in conjunction with the increased sales to
the hospitality, energy management and government markets.





The MST
Segment product costs primarily consist of equipment and installation labor for
installation and ancillary services provided to customers. For the year ended
December 31, 2007, product costs amounted to approximately
$299,000.




Recurring
(lease) Costs





The
Telkonet Segment recurring costs increased by approximately $822,000 for the
year ended December 31, 2007, when compared to the prior year.  This
increase is primarily due to the addition of Ethostream’s customer service and
support infrastructure, including an internal call center, to support the
Telkonet Segment recurring revenue from its customer portfolio.





The MST
Segment’s recurring costs increased by $1,265,000 for the year ended December
31, 2007.  These costs consist of customer support, programming and
amortization of the capitalized costs to support the subscriber revenue. 
Although MSTI's programming fees are a significant portion of the cost,
MSTI continues to pursue competitive agreements and volume discounts in
conjunction with the anticipated growth of the subscriber base. The customer
support costs include build-out of the support services necessary to develop and
support the build-out of the Quad-Play subscriber base in metropolitan New York.
The capitalized costs are amortized over the lease term and include equipment
and installation labor.  Additionally, MSTI’s recurring costs
increased due to the addition of the Newport subscribers in July
2007.




24




Gross
Profit





Year
      ended December 31,Gross
      Profit:
            
            2007
            
            2006
            
            VarianceProduct
            
            $
            2,002,957
            
            22%
            
            $
            1,030,568
            
            33%
            
            $
            972,389
            
            94%Rental
      (lease)
            
            
            479,180
            
            10%
            
            
            (329,899
            )
            -16%
            
            
            809,079
            
            -245%Total
            
            
            2,482,137
            
            18%
            
            
            700,669
            
            14%
            
            
            1,781,468
            
            254%





Product
Gross Profit





The gross
profit percentage for the year ended December 31, 2007 decreased compared to the
prior year. The primary result of the decrease is attributable to increased
costs in shipping and travel in the fourth quarter of 2007. Additionally, the
Company committed significant resources to achieve a year end commitment with
InTown Suites which resulted in the $3.8 million commitment for
2008.   We anticipate an increase in our gross profit trend for
product sales as energy management and hospitality opportunities expand as well
as the focus on opportunities in the government and utility
markets.  Additionally, the integration of acquired companies has
resulted in opportunities to increase operating efficiency by eliminating
redundant processes.





Recurring
(lease) Gross Profit





The
Telkonet Segment’s gross profit associated with recurring (lease) revenue
increased for the year ended December 31, 2007 by approximately
$1,268,000.  Gross profit represented approximately 48% of recurring
(lease) revenue for the year ended December 31, 2007.  Ethostream’s
centralized remote monitoring and management platform and customer support
center has provided the platform to increase the gross profit on the Telkonet
Segment recurring revenue.





The MST
Segment’s gross profit decreased by approximately $458,000 for the year ended
December 31, 2007, compared to the prior year, primarily due to increased
programming costs and expenses related to the addition of the IPTV platform to
the existing infrastructure.  MSTI anticipates that it will increase
its gross profit through expanding its subscriber base and reduce programming
costs through the IPTV platform.  Gross profit represented
approximately -36% of recurring (lease) revenue for the year ended December 31,
2007.





Operating
Expenses





Year
      ended December 31,2007
            
            
            2006
            
            
            VarianceTotal
            
            $
            25,939,690
            
            
            $
            18,263,255
            
            
            $
            7,676,435
            
            
            
            42%




Overall expenses increased for the year
ended December 31, 2007, when compared to the prior year, by approximately
$7,676,435, or 42%. The principal reasons for this increase were the additional
operating costs assumed through the acquisitions of SSI and Ethostream, which
accounted for approximately $3,275,000 of the total increase.  There
was a one time, non-cash charge to operations for the impairment write down of
MSTI’s goodwill and fixed assets in the amount of approximately $2,471,000 for
the year ended December 31, 2007.  Additionally, we increased research
and development costs (see discussion below), as well as our non-cash stock
compensation by $984,000, which is related to stock options and shares earned by
employees and consultants of Telkonet and MSTI, and additional non-cash
depreciation expense of $342,000, for the year ended December 31,
2007.  Also, there was an increase in selling and administrative
expenses for the Telkonet Segment and MST Segment during the year ended December
31, 2007.  We expect our operating expenses to decrease in 2008, when
compared to year ended December 31, 2007, as we continue the consolidation of
the operations within the Telkonet Segment including the closure of the Las
Vegas operations and increase in our overall operating
efficiency.




25




Research
and Development





Year
      ended December 31,2007
            
            
            2006
            
            
            VarianceTotal
            
            $
            2,349,690
            
            
            $
            1,925,746
            
            
            $
            423,944
            
            
            
            22%





The
Telkonet Segment research and development costs related to both existing and
development-stage products are expensed in the period that they are incurred.
Total expenses for the year ended December 31, 2007 increased by $423,944, or
22%, when compared to the prior year. This increase was primarily related to the
development of the next generation (Series Five) product suite and the
integration of new applications to the Telkonet iWire System, as well as
additional development of energy management products pursuant to the acquisition
of SSI.





Selling,
General and Administrative Expenses





Year
      ended December 31,2007
            
            
            2006
            
            
            VarianceTotal
            
            $
            17,897,974
            
            
            $
            14,346,364
            
            
            $
            3,551,610
            
            
            
            25%





Selling,
general and administrative expenses increased for the year ended December 31,
2007 over the comparable prior year by $3,551,610 or 25%. This increase is
primarily attributed to the administrative expenses of the acquired businesses
of approximately $2,755,000.  Additionally, sales and marketing costs
increased following the launch of our new integrated product offerings, and
professional fees increased due to the equity financing in February 2007, the
acquisitions of SSI and Ethostream, and the investment in Geeks on Call America,
Inc.  Prior year expenses related to the amortization and write-off of
financing fees $535,000 partially offset the overall increase. We expect
selling, general and administrative expenses to decrease in 2008, when compared
to the year ended December 31, 2007 as we continue the consolidation of the
operations within the Telkonet Segment including the closure of the Las Vegas
facility and increase in overall operating efficiency.




MSTI
selling, general, and administrative expenses which consist of commissions,
salaries, advertising, professional service fees, investor relations services
and overhead expenses, totaled approximately $4,100,000 during 2007 as compared
to $2,900,000 for 2006. This increase is primarily attributable to an
overall increase in administrative and investors relations services costs
compared to the prior period in conjunction with the acquisition of Newport
Telecommunications and the merger of MST with a public shell
corporation.





Year
Ended December 31, 2006 Compared to Year Ended December 31,
2005





Revenues





The
Company’s revenue consists of direct product sales and a recurring (lease) model
in the commercial, government and international markets of the Telkonet Segment.
Additionally, the MST Segment consists of eleven months of revenue from date of
acquisition through December 31, 2006 providing certain Quad-Play services. The
table below outlines product versus recurring (lease) revenues for comparable
periods:





Year
      ended December 31,Revenue:
            
            2006
            
            2005
            
            VarianceProduct
            
            $
            3,092,967
            
            60%
            
            $
            1,769,727
            
            71%
            
            $
            1,323,240
            
            75%Rental
      (lease)
            
            
            2,088,361
            
            40%
            
            
            718,596
            
            29%
            
            
            1,369,765
            
            191%Total
            
            
            5,181,328
            
            100%
            
            $
            2,488,323
            
            100%
            
            
            2,693,005
            
            108%




26


Product
Revenue
 
 Product
revenue in the Telkonet Segment increased approximately $800,000, excluding the
sale of certain rental contract agreements to Hospitality Leasing Corporation,
for the year ended December 31, 2006, and the MST Segment revenue amounted to
approximately $280,000 in installation and ancillary services provided to
customers for the eleven months ended December 31, 2006.  The Telkonet
Segment product revenue principally arises from the sale of the Telkonet iWire
SystemTM to
commercial resellers as well as directly to customers.  The Telkonet
iWire SystemTM utilizes a building’s electrical wires as the backbone for a local
area network, converting electrical outlets into data ports.  The
Telkonet iWire SystemTM
consists of the Telkonet Gateway, the Telkonet Extender, the patented Telkonet
Coupler, and the Telkonet iBridge, which “bridges” the connection from a
computer to the data port.  Customers can purchase Telkonet iBridges
on an as-needed basis, allowing vendors to supply equipment to meet their
occupancy demands.  Telkonet’s customers to date have been principally
located in the Commercial (Hospitality and Multi-Dwelling) and International
markets. Revenues to date have been principally derived from the Commercial
(Hospitality and Multi-Dwelling) and International business units. The Telkonet
Segment anticipates continued growth in Commercial and International product
revenue in the Value Added Reseller (VAR) purchase programs. The Telkonet
Segment expanded its international sales and marketing efforts upon receiving
its European certification (CE). The Company has received the FIPS 140-2
certification and continues to pursue opportunities within the government
sector. The Company has extended its iWire SystemTM to
included energy information, management and control solutions for residential
and commercial buildings.


In the
year ended December 31, 2006 and 2005, Telkonet consummated a non-recourse sale
of certain rental contract agreements and the related capitalized equipment
which were accounted for as operating leases with Hospitality Leasing
Corporation. The remaining rental income payments of the contracts were valued
at approximately $1,209,000 and $732,000 including the customer support
component of approximately $370,000 and $205,000 which Telkonet will retain and
continue to receive monthly customer support payments over the remaining average
unexpired lease term of 36 and 26 months, respectively. In the years ending
December 31, 2006 and 2005, the Company recognized revenue of approximately
$683,000 and $439,000, respectively, for the sale, calculated based on the
present value of total unpaid rental payments, and expensed the associated
capitalized equipment cost, net of depreciation, of approximately $340,000 and
$267,000, respectively, and expensed associated taxes of approximately $64,000
and $40,000, respectively.





Rental
(lease) Revenue





A
significant increase in the overall recurring revenue was attributable to the
addition of the MST Segment subscriber base in February 2006 and amounted to
approximately $1,476,000 for the eleven months ended December 31, 2006. The MST
Segment subscriber portfolio includes approximately 22 MDU properties with
service bulk service agreements and/or access licenses to service the individual
subscribers in metropolitan New York. The Telkonet Segment rental (lease)
revenue decreased by $95,000 in the year ended December 31, 2006 compared to the
prior year primarily due to the sale of rental contracts to Hospitality Leasing
Corporation and the VAR purchase program sales effort.





Cost
of Sales





Year
      ended December 31,Cost
      of Sales:
            
            2006
            
            2005
            
            VarianceProduct
            
            $
            2,062,399
            
            67%
            
            $
            1,183,574
            
            67%
            
            $
            878,825
            
            74%Rental
      (lease)
            
            
            2,418,260
            
            116%
            
            
            533,605
            
            74%
            
            
            1,884,655
            
            353%Total
            
            
            4,480,659
            
            86%
            
            $
            1,717,179
            
            69%
            
            
            2,763,480
            
            161%




Product
Costs




The
Telkonet Segment product cost for the Telkonet iWire SystemTM product
suite primarily includes equipment costs and installation labor. The related
product cost in connection with the non-recourse sale of approximately
$1,209,000 of rental contract agreements amounted to approximately $347,000 of
previously capitalized equipment cost and other related cost.





The MST
product costs primarily consist of equipment and installation labor for
installation and ancillary services provided to customers.




Rental
(lease) Costs





MST
Segment recurring costs primarily represent customer support, programming and
amortization of the capitalized costs to support the subscriber revenue. 
Although MST’s programming fees are a significant portion of the cost, MST
continues to pursue competitive agreements and volume discounts in conjunction
with the growth of the subscriber base. The customer support costs for the year
ended December 31, 2006 include build-out of the support services necessary for
the anticipated increase in subscribers in metropolitan New York. The
capitalized costs are amortized over the lease term and include equipment and
installation labor. The Telkonet Segment recurring costs increased for the year
ended December 31, 2006 compared to the prior year due to an increase in the
number of iBridges supported and through the utilization of an out-sourced Tier
I call center which was initiated in July 2005.




27




Gross
Profit





Year
      ended December 31,Gross
      Profit:
            
            2006
            
            2005
            
            VarianceProduct
            
            $
            1,030,568
            
            33%
            
            $
            586,153
            
            33%
            
            $
            444,415
            
            76%Rental
      (lease)
            
            
            (329,899
            )
            -16%
            
            
            184,991
            
            26%
            
            
            (514,890
            )
            -278%Total
            
            
            700,669
            
            14%
            
            
            771,144
            
            31%
            
            
            (70,475
            )
            -9%




Product
Gross Profit





The
increase of Telkonet gross profit for the year 2006 associated with product
revenues over the prior year offsets by ancillary services provided by
MST.





Rental
(lease) Gross Profit





Telkonet
gross profit associated with recurring (lease) revenue decreased as a result of
the sale of rental contracts to Hospitality Leasing Corporation resulting in a
decrease in recurring (lease) revenue which was more than offset by increased
customer support services related to the increased number of iBridges supported.
As MST developed the infrastructure and continued to build-out the subscriber
base, the gross margins were $417,664 or -28% for the 11 months end December 31,
2006, primarily due to programming costs and the support infrastructure. MST
anticipates increased margins in 2008 as the projected new subscriber base
absorbs the current infrastructure.




Operating
Expenses





Year
      ended December 31,2006
            
            2005
            
            VarianceTotal
            18,263,255
            
            $
            16,077,912
            
            2,185,343
            
            
            14%





Overall
expenses increased for the year ended December 31, 2006 over the comparable
period in 2005 by $2,185,343 or 14%. Of this increase, operating expenses
related to the acquisition of MST represented $2,632,449 and were principally
due to salary and other operating costs related to the build-out of the “Quad
Play” subscriber infrastructure, including managerial and back-office support
personnel, professional fees and the amortization of MST’s intangible
assets.  Additionally, the Telkonet operating expenses decreased for the
year ended December 31, 2006 due to a reduction in research and development
costs as well as a cost incurred in 2005 for the impairment of Telkonet’s
investment in Amperion.





Product
Research and Development





Year
      ended December 31,2006
            
            
            2005
            
            
            VarianceTotal
            
            $
            1,925,746
            
            
            $
            2,096,104
            
            
            $
            (170,358
            )
            
            
            -8%




Telkonet’s
research and development costs related to both present and future products are
expensed in the period incurred. Total expenses for the year ended December 31,
2006 decreased over the comparable prior year by $170,358 or -8%. This decrease
was primarily related to costs associated to CE, FIPS 140-2 and other required
certifications of the Company’s product that were incurred in 2005.





Selling,
General and Administrative





Year
      ended December 31,2006
            
            
            2005
            
            
            VarianceTotal
            
            $
            14,346,364
            
            
            $
            12,041,661
            
            
            $
            2,304,703
            
            
            
            19%




28




Selling,
general and administrative expenses increased for the year ended December 31,
2006 over the comparable prior year by $2,304,703 or 19%. This increase is
attributed to the administrative expenses associated with the acquisition of MST
such as payroll costs, advertising, trade shows, facility costs and professional
fees. Also, the selling, general and administrative expenses for Telkonet have
remained approximately the same as the prior year.




Liquidity
and Capital Resources





Our
working capital decreased by $2,460,030 during the twelve months ended December
31, 2007 from a working capital deficit of $(530,634) at December 31, 2006 to a
working capital deficit of $(2,990,664) at December 31, 2007. The decrease in
working capital for the twelve months ended December 31, 2007, is due to a
combination of factors, of which the significant factors are set out
below:





·
            Cash
      had a net decrease from working capital by $14,454 for the twelve months
      ended December 31, 2007. The most significant uses and proceeds of cash
      are as follows:





o
            Approximately
      $13,989,000 of cash consumed directly in operating
      activities




o
            A
      cash payment of $900,000 representing the second installment of the cash
      portion of the purchase price for the acquisition of
  MST





o
            The
      cash payment in the acquisition of Ethostream amounted to approximately
      $2,000,000, and as part of the acquisition the debt payoff amounted to
      approximately $200,000—see discussion of acquisition
  below;o
            The
      cash payments in the acquisition of SSI amounted to approximately
      $875,000—see discussion of acquisition
below;





o
            A
      private placement from the sale of 4,000,000 shares of common stock at
      $2.50 per share provided proceeds of $9,610,000.o
            A
      private placement and sale of debentures by MSTI Holdings Inc. for
      proceeds, net of placement fees, of $2,694,000 and $5,303,000,
      respectively.o
            A
      bridge loan in the amount of $1,500,000 issued as a Senior Note payable to
      GRQ Consultants, Inc.o
            A
      sale of Telkonet’s investment in BPL Global for gross proceeds of
      $2,000,000o
            A
      cash payment of $1,118,000 for the acquisition of the assets of Newport
      Telecommunications Co. by MSTI Holdings,
Inc.





Of the
total $7,004,168 current assets as of December 31, 2007, cash represented
$1,629,584. Of the total $3,766,079 current assets as of December 31, 2006, cash
represented $1,644,037.




Senior
Notes





In 2003,
the Company issued Senior Notes to Company officers, shareholders, and
sophisticated investors in exchange for $5,000,000, exclusive of placement costs
and fees. The remaining outstanding senior note of $100,000 matured and was
repaid in June 2006.





Convertible
Senior Notes





In
October 2005, the Company completed an offering of convertible senior notes (the
“Notes”) in the aggregate principal amount of $20 million. The capital raised in
the Note offering was used for general working capital purposes. The Notes bore
interest at a rate of 7.25%, payable in cash, and called for monthly principal
installments beginning March 1, 2006. The maturity date was 3 years from the
date of issuance of the Notes. The Noteholders were entitled, at any time, to
convert any portion of the outstanding and unpaid Conversion Amount into shares
of Company common stock. At the option of the Company, the principal payments
could be paid either in cash or in common stock. Upon conversion into common
stock, the value of the stock was determined by the lower of $5 or 92.5% of the
average recent market price. The Company also issued one million warrants to the
Noteholders exercisable for five years at $5 per share. At any time after six
months, should the stock trade at or above $8.75 for 20 of 30 consecutive
trading days, the Company could cause a mandatory redemption and conversion to
shares at $5 per share. At any time, the Company was entitled to pre-pay the
notes with cash or common stock. If the Company elected to use common stock to
pre-pay the Notes, the price of the common stock would be deemed to be the lower
of $5 or 92.5% of the average recent market price. If the Company prepaid the
Notes other than by mandatory conversion, the Company was obligated to issue
additional warrants to the Noteholders covering 65% of the amount pre-paid at a
strike price of $5 per share. In addition to standard financial covenants, the
Company agreed to maintain a letter of credit in favor of the Noteholders equal
to $10 million. Once the principal amount outstanding on the notes declined
below $15 million, the balance on the letter of credit was reduced by $.50 for
every $1 amortized.




29




These
notes were repaid on August 14, 2006 as discussed in greater detail below under
“Early Extinguishment of Debt.”




Principal Payments of
Debt





For the
period of January 1, 2006 through August 14, 2006, the Company paid down
principal of $1,250,000 in cash and issued an aggregate of 4,226,246 shares of
common stock in connection with the conversion of $10,821,686 aggregate
principal amount of the Senior Convertible Notes. Pursuant to the note
agreement, the Company issued an additional 1,081,820 warrants to the
Noteholders covering 65% of the $8,321,686 accelerated principal at a strike
price of $5 per share.





For the
period of January 1, 2006 through August 14, 2006, the Company amortized the
debt discount to the beneficial conversion feature and value of the attached
warrants, and recorded non-cash interest expense in the amount of $251,759 and
$500,353, respectively. The Company also wrote-off the unamortized debt discount
attributed to the beneficial conversion feature and the value of the attached
warrants in the amount of $708,338 and $1,397,857, respectively, in connection
with paydown and conversion of the note.





Early
Extinguishment of Debt





On August
14, 2006, the Company executed separate settlement agreements with the lenders
of its Convertible Senior Notes. Pursuant to the settlement agreements the
Company paid to the lenders in the aggregate $9,910,392 plus accrued but unpaid
interest of $23,951 and certain premiums specified in the Notes in satisfaction
of the amounts then outstanding under the Notes. Of the amount paid to the
lenders under the Notes, $6,500,000 was paid in cash through a drawdown on a
letter of credit previously pledged as collateral for the Company’s obligations
under the Notes. The remaining note balance of $1,428,314 and a Redemption
Premium of $1,982,078, calculated as 25% of remaining principal, was paid to the
lenders in shares of Company’s common stock valued at the lower of $5.00 per
share and 92.5% of the arithmetic average of the weighted average price of the
Company’s common stock on the American Stock Exchange for the twenty trading
days beginning on August 16, 2006. The Company also issued 862,452 warrants to
purchase shares of the Company’s common stock at the exercise price of the lower
of $2.58 per share and 92.5% of the average trading price as described above.
The Company accounted for the Redemption Premium and the warrants as non-cash
early extinguishment of debt expense during the year ended December 31, 2006.





As a
result of the execution of the settlement agreements and the payments required
thereby, the Company fully repaid and believes it satisfied all of its
obligations under the Notes. The Company also agreed to pay the expenses of the
lenders incurred in connection with the negotiation and execution of the
settlement agreements. The settlement agreements were negotiated following the
allegation by one of the lenders that the Company’s failure to meet the minimum
revenue test for the period ending June 30, 2006 as specified on the Notes may
have constituted an event of default under the Notes, which allegation the
Company disputed.





In
conjunction with the settlement agreement, the Company recorded $4,626,679 of
loss from early extinguishment of debt, which consists of $1,982,078 redemption
premium paid with the Company’s common stock, $1,014,934 of additional warrants
issued to the lenders, write-off of the remaining unamortized debt discount
attributed to the beneficial conversion feature and the value of the attached
warrants in the amount of $430,040 and $845,143, respectively, and write-off of
the remaining unamortized financing costs of $354,484.





The
settlement agreements provide that the number of shares issued to the
noteholders shall be adjusted based upon the arithmetic average of the weighted
average price of the Company’s common stock on the American Stock Exchange for
the twenty trading days immediately following the settlement date.  The
Company has concluded that, based upon the weighted average of the Company's
common stock between August 16, 2006 and September 13, 2006, the Company is
entitled to a refund from the two noteholders.  One of the noteholders has
informed the Company that it does not believe such a refund is required. 
As a result, the Company has declined to deliver to the noteholders certain
stock purchase warrants issued to them pursuant to the settlement agreements
pending resolution of this disagreement. One of the noteholders has alleged that
the Company has failed to satisfy its obligations under the settlement agreement
by failing to deliver the warrants. In addition, the noteholder maintains that
the Company has breached certain provisions of the registration rights agreement
and, as a result of such breach, such noteholder claims that it is entitled to
receive liquidated damages from the Company. As of March 28, 2008, no legal
claim has been filed by the noteholder.
  MSTI
Holdings, Inc. Convertible Debentures
  In May
2007, MSTI Holdings Inc., a majority owned subsidiary of the Company, issued
senior convertible debentures having a principal value of $6,576,350 to
investors, including an original issue discount of $526,350, in exchange for
$6,050,000 from investors, exclusive of placement fees.  The original issue
discount to the Debentures is amortized over 12 months.  The Debentures
accrue interest at 8% per annum commencing on the first anniversary of the
original issue date of the Debentures, payable quarterly in cash or common
stock, at MSTI Holdings Inc.'s option, and mature on April 30, 2010.  The
Debentures are not callable and are convertible at a conversion price of $0.65
per share into 10,117,462 shares of MSTI Holdings Inc. common
stock.


30




Acquisition
of Microwave Satellite Technologies, Inc.





On
January 31, 2006, the Company acquired a 90% interest in MST from Frank
Matarazzo, the sole stockholder of MST in exchange for $1.8 million in cash and
1.6 million unregistered shares of the Company’s common stock for an aggregate
purchase price of $9,000,000. The cash portion of the purchase price was paid in
two installments, $900,000 at closing and $900,000 in February 2007. The stock
portion is payable from shares held in escrow, 400,000 shares of which were paid
at closing and the remaining 1,200,000 shares of which shall be issued based on
the achievement of 3,300 “Triple Play” subscribers over a three year period.
During the year ended December 31, 2006, the Company issued 200,000 shares of
the purchase price contingency valued at $900,000 as an adjustment to goodwill.
In the event the Company’s common stock price is below $4.50 per share upon
issuance of the shares from escrow, a pro rata adjustment in the number of
shares will be required to support the aggregate consideration of $5.4 million.
As of December 31, 2006, the Company’s common stock price was below $4.50. To
the extent that the market price of Company’s common stock is below $4.50 per
share upon issuance of the shares from escrow, the number of shares issuable on
conversion is ratably increased, which could result in further dilution of the
Company’s stockholders.





Acquisition
of Smart Systems International (SSI)





On March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $7,000,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock.  1,090,909 shares were held in escrow for a period of one year
following the closing for the purpose of satisfying certain potential
indemnification obligations under the purchase agreement could be satisfied. The
aggregate number of shares held in escrow was subject to adjustment upward or
downward depending upon the trading price of the Company’s common stock during
the one year period following the closing date.  On March 12, 2008,
the Company released these shares from escrow and plans to issue an additional
1,909,091 shares pursuant to the adjustment provisions of the SSI asset purchase
agreement.





Acquisition
of Ethostream, LLC





On March
15, 2007, the Company acquired 100% of the outstanding membership units of
Ethostream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The Ethostream
acquisition enables Telkonet to provide installation and support for PLC
products and third party applications to customers across North America. The
purchase price of $11,756,097 was comprised of $2.0 million in cash and
3,459,609 shares of the Company’s common stock. The entire stock portion of the
purchase price is being held in escrow to satisfy certain potential
indemnification obligations of the sellers under the purchase agreement. The
shares held in escrow are distributable over the three years following the
closing.





Proceeds
from the issuance of common stock





During
the twelve months ended December 31, 2007, the Company received $124,460 from
the exercise of employee stock options.   No non-employee options
or warrants were exercised during the year ended December 31, 2007.





In
February 2007, the Company issued 4,000,000 shares of common stock valued at
$2.50 per share for an aggregate purchase price of $10,000,000. The Company also
issued to this investor warrants to purchase 2.6 million shares of its common
stock at an exercise price of $4.17 per share.





Additionally,
during the twelve months ended December 31, 2007, MSTI Holdings Inc. completed a
private placement resulting in proceeds of approximately
$2,694,000.




31




Cash
flow analysis





Cash
utilized in operating activities was $13,989,434 during the year ended December
31, 2007 compared to $13,971,529 and during the year ended December 31, 2006,
respectively. The primary use of cash during the twelve months ended December
31, 2007 was net operating expenses of the Company.




The
Company utilized and was provided cash for investing activities $5,048,217 and
$6,717,442 during the twelve months ended December 31, 2007 and 2006,
respectively. These expenditures were primarily the result of the payment of the
cash portion of the MST purchase price of $900,000 in February 2007, and cash
payments of $875,000 and $2,000,000, for the acquisition of SSI and Ethostream,
respectively, in March 2007 and $1,020,000 for the acquisition of Newport
Telecommunications in July 2007. The proceeds of the sale of the investment
in BPL Global provided $2,000,000 in November 2007. Additionally, cost of
equipment under operating leases, and cable and related equipment, amounted to
$1,568,651 and $1,939,759 for the twelve months ended December 31, 2007 and
2006. Equipment costs were net of $350,571 in proceeds from the sale of certain
equipment under operating leases during the twelve months ended December 31,
2006.  Purchases of property and equipment amounted to $310,715 and
$734,888 for the twelve months ended December 31, 2007 and 2006,
respectively.  During the period ended December 31, 2006, the proceeds
from the release of funds from the Restricted Certificate of Deposit provided
$10,000,000 in conjunction with the conversion and settlement agreement with the
lenders under the Company’s Convertible Senior Notes. The expenditures were
primarily the result of the acquisition of MST in January 2006 of $958,438, net
of acquired cash. Additionally, cost of equipment under operating leases
amounted to $1,589,188, net of proceeds from the sale of certain equipment under
operating leases of $350,571, and $458,271 for the December 31, 2006 and 2005,
respectively. Furthermore, purchases of property and equipment amounted to
$734,888 and $336,448 for the year ended December 31, 2006 and 2005,
respectively.





The
Company was provided cash from financing activities of $19,023,197 and $476,045
during the twelve months ended December 31, 2007 and 2006, respectively. The
financing activities involved the sale of 4.0 million shares of common stock at
$2.50 per share for a total of $9,610,000, net of placement fees, in February
2007. Additionally, proceeds from the exercise of stock options and warrants
were $124,460 and $2,684,663 during the twelve months ended December 31, 2007
and 2006, respectively. In July 2007, the Company issued a senior note payable
in the principal amount of $1,500,000.  Through its majority-owned
subsidiary MSTI Holdings, Inc., the Company raised $5,303,238 through the sale
of debentures, and $2,694,020 through the sale of common stock, during the
twelve months ended December 31, 2007. In 2006, the proceeds of the financing
activities were offset by repayment of debt principal of $8,162,119, including
$7,750,000 of principal payments in conjunction with the conversion and
settlement agreement with the lenders of its Convertible Senior Notes and
approximately $410,000 in conjunction with the acquisition of MST.




We are
reducing cash required for operations by reducing operating costs and reducing
staff levels. In addition, we are working to manage our current liabilities
while we continue to make changes in operations to improve our cash flow and
liquidity position.
  Our
registered independent certified public accountants have stated in their report
dated March 31, 2008, that we have incurred operating losses in the past years,
and that we are dependent upon management's ability to develop profitable
operations. These factors among others may raise substantial doubt about our
ability to continue as a going concern.
  While we
have raised capital in the First Quarter of 2008 to meet our working capital and
financing needs, additional financing is required in order to meet our current
and projected cashflow requirements from operations and development . Additional
investments are being sought, but we cannot guarantee that we will be able to
obtain such investments. Financing transactions may include the issuance of
equity or debt securities, obtaining credit facilities, or other financing
mechanisms. However, the trading price of our common stock and the downturn in
the U.S. stock and debt markets could make it more difficult to obtain financing
through the issuance of equity or debt securities. Even if we are able to raise
the funds required, it is possible that we could incur unexpected costs and
expenses, fail to collect significant amounts owed to us, or experience
unexpected cash requirements that would force us to seek alternative financing.
Further, if we issue additional equity or debt securities, stockholders may
experience additional dilution or the new equity securities may have rights,
preferences or privileges senior to those of existing holders of our common
stock. If additional financing is not available or is not available on
acceptable terms, we will have to curtail our operations.
  Inflation





We do not
believe that inflation has had a material effect on our business, financial
condition or results of operations. If our costs were to become subject to
significant inflationary pressures, we may not be able to fully offset such
higher costs through price increases. Our inability or failure to do so could
adversely affect our business, financial condition and results of
operations.




Off Balance Sheet
Arrangements


We do not
maintain off-balance sheet arrangements nor do we participate in any
non-exchange traded contracts requiring fair value accounting
treatment.





Acquisition
or Disposition of Plant and Equipment





During
the year ended December 31, 2007, fixed assets increased approximately
$2,341,000, including $2,323,000 for the MST Segment primarily from the addition
of the Newport assets acquired in July 2007 and equipment purchased for the MST
build-out. The remainder is related to computer equipment and peripherals used
in day-to-day operations. The Company anticipates significant expenditures in
the MST Segment to continue the build-out the head-end equipment, IPTV and other
related projects. The Telkonet Segment does not anticipate the sale or purchase
of any significant property, plant or equipment during the next twelve months,
other than computer equipment and peripherals to be used in the Company’s
day-to-day operations.




32




In April
2005, the Company entered into a three-year lease agreement for 6,742 square
feet of commercial office space in Crystal City, Virginia. Pursuant to this
lease, the Company agreed to assume a portion of the build-out cost for this
facility.  This lease terminates in March 2008.





MSTI
presently leases 12,600 square feet of commercial office space in Hawthorne, New
Jersey for its office and warehouse spaces. This lease will expire in April
2010.





Following
the acquisitions of SSI and Ethostream, the Company assumed leases on 9,000
square feet of office space in Las Vegas, NV for the SSI office and warehouse
space on a month to month basis and 4,100 square feet of office space in
Milwaukee, WI for Ethostream.  The Milwaukee lease expires in May
2011.   The Las Vegas, NV office lease will terminate effective
April 30, 2008.





New
Accounting Pronouncements





In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose
to measure many financial instruments, and certain other items, at fair value.
SFAS 159 applies to reporting periods beginning after November 15, 2007. The
adoption of SFAS 159 is not expected to have a material impact on the Company’s
financial condition or results of operations.




In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
141(R), “Business Combinations” (“Statement 141(R)”) and Financial Accounting
Standards No. 160, “Noncontrolling Interests in Consolidated Financial
Statements” (“Statement 160”). Statements 141(R) and 160 require most
identifiable assets, liabilities, noncontrolling interests and goodwill acquired
in a business combination to be recorded at “full fair value” and require
noncontrolling interests (previously referred to as minority interests) to be
reported as a component of equity.  Both statements are effective for
fiscal years beginning after December 15, 2008.  Statement 141(R) will
be applied to business combinations occurring after the effective
date.  Statement 160 will be applied prospectively to all
noncontrolling interests, including any that arose before the effective
date.  The Company has not determined the effect, if any, the adoption
of Statements 141(R) and 160 will have on the Company’s financial position or
results of operations.





Disclosure
of Contractual Obligations




Payment
      Due by PeriodContractual
      obligations
            
            Total
            
            
            Less
      than
              1
      year
            
            
            1-3
      years
            
            
            3-5
      years
            
            
            More
      than 5 yearsLong-Term
      Debt Obligations
            
            $
            6,576,350
            
            
            
            -
            
            
            
            6,576,350
            
            
            
            -
            
            
            
            -Current
      Debt Obligations
            
            $
            1,500,000
            
            
            
            1,500,000
            
            
            
            -
            
            
            
            -
            
            
            
            -Capital
      Lease Obligations
            
            $
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Operating
      Lease Obligations
            
            $
            2,082,799
            
            
            
            539,681
            
            
            
            852,142
            
            
            
            348,232
            
            
            
            342,744Purchase
      Obligations (1)(2)
            
            $
            2,386,564
            
            
            
            2,576,442
            
            
            
            
            
            
            
            
            
            
            
            -Other
      Long-Term Liabilities Reflected onthe
      Registrant’s Balance Sheet Under GAAP
            
            $
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            $
            12,545,713
            
            
            
            4,616,123
            
            
            
            7,428,492
            
            
            
            348,232
            
            
            
            342,744




(1)
            Purchase
      commitment for the IPTV build-out of MSTI subscriber base in the second
      half of 2007 in the amount of
$476,776.


(2)
            Purchase
      commitment of $1,909,788 for inventory orders of energy management
      products through April 2008.  The Company has prepaid
      approximately $380,000 as of December 31,
2007.





ITEM
7A.QUANTITATIVE AND
QUALITATIVE DISCLOSURES ABOUT MARKET RISK.





Short
Term Investments





We held
no marketable securities as of December 31, 2007. Our excess cash is held in
money market accounts in a bank and brokerage firms both of which are nationally
ranked top tier firms with an average return of approximately 400 basis points.
Due to the conservative nature of our investment portfolio, an increase or
decrease of 100 basis points in interest rates would not have a material effect
on our results of operations or the fair value of our portfolio.




33




Investments
in Privately Held Companies





We have
invested in privately held companies, which are in the startup or development
stages. These investments are inherently risky because the markets for the
technologies or products these companies are developing are typically in the
early stages and may never materialize. As a result, we could lose our entire
initial investment in these companies. In addition, we could also be required to
hold our investment indefinitely, since there is presently no public market in
the securities of these companies and none is expected to develop. These
investments are carried at cost, which as of March 1, 2008 was $8,000 in
Amperion and at December 31, 2007 are recorded in other assets in the
Consolidated Balance Sheets. The Company determined that its investment in
Amperion was impaired based upon forecasted discounted cash flow. Accordingly,
the Company wrote-off 92%, or $92,000, of the carrying value of its investment
through a charge to operations during the year ended December 31,
2006.  The Company sold its investment in BPL Global for $2,000,000
during the year ended December 31, 2007.  The fair value of the
Company’s investment in BPL Global was $131,044 at the time of the
sale.





On
October 19, 2007, the Company completed the acquisition of approximately 30.0%
of the issued and outstanding shares of common stock of Geeks on Call America,
Inc. (“GOCA”), the nation's premier provider of on-site computer services. 
Under the terms of the stock purchase agreement, the Company acquired
approximately 1,160,043 shares of GOCA common stock from several GOCA
stockholders in exchange for 2,940,202 shares of the Company’s common stock for
total consideration valued at approximately $4.5 million.




ITEM
8.FINANCIAL
STATEMENTS.





See the
Financial Statements and Notes thereto commencing on Page F-1.





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





None.





ITEM
9A.CONTROLS AND
PROCEDURES.




Evaluation of
Disclosure Controls and Procedures. Under the supervision and
with the participation of our management, including our Chief Executive Officer
and Chief Financial Officer, the Company evaluated the effectiveness of the
design and operation of its disclosure controls and procedures (as such term is
defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the
“Exchange Act”)).





The
Company's conclusion on the effectiveness of internal control over financial
reporting did not include the internal controls of the acquisitions in 2006 of
Smart Systems International, Ethostream, LLC, and Newport Telecommunications Co.
(the "acquisitions") which are included in the 2007 consolidated financial
statements of the Company.





Disclosure
controls and procedures are the controls and other procedures that the Company
designed to ensure that it records, processes, summarizes and reports in a
timely manner the information it must disclose in reports that it files with or
submits to the Securities and Exchange Commission under the Exchange Act. Based
on this evaluation, the Chief Executive Officer and the Chief Financial Officer
concluded that the Company’s disclosure controls and procedures were effective
as of the end of the period covered by this report.





Changes in
Internal Control over Financial Reporting. During the fourth quarter of
2007, there was no change in the Company’s internal control over financial
reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act)
that has materially affected, or is reasonably likely to materially affect, the
Company’s internal control over financial reporting.




Management Report
On Internal Control over Financial Reporting. The Company’s management is
responsible for establishing and maintaining adequate internal control over
financial reporting. Internal control over financial reporting is defined in
Rule 13a-15(f) under the Exchange Act as a process designed by, or under the
supervision of, the Company’s principal executive and principal financial
officers and effected by the Company’s board of directors, management and other
personnel, to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external
purposes in accordance with accounting principles generally accepted in the
United States of America and includes those policies and procedures
that:




34




·
            pertain
      to the maintenance of records that, in reasonable detail, accurately and
      fairly reflect the transactions and dispositions of the Company’s
      assets;





·
            provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with accounting
      principles generally accepted in the United States of America, and that
      the Company’s receipts and expenditures are being made only in accordance
      with authorization of management and directors;
  and





·
            provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of the Company’s assets that
      could have a material effect on the financial
  statements.





We have
excluded from this assessment the operations of Smart Systems International,
Ethostream, LLC, and Newport Telecommunications Co. These businesses were
acquired during 2007 and constituted $22.4 million total assets,
respectively, as of December 31, 2007 and $7.9 million of net sales for the year
then ended.





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





Under the
supervision and with the participation of the Company’s management, including
its principal executive and principal financial officers, the Company assessed,
as of December 31, 2007, the effectiveness of its internal control over
financial reporting. This assessment was based on criteria established in the
framework inInternal
Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Based on the Company’s assessment,
management concluded that the Company’s internal control over financial
reporting was effective as of December 31, 2007.




The
Company’s assessment of the effectiveness of its internal control over financial
reporting as of December 31, 2007 has been audited by RBSM LLP, an independent
registered public accounting firm, as stated in their report which is included
in this Annual Report on Form 10-K.




35


RBSM
LLP






REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





Board of
Directors


Telkonet,
Inc.


Germantown,
MD





We have
audited Telkonet, Inc. and its subsidiaries (the "Company") internal
control over financial
reporting as of December 31, 2007, based on criteria established inInternal
Control -- Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the COSO criteria). The Company’s
management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of
internal control over financial reporting, included in the accompanying
Management's Report on Internal Control over Financial Reporting. Our
responsibility is to express an opinion on the effectiveness of the Company's
internal control over financial reporting based on our audit.




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




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




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




As
indicated in the accompanying Management's Report on Internal Control Over
Financial Reporting, management's assessment of and conclusion on the
effectiveness of internal control over financial reporting did not include the internal
controls of Smart Systems International, Ethostream, LLC and Newport
Telecommunications Co. (the "acquisitions")
which are included in the 2007 consolidated financial statements of Telkonet,
Inc. and its subsidiaries and constituted $22.4 million total assets,
as of December 31, 2007 and $7.9 million
of net sales for the year then ended. Our audit of internal control over
financial reporting of Telkonet, Inc. and its subsidiaries also did not include
an evaluation of the internal controls over financial reporting of the
acquisitions.




In our
opinion, Telkonet, Inc. and its subsidiaries maintained, in all material
respects, effective internal control over financial reporting as of
December 31, 2007, based on the COSO criteria.




We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balances sheets of Telkonet,
Inc. and its subsidiaries as of December 31, 2007 and 2006, and the related
consolidated statements of losses, stockholders’ equity and cash flows for each
of the three years in the period ended December 31, 2007 and our report dated
March 31, 2008 expressed an unqualified opinion thereon and included an
explanatory paragraph related to the Company's ability to continue as a going
concern.





/s/ RBSM
      LLP
              Certified
      Public Accountants







McLean,
Virginia


March 31,
2008





36


ITEM
9B.OTHER
INFORMATION.





None.




PART
III





ITEM
10.DIRECTORS AND
EXECUTIVE OFFICERS OF THE REGISTRANT.





The
following table furnishes the information concerning the Company’s directors and
officers for the fiscal year ended December 31, 2007. The directors of the
Company are elected every year and serve until their successors are duly elected
and qualified.





Name
            Age
            TitleJason
      Tienor
            33
            President
      & Chief Executive OfficerDorothy
      E. Cleal
            58
            Chief
      Operating OfficerRichard
      J. Leimbach
            39
            Chief
      Financial Officer of Telkonet, Vice President Finance,  MSTI
      Holdings, Inc.Jeffrey
      Sobieski
            31
            Executive
      Vice President, Energy ManagementJames
      Landry
            52
            Chief
      Technology OfficerWarren
      V. Musser
            81
            Chairman
      of the BoardRonald
      W. Pickett
            60
            Vice
      Chairman of the Board, President, MSTI Holdings, IncThomas
      C. Lynch
            65
            Director
      (1), (2)Dr.
      Thomas M. Hall
            56
            Director
      (1), (2)James
      L. “Lou” Peeler
            74
            Director
      (1)Seth
      Blumenfeld
            67
            DirectorAnthony
      J. Paoni
            63
            Director
      (2)


_________________________


(1)
            Member
      of the Audit Committee


(2)
            Member
      of the Compensation Committee





Jason
Tienor—President and Chief Executive Officer





Mr.
Tienor has served as the Company’s President and Chief Executive Officer since
December 2007 and, from August 2007 until December 2007, he served as the
Company’s Chief Operating Officer.  Mr. Tienor has also served as
Chief Executive Officer of EthoStream, LLC, a wholly-owned subsidiary of the
Company, since March 2007.  From 2002 until his employment with the
Company, Mr. Tienor served as Chief Executive Officer of Ethostream, LLC, the
company that he co-founded. Mr. Tienor received a bachelor of business
administration in management information systems and marketing from the
University of Wisconsin – Oshkosh and a masters of business
administration from Marquette University.





Dorothy
E. Cleal—Chief Operating Officer





Ms. Cleal
has served as the Company’s Chief Operating Officer since December 2007 and,
from August 2007 until December 2007, she served as the Company’s Executive Vice
President. Prior to joining Telkonet, Ms. Cleal served, since 2005, as the
Company’s Vice President and Director, Navy and Marine Corps Business Program of
SRA International, a billion dollar leading provider of consulting services to
clients in the national security, civil government, health care and public
health industries.  From 2000 through 2005 she served as the Navy
account manager as well as the Navy and Marine Corps account manager with
SRA.  Prior to joining SRA, Ms. Cleal was the acting Chief Information
Officer and Associate Director for Information Systems and Technology at the
White House.




37




Richard
J. Leimbach—Chief Financial Officer




Mr.
Leimbach has served as the Company’s Chief Financial Officer since December 2007
and, from June 2006 until December 2007, he served as the Vice President of
Finance. He also served as the Company’s Controller from January 2004 until June
2006.  Mr. Leimbach is a certified public accountant with over fifteen
years of public accounting and private industry experience. Prior to joining
Telkonet, Mr. Leimbach was the Controller with Ultrabridge, Inc., an
applications solution provider. Mr. Leimbach also served as Corporate Accounting
Manager for Snyder Communications, Inc., a global provider of integrated
marketing solutions.





Jeffrey
Sobieski—Executive Vice President, Energy Management





Mr.
Sobieski has served as the Company’s Executive Vice President, Energy Management
since December 2007 and from March 2007 until December 2007, he served as Chief
Information Officer of Ethostream, LLC, wholly-owned subsidiary of the
Company.  From 2002 until his employment with the Company, Mr.
Sobieski served as Chief Information Officer of Ethostream, LLC, the company he
co-founded.  Mr. Sobieski is also the co-founder of Interactive
Solutions, a consulting firm providing support to the Insurance and
Telecommunications Industries.





James
F. Landry—Chief Technology Officer





Mr.
Landry has served as the Company’s Chief Technology Officer since December 2004
and Vice President of Engineering from September 2001 to May 2004. Before
joining Telkonet, Mr. Landry was a Senior Member of 3Com Technical Staff since
1994. Mr. Landry has over 20 years experience in developing communications
hardware for the enterprise/carrier market with 3Com, US Robotics, Penril
Datacomm and Data General. While at 3Com/US Robotics, he was responsible for the
development of the entire xDSL product line as well as a number of modems and
interface cards. At Penril, he served as the product development leader for the
Series 1544 multiplexer/channel bank and at Data General he was technical leader
of system integration for ISDN, WAN. Mr. Landry brings a wealth of practical
design leadership and a solid history of delivering products to the marketplace.
Mr. Landry holds four US patents.





Warren
V. Musser—Chairman of the Board of Directors





Warren V.
“Pete” Musserjoined the Board of
Telkonet in January, 2003.  Mr. Musser is the President and Chief
Executive Officer of The Musser Group LLC, a strategy consulting firm based in
Wayne, Pennsylvania which he started in 2001.  Mr. Musser is the
founder and former Chief Executive Officer and Chairman  and current
Chairman Emeritus of Safeguard Scientifics, Inc., a company that builds
value in high-growth, revenue-stage information technology and life sciences
businesses.  He was a founding investor of QVC, Novell, Compucom
Systems and Cambridge Technology Partners, among other companies.  Mr.
Musser currently serves as Chairman of InfoLogix, Inc. and Epitome Systems,
Inc. and is on the Board of Directors of NutriSystem, Inc., Internet
Capital Group, Inc., Health Benefits Direct Corporation and Health
Advocate.  Mr. Musser serves on a variety of civic and charitable boards,
including as Co-Chairman of the Eastern Technology Council, Chairman of
Economics PA and Vice Chairman of the National Center for the American
Revolution.


Ronald
W. Pickett—Vice Chairman of the Board of Directors





Mr.
Pickett was appointed as Vice Chairman of the Board of Directors subsequent to
his resignation as the Company’s Chief Executive Officer in December 2007, a
position which he held since January 2003. In addition, he has fostered the
development of Telkonet since 1999 as the Company’s principal investor and
co-founder. He was the founder, and for twenty years served as the Chairman of
the Board and President, of Medical Advisory Systems, Inc. (a company providing
international medical services and pharmaceutical distribution) until its merger
with Digital Angel Corporation (AMEX: DOC) in March 2002. A graduate of Gordon
College, Mr. Pickett has engaged in various entrepreneurial activities for 35
years. Mr. Pickett has been a director of the Company since January
2003.




38




Thomas
C. Lynch—Director





Mr. Lynch
is Senior Vice President of The Staubach Company’s Federal Sector (a real estate
management and advisory services firm) in the Washington, D.C. area. Mr. Lynch
joined The Staubach Company in November 2002 after 6 years as Senior Vice
President at Safeguard Scientifics, Inc. (NYSE: SFE) (a high-tech venture
capital company). While at Safeguard, he served nearly two years as President
and Chief Operating Officer at CompuCom Systems, a Safeguard subsidiary. After a
31-year career of naval service, Mr. Lynch retired in the rank of Rear Admiral.
Mr. Lynch’s Naval service included chief, Navy Legislative Affairs, command of
the Eisenhower Battle Group during Operation Desert Shield, Superintendent of
the United States Naval Academy from 1991 to 1994 and Director of the Navy Staff
in the Pentagon from 1994 to 1995.  Mr. Lynch
presently serves as Chairman of Sprinturf, a synthetic turf company, and also as
a Director of Epitome Systems, Infologix Systems, Mikros Systems Corp.,
Economics Pennsylvania, Armed Forces Benefit Association, Catholic Leadership
Institute, National Center for the American Revolution at Valley Forge, USO
Board of Governors and is currently a trustee of the US Naval Academy
Foundation.  Mr. Lynch has served as the President of Valley Forge
Historical Society, and Chairman of the Cradle of Liberty Council, Boy Scouts of
America.  Mr. Lynch graduated from the US Naval Academy with his
Bachelor of Science degree in 1964 and received his Master of Science degree
from the George Washington University.  Mr. Lynch has been a director
of the Company since October 2003.





Dr.
Thomas M. Hall—Director





Dr. Hall
is the Managing Director of Marrell Enterprises, LLC (a company that specializes
in international business development). For 12 years (until 2002), Dr. Hall was
the chief executive officer of Medical Advisory Systems, Inc. (a company
providing international medical services and pharmaceutical distribution). Dr.
Hall holds a bachelor of science and a medical degree from the George Washington
University and a master of international management degree from the University
of Maryland. Dr. Hall has been a director of the Company since April
2004.





James
L. “Lou” Peeler—Director





Mr.
Peeler was a founder and member of the board of Digital Communications
Corporation (DCC), which evolved into Hughes Network Systems (HNS), a provider
of global broadband, satellite, and wireless communications products for home
and business, such as DirecTV and DIRECWAY. Mr. Peeler retired as executive vice
president of operations in 1999 after 27 years of service and was a member of
the Advisory Council to Hughes Network Systems. Mr. Peeler also served on the
Board of Directors of Hughes Software Systems (HSS). Prior to the founding of
DCC, he was vice president of Engineering for Washington Technological
Associates (WTA) (a satellite communications development company), where he was
instrumental in the development of rocket and satellite communications and
instrumentation equipment. Mr. Peeler received a bachelor of science degree in
electrical engineering from Auburn University. Mr. Peeler has been a director of
the Company since April 2004.





Seth
D. Blumenfeld—Director





Mr.
Blumenfeld served as President of International Services for MCI International
(a provider of telecommunication services) from 1998 until his retirement in
January of 2005. Mr. Blumenfeld was President and Chief Operating Officer of
several of MCI's international subsidiaries from 1984 to 1998. Mr. Blumenfeld
earned his Doctorate Jurisprudence from Fordham University Law School in 1965.
He practiced law on Wall Street prior to serving as infantry captain for the
U.S. Army in Vietnam. From 1976 through 1978, Mr. Blumenfeld lived in Japan. Mr.
Blumenfeld's involvement on professional boards and community associations have
included Executive Committee member of the United States Council for
International Business, Member of the Board of Directors of the United States
Telecommunications Training Institute, Member of the State Department Advisory
Council on International Communications and Information Policy, Member of the
University of Colorado Institute for International Business Board of Advisors,
Member of the American Graduate School of International Management (Thunderbird)
Board of Advisors, Member of the Advisory Board of Visitors to Fordham
University School of Law, and honorary Chairman of the Connecticut Association
of Children with Learning Disabilities.





Anthony
J. Paoni - Director





Professor
Paoni has been a faculty member at Northwestern University’s Kellogg School of
Management since 1996. Previously, he spent 28 years in the information
technology industry with market leading organizations that provided computer
hardware, software and consulting services.  For the first 15 years of
his career Professor Paoni managed sales and marketing organizations and in the
later stages of his career he moved into general management positions starting
with PANSOPHIC Systems Incorporated. This Lisle, Illinois based firm was the
world’s fifth largest international software company prior to its acquisition by
Computer Associates, Incorporated. Subsequently, he became chief operating
officer of Cross Access, a venture capital funded software firm that provided
industry-leading solutions to the heterogeneous database connectivity market
segment. In addition, he has been president of two wholly-owned U.S.
subsidiaries of Ricardo Consulting, a U.K.-based international engineering
consulting firm focused on computer based automotive powertrain design. Prior to
joining the Kellogg faculty, Professor Paoni was chief executive officer of
Eolas, an Internet software company with patent pending Web technology - one of
the key technology drivers responsible for the rapid adoption of the Internet
platform.




39




Audit
Committee





The
Company maintains an Audit Committee of the Board of Directors. For the year
ended December 31, 2007, Messrs. Hall, Lynch and Peeler served on the Audit
Committee. The Company’s Board of Directors has determined that each of Messrs.
Hall, Lynch and Peeler is a “financial expert” as defined by Item 401 of
Regulation S-K promulgated under the Securities Act of 1933 and the Securities
Exchange Act of 1934. The Company’s Board of Directors also has determined that
each of Messrs. Hall, Lynch and Peeler are “independent” as such term is defined
in Section 121(A) of the AMEX Rules and Rule 10A-3 promulgated under the
Securities Exchange Act of 1934. The Board of Directors has adopted an audit
committee charter, which was ratified by the Company’s stockholders at the 2004
Annual Meeting of Stockholders.





Compensation
Committee





The
Company maintains a Compensation Committee of the Board of Directors. For the
year ended December 31, 2007, Dr. Hall and Messrs. Lynch and Paoni served on the
Compensation Committee. The committee held 2 meetings during
2007.  During the year ended December 31, 2007, Mr. Musser served on
the Compensation Committee until November 21, 2007, at which time Mr. Paoni was
elected to replace him.




Code of
Ethics





The Board
has approved, and Telkonet has adopted, a Code of Ethics that applies to all
directors, officers and employees of Telkonet. A copy of the Company’s Code of
Ethics was filed as Exhibit 14 to the Company’s Annual Report on Form 10-KSB for
the year ended December 31, 2003 (filed with the Securities and Exchange
Commission on March 30, 2004). In addition, the Company will provide a copy of
its Code of Ethics free of charge upon request to any person submitting a
written request to the Company’s Chief Executive Officer.




SECTION
16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE





Section
16(a) of the Securities Exchange Act of 1934 requires our directors and certain
of our officers to file reports of holdings and transactions in shares of
Telkonet common stock with the Securities and Exchange Commission. Based on our
records and other information, we believe that in 2007 our directors and our
officers who are subject to Section 16 met all applicable filing
requirements.





ITEM
11.EXECUTIVE
COMPENSATION.





COMPENSATION
COMMITTEE REPORT





The
Compensation Committee of the Board of Directors has reviewed and discussed the
section of this Form 10-K entitled “Compensation Discussion and Analysis” with
management. Based on this review and discussion, the Committee has recommended
to the Board that the section entitled “Compensation Discussion and Analysis,”
be included in this Form 10-K for the fiscal year ended December 31,
2007.





Thomas M.
Hall


Thomas C.
Lynch


Anthony
J. Paoni





COMPENSATION
DISCUSSION AND ANALYSIS





Oversight
of Executive Compensation Program





The
Compensation Committee of the Board of Directors oversees the Company’s
compensation programs, which are designed specifically for the Company’s most
senior executive officers, including the Chief Executive Officer, Chief
Financial Officer and the other executive officers named in the Summary
Compensation Table (collectively, the “named executive officers”). Additionally,
the Compensation Committee is charged with the review and approval of all annual
compensation decisions relating to named executive officers.




40




The
Compensation Committee is composed of 3 independent, non-management members of
the Board of Directors. Each year the Company reviews any and all relationships
that each director has with the Company and the Board of Directors subsequently
reviews these findings.





The
responsibilities of the Compensation Committee, as stated in its charter,
include the following:





·
            annually
      review and approve for the CEO and the executive officers of the Company
      the annual base salary, the annual incentive bonus, including the specific
      goals and amount, equity compensation, employment agreements, severance
      arrangements, and change in control agreements/provisions, and any other
      benefits, compensation or
arrangements.





·
            make
      recommendations to the Board with respect to incentive compensation plans,
      including reservation of shares for issuance under employee benefit
      plans.





·
            annually
      review and recommend to the Board of Directors for its approval the
      compensation, including cash, equity or other compensation, for members of
      the Board of Directors for their service as a member of the Board of
      Directors, a member of any committee of the Board of Directors, a Chair of
      any committee of the Board of Directors, and the Chairman of the Board of
      Directors.





·
            annually
      review the performance of the Company’s Chief Executive
      Officer.





·
            make
      recommendations to the Board of Directors on the Company’s executive
      compensation practices and policies, including the evaluation of
      performance by the Company’s executive officers and issues of management
      succession.





·
            review
      the Company’s compliance with employee benefit
  plans.





·
            make
      regular reports to the Board.





·
            annually
      review and reassess the adequacy of the Compensation Committee charter and
      recommend any proposed changes to the Board for
  approval.





The
Compensation Committee is also responsible for completing an annual report on
executive compensation for inclusion in the Company's proxy statement. In
addition to such annual report, the Compensation Committee maintains written
minutes of its meetings, which minutes are filed with the minutes of the
meetings of the Board.





Overview
of Compensation Program





In order
to recruit and retain the most qualified and competent individuals as senior
executives, the Company strives to maintain a compensation program that is
competitive in the global labor market. The purpose of the Company’s
compensation program is to reward exceptional organizational and individual
performance.





The
following compensation objectives are considered in setting the compensation
programs for our named executive officers:





·
            drive
      and reward performance which supports the Company’s core
      values;





·
            provide
      a percentage of total compensation that is “at-risk,” or variable, based
      on predetermined performance
criteria;





·
            design
      competitive total compensation and rewards programs to enhance the
      Company’s ability to attract and retain knowledgeable and experienced
      senior executives; and





·
            set
      compensation and incentive levels that reflect competitive market
      practices.




41




Compensation
Elements and Rationale





Compensation
for Named Executive Officers Other than the CEO





Compensation
for the named executive officers, other than the CEO, is made in the CEO’s sole
and exclusive discretion. While the Compensation Committee provides its
recommendations with respect to compensation for the named executive officers
(other than the CEO) as described in greater detail below, the CEO is only
required to consider the Compensation Committee’s recommendations, but is not
bound by its findings.





Compensation
for the Company’s CEO





To reward
both short and long-term performance in the compensation program and in
furtherance of the Company’s compensation objectives noted above, the Company’s
compensation program for the CEO is based on the following
objectives:





(i)
            Performance Goals





The
Compensation Committee believes that a significant portion of the CEO’s
compensation should be tied not only to individual performance, but also to the
Company’s performance as a whole measured against both financial and
non-financial goals and objectives. During periods when performance meets or
exceeds these established objectives, the CEO should be paid at or more than
expected levels. When the Company’s performance does not meet key objectives,
incentive award payments, if any, should be less than such levels.





(ii)
            Incentive
      Compensation





A large
portion of compensation should be paid in the form of short-term and long-term
incentives, which are calculated and paid based primarily on financial measures
of profitability and stockholder value creation. The CEO has the incentive of
increasing Company profitability and stockholder return in order to earn a major
portion of his compensation package.





(iii)
            Competitive Compensation
      Program





The
Compensation Committee reviews the compensation of chief executive officers at
peer companies to ensure that the compensation program for the CEO is
competitive. The Company believes that a competitive compensation program will
enhance its ability to retain a capable CEO.





Financial Metrics Used in
Compensation Programs





Several
financial metrics are commonly referenced in defining Company performance for
the CEO’s executive compensation. These metrics include quarterly metrics to
target cash flow break even and specific revenue goals to define Company
performance for purposes of setting the CEO’s compensation.





Compensation Benchmarking Relative to
Market





The
Company sets the CEO’s compensation by evaluating peer group companies. Peer
group companies are chosen based on size, industry, annual revenue and whether
they are publicly or privately held. Based on these criteria, the Compensation
Committee has identified 29 companies in the Company’s peer group. These peer
group companies include Catapult Communications Corp., Endwave Corp., Carrier
Access Corp., Crystal Technology, Echelon Corp. and FiberTower Corp. The
Compensation Committee has concluded that the CEO’s compensation falls within
the 50th
percentile of compensation for chief executive officers within the peer group
companies.





Review of Senior Executive
Performance





The
Compensation Committee reviews, on an annual basis, each compensation package
for the named executive officers. In each case, the Compensation Committee takes
into account the scope of responsibilities and experience and balances these
against competitive salary levels. The Compensation Committee has the
opportunity to meet with the named executive officers at least once per year,
which allows the Compensation Committee to form its own assessment of each
individual’s performance. As indicated above, with the exception of the CEO,
recommendations with respect to compensation packages for the named executive
officers must be considered by the CEO in connection with establishing
compensation for those named executive officers. However, the recommendations of
the Compensation Committee with respect to the compensation paid to the named
executive officers (other than the CEO) will not be binding on the
CEO.




42




Components of the Executive
Compensation Program





The
Compensation Committee believes the total compensation and benefits program for
named executive officers should consist of the following:





·
            base
      salary;


·
            stock
      incentive plan;


·
            retirement,
      health and welfare benefits;


·
            perquisites
      and perquisite allowance payments;
and


·
            termination
      benefits.




Base Salaries





With the
exception of the CEO, whose compensation is set by the Compensation Committee
and approved by the Board of Directors, base salaries and merit increases for
the named executive officers are determined by the CEO in his discretion after
consideration of a competitive analysis recommendation provided by the
Compensation Committee. The Compensation Committee’s recommendation is
formulated through the evaluation of the compensation of similar executives
employed by companies in the Company’s peer group.




Stock Incentive
Plan





Under the
Company’s Stock Incentive Plan (the “Plan”) incentive stock options and
non-qualified options to purchase shares of the Company’s common stock may be
granted to key employees. An important objective of the long-term incentive
program is to strengthen the relationship between the long-term value of the
Company’s stock price and the potential financial gain for employees as well as
the retention of senior management and key personnel. Stock options provide
named executive officers with the opportunity to purchase the Company’s common
stock at a price fixed on the grant date regardless of future market price.
Stock options generally vest ratably on a quarterly basis and become exercisable
over a five-year vesting period. A stock option becomes valuable only if the
Company’s common stock price increases above the option exercise price (at which
point the option will be deemed “in-the-money”) and the holder of the option
remains employed during the period required for the option to “vest” thus,
providing an incentive for an option holder to remain employed by the Company.
In addition, stock options link a portion of an employee’s compensation to
stockholders’ interests by providing an incentive to increase the market price
of the Company stock.




The
Company practice is that the exercise price for each stock option is equal to
the fair market value on the date of grant. Under the terms of the Plan, the
option price will not be less than the fair market value of the shares on the
date of grant or, in the case of a beneficial owner of more than 5.0% of the
Company’s outstanding common stock on the date of grant, the option price will
not be less than 110% of the fair market value of the shares on the date of
grant.





There is
a limited term in which Plan participants can exercise stock options, known as
the “option term.” The option term is generally ten years from the date of
grant. At the end of the option term, the right to exercise any unexercised
options expires. Option holders generally forfeit any unvested options if their
employment with the Company terminates.





Certain
key executives may be a party to option agreements containing clauses that cause
their options to become immediately and fully vested and exercisable upon a
Change of Control, as defined in the Plan. Additionally, death or disability of
the executive during his or her employment period may cause certain stock
options to immediately vest and become exercisable per the terms outlined in the
stock option award agreement.





The
Compensation Committee awards options to named executive officers upon
commencement of their employment with the Company, and for successfully
achieving or exceeding predetermined individual and Company performance goals.
In determining whether to award stock options and the number of stock options
granted to a named executive officer, the Compensation Committee reviews the
compensation of executives at peer group companies to ensure that the
compensation program is competitive.




43




Retirement,
Health and Welfare Benefits





The
Company offers a variety of health and welfare and retirement programs to all
eligible employees. The named executive officers generally are eligible for the
same benefit programs on the same basis as the rest of the broad-based
employees. The Company’s health and welfare programs include medical, dental,
vision, life, accidental death and disability, and short and long-term
disability insurance. In addition to the foregoing, the named executive officers
are eligible to participate in the Company’s 401(k) Profit Sharing
Plan.





401(k) Profit
Sharing Plan





Telkonet
maintains a defined contribution profit sharing plan for employees (the
“Telkonet 401(k)”) that is administered by a committee of trustees appointed by
the Company. All Company employees are eligible to participate upon the
completion of six months of employment, subject to minimum age
requirements. Contributions by employees under the Telkonet 401(k) are
immediately vested and each employee is eligible for distributions upon
retirement, death or disability or termination of employment. Depending upon the
circumstances, these payments may be made in installments or in a single lump
sum.





MSTI
maintains a defined contribution profit sharing plan for employees (the “MSTI
401(k)”) that is administered by a committee of trustees appointed by the
Company. All Company employees are eligible to participate upon the completion
of three months of employment, subject to minimum age requirements. Each
year the Company makes a contribution to the MSTI 401(k) without regard to
current or accumulated net profits of the Company. These contributions are
allocated to participants in amounts of 100% of the participants’ contributions
up to 1% of each participant’s gross pay, then 10% of the next 5% of each
participant’s gross pay (a higher contribution percentage may be determined at
the Company’s discretion). In addition, the Company makes a one-time, annual
contribution of 3% of each participant’s gross pay to each participant’s
contribution account in the MSTI 401(k) plan. Participants become vested in
equal portions of their Company contribution account for each year of service
until full vesting occurs upon the completion of six years of service.
Distributions are made upon retirement, death or disability in a lump sum or in
installments.




Perquisites





The
Company leases a vehicle for the use of Telkonet's CEO. The lease will
expire in September 2008. Additionally, in the first quarter of 2007 the Company
began providing monthly car allowance stipends to certain executives of
Telkonet, MSTI and Ethostream.





EXECUTIVE
COMPENSATION




The
following table sets forth certain information with respect to compensation for
services in all capacities for the years ended December 31, 2007, 2006 and
2005 paid to our Chief Executive Officer (principal executive officer), Chief
Financial Officer (principal financial officer) and the three other most highly
compensated executive officers who were serving as such as of December 31,
2007.




44




Summary
Compensation Table





Name
      and Principal Position
            Year
            Salary
              ($)
            Bonus
              ($)
            Stock
              Awards
              ($)
            Option
              Awards
              ($)
              (6)(7)(8)
            Non-Equity
              Incentive
      Plan
              Compensation
              ($)
            Change
      in
              Pension
      Value
              and
              Nonqualified
              Deferred
              Compensation
              Earnings
              ($)
            All
      Other
              Compen-sation
              ($)
            Total
              ($)Jason
      Tienor
            2007
            $133,022
            $0
            $0
            $111,230
            $0
            $0
            $6,139
            $250,391President
      and Chief
            2006
            $0
            $0
            $0
            $0
            $0
            $0
            $0
            $0Executive
      Officer (1)
            2005
            $0
            $0
            $0
            $0
            $0
            $0
            $0
            $0Richard
      J. Leimbach
            2007
            $133,491
            $25,000
            $0
            $0
            $0
            $0
            $0
            $158,491
      (9)Chief
      Financial
            2006
            $111,231
            $5,000
            $0
            $0
            $0
            $0
            $0
            $116,231Officer
            2005
            $102,340
            $3,936
            $0
            $156,300
            $0
            $0
            $0
            $262,576Ronald
      W. Pickett
            2007
            $424,075
            $150,000
            $0
            $0
            $0
            $0
            $2,296
            $576,371
      (10)President
      and Chief
            2006
            $245,423
            $0
            $0
            $0
            $0
            $0
            $4,593
            $250,016Executive
      Officer (2)
            2005
            $102,340
            $200,000
            $163,319
      (3)
            $0
            $0
            $0
            $0
            $465,659Dorothy
      E. Cleal
            2007
            $70,154
            $0
            $0
            $55,615
            $0
            $0
            $0
            $125,769Chief
      Operating
            2006
            $0
            $0
            $0
            $0
            $0
            $0
            $0
            $0Officer
      (4)
            2005
            $0
            $0
            $0
            $0
            $0
            $0
            $0
            $0Jeff
      Sobieski
            2007
            $122,003
            $0
            $0
            $0
            $0
            $0
            $6,139
            $128,142Executive
      Vice
            2006
            $0
            $0
            $0
            $0
            $0
            $0
            $0
            $0President
      (5)
            2005
            $0
            $0
            $0
            $0
            $0
            $0
            $0
            $0James
      F. Landry
            2007
            $175,698
            $0
            $0
            $0
            $0
            $0
            $0
            $175,698Chief
      Technology
            2006
            $174,886
            $6,789
            $0
            $0
            $0
            $0
            $0
            $181,675Officer
            2005
            $176,508
            $15,000
            $0
            $0
            $0
            $0
            $0
            $191,508


____________________


(1)
            Mr.
      Tienor was appointed as President and Chief Executive Officer of Telkonet,
      Inc. on December 11, 2007.  Prior to this appointment, Mr.
      Tienor served as Chief Executive Officer of Ethostream, the Company’s
      wholly-owned subsidiary since March 2007, and Chief Operating Officer of
      Telkonet, Inc. since August 20,
2007.


(2)
            Mr.
      Pickett resigned as President and Chief Executive Officer on December 11,
      2007.


(3)
            In
      the year ending December 31, 2005, Mr. Pickett earned 36,000 shares issued
      under the Company’s Employee Stock Incentive Plan as additional
      compensation pursuant to his employment agreement. The fair market value
      of these shares upon issuance was
$163,319.


(4)
            Ms.
      Cleal was appointed as Chief Operating Officer of Telkonet, Inc. on
      December 11, 2007.  Prior to this appointment, Ms. Cleal served
      as Executive Vice President since August 20,
  2007.


(5)
            Mr.
      Sobieski was appointed as Executive Vice President of Telkonet, Inc. on
      December 11, 2007.  Prior to this appointment, Mr. Sobieski
      served as Chief Information Officer of Ethostream, the Company’s
      wholly-owned subsidiary, since March
2007.


(6)
            In
      2005 the following assumptions were used to determine the fair value of
      stock option awards granted: historical volatility of 71% expected option
      life of 5.0 years and a risk-free interest rate of
  4.5%.


(7)
            In
      2006 the following assumptions were used to determine the fair value of
      stock option awards granted: historical volatility of 65% expected option
      life of 5.0 years and a risk-free interest rate of
  5.0%.


(8)
            In
      2007 the following assumptions were used to determine the fair value of
      stock option awards granted: historical volatility of 70% expected option
      life of 5.0 years and a risk-free interest rate of
  4.8%.


(9)
            Mr.
      Leimbach received $8,750 in salary for his services as Vice President
      Finance of MSTI, a position which he has held since July
    2007.


(10)
            Mr.
      Pickett received $34,615 in salary for his services as President of MSTI,
      a position which he has held since May
2007.




45




Employment
Agreements





Jason
Tienor, President and Chief Executive Officer, is employed pursuant to an
employment agreement dated March 15, 2007.  Mr. Tienor’s employment
agreement has a term of three years, which may be extended by mutual agreement
of the parties thereto, and provides for an annual base salary of $148,000 per
year and bonuses and benefits based on Telkonet’s internal
policies.  On August 20, 2007, Mr. Tienor’s annual salary was
increased to $200,000 and he remains eligible to participate in the incentive
and benefit plans pursuant to his existing employment agreement and Telkonet’s
internal policies.





Dorothy
(Dottie) Cleal, Chief Operating Officer, has been employed since August 20, 2007
with an annual salary of $190,000 and bonuses and benefits based upon Telkonet’s
internal policies.  Ms. Cleal does not have a written employment
agreement.





Richard
J. Leimbach, Chief Financial Officer, has been employed by the Company since
January 26, 2004.  Mr. Leimbach’s annual salary was increased from
$130,000 to $190,000 in December 2007 in connection with his appointment as
Chief Financial Officer.  He is also eligible to receive bonuses and
benefits based upon Telkonet’s internal policies.  Mr. Leimbach does
not have a written employment agreement.  In addition, Mr. Leimbach
receives an annual salary of $25,000 for his services as Vice President Finance
of MSTI.





James F.
Landry, Chief Technology Officer, has been employed with the Company since
September 24, 2001. Mr. Landry’s annual salary in 2007 was $176,508 and he is
entitled to receive bonuses and benefits based upon Telkonet’s internal
policies.  Mr. Landry does not have a written employment
agreement.





Jeff
Sobieski, Executive Vice President, Energy Management, is employed pursuant to
an employment agreement, dated March 15, 2007. Mr. Sobieski’s employment
agreement has a term of three years, which may be extended by mutual agreement
of the parties thereto, and provides for a base salary of $148,000 per year and
bonuses and benefits based upon Telkonet’s internal policies.  On
December 11, 2007, Mr. Sobieski’s salary was increased to $190,000 and he
remains eligible to participate in the incentive and benefit plans pursuant to
his existing employment agreement and Telkonet’s internal policies.





Ronald W.
Pickett, President and Chief Executive Officer, was employed pursuant to an
employment agreement for an unspecified term that commenced January 30, 2003. As
of January 1, 2007, Mr. Pickett’s annual salary was $250,000 and he was entitled
to receive bonuses and benefits based upon Telkonet’s internal
policies. On March 19, 2007, Mr. Pickett’s annual base salary was increased
to $425,000, including compensation in the annual amount of $75,000 for his
service as President of MSTI, and he was awarded an incentive bonus of $150,000
for his performance as Chief Executive Officer during the year ended December
31, 2006.  On
December 11, 2007, Mr. Pickett resigned as President and Chief Executive Officer
and on February 13, 2008, the Board of Directors approved a severance
compensation package of $350,000 plus benefits paid through 2008.  In
addition, Mr. Pickett agreed to provide services as Vice Chairman of the Board
of Directors in 2008 for no additional compensation.




In
addition, to the foregoing, stock options are periodically granted to employees
under the Company’s Plan at the discretion of the Compensation Committee of the
Board of Directors. Executives of Telkonet are eligible to receive stock option
grants, based upon individual performance and the performance of Telkonet as a
whole.





GRANT
OF PLAN BASED AWARDS





The
following table sets forth information concerning stock options granted in the
fiscal year ended December 31, 2007, to the persons listed on the Summary
Compensation Table.








Name
            Grant
      Date
            All
      Other
              Option
      Awards:
              Number
      of
              Securities
      Underlying
              Options
      Granted
              (#)
            Exercise
      Price or
              Base
      Price of
              Option
      Awards
              ($/sh)
            Grant
      Date
              Fair
      Value of Stock
              and
      Option AwardsJason
      Tienor
            8/10/2007
            100,000
            $1.80
            $111,230Richard
      J. Leimbach
            n/a
            0
            n/a
            n/aDorothy
      E. Cleal
            8/10/2007
            50,000
            $1.80
            $55,615Jeffrey
      Sobieski
            n/a
            0
            n/a
            n/aJames
      Landry
            n/a
            0
            n/a
            n/a





OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END TABLE





The
following table shows outstanding stock option awards classified as exercisable
and unexercisable as of December 31, 2007 for the named executive officers.
The table also shows unvested and unearned stock awards (both time-based awards
and performance-contingent) assuming a market value of $0.75 a share (the
closing market price of the Company’s stock on December 31,
2007).





46




OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END




Option
      Awards
            Stock
      AwardsName
            Number
      of
              Securities
              Underlying
              Unexercised
              Options
              (#)
              Exerciseable
            Number
      of
              Securities
              Underlying
              Unexercised
              Options
              (#)
              Unexerciseable
            Equity
              Incentive
              Plan
      Awards:
              Number
      of
              Securities
              Underlying
              Unexercised
              Unearned
              Options
              (#)
            Option
              Exercise
              Price
              ($)
            Option
              Expiration
              Date
            Number
      of
              Shares
      or
              Units
      of
              Stock
              That
      Have
              Not
      Vested
              (#)
            Market
              Value
      of
              Shares
      or
              Units
      of
              Stock
      That
              Have
      Not
              Vested
              ($)
            Equity
              Incentive
              Plan
      Awards:
              Number
      of
              Unearned
      Shares, Units
              or
      Other
              Rights
      That
              Have
      Not
              Vested
              (#)
            Equity
              Incentive
              Plan
      Awards:
              Market
      or Payout
              Value
      of Unearned Shares, Units
              or
      Other
              Rights
      That
              Have
      Not
              Vested
              ($)Jason
      Tienor
            5,000
            95,000
            -
            $1.80
            4/23/2012
    (3)
            -
            -
            -
            -Dorothy
      Cleal
            2,500
            47,500
            -
            $1.80
            4/23/2012
      (3)
            -
            -
            -
            -Richard
      J. Leimbach
            60,000
            27,500
            -
            (1)
            4/23/2012
      (3)
            -
            -
            -
            -James
      F.Landry
            450,000
            50,000
            -
            (2)
            4/23/2012
      (3)
            -
            -
            -
            -Jeffrey
      Sobieski
            -
            -
            -
            N/A
            N/A
            -
            -
            -
            -Ronald
      W. Pickett
            -
            -
            -
            N/A
            N/A
            -
            -
            -
            -


_________________





(1)
            Includes
      27,500 and 10,000 vested and unvested options, respectively, exerciseable
      at $2.59, and 32,500 and 17,500 vested and unvested options, respectively,
      exerciseable at $5.08 per share.(2)
            Includes
      250,000 fully vested options, exerciseable at $1.00 per share with
      expiration dates ranging from 12/3/2011 to 7/1/2013 and 200,000 and 50,000
      vested and unvested options, respectively, exerciseable at $3.45 per share
      with an expiration dates of 5/1/2014.(3)
            All
      options granted in accordance with the Telkonet Amended and Restated Stock
      Incentive Plan (the “Plan”) have an outstanding term equal to the shorter
      of ten years, or the expiration of the Plan.  The Plan expires
      on April 24, 2012.





OPTION
EXERCISES AND STOCK VESTED





There
were no options exercised by, or stock awards vested for the account of, the
named executive officers during 2007.




POTENTIAL
PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL




Each of
Mr. Tienor’s and Mr. Sobieski’s Employment Agreement obligate the Company to
continue to pay each executive’s base salary and provide continued participation
in employee benefit plans for the duration of the term of their employment
agreements in the event such executive is terminated without “cause” by the
Company or if the executive terminates his employment for “good reason.” “Cause”
is defined as the occurrence of any of the following: (i) theft, fraud,
embezzlement, or any other act of dishonesty by the executive; (ii) any material
breach by the executive of any provision of the employment agreement which
breach is not cured within a reasonable time (but not to exceed thirty (30) days
after written notification thereof to the executive by Telkonet; (iii) any
habitual neglect of duty or misconduct of the executive in discharging any of
his duties and responsibilities under the employment agreement after a written
demand for performance was delivered to the executive that specifically
identified the manner in which the board believed the executive had failed to
discharge his duties and responsibilities, and the executive failed to resume
substantial performance of such duties and responsibilities on a continuous
basis immediately following such demand; (iv) commission by the executive of a
felony or any offense involving moral turpitude; or (v) any default of the
executive’s obligations under the employment agreement, or any failure or
refusal of the executive to comply with the policies, rules and regulations of
Telkonet generally applicable to Telkonet employees, which default, failure or
refusal is not cured within a reasonable time (but not to exceed thirty (30)
days) after written notification thereof to the executive by Telkonet. If cause
exists for termination, the executive shall be entitled to no further
compensation, except for accrued leave and vacation and except as may be
required by applicable law. “Good reason” is defined as the occurrence of any of
the following: (i) any material adverse reduction in the scope of the
executive’s authority or responsibilities; (ii) any reduction in the amount of
the executive’s compensation or participation in any employee benefits; or (iii)
the executive’s principal place of employment is actually or constructively
moved to any office or other location 50 miles or more outside of Milwaukee,
Wisconsin.




47




In the
event Telkonet fails to renew the employment agreements upon expiration of the
term, then Telkonet shall continue to pay the executive's base salary and
provide the executive with continued participation in each employee benefit plan
in which the executive participated immediately prior to expiration of the term
for a period of three months following expiration of the term. Each of Messrs.
Tienor and Sobieski have agreed to not to compete with the Company or solicit
any Company employees for a period of one year following expiration or earlier
termination of the employment agreements.





Director
Compensation





Telkonet
reimburses non-management directors for costs and expenses in connection with
their attendance and participation at Board of Directors meetings and for other
travel expenses incurred on Telkonet’s behalf. Telkonet compensates each
non-management director $4,000 per month, 10,000 vested stock options per
quarter and $1,000 for each committee meeting of the Board of Directors such
director attends.




Mr. Musser,
as Chairman of the Board of Directors, is compensated $8,333 per month
(consisting of monthly payments in the amount of $4,000, which payments are
consistent with the monthly payments made to the other non-management directors,
and $4,333 per month, which payments are in lieu of the 10,000 vested stock
options per quarter and $1,000 for each committee meeting that the other
non-management directors receive). Payments to Mr. Musser for Board
services are made to The Musser Group pursuant to a consulting agreement
described below under the heading “Certain Relationships and Related
Transactions.”




On July
1, 2005, the Company executed a consulting agreement with Mr. Blumenfeld
pursuant to which Mr. Blumenfeld was issued 10,000 shares of Company common
stock upon execution of the agreement, 10,000 shares of Company common stock per
quarter for the first year (for a total 50,000 shares in the first year) and
5,000 shares of Company stock per quarter thereafter.  Under the terms
of the consulting agreement Mr. Blumenfeld was also entitled to receive a
commission equal to 5% on all international sales generated by him having gross
margins of 50% or more.  This commission was payable in cash or common
stock, at Mr. Blumenfeld’s option.  The agreement had a one year term,
and was renewable annually upon both parties’ agreement. The consulting
agreement expired on June 20, 2006 and was not renewed. On March 16, 2007, the
Board of Directors authorized a payment to Mr. Blumenfeld of $24,000 for Board
service between July 1, 2006, and December 31, 2006, which payments were
commensurate with the payments made to the other directors for Board service
during that time period.  Effective January 1, 2007, Mr. Blumenfeld
began receiving compensation in accordance with the non-management director
compensation plan.





The
following table summarizes all compensation paid to the Company’s directors in
the year ended December 31, 2007.





Name
            
            Fees
              Earned
      or
              Paid
      in
              Cash
              ($)
            
            
            Stock
              Awards
              ($)
            
            
            Option
              Awards
              ($)
            
            
            Non-Equity
              Incentive
      Plan Compensation
              ($)
            
            
            Change
      in
              Pension
      Value
              and
              Nonqualified
              Deferred
      Compensation Earnings
            
            
            All
      Other Compensation
              ($)
            
            
            Total
              ($)Warren
      V. Musser
            
            $
            48,000
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            52,000
            (1)
            
            $
            100,000Thomas
      M. Hall
            
            
            56,000
            
            
            
            -
            
            
            
            60,217
            (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            116,217Thomas
      C. Lynch
            
            
            56,000
            
            
            
            -
            
            
            
            60,217
            (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            116,217James
      L. Peeler
            
            
            52,000
            
            
            
            -
            
            
            
            60,217
            (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            112,217Seth
      D. Blumenfeld
            
            
            67,950
            (3)
            
            
            -
            
            
            
            60,217
            (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            128,167Ronald
      W. Pickett
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Anthony
      J. Paoni
            
            
            37,000
            
            
            
            -
            
            
            
            37,367
            (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            74,367


_________________


(1)
            fees
      for director services performed by Mr. Musser and paid to the Musser Group
      pursuant to a September 2003 consulting
  agreement.


(2)
            Stock
      options granted pursuant to the 2007 non-management director compensation
      plan.


(3)
            Includes
      a payment of $24,000 to Mr. Blumenfeld for his services as a director in
      2006.




48




COMPENSATION
COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION





During
the year ended December 31, 2007, Messrs, Hall, Lynch and Paoni served as
members of the Company’s Compensation Committee. None of the members of the
Compensation Committee was an employee of the Company during the year ended
December 31, 2007 nor has any of them been an officer of the Company. No
executive officer of the Company served during the year ended December 31, 2007
as a member of a compensation committee or as a director of any entity of which
any of the Company’s directors served as an executive officer.




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





The
following table provides information concerning securities authorized for
issuance pursuant to equity compensation plans approved by the Company’s
stockholders and equity compensation plans not approved by the Company’s
stockholders as of December 31, 2007.





Number
      of securities to
              be
      issued upon exercise
              of
      outstanding options,
              warrants
      and rights
            Weighted-average
              exercise
      price of
              outstanding
      options,
              warrants
      and rights
            Number
      of securities
              remaining
      available for
              future
      issuance under equity
              compensation
      plans
              (excluding
      securities
              reflected
      in column (a))(a)
            (b)
            (c)Equity
      compensation plans approved by security holders
            9,421,366
            $1.84
            2,170,423Equity
      compensation plans not approved by security holders
            -
            -
            -Total
            9,421,366
            $1.84
            2,170,423




The
following table sets forth, as of March 1, 2008, the number of shares of the
Company’s common stock beneficially owned by each director and executive officer
of the Company, by all directors and executive officers as a group, and by each
person known by the Company to own beneficially more than 5.0% of the Company’s
outstanding common stock. As of March 1, 2008, there were no issued and
outstanding shares of any other class of the Company’s equity
securities.




Name
      and Address of Beneficial Owner
              Amount
      and Nature of Beneficial Ownership
              Percentage
      of Class5%
      ShareholdersStephen
      L. Sadle
                20374
      Seneca Meadows Parkway
                Germantown,
      MD 20876
              4,254,514(1)
              5.8%Officers
      and DirectorsJason
      Tienor, President and Chief Executive Officer
                20374
      Seneca Meadows Parkway
                Germantown,
      MD 20876
              886,803(2)(3)
              1.2%Dorothy
      Cleal, Chief Operating Officer
                20374
      Seneca Meadows Parkway
                Germantown,
      MD 20876
              10,000(4)
              *




49




Richard
      Leimbach, Chief Financial Officer
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            61,000(5)
            0.1%James
      Landry, Chief Technology Officer
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            484,200(6)
            0.7%Jeffrey
      Sobieski, Executive Vice President
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            876,803(7)
            1.2%Warren
      V. Musser, Chairman
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            2,000,000(8)
            2.7%Ronald
      W. Pickett, Vice Chairman
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            2,537,699
            3.5%Thomas
      C. Lynch, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            170,000(9)
            0.2%Dr.
      Thomas M. Hall, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            707,790(10)
            1.0%James
      L. Peeler, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            154,400(11)
            0.2%Seth
      D. Blumenfeld, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            90,000(12)
            0.1%Anthony
      J. Paoni, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            40,000(13)
            0.1%All
      Directors and Executive Officers as a Group
            8,538,695
            11.2%


_____________________


* Represents less than
      0.1% beneficial ownership of Telkonet common stock as of reporting
      date





(1)
            Includes
      options exercisable within 60 days to purchase 900,000 shares of the
      Company’s common stock at $1.00 per share.(2)
            Includes
      876,803 shares of the Company’s common stock issued to Mr. Tienor in
      conjunction with the Company’s March 2007 acquisition of Ethostream,
      LLC.(3)
            Includes
      options exercisable within 60 days to purchase 10,000 shares of the
      Company’s common stock at $1.80 per share.(4)
            Includes
      options exercisable within 60 days to purchase 5,000 shares of the
      Company’s common stock at $1.80 per share.(5)
            Includes
      options exercisable within 60 days to purchase 27,500 and 32,500 shares of
      the Company’s common stock at $2.59 and $5.08 per share,
      respectively.(6)
            Includes
      options exercisable within 60 days to purchase 250,000 and 200,000 shares
      of the Company’s common stock at $1.00 and $3.45 per share,
      respectively.(7)
            Includes
      876,803 shares of the Company’s common stock issued to Mr. Sobieski in
      conjunction with the Company’s March 2007 acquisition of Ethostream,
      LLC.(8)
            Includes
      options exercisable within 60 days to purchase 2,000,000 shares of the
      Company’s common stock at $1.00 per share.(9)
            Includes
      options exercisable within 60 days to purchase 20,000, 70,000 and 80,000
      shares of the Company’s common stock at $2.00, $2.66 and $3.45 per share,
      respectively.(10)
            Includes
      options exercisable within 60 days to purchase 70,000 and 80,000 shares of
      the Company’s common stock at $2.66 and $3.45 per share,
      respectively.(11)
            Includes
      options exercisable within 60 days to purchase 70,000 and 80,000 shares of
      the Company’s common stock at $2.66 and $3.45 per share,
      respectively.(12)
            Includes
      options exercisable within 60 days to purchase 40,000 shares of the
      Company’s common stock at $2.66 per share.(13)
            Includes
      options exercisable within 60 days to purchase 40,000 shares of the
      Company’s common stock at $2.30 per
share.





50





ITEM
13.CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE





Description
of Related Party Transactions





In
September 2003, the Company entered into a consulting agreement (renewable
annually) with The Musser Group to compensate Mr. Musser in the amount of
$100,000 per year for his services to the Company as a director. Mr. Musser,
Chairman of the Board of Directors, is the sole principal and owner of The
Musser Group.  For the years ended December 31, 2007, 2006, and 2005, the
Company paid and expensed $100,000, $100,000 and $100,000,
respectively.





In
February 2007, the Company entered into a one-year professional services
agreement with Global Transport Logistics, Inc. (“GTI”), for the provision of
consulting services for which GTI is paid a fee of $10,000 per month. GTI is 50%
owned by Anthony Matarazzo, the brother of MSTI’s Chief Executive
Officer.





The Chief
Administrative Officer at MSTI, Laura Matarazzo, is the sister of the Chief
Executive Officer of MSTI and receives an annual base salary of approximately
$134,000 with bonuses and benefits based upon the Company’s internal
policies.





Company’s
Policies on Related Party Transactions





Under the
Company’s policies and procedures, related-party transactions that must be
publicly disclosed under the federal securities laws require prior approval
of the Company’s independent directors without the participation of
any director who may have a direct or indirect interest in the transaction in
question. Related parties include directors, nominees for director, principal
shareholders, executive officers and members of their immediate families. For
these purposes, a “transaction” includes all financial transactions,
arrangements or relationships, ranging from extending credit to the provision of
goods and services for value and includes any transaction with a company in
which a director, executive officer immediate family member of a director or
executive officer, or principal shareholder (that is, any person who
beneficially owns five percent or more of any class of the Company’s voting
securities) has an interest by virtue of a 10-percent-or-greater equity
interest. The Company’s policies and procedures regarding related-party
transactions are not a part of a formal written policy, but rather, represent
the Company’s historical course of practice with respect to approval of
related-party transactions.





Director
Independence





The Board
of Directors has determined that the following Directors are “independent” under
the listing standards of the American Stock Exchange (AMEX): Dr. Hall,
Mr. Lynch, Mr. Peeler and Mr. Paoni. Each of Dr. Hall, Mr. Peeler and Mr.
Lynch serve on, and are the only members of, the Company’s Audit Committee. Each
of Dr. Hall, Mr. Lynch and Mr. Paoni serve on, and are the only members of, the
Company’s Compensation Committee.  Although Telkonet does not maintain
a standing Nominating Committee, nominees for election as directors are
considered and nominated by a majority of Telkonet’s independent directors in
accordance with the AMEX listing standards. “Independence” for these purposes is
determined in accordance with Section 121(A) of the AMEX Rules and Rule
10A-3 under the Securities Exchange Act of 1934.





ITEM
14.PRINCIPAL
ACCOUNTANT FEES AND SERVICES.





The
following table sets forth fees billed to the Company by our auditors during the
fiscal years ended December 31, 2007 and 2006.




51




December
      31,
              2007
            
            December
      31,
              20061.
      Audit Fees
            $
            379,828
            
            $
            229,5522.
      Audit Related Fees
            
            136,525
            
            
            52,6003.
      Tax Fees
            
            --
            
            
            --4.
      All Other Fees
            
            --
            
            
            --Total
      Fees
            $
            516,353
            
            $
            282,152





Audit
fees consist of fees billed for professional services rendered for the audit of
the Company’s consolidated financial statements and review of the interim
consolidated financial statements included in quarterly reports and services
that are normally provided by RBSM LLP in connection with statutory and
regulatory filings or engagements.





Audit-related
fees consists of fees billed for assurance and related services that are
reasonably related to the performance of the audit or review of the Company’s
consolidated financial statements, which are not reported under “Audit
Fees.”





Tax fees
consist of fees billed for professional services for tax compliance, tax advice
and tax planning. The tax fees relate to federal and state income tax reporting
requirements.





All other
fees consist of fees for products and services other than the services reported
above.





Prior to
the Company’s engagement of its independent auditor, such engagement is approved
by the Company’s audit committee. The services provided under this engagement
may include audit services, audit-related services, tax services and other
services. Pre-approval is generally provided for up to one year and any
pre-approval is detailed as to the particular service or category of services
and is generally subject to a specific budget. Pursuant to the Company’s Audit
Committee Charter, the independent auditors and management are required to
report to the Company’s audit committee at least quarterly regarding the extent
of services provided by the independent auditors in accordance with this
pre-approval, and the fees for the services performed to date. The audit
committee may also pre-approve particular services on a case-by-case basis. All
audit fees, audit-related fees, tax fees and other fees incurred by the Company
for the year ended December 31, 2007, were approved by the Company’s audit
committee.





PART
IV





ITEM
15.EXHIBITS AND
FINANCIAL STATEMENT SCHEDULES.




The
following table sets forth selected unaudited quarterly information for the
Company’s year-ended December 31, 2007 and 2006.





QUARTERLY
FINANCIAL DATA


(unaudited)





March
      31,
              2007
            
            
            June
      30,
              2007
            
            
            September
      30,
              2007
            
            
            December
      31,
              2007Net
      Revenue
            
            $
            1,246,269
            
            
            $
            3,666,607
            
            
            $
            4,588,777
            
            
            $
            4,651,081Gross
      Profit
            
            $
            (70,192
            )
            
            $
            670,718
            
            
            $
            1,219,758
            
            
            $
            661,854Provision
      for income taxes
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Net
      loss per share -- basic
            
            $
            (0.09
            )
            
            $
            (0.07
            )
            
            $
            (0.07
            )
            
            $
            (0.08
            )Net
      loss per share -- diluted
            
            $
            (0.09
            )
            
            $
            (0.07
            )
            
            $
            (0.07
            )
            
            $
            (0.08
            )March
      31,
              2006
            
            
            June
      30,
              2006
            
            
            September
      30,
              2006
            
            
            December
      31,
              2006Net
      Revenue
            
            $
            1,943,912
            
            
            $
            1,152,470
            
            
            $
            1,143,097
            
            
            $
            941,848Gross
      Profit
            
            $
            648,342
            
            
            $
            139,628
            
            
            $
            83,049
            
            
            $
            (170,350
            )Provision
      for income taxes
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Net
      loss per share -- basic
            
            $
            (0.09
            )
            
            $
            (0.16
            )
            
            $
            (0.20
            )
            
            $
            (0.08
            )Net
      loss per share -- diluted
            
            $
            (0.09
            )
            
            $
            (0.16
            )
            
            $
            (0.20
            )
            
            $
            (0.08
            )




52




The
following table sets forth selected unaudited valuation and qualifying account
information for the Company’s year-ended December 31, 2007, 2006 and
2005.




SCHEDULE
II- VALUATION AND QUALIFYING ACCOUNTS


(unaudited)





DESCRIPTION
            
            BALANCE
              BEGINNING
              OF
      YEAR
            
            
            CHARGED
              TO
      COSTS
              AND
              EXPENSES
            
            
            DEDUCTIONS
            
            
            BALANCE,
              END
      OF
              YEARAllowance
      for doubtful accounts:Year
      ended December 31,2007
            
            $
            60,000
            
            
            $
            366,495
            
            
            $
            (314,538
            )
            
            $
            111,9572006
            
            
            30,000
            
            
            
            36,659
            
            
            
            (6,659
            )
            
            
            60,0002005
            
            
            13,000
            
            
            
            39,710
            
            
            
            (22,710
            )
            
            
            30,000Reserve
      for product returns:Year
      ended December 31,2007
            
            $
            47,300
            
            
            $
            83,901
            
            
            $
            (28,667
            )
            
            $
            102,5342006
            
            
            24,000
            
            
            
            23,300
            
            
            
            —
            
            
            
            47,3002005
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —




53


The
following exhibits are included herein or incorporated by
reference:





Exhibit
      Number
            Description
      Of Document2.1
            MST
      Stock Purchase Agreement and Amendment (incorporated by reference to our
      8-K filed on February 2, 2006)2.2
            Asset
      Purchase Agreement by and between Telkonet, Inc. and Smart Systems
      International, dated as of February 23, 2007 (incorporated by reference to
      our Form 8-K filed on March 2, 2007)2.3
            Unit
      Purchase Agreement by and among Telkonet, Inc., Ethostream, LLC and the
      members of Ethostream, LLC dated as of March 15, 2007 (incorporated by
      reference to our Form 8-K filed on March 16, 2007)3.1
            Articles
      of Incorporation of the Registrant (incorporated by reference to our Form
      8-K (No. 000-27305), filed on August 30, 2000 and our Form S-8 (No.
      333-47986), filed on October 16, 2000)3.2
            Bylaws
      of the Registrant (incorporated by reference to our Registration Statement
      on Form S-1 (No. 333-108307), filed on August 28, 2003)4.1
            Form
      of Series A Convertible Debenture (incorporated by reference to our Form
      10-KSB (No. 000-27305), filed on March 31, 2003)4.2
            Form
      of Series A Non-Detachable Warrant (incorporated by reference to our Form
      10- KSB (No. 000-27305), filed on March 31, 2003)4.3
            Form
      of Series B Convertible Debenture (incorporated by reference to our Form
      10-KSB (No. 000-27305), filed on March 31, 2003)4.4
            Form
      of Series B Non-Detachable Warrant (incorporated by reference to our Form
      10-KSB (No. 000-27305), filed on March 31, 2003)4.5
            Form
      of Senior Note (incorporated by reference to our Registration Statement on
      Form S-1 (No. 333-108307), filed on August 28, 2003)4.6
            Form
      of Non-Detachable Senior Note Warrant (incorporated by reference to our
      Registration Statement on Form S-1 (No. 333-108307), filed on August 28,
      2003)4.7
            Senior
      Convertible Note by Telkonet, Inc. in favor of Portside Growth &
      Opportunity Fund (incorporated by reference to our Form 8-K (No.
      001-31972), filed on October 31, 2005)4.8
            Senior
      Convertible Note by Telkonet, Inc. in favor of Kings Road Investments Ltd.
      (incorporated by reference to our Form 8-K (No. 001-31972), filed on
      October 31, 2005)4.11
            Warrant
      to Purchase Common Stock by Telkonet, Inc. in favor of Portside Growth
      & Opportunity Fund (incorporated by reference to our Form 8-K (No.
      001-31972), filed on October 31, 2005)4.12
            Warrant
      to Purchase Common Stock by Telkonet, Inc. in favor of Kings Road
      Investments Ltd. (incorporated by reference to our Form 8-K (No.
      001-31972), filed on October 31, 2005)4.13
            Form
      of Warrant to Purchase Common Stock (incorporated by reference to our
      Current Report on Form 8-K (No. 001-31972), filed on September 6,
      2006)4.14
            Form
      of Accelerated Payment Option Warrant to Purchase Common Stock
      (incorporated by reference to our Registration Statement on Form S-3 (No.
      333-137703), filed on September 29, 2006.4.15
            Form
      of Warrant to Purchase Common Stock (incorporated by reference to our
      Current Report on Form 8-K filed on February 5,
  2007)10.1
            Amended
      and Restated Telkonet, Inc. Incentive Stock Option Plan (incorporated by
      reference to our Registration Statement on Form S-8 (No. 333-412), filed
      on April 17, 2002)10.2
            Employment
      Agreement by and between Telkonet, Inc. and Stephen L. Sadle, dated as of
      January 18, 2003 (incorporated by reference to our Registration Statement
      on Form S-1 (No. 333-108307), filed on August 28, 200310.3
            Employment
      Agreement by and between Telkonet, Inc. and Robert P. Crabb, dated as of
      January 18, 2003 (incorporated by reference to our Registration Statement
      on Form S-1 (No. 333-108307), filed on August 28, 2003)10.4
            Employment
      Agreement by and between Telkonet, Inc. and Ronald W. Pickett, dated as of
      January 30, 2003 (incorporated by reference to our Registration Statement
      on Form S-1 (No. 333-108307), filed on August 28, 2003)10.5
            Registration
      Rights Agreement by and among Telkonet, Inc., Kings Road Investments Ltd.
      and Portside Growth & Opportunity Fund, dated October 27, 2005
      (incorporated by reference to our Form 8-K (No. 001-31972), filed on
      October 31, 2005)10.6
            Professional
      Services Agreement by and between Telkonet, Inc. and Seth D. Blumenfeld,
      dated July 1, 2005 (incorporated by reference to our Form 10-Q (No.
      000-27305), filed on November 9,
2005.




54




10.7
            Employment
      Agreement by and between Telkonet, Inc. and Frank T. Matarazzo, dated as
      of February 1, 2006 (incorporated by reference to our Form 10-K (No.
      001-31972), filed March 16, 2006)10.9
            Settlement
      Agreement by and among Telkonet, Inc. and Kings Road Investments Ltd.,
      dated as of August 14, 2006 (incorporated by reference to our Form 8-K
      (No. 001-31972), filed on August 16, 2006)10.10
            Settlement
      Agreement by and among Telkonet, Inc. and Portside Growth &
      Opportunity Fund, dated as of August 14, 2006 (incorporated by reference
      to our Form 8-K (No. 001-31972), filed on August 16,
  2006)10.11
            Securities
      Purchase Agreement, dated August 31, 2006, by and among Telkonet, Inc.,
      Enable Growth Partners LP, Enable Opportunity Partners LP and Pierce
      Diversified Strategy Master Fund LLC, Ena (incorporated by reference to
      our Form 8-K (No. 001-31972), filed on September 6,
    2006)10.12
            Registration
      Rights Agreement, dated August 31, 2006, by and among Telkonet, Inc.,
      Enable Growth Partners LP, Enable Opportunity Partners LP and Pierce
      Diversified Strategy Master Fund LLC, Ena (incorporated by reference to
      our Form 8-K (No. 001-31972), filed on September 6,
    2006)10.13
            Securities
      Purchase Agreement, dated February 1, 2007, by and among Telkonet, Inc.,
      Enable Growth Partners LP, Enable Opportunity Partners LP, Pierce
      Diversified Strategy Master Fund LLC, Ena, Hudson Bay Fund LP and Hudson
      Bay Overseas Fund, Ltd. (incorporated by reference to our Current Report
      on Form 8-K filed on February 5, 2007)10.14
            Registration
      Rights Agreement, dated February 1, 2007, by and among Telkonet, Inc.,
      Enable Growth Partners LP, Enable Opportunity Partners LP and Pierce
      Diversified Strategy Master Fund LLC, Ena, Hudson Bay Fund LP and Hudson
      Bay Overseas Fund, Ltd. (incorporated by reference to our Current Report
      on Form 8-K filed on February 5, 2007)10.15
            Employment
      Agreement by and between Telkonet, Inc. and William Dukes, dated as of
      March 9, 2007 (incorporated by reference to our Form 10-K (No. 001-31972),
      filed March 16, 2007)10.16
            Employment
      Agreement by and between Telkonet, Inc. and Robert Zirpoli, dated as of
      March 9, 2007 (incorporated by reference to our Form 10-K (No. 001-31972),
      filed March 16, 2007)10.17
            Employment
      Agreement by and between Telkonet, Inc. and Jason Tienor, dated as of
      March 15, 2007 (incorporated by reference to our Form 10-K (No.
      001-31972), filed March 16, 2007)10.18
            Employment
      Agreement by and between Telkonet, Inc. and Jeff Sobieski, dated as of
      March 15, 2007 (incorporated by reference to our Form 10-K (No.
      001-31972), filed March 16, 2007)14
            Code
      of Ethics (incorporated by reference to our Form 10-KSB (No. 001-31972),
      filed on March 30, 2004).21
            Telkonet,
      Inc. Subsidiaries23
            Consent
      of RBSM LLP , Independent Registered Certified Public Accounting Firm,
      filed herewith24
            Power
      of Attorney (incorporated by reference to our Registration Statement on
      Form S-1 (No. 333-108307), filed on August 28, 2003)31.1
            Certification
      Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Jason
      Tienor31.2
            Certification
      Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Richard J.
      Leimbach32.1
            Certification
      of Jason Tienor pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
      Section 906 of the Sarbanes-Oxley Act of 200232.2
            Certification
      of Richard J. Leimbach pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002




55





SIGNATURES





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




TELKONET,
      INC.
              
              /s/ Jason
      Tienor
              Jason
      Tienor
              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.





Name
            Position
            Date/s/ Jason
      Tienor
              Jason
      Tienor
            Chief
      Executive Officer
              (principal
      executive officer)
            April
      1, 2008/s/ Richard J.
      Leimbach
              Richard
      J. Leimbach
            Chief
      Financial Officer
              (principal
      financial officer)
              (principal
      accounting officer)
            April
      1, 2008/s/ Warren V.
      Musser
              Warren
      V. Musser
            Chairman
      of the Board
            April
      1, 2008/s/ Ronald
      W.  Pickett
              Ronald
      W.  Pickett
            Vice
      Chairman of the Board
            April
      1, 2008/s/ Anthony J.
      Paoni
              Anthony
      J. Paoni
            Director
            April
      1, 2008/s/ Dr. Thomas M.
      Hall
              Dr. Thomas M. Hall
            Director
            April
      1, 2008/s/ James L.
      Peeler
              James L. Peeler
            Director
            April
      1, 2008/s/ Seth D.
      Blumenfeld
              Seth D. Blumenfeld
            Director
            April
      1, 2008/s/ Thomas C.
      Lynch
              Thomas
      C. Lynch
            Director
            April
      1, 2008




56




SECURITIES
AND EXCHANGE COMMISSION
 
 WASHINGTON,
D.C. 20549
 
  FINANCIAL
STATEMENTS AND SCHEDULES
 
 DECEMBER
31, 2007 AND 2006
 
  FORMING
A PART OF ANNUAL REPORT
 PURSUANT
TO THE SECURITIES EXCHANGE ACT OF 1934
 
 
 TELKONET,
INC.
  F-1
  TELKONET,
INC.
 
 Index
to Financial Statements
 
 Report
      of Independent Registered Certified Public Accounting Firm
              F-3Consolidated
      Balance Sheets at December 31, 2007 and 2006
              F-4Consolidated
      Statements of Losses for the Years ended December 31, 2007, 2006 and
      2005
              F-5Consolidated
      Statements of Stockholders’ Equity for the Years ended December 31, 2007,
      2006 and 2005
              F-6Consolidated
      Statements of Cash Flows for the Years ended December 31, 2007, 2006 and
      2005
              F-9Notes
      to Consolidated Financial Statements
              F-11
   F-2
  RBSM
LLP
 CERTIFIED
PUBLIC ACCOUNTANTS
 
 REPORT OF INDEPENDENT
REGISTERED CERTIFIED PUBLIC ACCOUNTING FIRM
 
 Board of
Directors
 Telkonet,
Inc.
 Germantown,
MD
  We have
audited the accompanying consolidated balance sheets of Telkonet, Inc. and its
subsidiaries (the "Company") as of December 31, 2007 and 2006 and the related
consolidated statements of losses, stockholders' equity, and cash flows for each
of the three years in the period ended December 31, 2007. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based upon
our audit.
 
 We
conducted our audits in accordance with standards of the Public Company
Accounting Oversight Board (United States of America). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatements. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe 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 Telkonet, Inc. and its
subsidiaries as of December 31, 2007 and 2006, and the results of its operations
and its cash flows for each of the three years in the period ended
December 31, 2007, in conformity with accounting principles generally
accepted in the United States of America.
 As
discussed in Note 1 to the consolidated financial statements, the Company
adopted the provisions of Statement of Financial Accounting Standards No.
123(R), "Share-Based Payment", effective January 1, 2006.
 The
accompanying consolidated financial statements have been prepared assuming the
Company will continue as a going concern. As discussed in the Note A to the
accompanying financial statements, the Company has incurred significant
operating losses in current year and also in the past. These factors, among
others, raise substantial doubt about the Company's ability to continue as a
going concern. The financial statements do not include any adjustments that
might result from the outcome of this uncertainty.
  We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of the Company’s internal
control over financial reporting as of December 31, 2007, based on the
criteria established inInternal
Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission and our report dated March 31, 2008
express an unqualified opinion on the effectiveness of the Company’s internal
control over financial reporting.
 
 /s/ RBSM
      LLPCertified
      Public Accountants
  McLean,
Virginia
 March 31,
2008
  F-3
 TELKONET,
INC.
 CONSOLIDATED
BALANCE SHEETS
 DECEMBER
31, 2007 AND 2006
  ASSETS
              2007
              
              
              2006Current
      assets:Cash
      and cash equivalents
              
              $
              1,629,583
              
              
              $
              1,644,037Accounts
      receivable, net of allowance for doubtful accounts of $111,957and
      $60,000 at December 31, 2007 and 2006,respectively
              
              
              2,134,978
              
              
              
              295,116Investment
      in Sales Type Leases    (Note T)
              
              
              16,501
              
              
              
              -Income
      tax receivable (Note L)
              
              
              -
              
              
              
              291,000Inventories
      (Note D)
              
              
              2,578,084
              
              
              
              1,306,593Prepaid
      expenses and deposits
              
              
              645,022
              
              
              
              229,333Total
      current assets
              
              
              7,004,168
              
              
              
              3,766,079Property and equipment, at
      cost (Note E):Furniture
      and equipment
              
              
              1,660,493
              
              
              
              1,370,780Less:
      accumulated depreciation
              
              
              809,915
              
              
              
              577,759Total
      property and equipment, net
              
              
              850,578
              
              
              
              793,021Equipment under operating
      leases, at cost (Note F):Telecommunications
      and related equipment, at cost
              
              
              313,941
              
              
              
              471,207Less:
      accumulated depreciation
              
              
              243,894
              
              
              
              225,346Total
      equipment under operating leases, net
              
              
              70,047
              
              
              
              245,861Cable and related
      equipment (Note G):Telecommunications
      and related equipment, at cost
              
              
              5,764,645
              
              
              
              3,555,049Less:
      accumulated depreciation
              
              
              1,537,862
              
              
              
              343,376Total
      equipment under operating leases, net
              
              
              4,226,783
              
              
              
              3,211,673Other
      assets:Long-term
      investments (Note H)
              
              
              4,603,970
              
              
              
              193,847Intangible
      assets, net of accumulated amortization of $895,085 and $282,325 atDecember
      31, 2007 and December 31, 2006, respectively (Note B and
      C)
              
              
              6,449,029
              
              
              
              2,181,602Financing
      Costs, net of accumulated amortization and write-off of $168,353 and
      $1,219,410 at December 31, 2007 and 2006, respectively (Note
      I)
              
              
              697,461
              
              
              
              -Investment
      in Sales Type Leases  (Note T)
              
              
              11,169
              
              
              
              -Goodwill
      (Note B and C)
              
              
              14,670,455
              
              
              
              1,977,768Deposits
              
              
              157,685
              
              
              
              146,665Total
      other assets
              
              
              26,589,769
              
              
              
              4,499,882Total
    Assets
              
              $
              38,741,345
              
              
              $
              12,516,516LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable and accrued liabilities (Note P)
              
              $
              7,354,177
              
              
              $
              2,865,144Note
      Payable - officer (Note L)
              
              
              -
              
              
              
              80,444Income
      tax refund due to officer (Note L)
              
              
              291,000
              
              
              
              291,000Note
      payable in connection with subsidiary acquisition (Note B)
              
              
              -
              
              
              
              900,000Senior
      note payable, net of debt discounts (Note I)
              
              
              1,470,820
              
              
              
              -Registration
      Rights Liability (Note I)
              
              
              500,000
              
              
              
              -Deferred
      revenue
              
              
              250,613
              
              
              
              160,125Customer
      deposits and other
              
              
              128,222
              
              
              
              -Total
      current liabilities
              
              
              9,994,832
              
              
              
              4,296,713Long-term
      liabilities:Convertible
      debentures, net of debt discounts (Note I)
              
              
              4,432,342
              
              
              
              -Deferred
      revenue
              
              
              8,436
              
              
              
              42,019Deferred
      lease liability and other
              
              
              58,676
              
              
              
              42,561Total
      long-term liabilities
              
              
              4,499,454
              
              
              
              84,580Commitments and
      contingencies (Note Q)
              
              
              -
              
              
              
              -Minority interest (Note
      R)
              
              
              2,978,918
              
              
              
              -Stockholders’ equity
      (Note J)Preferred
      stock, par value $.001 per share; 15,000,000 shares
      authorized;
                none issued and outstanding at December 31, 2007 and 2006
              
              
              -
              
              
              
              -Common
      stock, par value $.001 per share; 100,000,000 shares authorized;
      70,826,544 and
                56,992,301 shares issued and outstanding at December 31, 2007 and 2006,
      respectively
              
              
              70,827
              
              
              
              56,992Additional
      paid-in-capital
              
              
              112,013,093
              
              
              
              78,502,900Accumulated
      deficit
              
              
              (90,815,779
              )
              
              
              (70,424,669
              )Stockholders’
      equity
              
              
              21,268,141
              
              
              
              8,135,223Total
      Liabilities and Stockholders’ Equity
              
              $
              38,741,345
              
              
              $
              12,516,516
  See
accompanying notes to consolidated financial statements
 F-4
  TELKONET,
INC.
 CONSOLIDATED
STATEMENTS OF LOSSES
 FOR
THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
  2007
              
              
              2006
              
              
              2005Revenues,
      net:Product
              
              $
              9,168,077
              
              
              $
              3,092,967
              
              
              $
              1,769,727Rental
              
              
              4,984,656
              
              
              
              2,088,361
              
              
              
              718,596Total
      Revenue
              
              
              14,152,733
              
              
              
              5,181,328
              
              
              
              2,488,323Cost
      of Sales:Product
              
              
              7,165,120
              
              
              
              2,062,399
              
              
              
              1,183,574Rental
              
              
              4,505,476
              
              
              
              2,418,260
              
              
              
              533,605Total
      Cost of Sales
              
              
              11,670,596
              
              
              
              4,480,659
              
              
              
              1,717,179Gross
      Profit
              
              
              2,482,137
              
              
              
              700,669
              
              
              
              771,144Operating
      Expenses:Research
      and Development (Note A)
              
              
              2,349,690
              
              
              
              1,925,746
              
              
              
              2,096,104Selling,
      General and Administrative
              
              
              17,897,974
              
              
              
              14,346,364
              
              
              
              12,041,661Impairment
      Write-Down in Goodwill of Subsidiary (Note C)
              
              
              1,977,768
              
              
              
              -
              
              
              
              -Impairment
      Write-Down in Long Lived Assets of Subsidiary (Note G)
              
              
              493,512
              
              
              
              -
              
              
              
              -Impairment
      Write-Down in Investment in Affiliate (Note H)
              
              
              -
              
              
              
              92,000
              
              
              
              400,000Non-Employee
      Stock Based Compensation
              
              
              470,220
              
              
              
              277,344
              
              
              
              1,354,219Non-Employee
      Stock Based Compensation of Subsidiary
              
              
              337,500
              
              
              
              -
              
              
              
              -Employee
      Stock Based Compensation (Note K)
              
              
              1,225,626
              
              
              
              1,080,895
              
              
              
              -Employee
      Stock Based Compensation of Subsidiary
              
              
              308,634
              
              
              
              -
              
              
              
              -Depreciation
      and Amortization
              
              
              878,766
              
              
              
              540,906
              
              
              
              185,928Total
      Operating Expenses
              
              
              25,939,690
              
              
              
              18,263,255
              
              
              
              16,077,912Loss
      from Operations
              
              
              (23,457,553
              )
              
              
              (17,562,586
              )
              
              
              (15,306,768
              )Other
      Income (Expenses):Gain
      on Sale of Investment in Affiliate (Note H)
              
              
              1,868,956
              
              
              
              -
              
              
              
              -Registration
      Rights Liquidated Damages of Subsidiary (Note I)
              
              
              (500,000
              )
              
              
              -
              
              
              
              -Loss
      on Early Extinguishment of Debt (Note I)
              
              
              -
              
              
              
              (4,626,679
              )
              
              
              -Other
      Income (Note I)
              
              
              -
              
              
              
              -
              
              
              
              8,600Interest
      Income
              
              
              116,043
              
              
              
              327,184
              
              
              
              166,070Interest
      Expense
              
              
              (1,328,624
              )
              
              
              (5,594,604
              )
              
              
              (
      646,183
              )Total
      Other Income (Expenses)
              
              
              156,375
              
              
              
              (9,894,099
              )
              
              
              (471,513
              )Loss
      Before Provision for Income Taxes
              
              
              (23,301,178
              )
              
              
              (27,456,685
              )
              
              
              (15,778,281
              )Minority
      interest (Note R)
              
              
              2,910,068
              
              
              
              19,569
              
              
              
              -Provision
      for Income Tax (Note N)
              
              
              -
              
              
              
              -
              
              
              
              -Net
      (Loss)
              
              $
              (20,391,110
              )
              
              $
              (27,437,116
              )
              
              $
              (15,778,281
              )Loss
      per common share (basic and assuming dilution) (Note O)
              
              $
              (0.31
              )
              
              $
              (0.54
              )
              
              $
              (0.35
              )Weighted
      average common shares outstanding
              
              
              65,414,875
              
              
              
              50,823,652
              
              
              
              44,743,223
 
  See
accompanying notes to consolidated financial statements
 F-5
  TELKONET,
INC.
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)
 FOR
THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
  Preferred
      Shares
              
              Preferred
                Stock
                Amount
              
              Common
      Shares
              
              Common
                Stock
                Amount
              
              Additional
                Paid
      in
                Capital
              
              
              Accumulated
      Deficit
              
              
              TotalBalance
      at January 1, 2005
              -
              
              $
              -
              
              44,335,989
              
              $
              44,336
              
              $
              40,811,208
              
              
              $
              (27,209,272
              )
              
              $
              13,646,272Shares
      issued for employee stock options exercised at approximately $1.19 per
      share
              -
              
              
              -
              
              415,989
              
              
              416
              
              
              496,077
              
              
              
              -
              
              
              
              496,493Shares
      issued in exchange for non-employee options exercised at approximately
      $2.07 per share
              -
              
              
              -
              
              172,395
              
              
              172
              
              
              355,973
              
              
              
              -
              
              
              
              356,145Shares
      issued to noteholders for warrants exercised at $1.00 per
      share
              -
              
              
              -
              
              321,900
              
              
              322
              
              
              321,578
              
              
              
              -
              
              
              
              321,900Shares
      issued to noteholders for cashless warrants exercised
              -
              
              
              -
              
              36,150
              
              
              36
              
              
              (36
              )
              
              
              -
              
              
              
              -Shares
      issued to an employee in exchange for services at approximately $4.65 per
      share
              -
              
              
              -
              
              36,000
              
              
              36
              
              
              163,283
              
              
              
              -
              
              
              
              163,319Shares
      issued to director in exchange for services rendered at approximately
      $4.26 per share
              -
              
              
              -
              
              30,000
              
              
              30
              
              
              127,766
              
              
              
              -
              
              
              
              127,796Shares
      issued to consultants in exchange for services rendered at approximately
      $4.28 per share
              -
              
              
              -
              
              1,968
              
              
              2
              
              
              9,000
              
              
              
              -
              
              
              
              9,002Shares
      issued in exchange for convertible debentures at $0.55 per
      share
              -
              
              
              -
              
              363,636
              
              
              364
              
              
              199,636
              
              
              
              -
              
              
              
              200,000Shares
      issued in exchange for interest expense on convertible
      debentures
              -
              
              
              -
              
              51,144
              
              
              51
              
              
              28,080
              
              
              
              -
              
              
              
              28,131Beneficial
      conversion feature of convertible debentures (Note I)
              -
              
              
              -
              
              -
              
              
              -
              
              
              1,479,300
              
              
              
              -
              
              
              
              1,479,300Value
      of warrants attached to convertible debentures
                (Note
      I)
              -
              
              
              -
              
              -
              
              
              -
              
              
              2,910,700
              
              
              
              -
              
              
              
              2,910,700Stock
      options and warrants granted to consultants in exchange for services
      rendered
              -
              
              
              -
              
              -
              
              
              -
              
              
              1,354,219
              
              
              
              -
              
              
              
              1,354,219Net
      loss
              -
              
              
              -
              
              -
              
              
              -
              
              
              -
              
              
              
              (15,778,281
              )
              
              
              (15,778,281
              )Balance
      at December 31, 2005
              -
              
              $
              -
              
              45,765,171
              
              $
              45,765
              
              $
              48,256,784
              
              
              $
              (42,987,553
              )
              
              $
              5,314,996
   See
accompanying footnotes to consolidated financial statements
 F-6
  TELKONET,
INC.
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)
 FOR
THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
  Preferred
                Shares
              
              Preferred
      Stock
                Amount
              
              Common
      Shares
              
              Common
                Stock
                Amount
              
              Additional
                Paid
      in
                Capital
              
              Accumulated
      Deficit
              
              
              TotalBalance
      at January 1, 2006
              
              
              -
              
              -
              
              45,765,171
              
              
              45,765
              
              
              48,256,784
              
              
              (42,987,553
              )
              
              
              5,314,996Shares
      issued for employee stock options exercised at approximately $1.36 per
      share
              
              
              -
              
              -
              
              2,051,399
              
              
              2,051
              
              
              2,656,774
              
              
              -
              
              
              
              2,658,825Shares
      issued in exchange for non-employee options exercised at $1.00 per
      share
              
              
              -
              
              -
              
              25,837
              
              
              26
              
              
              25,811
              
              
              -
              
              
              
              25,837Shares
      issued in exchange for warrants exercised at $1.15 per
    share
              
              
              -
              
              -
              
              47,750
              
              
              48
              
              
              55,090
              
              
              -
              
              
              
              55,138Issuance
      of shares for purchase of subsidiary (Note B)
              
              
              -
              
              -
              
              600,000
              
              
              600
              
              
              2,699,400
              
              
              -
              
              
              
              2,700,000Shares
      issued in exchange for services rendered at approximately $3.87 per
      share
              
              
              -
              
              -
              
              52,420
              
              
              52
              
              
              202,974
              
              
              -
              
              
              
              203,026Shares
      issued in exchange for convertible debentures, interest expense and
      penalty at approximately $2.36 per share (Note I)
              
              
              -
              
              -
              
              6,049,724
              
              
              6,050
              
              
              14,249,979
              
              
              -
              
              
              
              14,256,029Shares
      issued for cash in connection with a private placement, shares issued at
      $2.50 per share
              
              
              -
              
              -
              
              2,400,000
              
              
              2,400
              
              
              5,997,600
              
              
              -
              
              
              
              6,000,000Value
      of additional warrants issued in conjunction with exchange of convertible
      debentures (Note I)
              
              
              -
              
              -
              
              -
              
              
              -
              
              
              3,000,249
              
              
              -
              
              
              
              3,000,249Stock-based
      compensation expense related to employee stock options (Note
      K)
              
              
              -
              
              -
              
              -
              
              
              -
              
              
              1,080,895
              
              
              -
              
              
              
              1,080,895Stock
      options and warrants granted to consultants in exchange for services
      rendered (Note K)
              
              
              -
              
              -
              
              -
              
              
              -
              
              
              277,344
              
              
              -
              
              
              
              277,344Net
      Loss
              
              
              -
              
              -
              
              -
              
              
              -
              
              
              -
              
              
              (27,437,116
              )
              
              
              (27,437,116
              )Balance
      at December 31, 2006
              
              
              -
              
              -
              
              56,992,301
              
              $
              56,992
              
              $
              78,502,900
              
              $
              (70,424,669
              )
              
              $
              8,135,223
    See
accompanying footnotes to consolidated financial statements
 F-7
 
 TELKONET,
INC.
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)
 FOR
THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
 
 Preferred
      Shares
              
              
              Preferred
                Stock
                Amount
              
              
              Common
      Shares
              
              
              Common
                Stock
                Amount
              
              
              Additional
                Paid
      in
                Capital
              
              
              Accumulated
      Deficit
              
              
              TotalBalance
      at January 1, 2007
              
              
              -
              
              
              
              -
              
              
              
              56,992,301
              
              
              $
              56,992
              
              
              $
              78,502,900
              
              
              $
              (70,424,669
              )
              
              $
              8,135,223Shares
      issued for employee stock options exercised at approximately $1.05 per
      share (Note K)
              
              
              -
              
              
              
              -
              
              
              
              118,500
              
              
              
              119
              
              
              
              124,342
              
              
              
              -
              
              
              
              124,460Shares
      issued in exchange for services rendered at approximately $2.63 per
      share
              
              
              -
              
              
              
              -
              
              
              
              21,803
              
              
              
              22
              
              
              
              57,320
              
              
              
              -
              
              
              
              57,342Shares
      issued in exchange for services at $1.36 per share (Note
J)
              
              
              -
              
              
              
              -
              
              
              
              200,000
              
              
              
              200
              
              
              
              271,300
              
              
              
              -
              
              
              
              271,500Issuance
      of shares for purchase of subsidiary (Note B)
              
              
              -
              
              
              
              -
              
              
              
              2,227,273
              
              
              
              2,227
              
              
              
              5,997,773
              
              
              
              -
              
              
              
              6,000,000Issuance
      of shares for purchase of subsidiary (Note B)
              
              
              -
              
              
              
              -
              
              
              
              3,459,609
              
              
              
              3,460
              
              
              
              9,752,637
              
              
              
              -
              
              
              
              9,756,097Issuance
      of shares for acquisition by subsidiary (Note B)
              
              
              -
              
              
              
              -
              
              
              
              866,856
              
              
              
              867
              
              
              
              1,529,133
              
              
              
              -
              
              
              
              1,530,000Shares
      Issued in connection with Private Placement
              
              
              -
              
              
              
              -
              
              
              
              4,000,000
              
              
              
              4,000
              
              
              
              9,606,000
              
              
              
              -
              
              
              
              9,610,000Issuance
      of shares for investment in affiliate (Note H)
              
              
              -
              
              
              
              -
              
              
              
              2,940,202
              
              
              
              2,940
              
              
              
              4,463,227
              
              
              
              -
              
              
              
              4,466,167Value
      of additional warrants issued in conjunction with exchange of convertible
      debentures (Note K)
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              132,949
              
              
              
              -
              
              
              
              132,949Debt
      discount attributable to warrants attached to Note (Note
I)
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              195,924
              
              
              
              -
              
              
              
              195,924Stock-based
      compensation expense related to employee stock options (Note
      K)
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,225,626
              
              
              
              -
              
              
              
              1,225,626Stock-based
      compensation related to Stock option expenses accrued in prior
      period
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              153,963
              
              
              
              -
              
              
              
              153,963Net
      Loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (20,391,110
              )
              
              
              (20,391,110
              )Balance
      at December 31, 2007
              
              
              -
              
              
              $
              -
              
              
              
              70,826,544
              
              
              $
              70,827
              
              
              $
              112,013,093
              
              
              $
              (90,815,779
              )
              
              $
              21,268,141
 
 See
accompanying footnotes to consolidated financial statements
 F-8
  TELKONET,
INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 FOR
THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
  2007
              
              
              2006
              
              
              2005Increase
      (Decrease) In Cash and EquivalentsCash
      Flows from Operating Activities:Net
      loss from operating activities
              
              $
              (20,391,110
              )
              
              $
              (27,437,116
              )
              
              $
              (15,778,281
              )Adjustments
      to reconcile net loss from operations to cash used in operating
      activities:Minority
      interest
              
              
              (2,910,068
              )
              
              
              (19,569
              )
              
              
              -Amortization
      and write-off of debt discount - beneficial conversion feature of
      convertible debentures (Note I)
              
              
              -
              
              
              
              1,390,137
              
              
              
              138,406Amortization
      and write-off of debt discount - value of warrants attached to convertible
      debentures
                (Note
      I)
              
              
              -
              
              
              
              2,743,342
              
              
              
              198,805Amortization
      and write-off of financing costs
              
              
              -
              
              
              
              1,145,911
              
              
              
              73,499Impairment
      write-down of goodwill of subsidiary (Note C)
              
              
              1,977,768
              
              
              
              -
              
              
              
              -Impairment
      write-down of long lived assets of subsidiary( Note G)
              
              
              493,512
              
              
              
              -
              
              
              
              -Write-off
      of fixed assets in conjunction with loss on sublease
              
              
              64,608
              
              
              
              -
              
              
              
              -Registration
      rights liquidated damages of subsidiary
              
              
              500,000
              
              
              
              -
              
              
              
              -Gain
      on sale of investment in affiliate
              
              
              (1,868,956
              )Warrants
      issued for interest expense
              
              
              764,279
              
              
              
              -
              
              
              
              -Other
      income in connection with derivative warrant liabilities (Note
      I)
              
              
              -
              
              
              
              -
              
              
              
              (8,600
              )Warrants
      issued prepayment of debt
              
              
              -
              
              
              
              3,000,249
              
              
              
              -Amortization
      of debt discount and financing costs
              
              
              475,391
              
              
              
              -
              
              
              
              -Common
      stock issued in exchange for and penalty in connection with early
      extinguishment of debt
                (Note
      I)
              
              
              -
              
              
              
              2,006,029
              
              
              
              -Stock
      options and warrants issued in exchange for services (Note
    K)
              
              
              1,534,260
              
              
              
              1,358,239
              
              
              
              1,354,219Common
      stock issued in exchange for services rendered (Note J)
              
              
              706,842
              
              
              
              203,026
              
              
              
              300,117Common
      stock issued in exchange for conversion of interest
              
              
              -
              
              
              
              -
              
              
              
              28,131Other
              
              
              (12,184
              )
              
              
              -
              
              
              
              -Depreciation
      and Amortization
              
              
              1,721,224
              
              
              
              980,470
              
              
              
              430,104Impairment
      write-down in investment in Amperion (Note H)
              
              
              -
              
              
              
              92,000
              
              
              
              400,000Increase
      / decrease in:Accounts
      receivable, trade and other
              
              
              (1,469,450
              )
              
              
              (143,013
              )
              
              
              (56,044
              )Inventory
              
              
              251,185
              
              
              
              169,213
              
              
              
              397,912Investment
      in sales type leases
              
              
              27,866
              
              
              
              -
              
              
              
              -Customer
      Deposits
              
              
              20,936
              
              
              
              -
              
              
              
              -Prepaid
      expenses and deposits
              
              
              (106,661
              )
              
              
              405,952
              
              
              
              (313,956
              )Deferred
      lease liability
              
              
              -
              
              
              
              245
              
              
              
              11,406Deferred
      rent
              
              
              11,401
              
              
              
              -
              
              
              
              -Deferred
      revenue
              
              
              (88,857
              )
              
              
              68,801
              
              
              
              59,020Other
              
              
              30,238
              
              
              
              -
              
              
              
              -Accounts
      payable, accrued expenses, net
              
              
              4,278,342
              
              
              
              64,555
              
              
              
              679,230Net
      Cash Used In Operating Activities
              
              
              (13,989,434
              )
              
              
              (13,971,529
              )
              
              
              (12,086,032
              )Cash
      Flows From Investing Activities:Costs
      of equipment under operating leases and Cable and related
      equipment
              
              
              (1,568,651
              )
              
              
              (1,939,759
              )
              
              
              (458,271
              )Sale
      of equipment under operating lease, net
              
              
              -
              
              
              
              350,571
              
              
              
              -Purchase
      of property and equipment, net
              
              
              (310,715
              )
              
              
              (734,888
              )
              
              
              (336,448
              )Proceeds
      (Investment) in Restricted Certificate of Deposit (Note A)
              
              
              -
              
              
              
              10,000,000
              
              
              
              (10,000,000
              )Investment
      in Newport
              
              
              (1,118,294
              )
              
              
              -
              
              
              
              -Payment
      of note payable and investment in subsidiary (Note B)
              
              
              (900,000
              )
              
              
              (1,017,822
              )
              
              
              -Net
      cash acquired from MST (Note B)
              
              
              -
              
              
              
              59,384
              
              
              
              -Investment
      in subsidiaries
              
              
              (3,150,557
              )
              
              
              -
              
              
              
              -Proceeds
      from (Investment in) and BPL Global (Note H)
              
              
              2,000,000
              
              
              
              (44
              )
              
              
              (131,000
              )Net
      Cash Used In Investing Activities
              
              
              (5,048,217
              )
              
              
              6,717,442
              
              
              
              (10,925,719
              )Cash
      Flows From Financing Activities:Proceeds
      from sale of common stock, net of costs and fees (Note J)
              
              
              9,610,000
              
              
              
              6,000,000
              
              
              
              -Proceeds
      from issuance of senior note payable
              
              
              1,500,000
              
              
              
              -
              
              
              
              -Proceeds
      from subsidiaries’ sale of common stock, net of costs
              
              
              2,694,023
              
              
              
              -
              
              
              
              -Proceeds
      from issuance of convertible debentures, net of costs and fees (Note
      I)
              
              
              5,303,238
              
              
              
              -
              
              
              
              18,780,590Repayment
      of convertible debenture (Note I)
              
              
              -
              
              
              
              (7,750,000
              )
              
              
              (10,000
              )Repayment
      of senior notes (Note J)
              
              
              -
              
              
              
              (100,000
              )
              
              
              (350,000
              )Proceeds
      from exercise of warrants (Note K)
              
              
              -
              
              
              
              55,138
              
              
              
              321,900Proceeds
      from exercise of stock options and warrants (Note K)
              
              
              124,460
              
              
              
              2,684,663
              
              
              
              852,638Repayments
      of loans
              
              
              (208,524
              )
              
              
              (413,756
              )
              
              
              -Net
      Cash Provided By Financing Activities
              
              
              19,023,197
              
              
              
              476,045
              
              
              
              19,595,128Net
      Increase (Decrease) In Cash and Equivalents
              
              
              (14,454
              )
              
              
              (6,778,042
              )
              
              
              (3,416,623
              )Cash
      and cash equivalents at the beginning of the year
              
              
              1,644,037
              
              
              
              8,422,079
              
              
              
              11,838,702Cash
      and cash equivalents at the end of the year
              
              $
              1,629,583
              
              
              $
              1,644,037
              
              
              $
              8,422,079
  See
accompanying notes to consolidated financial statements
 F-9
  TELKONET,
INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS (Continued)
 FOR
THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
 
 2007
              
              2006
              
              2005Supplemental
      Disclosures of Cash Flow Information:Cash
      transactions:Cash
      paid during the period for interest
              
              $
              4,521
              
              
              $
              990,846
              
              
              $
              40,645Income
      taxes paid
              
              
              -
              
              
              
              -
              
              
              
              -Non-cash
      transactions:
 Stock
      options and warrants issued in exchange for services (Note
    K)
              
              
              1,534,260
              
              
              
              1,358,239
              
              
              
              1,354,219Common
      stock issued in exchange for services rendered (Note J)
              
              
              706,842
              
              
              
              203,026
              
              
              
              300,117
 Common
      stock issued in exchange for interest (Note J)
              
              
              -
              
              
              
              -
              
              
              
              28,131Note
      payable under subsidiary acquisition (Note B)
              
              
              -
              
              
              
              900,000
              
              
              
              -Common
      stock issued in exchange for interest expense and penalty in connection
      with early extinguishment of debt (Note I)
              
              
              -
              
              
              
              2,006,030
              
              
              
              -Registration
      rights liquidated damages of subsidiary
              
              
              500,000Issuance
      of shares for purchase of subsidiary
              
              
              17,286,097
              
              
              
              2,700,000
              
              
              
              -Issuance
      of shares for investment in affiliate (Note H)
              
              
              4,466,167
              
              
              
              -
              
              
              
              -Common
      stock issued in exchange for conversion of convertible debenture (Note I
      and K)
              
              
              -
              
              
              
              12,250,000
              
              
              
              200,000Write-off
      of beneficial conversion feature for conversion of
    debenture
              
              
              -
              
              
              
              -
              
              
              
              -Write-off
      of value of warrants attached to debenture in connection with
      conversion
              
              
              -
              
              
              
              -
              
              
              
              -Impairment
      write-down of goodwill (Note B)
              
              
              1,977,768
              
              
              
              -
              
              
              
              -Impairment
      write-down of long-lived assets (Note G)
              
              
              493,512
              
              
              
              -
              
              
              
              -Impairment
      write-down in investment in affiliate (Note H)
              
              
              -
              
              
              
              92,000
              
              
              
              400,000Beneficial
      conversion feature on convertible debentures (Note I)
              
              
              1,457,815
              
              
              
              -
              
              
              
              1,479,300Value
      of warrants attached to convertible debentures (Note I)
              
              
              931,465
              
              
              
              -
              
              
              
              2,910,700Value
      of warrants attached to senior note (Note I)
              
              
              359,712
              
              
              
              -
              
              
              
              -Value
      of common stock received for outstanding accounts
    receivable
              
              
              75,000
              
              
              
              -
              
              
              
              -Acquisition
      of Subsidiaries (Note B):Assets
      acquired
              
              
              3,052,880
              
              
              
              1,656,673
              
              
              
              -Subscriber
      lists
              
              
              4,781,893
              
              
              
              2,463,927
              
              
              
              -Goodwill
      (including purchase price contingency)
              
              
              15,096,922
              
              
              
              6,477,767
              
              
              
              -Minority
      Interest
              
              
              -
              
              
              
              (19,569
              )
              
              
              -Liabilities
      assumed
              
              
              (1,356,415
              )
              
              
              (1,460,976
              )
              
              
              -Common
      stock issued
              
              
              (17,286,097
              )
              
              
              (2,700,000
              )
              
              
              -Notes
      payable issued
              
              
              -
              
              
              
              (900,000
              )
              
              
              -Purchase
      price contingency
              
              
              -
              
              
              
              (4,500,000
              )
              
              
              -Direct
      acquisition costs
              
              
              (394,183
              )
              
              
              (117,822
              )
              
              
              -Cash
      paid for acquisition
              
              
              3,895,000
              
              
              
              900,000
              
              
              
              -
 
  See
accompanying notes to consolidated financial statements
 F-10
  TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2007, 2006 AND 2005
  NOTE
A-SUMMARY OF ACCOUNTING POLICIES
 
 A summary
of the significant accounting policies applied in the preparation of the
accompanying consolidated financial statements follows.
 
 Business and Basis of
Presentation
 
 Telkonet,
Inc., formed in 1999 and incorporated under the laws of the State of Utah, is a
leading provider of innovative, centrally managed solutions for integrated
energy management, networking, building automation and proactive support
services.  Prior to January 1, 2007, the Company was primarily engaged
in the business of developing, producing and marketing proprietary equipment
enabling the transmission of voice and data communications over electric utility
lines.
 
 In
January 2006, following the acquisition of Microwave Satellite Technologies
(MST) (Note B), the Company began offering complete sales, installation,
and service of VSAT and business television networks, and became a
full-service national Internet Service Provider (ISP). The MST solution offers a
complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
BroadbandInternet access and wireless fidelity (“Wi-Fi”) access, to commercial
multi-dwelling units and hotels.
 
 In March
2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada.
 
 In March
2007, the Company acquired 100% of the outstanding membership units of
Ethostream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The Ethostream
acquisition will enable Telkonet to provide installation and support for PLC
products and third party applications to customers across North
America.
 
 In May
2007, Microwave Acquisition Corp., a newly formed, wholly-owned subsidiary of
MSTI Holdings Inc. (formerly Fitness Xpress-Software Inc.) merged with MST.
As a result of the merger, the Company’s common stock in MST was exchanged for
shares of common stock of MSTI Holdings Inc. Immediately following the merger,
MSTI Holdings Inc. completed a private placement of its common stock for
aggregate gross proceeds of $3,078,716 and sold senior convertible debentures in
the aggregate principal amount of $6,050,000 (plus an 8% original issue discount
added to such principal amount). As a result of these transactions, the
Company’s 90% interest in MST became a 63% interest in MSTI Holdings
Inc.
 
 In July
2007, Microwave Satellite Technologies, Inc., the wholly-owned subsidiary of the
Company’s majority owned subsidiary MSTI Holdings Inc., acquired substantially
all of the assets of Newport Telecommunications Co., a New Jersey general
partnership. Pursuant to the terms of the acquisition, the total consideration
paid was $2,550,000, consisting of unregistered shares of the Company’s common
stock, equal to $1,530,000, and (ii) $1,020,000 in cash, subject to adjustments.
The total consideration will be increased or decreased depending on the number
of subscriber accounts acquired in the acquisition that were in good standing at
that time.
 
 The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries, Telkonet Communications, Inc. and Ethostream, LLC and
63%-owned subsidiary MSTI Holdings Inc. (reported as the Company’s MSTI
segment). Significant intercompany transactions have been eliminated in
consolidation.
 
 Investments
in entities over which the Company has significant influence, typically those
entities that are 20 to 50 percent owned by the Company, are accounted for
using the equity method of accounting, whereby the investment
is carried at cost of acquisition, plus the Company’s equity in undistributed
earnings or losses since acquisition.
 
 Going
Concern
 
 The   accompanying   consolidated   financial   statements
have been prepared in conformity with accounting principles generally
accepted in the United States of
America, which contemplate continuation of the Company as a going
concern. However, the Company has reported a net loss of $20,391,110 for
the year ended December 31, 2007, accumulated deficit of $90,815,779 and a
working capital deficit of $2,990,664 as of December 31, 2007.
 
 F-11
 The
Company believes that anticipated revenues from operations will be insufficient
to satisfy its ongoing capital requirements for at least the next 12
months.  If the Company’s financial resources are
insufficient, the Company will require additional financing in order
to execute its operating plan and continue as a going concern. The
Company cannot predict whether this additional financing will be in
the form of equity or debt, or be in another form. The Company may not be able
to obtain the necessary additional capital on a
timely basis, on acceptable terms, or at
all.  In any of these events, the Company may be unable to
implement its current plans for expansion,
repay its debt obligations as they become due,
or respond to competitive pressures, any
of       which circumstances would
have a material adverse effect on its business, prospects, financial condition
and results of operations.
 
 Management
plans to take the following steps that it believes will be sufficient
to provide the Company with ability to continue as
a going concern. Management intends to raise capital through
asset-based financing and/or the sale of its stock in private
placements.  Management believes that with this financing, the Company
will be able to generate additional revenues that will allow the Company to
continue as a going concern. There can be no assurance that the Company
will be sucessful in obtaining additional funding.
 
 Concentrations of Credit
Risk
 
 Financial
instruments and related items, which potentially subject the Company to
concentrations of credit risk, consist primarily of cash and cash equivalents.
The Company places its cash and temporary cash investments with credit quality
institutions. At times,
such investments may be in excess of the FDIC insurance limit. The allowance for
doubtful accounts was $111,957 and $60,000 at December 31, 2007 and December 31,
2006, respectively.
 
 Cash and Cash
Equivalents
 
 For
purposes of the Statements of Cash Flows, the Company considers all highly
liquid debt instruments purchased with an original maturity date of three months
or less to be cash equivalents.
 
 Liquidity
  As shown
in the accompanying consolidated financial statements, the Company incurred net
loss of $20,391,110, $27,437,116 and $15,778,281 for the years ended December
31, 2007, 2006 and 2005, respectively. The Company's current liabilities, on a
consolidated basis, exceeded its current assets by $2,990,664 as of December 31,
2007.
 
 Property and
Equipment
 
 Property
and equipment is stated at cost. Depreciation is calculated using the
straight-line method over the estimated useful lives of the assets. The
estimated useful life ranges from 3 to 10 years.
 
 Goodwill and Other
Intangibles
 
 Goodwill
represents the excess of the cost of businesses acquired over fair value or net
identifiable assets at the date of acquisition. Goodwill is subject to a
periodic impairment assessment by applying a fair value test based upon a
two-step method. The first step of the process compares the fair value of the
reporting unit with the carrying value of the reporting unit, including any
goodwill. The Company utilizes a discounted cash flow valuation methodology to
determine the fair value of the reporting unit. If the fair value of the
reporting unit exceeds the carrying amount of the reporting unit, goodwill is
deemed not to be impaired in which case the second step in the process is
unnecessary. If the carrying amount exceeds fair value, the Company performs the
second step to measure the amount of impairment loss. Any impairment loss is
measured by comparing the implied fair value of goodwill, calculated per SFAS
No. 142, with the carrying amount of goodwill at the reporting unit, with
the excess of the carrying amount over the fair value recognized as an
impairment loss.
 
 Long-Lived
Assets
 
 The
Company has adopted Statement of Financial Accounting Standards No. 144 (SFAS
144). The Statement requires that long-lived assets and certain identifiable
intangibles held and used by the Company be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Events relating to recoverability may include
significant unfavorable changes in business conditions, recurring losses, or a
forecasted inability to achieve break-even operating results over an extended
period. The Company evaluates the recoverability of long-lived assets based upon
forecasted discounted cash flows. Should impairment in value be indicated, the
carrying value of intangible assets will be adjusted, based on estimates of
future discounted cash flows resulting from the use and ultimate disposition of
the asset. SFAS No. 144 also requires assets to be disposed of be reported at
the lower of the carrying amount or the fair value less costs to
sell.
  Inventories
 
 Inventories
consist of the primary components of the Telkonet iWire SystemTM, which are
Gateways, Extenders, iBridges and Couplers, and the primary components of the
Telkonet SmartEnergy energy management solution , which are thermostats, sensors
and controllers.  Cost is determined by the first-in, first-out
method. (Note D).
 
 F-12
 Investments
 
 Telkonet
maintains an investment in two publicly-traded companies for the year ended
December 31, 2007.  These investments are accounted for using the cost
method as of the transaction date since the securities held are not eligible for
sale by the Company under Rule 144 of the Securities Act of 1933, as of December
31, 2007.
 
 Income
Taxes
 
 The
Company has implemented the provisions on Statement of Financial Accounting
Standards No. 109, "Accounting for Income Taxes" (SFAS 109). SFAS 109 requires
that income tax accounts be computed using the liability method. Deferred taxes
are determined based upon the estimated future tax effects of differences
between the financial reporting and tax reporting bases of assets and
liabilities given the provisions of currently enacted tax laws.
  In June
2006, the FASB issued FASB Interpretation No. 48,Accounting for Uncertainty in
Income Taxes-an interpretation of FASB Statement No. 109 ("FIN 48").
FIN 48 prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. FIN 48 also provides guidance on
derecognition, classification, treatment of interest and penalties, and
disclosure of such positions. Effective January 1, 2007, the Company
adopted the provisions of FIN 48, as required. As a result of implementing FIN
48, there has been no adjustment to the Company’s financial statements and the
adoption of FIN 48 did not have a material effect on the Company’s consolidated
financial statements for the year ending December 31, 2007.
 
 Net Loss per Common
Share
 
 The
Company computes earnings per share under Financial Accounting Standard No. 128,
"Earnings Per Share" (SFAS 128). Net loss per common share is computed by
dividing net loss by the weighted average number of shares of common stock and
dilutive common stock equivalents outstanding during the year. Dilutive common
stock equivalents consist of shares issuable upon conversion of convertible
notes and the exercise of the Company's stock options and warrants (calculated
using the treasury stock method). During 2007, 2006 and 2005, common stock
equivalents are not considered in the calculation of the weighted average number
of common shares outstanding because they would be anti-dilutive, thereby
decreasing the net loss per common share.
 
 Use of
Estimates
 
 The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect certain reported amounts and disclosures. Accordingly, actual results
could differ from those estimates.
  Revenue
Recognition
 
 For
revenue from product sales, the Company recognizes revenue in accordance with
Staff Accounting Bulletin No. 104, Revenue Recognition
(“SAB104”), which superseded Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
Statements (“SAB101”). SAB 101 requires that four basic criteria must be
met before revenue can be recognized: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred; (3) the selling price is fixed and
determinable; and (4) collectibility is reasonably assured. Determination of
criteria (3) and (4) are based on management’s judgments regarding the fixed
nature of the selling prices of the products delivered and the collectibility of
those amounts. Provisions for discounts and rebates to customers, estimated
returns and allowances, and other adjustments are provided for in the same
period the related sales are recorded. The Company defers any revenue for which
the product has not been delivered or is subject to refund until such time that
the Company and the customer jointly determine that the product has been
delivered or no refund will be required. SAB 104 incorporates Emerging Issues
Task Force 00-21 (“EITF 00-21”), Multiple-Deliverable Revenue
Arrangements.EITF 00-21 addresses accounting for arrangements that may
involve the delivery or performance of multiple products, services and/or rights
to use assets.
 
 For
equipment under lease, revenue is recognized over the lease term for operating
lease and rental contracts. All of the Company’s leases are accounted for as
operating leases. At the inception of the lease, no lease revenue is recognized
and the leased equipment and installation costs are capitalized and appear on
the balance sheet as “Equipment Under Operating Leases.” The capitalized cost of
this equipment is depreciated from two to three years, on a straight-line basis
down to the Company’s original estimate of the projected value of the equipment
at the end of the scheduled lease term. Monthly lease payments are recognized as
rental income. The Company has sold a portion of its lease portfolio in December
2005 and substantially all the remaining portfolio during 2006. The related
equipment was charged to cost of sales commensurate with the associated revenue
recognition (Note F).
 
 F-13
 MST
accounts for the revenue, costs and expense related to residential cable
services as the related services are performed in accordance with SFAS
No. 51, Financial
Reporting by Cable Television Companies. Installation revenue for
residential cable services is recognized to the extent of direct selling costs
incurred. Direct selling costs have exceeded installation revenue in all
reported periods. Generally, credit risk is managed by disconnecting services to
customers who are delinquent.
 
 Management
identifies a delinquent customer based upon the delinquent payment status of an
outstanding invoice, generally greater than 30 days past due
date.  The delinquent account designation does not trigger an
accounting transaction until such time the account is deemed uncollectible. The
allowance for doubtful accounts is determined by examining the reserve history
and any outstanding invoices that are over 30 days past due as of the end of the
reporting period.  Accounts are deemed uncollectible on a case-by-case
basis, at management’s discretion based upon an examination of the communication
with the delinquent customer and payment history.  Typically, accounts
are only escalated to “uncollectible” status after multiple attempts have been
made to communicate with the customer.
 
 Revenue
from sales-typeleases for
Ethostream products is recognized at the time of lessee acceptance, which
follows installation.The Company recognizes revenue
fromsales-typeleases at the net present value of
future lease payments. Revenue from operating leases is recognized ratably over
the lease period
 
 Guarantees and Product
Warranties
 
 FASB
Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”),
requires that upon issuance of a guarantee, the guarantor must disclose and
recognize a liability for the fair value of the obligation it assumes under that
guarantee.
 
 The
Company’s guarantees were issued subject to the recognition and disclosure
requirements of FIN 45 as of December 31, 2007 and 2006. The Company records a
liability for potential warranty claims. The amount of the liability is based on
the trend in the historical ratio of claims to sales, the historical length of
time between the sale and resulting warranty claim, new product introductions
and other factors. The products sold are generally covered by a warranty for a
period of one year. In the event the Company determines that its current or
future product repair and replacement costs exceed its estimates, an adjustment
to these reserves would be charged to earnings in the period such determination
is made. During the year ended December 31, 2007 and 2006, the Company
experienced approximately three percent of units returned. As of December 31,
2007 and 2006, the Company recorded warranty liabilities in the amount of
$102,534 and $47,300, respectively, using this experience factor.
 
 Advertising
 
 The
Company follows the policy of charging the costs of advertising to expenses
incurred. The Company incurred $592,313, $663,323 and $657,794 in advertising
costs during the years ended December 31, 2007, 2006 and 2005,
respectively.
 
 Research and
Development
 
 The
Company accounts for research and development costs in accordance with the
Financial Accounting Standards Board's Statement of Financial Accounting
Standards No. 2 ("SFAS 2"), "Accounting for Research and Development Costs.”
Under SFAS 2, all research and development costs must be charged to expense as
incurred. Accordingly, internal research and development costs are expensed as
incurred. Third-party research and developments costs are expensed when the
contracted work has been performed or as milestone results have been achieved.
Company-sponsored research and development costs related to both present and
future products are expensed in the period incurred. Total expenditures on
research and product development for 2007, 2006 and 2005 were $2,349,690,
$1,925,746 and $2,096,104, respectively.
  Comprehensive
Income
 
 Statement
of Financial Accounting Standards No. 130 ("SFAS 130"), "Reporting Comprehensive
Income," establishes standards for reporting and displaying of comprehensive
income, its components and accumulated balances. Comprehensive income is defined
to include all changes in equity except those resulting from investments by
owners and distributions to owners. Among other disclosures, SFAS 130 requires
that all items that are required to be recognized under current accounting
standards as components of comprehensive income be reported in a financial
statement that is displayed with the same prominence as other financial
statements. The Company does not have any items of comprehensive income in any
of the periods presented.
 
 F-14
 Reclassifications
 
 Certain
reclassifications have been made in prior year's financial statements to conform
to classifications used in the current year.
 
 Stock Based
Compensation
 
 On
January 1, 2006, the Company adopted Statement of Financial Accounting Standards
No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which
requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors including employee
stock options based on estimated fair values. SFAS 123(R) supersedes the
Company’s previous accounting under Accounting Principles Board Opinion
No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods
beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission
issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS
123(R). The Company has applied the provisions of SAB 107 in its adoption of
SFAS 123(R).
  The
Company adopted SFAS 123(R) using the modified prospective transition method,
which requires the application of the accounting standard as of January 1, 2006,
the first day of the Company’s fiscal year 2006. The Company’s Consolidated
Financial Statements as of and for the year ended December 31, 2006 reflect the
impact of SFAS 123(R). In accordance with the modified prospective transition
method, the Company’s Consolidated Financial Statements for prior periods have
not been restated to reflect, and do not include, the impact of SFAS 123(R).
Stock-based compensation expense recognized under SFAS 123(R) for the years
ended December 31, 2007 and 2006 was $1,534,260, and $1,080,895, respectively,
net of tax effect.
 
 SFAS
123(R) requires companies to estimate the fair value of share-based payment
awards on the date of grant using an option-pricing model. The value of the
portion of the award that is ultimately expected to vest is recognized as
expense over the requisite service periods in the Company’s Consolidated
Statement of Operations. Prior to the adoption of SFAS 123(R), the Company
accounted for stock-based awards to employees and directors using the intrinsic
value method in accordance with APB 25 as allowed under Statement of Financial
Accounting Standards No. 123, “Accounting for Stock-Based Compensation”
(“SFAS 123”). Under the intrinsic value method, no stock-based compensation
expense had been recognized in the Company’s Consolidated Statement of
Operations because the exercise price of the Company’s stock options granted to
employees and directors approximated or exceeded the fair market value of the
underlying stock at the date of grant.
  Stock-based
compensation expense recognized during the period is based on the value of the
portion of share-based payment awards that is ultimately expected to vest during
the period. Stock-based compensation expense recognized in the Company’s
Consolidated Statement of Operations for the year ended December 31, 2007 and
2006 included compensation expense for share-based payment awards granted but
not yet vested prior to January 1, 2006 based on the grant date fair value
estimated in accordance with the pro forma provisions of SFAS 123 and
compensation expense for the share-based payment awards granted on or after
January 1, 2006 based on the grant date fair value estimated in accordance with
the provisions of SFAS 123(R). SFAS 123(R) requires forfeitures to be estimated
at the time of grant and revised, if necessary, in subsequent periods if actual
forfeitures differ from those estimates. In the Company’s pro forma information
required under SFAS 123 for the periods prior to fiscal 2006, the Company
accounted for forfeitures as they occurred.
  Upon
adoption of SFAS 123(R), the Company is using the Black-Scholes option-pricing
model as its method of valuation for share-based awards granted beginning in
fiscal 2006, which was also previously used for the Company’s pro forma
information required under SFAS 123. The Company’s determination of fair value
of share-based payment awards on the date of grant using an option-pricing model
is affected by the Company’s stock price as well as assumptions regarding a
number of highly complex and subjective variables. These variables include, but
are not limited to the Company’s expected stock price volatility over the term
of the awards, and certain other market variables such as the risk free interest
rate.
 
 The
following table shows the effect on net earnings and earnings per share had
compensation cost been recognized based upon the estimated fair value on the
grant date of stock options for the year ended December 31, 2005, in accordance
with SFAS 123, as amended by SFAS No. 148 “Accounting for Stock-Based
Compensation - Transition and Disclosure."
  2005Net
      loss - as reported
              
              $
              (15,778,281
              )Deduct:
      stock-based compensation expense, net of tax
              
              
              (2,440,097
              )Net
      loss - pro forma
              
              $
              (18,218,378
              )Net
      loss per common share — basic (and assuming dilution):As
      reported
              
              $
              (0.35
              )Deduct:
      stock-based compensation expense, net of tax
              
              
              (0.06
              )Pro
      forma
              
              $
              (0.41
              )
  F-15
  Disclosure
for the years ended December 31, 2007 and 2006 is not presented because the
amounts are recognized in the consolidated financial statements. The fair value
for stock awards was estimated at the date of grant using the Black-Scholes
option valuation model with the following weighted average assumptions for the
year ended December 31, 2005:
 
 2005Significant
      assumptions (weighted-average):Risk-free
      interest rate at grant date
              
              
              4.5%Expected
      stock price volatility
              
              
              71%Expected
      dividend payout
              
              
              -Expected
      option life (in years)
              
              
              5.0
 
 The
expected term of the options represents the estimated period of time until
exercise and is based on historical experience of similar awards, giving
consideration to the contractual terms, vesting schedules and expectations of
future employee behavior. For 2007 and prior years, expected stock price
volatility is based on the historical volatility of the Company’s stock for the
related vesting periods. Prior to the adoption of SFAS 123R, expected stock
price volatility was estimated using only historical volatility. The risk-free
interest rate is based on the implied yield available on U.S. Treasury constant
maturity securities with an equivalent remaining term. The Company has not paid
dividends in the past and does not plan to pay any dividends in the near
future.
 
 The
Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options, which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions, particularly for the expected term and expected stock
price volatility. The Company’s employee stock options have characteristics
significantly different from those of traded options, and changes in the
subjective input assumptions can materially affect the fair value estimate.
Because Company stock options do not trade on a secondary exchange, employees do
not derive a benefit from holding stock options unless there is an increase,
above the grant price, in the market price of the Company’s stock. Such an
increase in stock price would benefit all shareholders
commensurately.
 
 Segment
Information
 
 Statement
of Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS 131") establishes standards for
reporting information regarding operating segments in annual financial
statements and requires selected information for those segments to be presented
in interim financial reports issued to stockholders. SFAS 131 also establishes
standards for related disclosures about products and services and geographic
areas. Operating segments are identified as components of an enterprise about
which separate discrete financial information is available for evaluation by the
chief operating decision maker, or decision-making group, in making decisions
how to allocate resources and assess performance. The information disclosed
herein materially represents all of the financial information related to the
Company's principal operating segment.
 
 Registration Payment
Arrangements
 
 The
Company accounts for registration payment arrangements under Financial
Accounting Standards board (FASB) Staff Position EITF 00-19-2, “Accounting for
Registration Payment Arrangements” (FSP EITF 00-19-2). FSP EITF 00-19-2
specifies that the contingent obligation to make future payments under a
registration payment arrangement should be separately recognized and measured in
accordance with SFAS No. 5, Accounting for Contingencies. FSP EITF 00-19-2 was
issued in December, 2006.  As of December 31, 2007, the Company had
accrued an estimated penalty (see Note I).
 
 New Accounting
Pronouncements
 
 In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose
to measure many financial instruments, and certain other items, at fair value.
SFAS 159 applies to reporting periods beginning after November 15, 2007. The
adoption of SFAS 159 is not expected to have a material impact on the Company’s
financial condition or results of operations.
 
 In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
141(R), “Business Combinations” (“Statement 141(R)”) and Financial Accounting
Standards No. 160, “Noncontrolling Interests in Consolidated Financial
Statements” (“Statement 160”). Statements 141(R) and 160 require most
identifiable assets, liabilities, noncontrolling interests and goodwill acquired
in a business combination to be recorded at “full fair value” and require
noncontrolling interests (previously referred to as minority interests) to be
reported as a component of equity.  Both statements are effective for
fiscal years beginning after December 15, 2008.  Statement 141(R) will
be applied to business combinations occurring after the effective
date.  Statement 160 will be applied prospectively to all
noncontrolling interests, including any that arose before the effective
date.  The Company has not determined the effect, if any, the adoption
of Statements 141(R) and 160 will have on the Company’s financial position or
results of operations.
 
 F-16
 NOTE
B - ACQUISITION OF SUBSIDIARY
  Acquisition of Microwave
Satellite Technologies, Inc.
 
 On
January 31, 2006, the Company acquired a 90% interest in Microwave Satellite
Technologies, Inc. (“MST”) from Frank Matarazzo, the sole stockholder of MST, in
exchange for $1.8 million in cash and 1.6 million unregistered shares of the
Company’s common stock for an aggregate purchase price of $9,000,000. The
purchase price of $9,000,000 was increased by $117,822 for direct costs related
to the acquisition. These direct costs included legal, accounting and other
professional fees. The cash portion of the purchase price was paid in two
installments, $900,000 at closing and $900,000 in February 2007. The stock
portion is payable from shares held in escrow, 400,000 shares at closing and the
remaining 1,200,000 “purchase price contingency” shares issued based on the
achievement of 3,300 “Triple Play” subscribers over a three year period. In the
year ended December 31, 2006, the Company issued 200,000 shares of the purchase
price contingency valued at $900,000 as an adjustment to Goodwill.
 
 On May
24, 2007, MST completed a merger transaction pursuant to which it became a
wholly-owned subsidiary of MSTI Holdings, Inc. (formerly Fitness Xpress, Inc.
("FXS")), an inactive publicly registered shell corporation with no significant
assets or operations. As a result of the merger, there was a change in control
of the public shell corporation. In accordance with SFAS No. 141, MST was the
acquiring entity. While the transaction is accounted for using the purchase
method of accounting, in substance the transaction represented a
recapitalization of MST’s capital structure. For accounting purposes, the
Company accounted for the transaction as a reverse acquisition and MST is the
surviving entity. MST did not recognize goodwill or any intangible assets in
connection with the transaction. In connection with the acquisition, the
Company’s 90% interest in MST was converted to a 63% interest in MSTI Holdings,
Inc.
 
 The
purchase price contingency shares are price protected for the benefit of the
former owner of MSTI. In the event the Company’s common stock price is below
$4.50 per share upon issuance of the shares from escrow, a pro rata adjustment
in the number of shares will be required to support the aggregate consideration
of $5.4 million. The price protection provision provides a cash benefit to the
former owner of MSTI if the as-defined market price of the Company’s common
stock is less than $4.50 per share at the time of issuance from the escrow. The
issuance of additional shares or distribution of other consideration upon
resolution of the contingency based on the Company’s common stock prices will
not affect the cost of the acquisition. When the contingency is resolved or
settled, and additional consideration is distributable, the Company will record
the current fair value of the additional consideration and the amount previously
recorded for the common stock issued will be simultaneously reduced to the lower
current value of the Company’s common stock.
 
 MSTI is a
communications technology company that offers complete sales, installation, and
service of Very Small Aperture Terminal (VSAT) and business television networks,
and is a full-service national Internet Service Provider (ISP).  Management
believes that the MSTI acquisition will enable Telkonet to provide a complete
“Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
BroadbandInternet access and wireless fidelity (“Wi-Fi”) access, to commercial
multi-dwelling units and hotels.
 
 The
acquisition of MSTI was accounted for using the purchase method in accordance
with SFAS 141, “Business Combinations.” The value of the Company’s common stock
issued as a part of the acquisition was determined based on the average price of
the Company's common stock for several days before and after the acquisition of
MSTI. The results of operations for MST have been included in the Consolidated
Statements of Operations since the date of acquisition. The components of
the purchase price were as follows:
  As
      Reported
              
              
              Including
                Purchase
                Price
      Contingency
                (*)Common
      stock
              
              $
              2,700,000
              
              
              $
              7,200,000Cash
      (including note payable)
              
              
              1,800,000
              
              
              
              1,800,000Direct
      acquisition costs
              
              
              117,822
              
              
              
              117,822Purchase
      price
              
              
              4,617,822
              
              
              
              9,117,822Minority
      interest
              
              
              19,569
              
              
              
              19,569Total
              
              $
              4,637,391
              
              
              $
              9,137,391
  F-17
  In
accordance with Financial Accounting Standard (SFAS) No. 141, Business
Combinations, the total purchase price was allocated to the estimated fair value
of assets acquired and liabilities assumed. The fair value of the assets
acquired was based on management’s best estimates. The purchase price was
allocated to the fair value of assets acquired and liabilities assumed as
follows:
 
 As
      Reported
              
              
              Including
                Purchase
                Price
      Contingency
                (*)Cash
      and other current assets
              
              $
              346,548
              
              
              $
              346,548Equipment
      and other assets
              
              
              1,310,125
              
              
              
              1,310,125Subscriber
      lists
              
              
              2,463,927
              
              
              
              2,463,927Goodwill
              
              
              1,977,767
              
              
              
              6,477,767Subtotal
              
              
              6,098,367
              
              
              
              10,598,367Current
      liabilities
              
              
              1,460,976
              
              
              
              1,460,976Total
              
              $
              4,637,391
              
              
              $
              9,137,391
 
 (*) At
the date of the acquisition, the effect of the “purchase price contingency”
shares valued at approximately $5.4 million had not been recorded in accordance
with FAS 141. In the second quarter of 2006, the Company issued 200,000 shares
of the purchase price contingency valued at $900,000 as an adjustment to
Goodwill. The remaining shares, when issued, will reflect an adjustment to
Goodwill and Other Intangibles.
 
 Goodwill
and other intangible assets represent the excess of the purchase price over the
fair value of the net tangible assets acquired. The Company used a discounted
cash flow model to determine the value of the intangible assets and to allocate
the excess purchase price to the intangible assets and goodwill as appropriate.
In this model, expected cash flows from subscribers were discounted to their
present value at a rate of return of 20% (incorporating the risk-free rate,
expected inflation, and related business risks) over a period of eight years.
Expected costs such as income taxes and cost of sales were deducted from
expected revenues to arrive at after tax cash flows. In accordance with SFAS
142, goodwill is not amortized and will be tested for impairment at least
annually. The subscriber list was valued at $2,463,927 with an estimated useful
life of eight years.
 
 The acquisition of MSTI
resulted in the valuation of MSTI’s subscriber lists as intangible assets. The
MSTI subscriber list was determined to have an eight-year life. This intangible
was amortized using that life, and amortization from the date of the acquisition
through December 31, 2007, was taken as a charge against income in the
consolidated statement of operations. In accordance with SFAS 144, Accounting
for the Impairment or Disposal of Long-Lived Assets, the intangible asset
subject to amortization was reviewed for impairment at December 31,
2007.
 
 Goodwill
of $1,977,768, excluding the remaining purchase price contingency, represented
the excess of the purchase price over the fair value of the net tangible and
intangible assets acquired.  In accordance with SFAS 142, goodwill is
not amortized and will be tested for impairment at least annually.  At
December 31, 2007, the Company performed an impairment test on the goodwill.
Based upon management’s assessment of operating results and forecasted
discounted cash flow, the carrying value of goodwill was determined to be
impaired and therefore the entire value of $1,977,768 was written off during the
year ended December 31, 2007.
 
 Acquisition of Smart Systems
International, Inc.
 
 On March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $6,875,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. The Company is obligated to register the stock portion of the purchase
price on or before May 15, 2007 and on March 14, 2008, this registration
statement was declared effective.  Additionally, 1,090,909 of these
shares were held in an escrow account for a period of one year following the
closing from which certain potential indemnification obligations under the
purchase agreement could be satisfied. The aggregate number of shares held in
escrow was subject to adjustment upward or downward depending upon the trading
price of the Company’s common stock during the one year period following the
closing date.  On March 12, 2008, the Company released these shares
from escrow and plans to issue an additional 1,909,091 shares pursuant to the
adjustment provision in the SSI asset purchase agreement (Note V).
 
 F-18
 The
acquisition of SSI was accounted for using the purchase method in accordance
with SFAS 141, “Business Combinations.” The value of the Company’s common stock
issued as a part of the acquisition was determined based on the most recent
price of the Company's common stock on the day immediately preceding the
acquisition date. The results of operations for SSI have been included in the
Consolidated Statements of Operations since the date of acquisition.  The
components of the purchase price were as follows:
 
 As
                ReportedCommon
      stock
              
              $
              6,000,000Cash
              
              
              875,000Direct
      acquisition costs
              
              
              131,543Total
      Purchase Price
              
              $
              7,006,543
 
 
 In
accordance with Financial Accounting Standard (SFAS) No. 141, Business
Combinations, the total purchase price was allocated to the estimated fair value
of assets acquired and liabilities assumed. The fair value of the assets
acquired was based on management’s best estimates. The purchase price was
allocated to the fair value of assets acquired and liabilities assumed as
follows:
 
 Current
      assets
              
              $
              1,646,054Property,
      plant and equipment
              
              
              36,020Other
      assets
              
              
              8,237Goodwill
              
              
              5,874,016Total
      assets acquired
              
              
              7,564,327Accounts
      payable and accrued liabilities
              
              
              (557,784
              )Total
      liabilities assumed
              
              
              (557,784
              )Net
      assets acquired
              
              $
              7,006,543
  Goodwill
represents the excess of the purchase price over the fair value of the net
tangible assets acquired.  In accordance with SFAS 142, goodwill is
not amortized and will be tested for impairment at least annually.  We
completed our annual impairment testing during the fourth quarter of 2007, and
determined that there was no impairment to the carrying value of
goodwill.
 
 Acquisition of Ethostream
LLC
 
 On March
15, 2007, the Company acquired 100% of the outstanding membership units of
Ethostream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The Ethostream
acquisition will enable Telkonet to provide installation and support for PLC
products and third party applications to customers across North America. The
purchase price of $11,756,097 was comprised of $2.0 million in cash and
3,459,609 shares of the Company’s common stock. The entire stock portion of the
purchase price is being held in escrow to satisfy certain potential
indemnification obligations of the sellers under the purchase agreement. The
shares held in escrow are distributable over the three years following the
closing.  If during the twelve months following the Closing, the common
stock has a volume-weighted average trading price of at least $4.50, as reported
on the American Stock Exchange, for twenty (20) consecutive trading days, the
aggregate number of shares of common stock issuable to the sellers shall be
adjusted such that the number of shares of common stock issuable as the stock
consideration shall be determined assuming a per share price equal to
$4.50.
 
 The
acquisition of Ethostream was accounted for using the purchase method in
accordance with SFAS 141, “Business Combinations.” The value of the Company’s
common stock issued as a part of the acquisition was determined based on the
most recent price of the Company's common stock prior to the acquisition date.
The results of operations for Ethostream have been included in the Consolidated
Statements of Operations since the date of acquisition.  The components of
the purchase price were as follows:
 
 F-19
 AsReportedCommon
      stock
              
              $
              9,756,097Cash
              
              
              2,000,000Direct
      acquisition costs
              
              
              164,346Total
      Purchase Price
              
              $
              11,920,443
 
 In
accordance with Financial Accounting Standard (SFAS) No. 141, Business
Combinations, the total purchase price was allocated to the estimated fair value
of assets acquired and liabilities assumed. The fair value of the assets
acquired was based on management’s best estimates. The purchase price was
allocated to the fair value of assets acquired and liabilities assumed as
follows:
 
 Current
      assets
              
              $
              949,308Property,
      plant and equipment
              
              
              51,724Other
      assets
              
              
              21,602Subscriber
      lists
              
              
              2,900,000Goodwill
              
              
              8,796,440Total
      assets acquired
              
              
              12,719,074Accounts
      payable and accrued liabilities
              
              
              (798,631
              )Total
      liabilities assumed
              
              
              (798,631
              )Net
      assets acquired
              
              $
              11,920,443
  Goodwill
and other intangible assets represent the excess of the purchase price over the
fair value of the net tangible assets acquired. The Company used a discounted
cash flow model to determine the value of the intangible assets and to allocate
the excess purchase price to the intangible assets and goodwill as appropriate.
In this model, expected cash flows from subscribers were discounted to their
present value at a rate of return of 20% (incorporating the risk-free rate,
expected inflation, and related business risks) over a period of twelve years.
Expected costs such as income taxes and cost of sales were deducted from
expected revenues to arrive at after tax cash flows. In accordance with SFAS
142, goodwill is not amortized and will be tested for impairment at least
annually.
 
 The
subscriber list was valued at $2,900,000 with an estimated useful life of twelve
years. This intangible was amortized using that life, and amortization from the
date of the acquisition through December 31, 2007, was taken as a charge against
income in the consolidated statement of operations.
 
 In
accordance with SFAS 142, goodwill is not amortized and will be tested for
impairment at least annually.  We completed our annual impairment
testing during the fourth quarter of 2007, and determined that there was no
impairment to the carrying value of goodwill.
 
 Acquisition of Newport
Telecommunications Co. by Subsidiary
 
 On July
18, 2007, Microwave Satellite Technologies, Inc., the wholly-owned subsidiary of
the Company’s majority owned subsidiary MSTI Holdings Inc., acquired
substantially all of the assets of Newport Telecommunications Co., a New Jersey
general partnership (“NTC”), relating to NTC’s business of providing broadband
internet and telephone services at certain residential and commercial properties
in the development known as Newport in Jersey City, New Jersey. Pursuant to the
terms of the NTC acquisition, the total consideration paid was $2,550,000,
consisting of (i) 866,856 unregistered shares of the Company’s common stock,
equal to $1,530,000 (which is based on the average closing prices for the
Company common stock for the ten trading days immediately prior to the closing
date), and (ii) $1,020,000 in cash.
 
 The
acquisition of Newport was accounted for using the purchase method in accordance
with SFAS 141, “Business Combinations.” The value of the Company’s common stock
issued as a part of the acquisition was determined based on the average closing
prices for the Company common stock for the ten trading days immediately prior
to the closing date. The results of operations for Newport have been included in
the Consolidated Statements of Operations since the date of acquisition. 
The components of the purchase price were as follows:
 
 F-20
 As
      ReportedCommon
      stock
              
              $
              1,530,000Cash
              
              
              1,020,000Direct
      acquisition costs
              
              
              98,294Total
      Purchase Price
              
              $
              2,648,294
 
 In
accordance with Financial Accounting Standard (SFAS) No. 141, Business
Combinations, the total purchase price was allocated to the estimated fair value
of assets acquired and liabilities assumed. The fair value of the assets
acquired was based on management’s best estimates. The purchase price was
allocated to the fair value of assets acquired and liabilities assumed as
follows:
 
 Current
      assets
              
              $
              -Property,
      plant and equipment
              
              
              668,107Subscriber
      lists
              
              
              1,980,187Total
      assets acquired
              
              
              2,648,294Accounts
      payable and accrued liabilities
              
              
              -Total
      liabilities assumed
              
              
              -Net
      assets acquired
              
              $
              2,648,294
 
 Goodwill
and other intangible assets represent the excess of the purchase price over the
fair value of the net tangible assets acquired. The subscriber list was valued
at $1,980,187 with an estimated useful life of eight years.
 
 The
following unaudited condensed combined pro forma results of operations reflect
the pro forma combination of the Telkonet, MSTI, SSI, Ethostream and Newport
businesses as if the combination had occurred at the beginning of the periods
presented compared with the actual results of operations of Telkonet for the
same period. The unaudited pro forma condensed combined results of operations do
not purport to represent what the companies’ combined results of operations
would have been if such transaction had occurred at the beginning of the periods
presented, and are not necessarily indicative of Telkonet’s future
results.
 
 Year
      Ended December 31, 2007As
      Reported
              
              
              Pro
      Forma Adjustments
              
              
              Pro
      FormaRevenues
              
              $
              14,152,733
              
              
              $
              2,423,320
              
              
              $
              16,576,053Net
      profit (loss)
              
              $
              (20,391,110
              )
              
              $
              511,538
              
              
              $
              (19,879,572
              )Net
      (loss) per common share outstanding - basic
              
              $
              (0.31
              )
              
              $
              0.02
              
              
              $
              (0.29
              )Weighted
      average common shares outstanding - basic
              
              
              65,414,875
              
              
              
              2,588,959
              
              
              
              68,003,834
  Year
      Ended December 31, 2006As
      Reported
              
              
              Pro
      Forma Adjustments
              
              
              Pro
      FormaRevenues
              
              $
              5,181,328
              
              
              $
              6,865,181
              
              
              $
              12,046,506Net
      (loss)
              
              $
              (27,437,116
              )
              
              $
              (269,276
              )
              
              $
              (27,806,392
              )Net
      (loss) per common share outstanding - basic
              
              $
              (0.54
              )
              
              $
              0.06
              
              
              $
              (0.48
              )Weighted
      average common shares outstanding - basic
              
              
              50,823,652
              
              
              
              7,553,738
              
              
              
              58,377,390
  Year
      Ended December 31, 2005As
      Reported
                
                
                Pro
      Forma Adjustments
                
                
                Pro
      FormaRevenues
                
                $
                2,488,323
                
                
                $
                7,268,599
                
                
                $
                9,756,922Net
      (loss)
                
                $
                (15,778,281
                )
                
                $
                (2,893,681
                )
                
                $
                (18,681,962
                )Net
      (loss) per common share outstanding - basic
                
                $
                (0.35
                )
                
                $
                (0.01
                )
                
                $
                (0.36
                )Weighted
      average common shares outstanding - basic
                
                
                44,743,223
                
                
                
                7,553,738
                
                
                
                52,296,961
 NOTE
C - INTANGIBLE ASSETS AND GOODWILL
 
 As a
result of the MSTI acquisition at January 31, 2006 and the Ethostream
acquisition on March 15, 2007 and MSTI Holdings, Inc.’s acquisition of Newport
on July 18, 2007, the Company had intangibles totaling $7,344,114 at December
31, 2007 (Note B).
 
 The
Company has adopted Statement of Financial Accounting Standards No. 144 (SFAS
144). The Statement requires that long-lived assets and certain identifiable
intangibles held and used by the Company be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Events relating to recoverability may include
significant unfavorable changes in business conditions, recurring losses, or a
forecasted inability to achieve break-even operating results over an extended
period.   The Company has determined that the value of MSTI’s
capitalized cable and related equipment has been impaired based upon managements
assessment of forecasted discounted cash flow from subscriber revenue and has
written off $493,512 of its value, based on the lower of the carrying amount or
the fair value less costs to sell, for the year ended December 31, 2007 (Note
G).  During the year ended December 31, 2006 and 2005, the Company
determined that its investment in Amperion Inc. had been impaired based upon
forecasted discounted cash flow and wrote off $92,000 and $400,000,
respectively, of its investment based on management’s assessment (Note
H).
 
 F-21
 We used a
discounted cash flow model to determine the value of the intangible assets and
to allocate the excess purchase price to the intangible assets and goodwill as
appropriate. In this model, expected cash flows from subscribers were discounted
to their present value at a rate of return of 20% (incorporating the risk-free
rate, expected inflation, and related business risks) over a determined length
of life year. Expected costs such as income taxes and cost of sales were
deducted from expected revenues to arrive at after tax cash flows.
 
 We have
applied the same discounted cash flow methodology to the assessment of value of
the intangible assets of Ethostream, LLC, during the acquisition completed on
March 15, 2007, for purposes of determining the purchase price.
 
 The MSTI
subscriber list was determined to have an eight-year life. This intangible was
amortized using that life and amortization from the date of the acquisition
through December 31, 2007 was taken as a charge against income in the
consolidated statement of operations.
  Total
identifiable intangible assets acquired and their carrying values at December
31, 2006 are:
 
 Gross
                Carrying
                Amount
              
              
              Accumulated
      Amortization
              
              
              Net
              
              
              Residual
                Value
              
              
              Weighted
                Average
                Amortization
                Period
                (Years)Amortized
      Identifiable intangible Assets:Subscriber
      lists - MSTI
              
              $
              2,463,927
              
              
              $
              (282,325
              )
              
              $
              2,181,602
              
              
              $
              -
              
              
              
              8.0Total
      Amortized Identifiable Intangible Assets
              
              
              2,463,927
              
              
              
              (282,325
              )
              
              
              2,181,602
              
              
              $
              -
              
              
              
              8.0Unamortized
      Identifiable Intangible Assets:
              
              NoneTotal
              
              $
              2,463,927
              
              
              $
              (282,325
              )
              
              $
              2,181,602
              
              
              $
              -
              
              
              
              8.0
 
 Total
identifiable intangible assets acquired and their carrying values at December
31, 2007 are:
 
 Gross
                Carrying
                Amount
              
              
              Accumulated
      Amortization
              
              
              Net
              
              
              Residual
                Value
              
              
              Weighted
      Average Amortization Period (Years)Amortized
      Identifiable Intangible Assets:Subscriber
      lists – MSTI
              
              $
              4,444,114
              
              
              $
              (703,765
              )
              
              
              3,740,349
              
              
              
              
              
              
              8.0Subscriber
      lists - Ethostream
              
              
              2,900,000
              
              
              $
              (191,320
              )
              
              
              2,708,680
              
              
              $
              -
              
              
              
              12.0Total
      Amortized Identifiable Intangible Assets
              
              
              7,344,114
              
              
              $
              (895,085
              )
              
              
              6,449,029
              
              
              
              -
              
              
              
              9.6Unamortized
      Identifiable Intangible Assets:
              
              NoneTotal
              
              $
              7,344,114
              
              
              $
              (895,085
              )
              
              
              6,449,029
              
              
              $
              -
              
              
              
              9.6
 
 Total
amortization expense charged to operations for the year ended December 31,
2007 and 2006 was $612,760 and $282,325, respectively. Estimated amortization
expense as of December 31, 2007 is as follows:
 
 Years
      Ended December 31,2008
              
              
              797,1812009
              
              
              797,1812010
              
              
              797,1812011
              
              
              797,1812012
      and after
              
              
              3,260,305Total
              
              $
              6,449,029
  F-22
 The
Company does not amortize goodwill. The Company recorded goodwill in the amount
of $1,977,768 as a result of the acquisition of MSTI during the year ended
December 31, 2006, and additional $14,670,455 as a result of the acquisition of
Ethostream and SSI during the year ended December 31, 2007 (Note
B).  At December 31, 2007, the Company has determined that the value
of MSTI’s goodwill has been impaired based upon managements assessment of
operating results and forecasted discounted cash flow and has written off the
entire $1,977,768 of its value.
 
 NOTE
D - INVENTORIES
 
 Inventories
are stated at the lower of cost or market determined by the first-in, first-out
(FIFO) method.  Inventories consist of the primary components of the
Telkonet iWire SystemTM, which are Gateways, Extenders, iBridges and Couplers,
and the primary components of the Telkonet SmartEnergy energy management
solution , which are thermostats, sensors and controllers.
 
 Components
of inventories as of December 31, 2007 and 2006 are as follows:
 
 2007
              
              
              2006Raw
      Materials
              
              $
              928,739
              
              
              $
              516,604Finished
      Goods
              
              
              1,649,345
              
              
              
              789,989Total
              
              $
              2,578,084
              
              
              $
              1,306,593
 
 NOTE
E - PROPERTY, PLANT AND EQUIPMENT
 
 The
Company’s property and equipment at December 31, 2007 and 2006 consists of the
following:
 
 2007
              
              
              2006Development
      Test Equipment
              
              $
              153,487
              
              
              $
              184,575Computer
      Software
              
              
              160,894
              
              
              
              151,986Leasehold
      Improvements
              
              
              512,947
              
              
              
              394,871Office
      Equipment
              
              
              426,813
              
              
              
              297,686Office
      Fixtures and Furniture
              
              
              406,352
              
              
              
              341,662Total
              
              
              1,660,493
              
              
              
              1,370,780Accumulated
      Depreciation
              
              
              (809,915
              )
              
              
              (577,759
              )$
              850,578
              
              
              $
              793,021
 
 Depreciation
expense included as a charge to income was $266,006, $258,581 and $185,928 for
the years ended December 31, 2007, 2006 and 2005, respectively.
 
 NOTE
F - EQUIPMENT UNDER OPERATING LEASES
 
 Equipment
leased to customers under operating leases is recorded at cost and is
depreciated on the straight line basis to its estimated residual value.
Estimated useful lives are two to ten years. Equipment under operating leases at
December 31, 2007 and 2006 consist of the following:
 
 2007
              
              
              2006Telecommunications
      and related equipment
              
              $
              313,941
              
              
              $
              471,207Less:
      accumulated depreciation
              
              
              (243,894
              )
              
              
              (225,346
              )Capitalized
      equipment, net of accumulated depreciation
              
              
              70,047
              
              
              
              245,861Less:
      estimated reserve for residual values
              
              
              -
              
              
              
              -Capitalized
      equipment under operating leases, net
              
              
              70,047
              
              
              
              245,861
 
 In the
year end December 31, 2006 the Company consummated a non-recourse sale of
certain rental contract agreements and the related capitalized equipment which
were accounted for as operating leases with Hospitality Leasing Corporation. The
remaining rental income payments of the contracts were valued at approximately
$1,209,000 including the customer support component of approximately $370,000
which the Company will retain and continue to receive monthly customer support
payments over the remaining average unexpired lease term of 36 months. In the
year ending December 31, 2006 the Company recognized revenue of approximately
$683,000 for the sale, calculated based on the present value of total unpaid
rental payments, and expensed the associated capitalized equipment cost, net of
depreciation, of approximately $340,000 and expensed associated taxes of
approximately $64,000.
  F-23
 The
following is a schedule by years of minimum future rentals on non-cancellable
operating leases as of December 31, 2007:
 
 2008
              
              $
              116,3782009
              
              
              50,2372010
              
              
              19,5142011
              
              
              -2012
              
              
              -Total
              
              $
              186,129
 
 NOTE
G - CABLE AND RELATED EQUIPMENT
 
 MSTI
currently maintains service agreements with approximately 22 MDU and MTU
properties and the equipment is capitalized under Cable and related
equipment.  Generally, under the terms of a service agreement, MSTI
provides either (i) “bulk services,” which may include one or all of a bundle of
products and services, at a fixed price per month to the owner of the MDU or MTU
property, and contract with individual residents for enhanced services, such as
premium cable channels, for a monthly fee or (ii) contract with individual
residents of the MDU property for one or more basic or enhanced services for a
monthly fee.
 
 Equipment
maintained for customers under Cable and related equipment is recorded at cost
and is depreciated on the straight line basis to its estimated residual value.
Estimated useful lives are three to ten years. Cable and related equipment at
December 31, 2007 and December 31, 2006 consists of the following:
 
 December
      31,
                2007
              
              
              December
      31,
                2006Cable
      equipment and installations
              
              $
              5,764,645
              
              
              $
              3,555,049Less:
      accumulated depreciation
              
              
              (1,537,862
              )
              
              
              (343,376
              )Capitalized
      equipment, net of accumulated depreciation
              
              
              4,226,783
              
              
              
              3,211,673Less:
      estimated reserve for residual values
              
              
              -
              
              
              
              -Capitalized
      Cable equipment and installations, net
              
              $
              4,226,783
              
              
              $
              3,211,673
 
 The
Company has determined that the value of MSTI’s capitalized equipment maintained
at certain properties has been impaired based upon management’s assessment of
forecasted discounted cash flow from subscriber revenue and has written off
$493,512 of its value, based on the lower of the carrying amount or the fair
value less costs to sell, for the year ended December 31, 2007.
 
 The
following is a schedule by years of minimum future rentals under bulk services
of non-cancelable operating agreements as of December 31, 2007:
 
 2008
              
              $
              512,8132009
              
              
              484,9142010
              
              
              456,9722011
              
              
              315,9342012
              
              
              256,9252013
              
              
              75,305Total
              
              $
              2,102,863
 
 NOTE
H - LONG-TERM INVESTMENTS
  Amperion,
Inc.
  On
November 30, 2004, the Company entered into a Stock Purchase Agreement
(“Agreement”) with Amperion, Inc. ("Amperion"), a privately held company.
Amperion is engaged in the business of developing networking hardware and
software that enables the delivery of high-speed broadband data over
medium-voltage power lines. Pursuant to the Agreement, the Company invested
$500,000 in Amperion in exchange for 11,013,215 shares of Series A Preferred
Stock for an equity interest of approximately 0.8%. The Company has the right to
appoint one person to Amperion’s seven-person board of directors. The Company
accounted for this investment under the cost method, as the Company does not
have the ability to exercise significant influence over operating and financial
policies of the investee.
  F-24
 It is the
policy of the Company to regularly review the assumptions underlying the
operating performance and cash flow forecasts in assessing the carrying values
of the investment. The Company identifies and records impairment losses on
investments when events and circumstances indicate that such decline in fair
value is other than temporary. Such indicators include, but are not limited to,
limited capital resources, limited prospects of receiving additional financing,
and limited prospects for liquidity of the related securities. The Company
determined that its investment in Amperion was impaired based upon forecasted
discounted cash flow. Accordingly, the Company wrote-off $92,000 and $400,000 of
the carrying value of its investment through a charge to operations during the
year ended December 31, 2006 and 2005, respectively. The remaining value of
the Company’s investment in Amperion is $8,000 at December 31, 2007 and 2006,
respectively, and this amount represents the current fair value.
 
 BPL Global,
Ltd.
  On
February 4, 2005, the Company’s Board of Directors approved an investment in BPL
Global, Ltd. (“BPL Global”), a privately held company. The Company funded an
aggregate of $131,000 as of December 31, 2005 and additional $44 during the year
of 2006. This investment represents an equity interest of approximately 4.67% at
December 31, 2006. BPL Global is engaged in the business of developing broadband
services via power lines through joint ventures in the United States, Asia,
Eastern Europe and the Middle East. The Company accounted for this investment
under the cost method, as the Company does not have the ability to exercise
significant influence over operating and financial policies of the investee. The
Company reviewed the assumptions underlying the operating performance and cash
flow forecasts in assessing the carrying values of the investment. The fair
value of the Company's investment in BPL Global, Ltd. amounted $131,044 as of
December 31, 2006.  On November 7, 2007, the Company completed the
sale of its investment in BPL Global, Ltd for $2,000,000 in cash to certain
existing stockholders of BPL Global. The Company recorded $1,868,956 of gain on
sale of the investment.
 
 Interactivewifi.com,
LLC
  MST
maintains an investment in Interactivewifi.com, LLC a privately held company.
This investment represents an equity interest of approximately 50% at December
31, 2007. Interactivewifi.com is engaged in providing internet and related
services to customers throughout metropolitan New York, including the Nuvisions
internet services. MST accounted for this investment under the cost method, as
MST does not have the ability to exercise significant influence over operating
and financial policies of the investee. Telkonet reviewed the assumptions
underlying the operating performance and cash flow forecasts in assessing the
carrying values of the investment. The fair value of MST’s investment in
Interactivewifi.com amounted to approximately $55,000 as of December 31, 2007
and 2006.
 
 Geeks on Call America,
Inc.
 
 On
October 19, 2007, the Company completed the acquisition of approximately 30.0%
of the issued and outstanding shares of common stock of Geeks on Call America,
Inc. (“GOCA”), the nation's premier provider of on-site computer services. 
Under the terms of the stock purchase agreement, the Company acquired
approximately 1,160,043 shares of GOCA common stock from several GOCA
stockholders in exchange for 2,940,200 shares of the Company’s common stock for
total consideration valued at approximately $4.5 million. The number of shares
issued in connection with this transaction was determined using a per share
price equal to the average closing price of the Company’s common stock on the
American Stock Exchange (AMEX) during the ten trading days immediately preceding
the closing date. The number of shares is subject to adjustment on the date the
Company files a registration statement for the shares issued in this
transaction, which must occur no later than the 180th day
following the closing date. The increase or decrease to the number of shares
issued will be determined using a per share price equal to the average closing
price of the Company’s common stock on the AMEX during the ten trading days
immediately preceding the date the registration statement is
filed.  The Company accounted for this investment under the cost
method, as the Company does not have the ability to exercise significant
influence over operating and financial policies of the investee.
 
 On
February 8 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned
subsidiary of Geeks On Call Holdings, Inc., (formerly Lightview, Inc.) merged
with Geeks on Call America, Inc (“GOCA”). As a result of the merger, the
Company’s common stock in GOCA was exchanged for shares of common stock of Geeks
on Call Holdings Inc.  Immediately following the merger, Geeks on Call
Holdings Inc. completed a private placement of its common stock for aggregate
gross proceeds of $3,000,000. As a result of this transaction, the Company’s 30%
interest in GOCA became an 18% interest in Geeks on Call Holdings
Inc.
 
 F-25
 Multiband
Corporation
 
 In
connection with a payment of $75,000 of accounts receivable, the company
received 30,000 shares of common stock of Multiband Corporation, a
Minnesota-based communication services provider to multiple dwelling
units.  The Company accounted for this investment under the cost
method as the Company does not have the ability to exercise significant
influence over operating and financial policies of the investee, and the shares
are not eligible for sale by the Company under Rule 144 of the Securities Act of
1933.  The value of this investment amounted to $75,000 as of December
31, 2007.
 
 NOTE
I - SENIOR CONVERTIBLE DEBENTURES AND SENIOR NOTES PAYABLE
 
 Senior Convertible
Debentures
 
 A summary
of convertible promissory notes payable at December 31, 2007 and December 31,
2006 is as follows:
 
 2007
              
              
              2006Senior
      Convertible Debentures, accrue interest at 8% per annum commencing on the
      first anniversary of the original issue date of the debentures, payable
      quarterly in cash or common stock, at MSTI Holdings Inc.’s option, and
      mature on April 30, 2010
              
              $
              6,576,350
              
              
              $
              -Original
      Issue Discount - net of accumulated amortization of $307,037 and $0 at
      December 31, 2007 and December 31, 2006, respectively.
              
              
              (219,312
              )
              
              
              -Debt
      Discount - beneficial conversion feature, net of accumulated amortization
      of $283,464 and $0 at December 31, 2007 and December 31, 2006,
      respectively.
              
              
              (1,174,351
              )Debt
      Discount - value attributable to warrants attached to notes, net of
      accumulated amortization of $181,118 and $0 at December 31, 2007 and
      December 31, 2006, respectively.
              
              
              (750,347
              )
              
              
              -Total
              
              $
              4,432,342
              
              
              $
              -Less:
      current portion
              
              
              -
              
              
              
              -$
              4,432,342
              
              
              $
              -
 
 Aggregate
maturities of long-term debt as of December 31, 2007 are as
follows:
 
 For the twelve months
      ended December 31
              
              Amount2008
              
              
              -2009
              
              
              -2010
              
              
              6,576,350$
              6,576,350
 
 During
the year ended December 31, 2007, MSTI Holdings Inc., a majority owned
subsidiary of Telkonet, Inc., issued senior convertible debentures (the
"Debentures") having a principal value of $6,576,350 to
investors, including an original issue discount of $526,350, in
exchange for $6,050,000 from investors, exclusive of placement fees. The
original issue discount to the Debentures is amortized over 12 months. The
Debentures accrue interest at 8% per annum commencing on the first anniversary
of the original issue date of the Debentures, payable quarterly in cash or
common stock, at MSTI Holdings Inc.’s option, and mature on April 30, 2010. The
Debentures are not callable and are convertible at a conversion price of $0.65
per share into 10,117,462 shares of MSTI Holdings Inc. common stock, subject to
certain limitations.  The
Company and noteholders are subject to a “Beneficial Ownership Limitation”
pursuant to which the number of shares of common stock of MSTI Holdings, Inc.
held by such noteholders immediately following conversion of the Debenture shall
not exceed 4.99% of all of the issued and outstanding common stock of MSTI
Holdings, Inc.  The Debentures are senior indebtedness and the holders
of the Debentures have a security interest in all of MSTI assets and its
subsidiaries.
 
 In
accordance with Emerging Issues Task Force Issue 98-5, Accounting for
Convertible Securities with a Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios ("EITF 98-5"), MSTI recognized an imbedded
beneficial conversion feature present in the notes. The Company allocated a
portion of the proceeds equal to the intrinsic value of that feature to the MSTI
additional paid in capital included in the Company’s minority interest. The
Company recognized and measured an aggregate of $1,457,815 of the proceeds,
which is equal to the intrinsic value of the imbedded beneficial conversion
feature, to additional paid in capital and a discount against the Notes issued
during the year ended December 31, 2007. The debt discount attributed to the
beneficial conversion feature is amortized over the Notes maturity period (three
years) as interest expense.
  In
connection with the placement of the Debentures, MSTI Holdings, Inc. has also
agreed to issue to the Noteholders, five-year warrants to purchase an aggregate
of 5,058,730 shares of MSTI Holdings, Inc. common stock at an exercise price of
$1.00 per share. MSTI Holdings Inc. valued the warrants in accordance with EITF
00-27 using the Black-Scholes pricing model and the following assumptions:
contractual terms of 5 years, an average risk free interest rate of 5.00%, a
dividend yield of 0%, and volatility of 54%. The $931,465 of debt discount
attributed to the value of the warrants issued is amortized over the Notes
maturity period (three years) as interest expense.
 
 F-26
 In
connection with the issuance of the Debentures, MSTI Holdings Inc. incurred
placement fees of $423,500. Additionally, MSTI Holdings Inc. issued such agents
five-year warrants to purchase 708,222 shares of MSTI Holdings Inc. common stock
at an exercise price of $1.00.
 
 The
Company amortized the original issue discount, the beneficial conversion feature
and the value of the attached warrants, and recorded non-cash interest expense
in the amount of $307,037, $283,464, and $181,118, respectively, for the year
ended December 31, 2007.
 
 Registration
Rights Liquidated Damages
 
 On
May 24, 2007, the Company’s majority-owned subsidiary, MSTI Holdings, Inc.
completed a private placement, pursuant to which 5,597,664 shares of common
stock and five-year warrants to purchase 2,798,836 shares of common stock were
issued at an exercise price of $1.00 per share, for total proceeds of
$2,694,020.  Additionally, MSTI Holdings, Inc. also sold senior
convertible debentures for total proceeds of $6,050,000.  The
debentures bear interest at a rate of 8% per annum, commencing on the first
anniversary of the original issue date of the debentures, payable quarterly in
cash or common stock, at MSTI Holdings, Inc. option, and mature on
April 30, 2010. The debentures are not callable and are convertible at a
price of $0.65 per share into 10,117,462 shares of common stock.  In
addition, holders of the debentures received five-year warrants to purchase an
aggregate of 5,058,730 shares of MSTI Holdings, Inc. common stock at an exercise
price of $1.00 per share.
 
 MSTI
Holdings, Inc. agreed to file a “resale” registration statement with the SEC
within 60 days after the final closing of the private placement and the issuance
of the debentures covering all shares of common stock sold in the private
placement and underlying the debentures, as well as the warrants attached to the
private placement. MSTI Holdings, Inc. has agreed to its our best efforts to
have such “resale” registration statement declared effective by the SEC as soon
as possible and, in any event, within 120 days after the initial closing of the
private placement and the issuance of the debentures.
 
 In
addition, with respect to the shares of common stock sold in the private
placement and underlying the warrants, MSTI Holdings, Inc. agreed to maintain
the effectiveness of the “resale” registration statement from the effective date
until the earlier of (i) 18 months after the date of the closing of the private
placement or (ii) the date on which all securities registered under the
registration statement (a) have been sold, or (b) are otherwise able to be sold
pursuant to Rule 144, at which time exempt sales may be permitted for purchasers
of the Units, subject to MSTI Holdings right to suspend or defer the use of
the registration statement in certain events.
 
 The
registration rights agreement requires the payment of liquidated damages to the
investors of approximately 1% per month of the aggregate proceeds of $9,128,717,
or the value of the unregistered shares at the time that the liquidated damages
are assessed, until the registration statement is declared effective, payable at
the option of MSTI Holdings, Inc.  In accordance with EITF 00-19-2,
the Company evaluated the likelihood of achieving registration statement
effectiveness.  Accordingly, the Company has accrued an estimate of
$500,000 as of December 31, 2007, to account for these potential liquidated
damages until the expected effectiveness of the registration statement is
achieved.
 
 On
February 11, 2008, the Purchasers executed a letter agreement (the “Letter
Agreement”) with us containing, among other things, the following:
 
 (i)
              The
      Purchasers waived any non-compliance with clause (a) above, along with any
      and all related penalties, damages and claims, in connection with our
      issuance of (A) $3 million of shares of common stock to Telkonet, Inc.,
      (B) shares of common stock in connection with acquisitions or strategic
      transactions approved by our directors, but not including a transaction
      where the shares are being issued primarily for the purpose of raising
      capital or to an entity whose primary business is investing in securities,
      and (C) 2,000,000 shares of common stock to employees and consultants
      under our 2007 Stock Incentive Plan at an exercise price of no less than
      $0.65 per share;
 
 (ii)
              The
      Purchasers waived any non-compliance with clause (b) above, along with any
      default, breach or threatened breach, arising under the Registration
      Rights Agreement, the Debentures or the Warrants, and waiving any
      Liquidated Damages, in each case resulting or that could result from our
      failure to have the Registration Statement declared effective by the SEC
      by  the Effectiveness Date. In exchange for the investors waiving
      their rights to Liquidated Damages, we agreed to reduce the exercise price
      of the Warrants from $1.00 to
$0.65;
 
 (iii)
              If
      Frank Matarazzo ceases being our Chief Executive Officer, that would be an
      event of default under the Debentures;
and
  F-27
 (iv)
              The
      exercise price of all of our outstanding options and warrants was set at
      $0.65 per share.
 
 Senior Convertible
Notes
 
 During
the year ended December 31, 2005, the Company issued convertible
senior notes (the "Convertible Senior Notes") having an aggregate principal
value of $20 million to sophisticated investors in exchange for
$20,000,000, exclusive of $1,219,410 in placement costs and fees. The
Convertible Senior Notes accrue interest at 7.25% per annum and call for monthly
principal installments beginning March 1, 2006. The maturity date is 3 years
from the date of issuance of the notes. At any time or times, the Noteholders
shall be entitled to convert any portion of the outstanding and unpaid note
amount into fully paid and nonassessable shares of the Company’s common Shares
at $5 per share. At any time at the option of the Company, the principal
payments may be paid either in cash or in common stock at the lower of $5 or
92.5% of the average recent market price. At any time after nine months should
the stock trade at or above $8.75 for 20 of 30 consecutive trading days, the
Company can cause a mandatory redemption and conversion to shares at $5 per
share. At any time, the Company can pre-pay the notes with cash or common stock.
Should the Company pre-pay the Notes other than by mandatory conversion, the
Company must issue additional warrants to the Noteholders covering 65% of the
amount pre-paid at a strike price of $5 per share. In addition to standard
financial covenants, the Company has agreed to maintain a letter of credit in
favor of the Noteholders equal to $10 million. Once the principal amount of the
note declines below $15 million, the balance is reduced by $.50 for every $1
amortized. In accordance with Emerging Issues Task Force Issue 98-5, Accounting
for Convertible Securities with a Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios ("EITF 98-5"), the Company recognized an imbedded
beneficial conversion feature present in the notes. The Company allocated a
portion of the proceeds equal to the intrinsic value of that feature to
additional paid in capital. The Company recognized and measured an aggregate of
$1,479,300 of the proceeds, which is equal to the intrinsic value of the
imbedded beneficial conversion feature, to additional paid in capital and a
discount against the Notes issued during the year ended December 31, 2005. The
debt discount attributed to the beneficial conversion feature is amortized over
the Notes maturity period (three years) as interest expense.
  In
connection with the placement of the Notes in October 2005, the Company has also
agreed to issue to the Noteholders one million warrants to purchase company
common stock exercisable for five years at $5 per share. The Company recognized
the value attributable to the warrants in the amount of $2,919,300 to a
derivative liability due to the possibility of the Company having to make a cash
settlement, including penalties, in the event the Company failed to register the
shares underlying the warrants under the Securities Act of 1933, as amended,
within 90 days after the closing of the transaction. The Company accounted
for this warrant derivative in accordance with EITF 00-19 Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock. The warrants were included as a liability and valued at
fair market value until the Company met the criteria under EITF 00-19 for
permanent equity. A registration statement covering shares issuable to the
Noteholders upon conversion, amortization and/or redemption of the Convertible
Senior Notes and upon exercise of the warrants was filed with the Securities and
Exchange Commission on Form S-3 on November 23, 2005 and was declared
effective on December 13, 2005. The warrant derivative liability was valued at
the issuance date of the Notes in the amount of $2,919,300 and then revalued at
$2,910,700 on December 13, 2005 upon effectiveness of the Form S-3.
The Company charged $8,600 to Other Income and the derivative warrant liability
was reclassified to additional paid in capital at December 13, 2005. The Company
valued the warrants in accordance with EITF 00-27 using the Black-Scholes
pricing model and the following assumptions: contractual terms of 5 years, an
average risk free interest rate of 4.00%, a dividend yield of 0%, and volatility
of 76%. The $2,919,300 of debt discount attributed to the value of the warrants
issued is amortized over the Notes maturity period (three years) as interest
expense.
 
 Principal
Payments of Debt
 
 For the
period of January 1, 2006 through August 14, 2006, the Company paid down
principal of $1,250,000 in cash and issued an aggregate of 4,226,246 shares of
common stock in connection with the conversion of $10,821,686 aggregate
principal amount of the Senior Convertible Notes. Pursuant to the note
agreement, the Company issued warrants to purchase 1,081,820 shares of common
stock to the Noteholders, at a strike price of $5.00 per share, which
represented 65% of the $8,321,686 accelerated principal at a strike price of $5
per share. The Company valued the warrants at $1,906,089 using the Black-Scholes
pricing model and the following assumptions: contractual terms of 5 years, an
average risk free interest rate of 5.00%, a dividend yield of 0%, and volatility
of 65%. The warrants are subject to anti-dilution protection in
conjunction with the issuance of certain equity securities. The Company has
warrants due the Noteholders as a result of the anti-dilution impact from a
$6,000,000 private placement in September 2006 (Note K). The Company has
accounted for the additional warrants issued as interest expense during the
period ended September 30, 2006.
 
 For the
period of January 1, 2006 through August 14, 2006, the Company amortized the
debt discount to the beneficial conversion feature and value of the attached
warrants, and recorded non-cash interest expense in the amount of $251,759 and
$500,353, respectively. The Company also wrote-off the unamortized debt discount
attributed to the beneficial conversion feature and the value of the attached
warrants in the amount of $708,338 and $1,397,857, respectively, in connection
with paydown and conversion of the note.
 
 F-28
 The
Company has warrants due the Noteholders as a result of the anti-dilution impact
from a $10,000,000 private placement in February 2007 (Note K). The Company has
accounted for the additional 76,230 warrants issued, valued at $131,009, as
interest expense during the year ended December 31, 2007. The Company valued the
warrants using the Black-Scholes pricing model and the following assumptions:
contractual terms of 5 years, an average risk free interest rate of 4.75%, a
dividend yield of 0%, and volatility of 70%.
 
 Early
Extinguishment of Debt
 
 On August
14, 2006, the Company executed separate settlement agreements with the lenders
of its Convertible Senior Notes. Pursuant to the settlement agreements the
Company paid to the lenders on August 15, 2006 in the aggregate $9,910,392 plus
accrued but unpaid interest of $23,951 and certain premiums specified in the
Notes in satisfaction of the amounts then outstanding under the Notes. Of the
amount to be paid to the lenders under the Notes, $6,500,000 was paid in cash
through a drawdown on a letter of credit previously pledged as collateral for
the Company’s obligations under the Notes. The remaining note balance of
$1,428,314 and a Redemption Premium of $1,982,078, calculated as 25% of
remaining principal, was paid to the lenders in shares of the Company’s common
stock valued at the lower of $5.00 per share and 92.5% of the arithmetic average
of the weighted average price of the Company’s common stock on the American
Stock Exchange for the twenty trading days beginning on August 16, 2006. The
Company also issued 862,452 warrants to purchase shares of the Company’s common
stock at the exercise price of $2.58 per share (92.5% of the average trading
price as described above) and a contractual  term of 5 years. The
warrants were issued fully exercisable, and, upon exercise, the warrants will be
exchanged for shares of the Company’s common stock.  The Company
valued the warrants at $1,014,934 using the Black-Scholes pricing model and the
following assumptions: contractual terms of 5 years, an average risk free
interest rate of 5.00%, a dividend yield of 0%, and volatility of 65%. The
Company has accounted for the Redemption Premium and the additional warrants
issued as non-cash early extinguishment of debt expense during the year ended
December 31, 2006. Registration statements covering the shares underlying the
warrants, were filed with the Securities and Exchange Commission on
Form S-3 on September 29, 2006 and October 13, 2006 and were declared
effective on October 16, 2006 and October 24, 2006, respectively.  As
of December 31, 2006, the Company included the warrant derivatives as equity
since the criteria under EITF 00-19 for permanent equity was achieved in a
nominal period of time subsequent to year end. The achievement of permanent
equity had been realized on October 16, 2006 and October 24, 2006 upon the
declared effectiveness of the Form S-3. Upon the declared effectiveness of the
Form S-3, the registration rights agreement requirements had been satisfied and
achieved; therefore the warrants were accounted for as equity. The registrations
rights agreement required liquidated damages in the event of failure to achieve
the registration with the SEC.
  As a
result of the execution of the settlement agreements and the payments required
thereby, the Company fully believes it repaid and satisfied all of its
obligations under the Notes. The Company also agreed to pay the expenses of the
lenders incurred in connection with the negotiation and execution of the
settlement agreements. The settlement agreements were negotiated following the
allegation by one of the lenders that the Company’s failure to meet the minimum
revenue test for the period ending June 30, 2006 as specified on the Notes
constituted an event of default under the Notes, which allegation the Company
disputed.
 
 The
Settlement Agreement provides that the number of shares issued to the
Noteholders shall be adjusted based upon the arithmetic average of the weighted
average price of the Company’s common stock on the American Stock Exchange for
the twenty trading days immediately following the settlement date.  The
Company has concluded that, based upon the weighted average of the Company's
common stock between August 16, 2006 and September 13, 2006, the Company is
entitled to a refund from the two Noteholders.  One of the Noteholders has
informed the Company that it does not believe such a refund is required. 
As a result, the Company has declined to deliver to the Noteholders certain
stock purchase warrants issued to them pursuant to the Settlement Agreement
pending resolution of this disagreement. The Noteholder has alleged that the
Company has failed to satisfy its obligations under the Settlement Agreement by
failing to deliver the warrants. In addition, the Noteholder maintains that the
Company has breached certain provisions of the Registration Rights Agreement
and, as a result of such breach, such Noteholder claims that it is entitled to
receive liquidated damages from the Company.
 
 Senior Note
Payable
 
 A summary
of the senior notes payable at December 31, 2007 and December 31, 2006 is as
follows:
 
 2007
              
              
              2006Senior
      Note Payable, accrues interest at 6% per annum, and mature on the earlier
      to occur of (i) the closing of the Company’s next financing, or (ii)
      January 28, 2008.
              
              $
              1,500,000
              
              
              $
              -Debt
      Discount - value attributable to warrants attached to notes, net of
      accumulated amortization of $166,744 and $0 at December 31, 2007 and
      December 31, 2006, respectively.
              
              
              (29,180
              )
              
              
              -Total
              
              $
              1,470,820
              
              
              $
              -Less:
      current portion
              
              
              1,470,820
              
              
              
              -$
              -
              
              
              $
              -
 
 F-29
 Aggregate
maturities of the Senior Note as of December 31, 2007 are as
follows:
 
 For the twelve months
      ended December 31
              
              Amount2008
              
              
              1,500,0002009
              
              
              -2010
              
              
              -$
              1,500,000
  On July
24, 2007, Telkonet entered into a Senior Note Purchase Agreement with GRQ
Consultants, Inc. (“GRQ”) pursuant to which the Company issued to GRQ a Senior
Promissory Note (the “Note”) in the aggregate principal amount of $1,500,000.
The Note is due and payable on the earlier to occur of (i) the closing of the
Company’s next financing, or (ii) January 28, 2008, and bears interest at a rate
of six (6%) percent per annum. The Company has incurred approximately $25,000 in
fees in connection with this transaction. The net proceeds from the issuance of
the Note will be for general working capital needs.
 
 In
connection with the issuance of the Note, the Company also issued to GRQ
warrants to purchase 359,712 shares of common stock at $4.17 per share. These
warrants expire five years from the date of issuance. The Company valued the
warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and
the following assumptions: contractual terms of 5 years, an average risk free
interest rate of 4.00%, a dividend yield of 0%, and volatility of 76%. The
$195,924 of debt discount attributed to the value of the warrants issued is
amortized over the note maturity period (six months) as non-cash interest
expense. The Company amortized the value of the attached warrants, and recorded
non-cash interest expense in the amount of $166,744, respectively, for the year
ended December 31, 2007.
 
 NOTE
J - CAPITAL STOCK
 
 The
Company has authorized 15,000,000 shares of preferred stock, with a par value of
$.001 per share. As of December 31, 2007, 2006 and 2005, the Company has no
preferred stock issued and outstanding. The company has authorized 100,000,000
shares of common stock, with a par value of $.001 per share. As of December 31,
2007, 2006 and 2005, the Company has 70,826,544, 56,992,301, and 45,765,171
shares, respectively, of common stock issued and outstanding.
 
 During
the year ended December 31, 2005, the Company issued an aggregate of 415,989
shares of common stock for an aggregate purchase price of $496,493 to certain
employees upon exercise of employee stock options at approximately $1.19 per
share. Additionally, the Company issued an aggregate of 172,395 shares of common
stock for an aggregate purchase price of $356,145 to consultants upon exercise
of non-employee stock options at $2.07 per share (Note K).
 
 During
the year ended December 31, 2005, the Company issued an aggregate of 1,968
shares of common stock, having an aggregate fair market value of $9,002, to
consultants in exchange for services rendered, which approximated the fair value
of the shares issued during the period services were completed and rendered.
Compensation costs of $9,002 were charged to operations during the year ended
December 31, 2005.
 
 The
Company issued an aggregate of 321,900 shares of common stock to its convertible
noteholders upon the exercise of warrants at $1.00 per share. The Company also
issued 36,150 shares of common stock in exchange for 50,000 cashless warrants
exercised.
  The
Company issued an aggregate of 36,000 shares of common stock to an employee in
exchange for $163,319 of services rendered, which approximated the fair value of
the shares issued during the period services were completed and rendered.
Compensation costs of $163,319 were charged to operations during the year ended
December 31, 2005.
 
 The
Company issued an aggregate of 30,000 shares of common stock to a member of the
board of directors in exchange for $127,796 of consulting services rendered,
which approximated the fair value of shares issued during the period services
were completed and rendered. Compensation costs of $127,796 were charged to
operations during the year ended December 31, 2005.
 
 F-30
 During
the year ended December 31, 2005, the Company issued an aggregate of 363,636
shares of common stock to its convertible debenture holders in exchange for
$200,000 of Series B Debentures. The Company also issued an aggregate of 51,114
shares of common stock in exchange for accrued interest of $28,131 for Series B
Debentures.
 
 During
the year ended December 31, 2006, the Company issued an aggregate of 2,051,399
shares of common stock for an aggregate purchase price of $2,658,826 to certain
employees upon exercise of employee stock options at approximately $1.36 per
share. Additionally, the Company issued an aggregate of 25,837 shares of common
stock for an aggregate purchase price of $25,837 to consultants upon exercise of
non-employee stock options at $1.00 per share (Note K).
  During
the year ended December 31, 2006, the Company issued an aggregate of 52,420
shares of common stock, valued at $203,026, to consultants in exchange for
services rendered, which approximated the fair value of the shares issued during
the year services were completed and rendered.
  During
the year ended December 31, 2006, the Company issued an aggregate of 6,049,724
shares of common stock at approximately $2.36 per share to its senior
convertible debenture holders in exchange for $12,250,000 of debt, $23,951 of
interest expenses, and $1,982,078 of redemption premium (Note I).
 
 The
Company issued an aggregate of 47,750 shares of common stock to debenture
holders upon the exercise of warrants at approximately $55,138 per share (Note
K).
  On
January 31, 2006, the Company entered into a Stock Purchase Agreement
(“Agreement”) with MST, a privately held company. Pursuant to the Agreement, the
Company issued 600,000 shares of Common Stock valued at $4.50 per share (Note
B).
 
 During
the year ended December 31, 2006, the Company issued 2,400,000 shares of Common
Stock valued at $2.50 per share for an aggregate purchase price of $6,000,000.
The Company also has issued to this investor warrants to purchase 1.56 million
shares of its common stock at an exercise price of $4.17 per share. A
registration statement covering the shares underlying the warrants was filed
with the Securities and Exchange Commission on Form S-3 on September 29,
2006 and was declared effective on October 16, 2006. As of December 31, 2006,
the Company included the warrant derivatives as equity since the criteria under
EITF 00-19 for permanent equity was achieved (Note K).
 
 During
the year ended December 31, 2007, the Company issued an aggregate of 118,500
shares of common stock for an aggregate purchase price of $124,460 to certain
employees upon exercise of employee stock options at approximately $1.05 per
share. (Note K).
 
 During
the year ended December 31, 2007, the Company issued an aggregate of 21,803
shares of common stock, valued at $57,342, to a consultant and an employee in
exchange for services, which approximated the fair value of the shares issued
during the period services were completed and rendered.
 
 During
the year ended December 31, 2007, the Company issued 200,000 shares of common
stock pursuant to a consulting agreement.  These shares were valued at
$271,500, which approximated the fair value of the shares issued during the
period services were completed and rendered (Note Q).
  On March
9, 2007, the Company entered into an Asset Purchase Agreement (“Agreement”) with
Smart Systems International, a privately held company. Pursuant to the
Agreement, the Company issued 2,227,273 shares of Common Stock at approximately
$2.69 per share (Note B).
 
 On March
15, 2007, the Company entered into a Purchase Agreement (“Agreement”) with
Ethostream, LLC, a privately held company. Pursuant to the Agreement, the
Company issued 3,459,609 shares of Common Stock at approximately $2.82 per share
(Note B).
 
 On July
18, 2007, Telkonet issued 866,856 unregistered shares of common stock of
Telkonet, Inc. in connection with the acquisition of substantially all of the
assets of Newport Telecommunications Co. by the Telkonet majority-owned
subsidiary, Microwave Satellite Holdings, Inc.   The Common Stock
issued by Telkonet represented $1,530,000 of the total consideration
of $2,550,000 paid in the asset purchase (Note B).
 
 In
February 2007, the Company issued 4,000,000 shares of Common Stock valued at
$2.50 per share for an aggregate purchase price of $9,610,000, net of placement
fees. The Company also issued to this investor warrants to purchase 2.6 million
shares of its common stock at an exercise price of $4.17 per share in this
private placement transaction. A registration statement covering the shares
underlying the warrants was filed with the Securities and Exchange Commission on
Form S-3 on March 5, 2007 and was declared effective on March 20,
2007.  In accordance with EITF 00-19-02, “Accounting for Registration
Payment Arrangements”, at the time of the issuance of the equity for
registration the Company deemed it probable that a registration of shares would
be deemed effective therefore a loss contingency would not be necessary and the
equity was recorded at fair value on the date of issuance.
 
 F-31
 On
October 19, 2007, the Company completed the acquisition of approximately 30.0%
of the issued and outstanding shares of common stock of Geeks on Call America,
Inc. (“GOCA”), the nation's premier provider of on-site computer services. 
Under the terms of the stock purchase agreement, the Company acquired
approximately 1,160,043 shares of GOCA common stock from several GOCA
stockholders in exchange for 2,940,202 shares of the Company’s common stock for
total consideration valued at approximately $4.5 million (Note H).  On
February 8 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned
subsidiary of Geeks On Call Holdings, Inc., (formerly Lightview, Inc.) merged
with Geeks on Call America, Inc (“GOCA”). As a result of the merger, the
Company’s common stock in GOCA was exchanged for shares of common stock of Geeks
on Call Holdings Inc.  Immediately following the merger, Geeks on Call
Holdings Inc. completed a private placement of its common stock for aggregate
gross proceeds of $3,000,000. As a result of this transaction, the Company’s 30%
interest in GOCA became an 18% interest in Geeks on Call Holdings
Inc.
 
 NOTE
K - STOCK OPTIONS AND WARRANTS
 
 Employee Stock
Options
 
 The
following table summarizes the changes in options outstanding and the related
prices for the shares of the Company’s common stock issued to employees of the
Company under a non-qualified employee stock option plan.
 
 Options
      Outstanding
              
              Options
      ExercisableExercise
      Prices
              
              Number
                Outstanding
              
              Weighted
                Average
                Remaining
                Contractual
                Life
                (Years)
              
              Weighted
                Average
                Exercise
                Price
              
              Number
                Exercisable
              
              Weighted
                Average
                Exercise
                Price$1.00
      - $1.99
              
              4,273,429
              
              5.16
              
              $1.04
              
              4,089,179
              
              $1.00$2.00
      - $2.99
              
              1,875,250
              
              7.18
              
              $2.54
              
              1,389,500
              
              $2.49$3.00
      - $3.99
              
              1,661,750
              
              7.37
              
              $3.29
              
              927,000
              
              $3.37$4.00
      - $4.99
              
              160,000
              
              7.22
              
              $4.44
              
              76,000
              
              $4.44$5.00
      - $5.99
              
              135,000
              
              7.11
              
              $5.24
              
              70,250
              
              $5.228,105,429
              
              6.15
              
              $1.98
              
              6,551,929
              
              $1.74
  Transactions
involving stock options issued to employees are summarized as
follows:
 
 Number
      of
                Shares
              
              
              Weighted
                Average
                Price
                Per
      ShareOutstanding
      at January 1, 2005
              
              
              9,614,267
              
              
              $
              1.61Granted
              
              
              1,325,000
              
              
              
              3.97Exercised
      (Note J)
              
              
              (415,989
              )
              
              
              1.18Cancelled
      or expired
              
              
              (372,200
              )
              
              
              3.74Outstanding
      at December 31, 2005
              
              
              10,151,078
              
              
              $
              1.85Granted
              
              
              1,125,000
              
              
              
              3.01Exercised
      (Note J)
              
              
              (2,051,399
              )
              
              
              1.30Cancelled
      or expired
              
              
              (703,750
              )
              
              
              2.67Outstanding
      at December 31, 2006
              
              
              8,520,929
              
              
              $
              2.06Granted
              
              
              935,000
              
              
              
              2.55Exercised
      (Note J)
              
              
              (118,500
              )
              
              
              1.05Cancelled
      or expired
              
              
              (1,232,000
              )
              
              
              3.00Outstanding
      at December 31, 2007
              
              
              8,105,429
              
              
              $
              1.98
  F-32
  The
weighted-average fair value of stock options granted to employees during the
years ended December 31, 2007, 2006 and 2005 and the weighted-average
significant assumptions used to determine those fair values, using a
Black-Scholes option pricing model are as follows:
 
 2007
              
              
              2006
              
              
              2005Significant
      assumptions (weighted-average):Risk-free
      interest rate at grant date
              
              
              4.8
              %
              
              
              5.0
              %
              
              
              4.5
              %Expected
      stock price volatility
              
              
              70
              %
              
              
              65
              %
              
              
              71
              %Expected
      dividend payout
              
              
              -
              
              
              
              -
              
              
              
              -Expected
      option life (in years)
              
              
              5.0
              
              
              
              5.0
              
              
              
              5.0Fair
      value per share of options granted
              
              $
              1.57
              
              
              $
              1.82
              
              
              $
              2.40
 
 The
expected life of awards granted represents the period of time that they are
expected to be outstanding. We determine the expected life based on historical
experience with similar awards, giving consideration to the contractual terms,
vesting schedules, exercise patterns and pre-vesting and post-vesting
forfeitures. We estimate the volatility of our common stock based on the
calculated historical volatility of our own common stock using the trailing 24
months of share price data prior to the date of the award. We base the risk-free
interest rate used in the Black-Scholes-Merton option valuation model on the
implied yield currently available on U.S. Treasury zero-coupon issues with an
equivalent remaining term equal to the expected life of the award. We have not
paid any cash dividends on our common stock and do not anticipate paying any
cash dividends in the foreseeable future. Consequently, we use an expected
dividend yield of zero in the Black-Scholes-Merton option valuation model. We
use historical data to estimate pre-vesting option forfeitures and record
share-based compensation for those awards that are expected to vest. In
accordance with SFAS No. 123R, we adjust share-based compensation for
changes to the estimate of expected equity award forfeitures based on actual
forfeiture experience.
 
 The total
intrinsic value of the options exercised in 2005, 2006 and 2007 is $1,235,487,
$2,810,417 and $137,666, respectively. Additionally, the total fair value of
shares vested during these years is $2,440,097, $1,080,095 and $1,225,626,
respectively.
 
 Total
stock-based compensation expense recognized in the consolidated statement of
earnings for the year ended December 31, 2007 and 2006 was $1,534,260 and
1,080,895, respectively, net of tax effect. Additionally, the aggregate
intrinsic value of options outstanding and unvested as of December 31, 2007 is
$0.
 
 The
financial statements for the year ended December 31, 2005 has not been restated.
Had compensation expense for employee stock options granted under the plan been
determined based on the fair value at the grant date consistent with SFAS 123R,
the Company’s pro forma net loss and net loss per share would have been
$(18,218,378) and $(0.41), respectively, for the year ended December 31,
2005.
 
 Non-Employee Stock
Options
 
 The
following table summarizes the changes in options outstanding and the related
prices for the shares of the Company’s common stock issued to the Company
consultants. These options were granted in lieu of cash compensation for
services performed.
  Options
      Outstanding
              
              Options
      ExercisableExercise
      Prices
              
              Number
                Outstanding
              
              Weighted
                Average
                Remaining
                Contractual
                Life
      (Years)
              
              Weighted
                Average
                Exercise
      Price
              
              Number
                Exercisable
              
              Weighted
                Average
                Exercise
      Price$1.00
              
              1,815,937
              
              4.34
              
              $1.00
              
              1,815,937
              
              $1.00
 
 Transactions
involving options issued to non-employees are summarized as
follows:
  F-33
  Number
      of Shares
              
              
              Weighted
      Average Price Per ShareOutstanding
      at January 1, 2005
              
              
              1,999,169
              
              
              $
              1.07Granted
              
              
              15,000
              
              
              
              3.45Exercised
      (Note J)
              
              
              (172,395
              )
              
              
              2.07Canceled
      or expired
              
              
              -
              )
              
              
              -Outstanding
      at December 31, 2005
              
              
              1,841,774
              
              
              $
              1.00Granted
              
              
              -
              
              
              
              -Exercised
      (Note J)
              
              
              (25,837
              )
              
              
              1.00Canceled
      or expired
              
              
              -
              
              
              
              -Outstanding
      at December 31, 2006
              
              
              1,815,937
              
              
              $
              1.00Granted
              
              
              -
              
              
              
              -Exercised
              
              
              -
              
              
              
              -Canceled
      or expired
              
              
              -
              
              
              
              -Outstanding
      at December 31, 2007
              
              
              1,815,937
              
              
              $
              1.00
  There
were no non-employee stock options vested during the year ended December 31,
2007.  The estimated value of the non-employee stock options vested
during the years ended December 31, 2006 and 2005 was determined using the
Black-Scholes option pricing model and the amount of the expense charged to
operations in connection with granting the options was $273,499 and $1,191,767
during the years ended December 31, 2006 and 2005, respectively.
 
 Warrants
 
 The
following table summarizes the changes in warrants outstanding and the related
prices for the shares of the Company’s common stock issued to non-employees of
the Company. These warrants were granted in lieu of cash compensation for
services performed or financing expenses and in connection with placement of
convertible debentures.
  Warrants
      Outstanding
              
              
              
              Warrants
      ExercisableExercise
      Prices
              
              Number
                Outstanding
              
              Weighted
      Average
                Remaining
      Contractual
                Life
      (Years)
              
              Weighed
                Average
                Exercise
      Price
              
              Number
                Exercisable
              
              Weighted
                Average
                Exercise
      Price$2.59
              
              862,452
              
              3.62
              
              $2.59
              
              862,452
              
              $2.59$4.17
              
              4,596,451
              
              3.98
              
              $4.17
              
              4,596,451
              
              $4.17$4.70
              
              2,214,724
              
              3.21
              
              $4.70
              
              2,214,724
              
              $4.707,673,627
              
              3.72
              
              $4.15
              
              7,673,627
              
              $4.15
 
 Transactions
involving warrants are summarized as follows:
 
 Number
      of
                Shares
              
              
              Weighted
                Average
      Price
                Per
      ShareOutstanding
      at January 1, 2005
              
              
              575,900
              
              
              $
              1.12Granted
              
              
              1,040,000
              
              
              
              4.85Exercised
      (Note J)
              
              
              (371,900
              )
              
              
              1.00Canceled
      or expired
              
              
              (14,000
              )
              
              
              1.00Outstanding
      at December 31, 2005
              
              
              1,230,000
              
              
              $
              4.31Granted
              
              
              3,657,850
              
              
              
              4.03Exercised
      (Note J)
              
              
              (47,750
              )
              
              
              1.15Canceled
      or expired
              
              
              (282,250
              )
              
              
              2.64Outstanding
      at December 31, 2006
              
              
              4,557,850
              
              
              $
              4.20Granted
              
              
              3,115,777
              
              
              
              4.18Exercised
              
              
              -
              
              
              
              -Canceled
      or expired
              
              
              -
              
              
              
              -Outstanding
      at December 31, 2007
              
              
              7,673,627
              
              
              $
              4.15
  F-34
 The
Company granted 79,326, 2,097,850 and 1,000,000 warrants to Convertible Senior
Notes holders (Note I), 2,600,000, 1,560,000 and 0 warrants to private placement
investors (Note J), and 76,739, 0 and 40,000 compensatory warrants to
non-employees during the years ended December 31, 2007, 2006 and 2005,
respectively.  Additionally, 359,712 warrants were granted to a Senior
Note holder in July 2007.  The estimated value of compensatory
warrants granted during the period ended December 31, 2007 was determined using
the Black-Scholes option pricing model and the following assumptions:
contractual term of 5 years, a risk free interest rate of approximately 4.75%, a
dividend yield of 0% and volatility of 70%. Compensation expense of $139,112,
$3,845 and $162,453 was charged to operations for the year ended December 31,
2007, 2006 and 2005, respectively. The purchase price of the warrants issued to
Convertible Senior Notes holders was adjusted from $4.87 to $4.70 per share and
approximately 79,000 additional warrants were issued during the year ended
December 31, 2007 in accordance with the anti-dilution protection provision of
the Convertible Senior Notes Payable Agreement dated October 27, 2005 (Note I),
upon the issuance of the 4,000,000 shares of common stock and 2,400,000 warrants
to private placement investors (Note J) for a price per share lower than
$4.70.
 
 NOTE
L - RELATED PARTY TRANSACTIONS
 
 In
January 2003, the Company entered into an employment agreement with Ronald W.
Pickett, President and Chief Executive Officer of the Company, to provide for an
annual compensation of $100,000 and 3,000 shares of restricted stock from the
Employee Stock Option Plan for each month that he serves as President. As of
December 31, 2006, and 2005, the Company has provided for the issuance of
36,000, and 36,000 shares, respectively, of its common stock to Mr.
Pickett.  During the year ended December 31, 2007, there were no
shares issued to Mr. Pickett.
  In
September 2003, the Company entered into a consulting agreement that provides
for annual compensation of $100,000, payable monthly, with The Musser Group, an
entity controlled by the Company's Chairman of the Board of Directors, for
certain services. As of December 31, 2007, 2006, and 2005, an aggregate of
$100,000 of consulting fees was charged to income each year pursuant to the
agreement.
 
 On
July 1, 2005, the Company and Mr. Blumenfeld executed a consulting
agreement pursuant to which Mr. Blumenfeld agreed to act as a consultant with
respect to international sales.  Pursuant to the terms of the
agreement, Mr. Blumenfeld received 10,000 shares of Telkonet stock upon
execution of the agreement, 10,000 shares of Telkonet stock per quarter for the
first year (for a total 50,000 shares in the first year) and 5,000 shares of
Telkonet stock per quarter thereafter plus a five percent (5%) commission
(payable in cash or Telkonet stock at the Consultant’s option) on international
sales generated by him with gross margins of 50% or greater. The stock awarded
to Mr. Blumenfeld pursuant to the agreement is restricted stock. The
agreement has a one year term, which is renewable annually upon both parties’
agreement.  The agreement was not renewed and therefore expired
effective June 30, 2006.  On March 16, 2007, the Board of Directors
approved the payment of compensation to Mr. Blumenfeld in the amount of $24,000
for his service as a director during the period of July 1, 2006 through December
31, 2006, which payment is commensurate with the payments made to the other
directors for their board service.   In addition, effective
January 1, 2007, Mr. Blumenfeld is being compensated according to the
non-management compensation plan.
 
 In
December 2005, the Company issued an aggregate of 363,636 shares of common stock
to Ronald W. Pickett, President and Chief Executive Officer of the Company, a
convertible debenture holder in exchange for $200,000 of Series B Debentures.
The Company also issued an aggregate of 48,858 shares of common stock in
exchange for accrued interest of $26,872 for Series B Debentures. In addition,
the Company issued an aggregate of 200,000 shares of common stock upon the
exercise of warrants at $1.00 per share upon conversion of the notes.
 
 In
conjunction with the acquisition of MST (Note B) on January 31, 2006, the
Company assumed a non-interest bearing demand promissory note in the amount of
$80,444 due to Frank Matarazzo, MST President. Additionally, an estimated
$291,000 income tax receivable due to the Company for certain carryback tax
losses of MST for the period prior to the Company’s acquisition is payable to
Frank Matarazzo.
 
 In
February 2007, the Company entered into a one-year professional services
agreement with Global Transport Logistics, Inc. (“GTI”), for the provision of
consulting services for which GTI is paid a fee of $10,000 per month. GTI is 50%
owned by Anthony Matarazzo, the brother of MST’s Chief Executive
Officer.
 
 The Chief
Administrative Officer at MST, Laura Matarazzo, is the sister of the Chief
Executive Officer of MST and receives an annual base salary of approximately
$134,000 with bonuses and benefits based upon the Company’s internal
policies.
 
 The
Company’s Vice President of Government Sales, John Vasilj, is the son-in-law of
the Vice Chairman of the Board of Directors of the Company and receives an
annual base salary of approximately $150,000 with bonuses and benefits based
upon the Company’s internal policies.  Mr. Vasilj’s employment with
the Company terminated on January 18, 2008.
 
 On August
1, 2007, the Company entered into an agreement with Barry Honig, President of
GRQ Consultants, Inc. (“GRQ”). Telkonet has agreed to pay Mr. Honig 50,000
shares of common stock per month for six (6) months, to provide the Company with
transaction advisory services. As of December 31, 2007, GRQ held a Senior
Promissory Note issued by Telkonet on July 24, 2007, in the principal amount of
$1,500,000 (Note I).  On February 8, 2008, this note was repaid in
full including $49,750 in accrued but unpaid interest from the issuance date
through the date of repayment.
 
 F-35
 From time
to time the Company may receive advances from certain of its officers to meet
short term working capital needs.  These advances may not have formal
repayment terms or arrangements.  As of December 31, 2007, there were
no amounts due to officers of the Company.
 
 NOTE
M - BUSINESS SEGMENTS AND GEOGRAPHIC INFORMATION
  The
Company's reportable operating segments are strategic businesses differentiated
by the nature of their products, activities and customers and are described as
follows:
  Telkonet
(TKO) is engaged in the business of developing products for use in the powerline
communications (PLC) industry. PLC products use existing electrical wiring in
commercial buildings and residences to carry high speed data communications
signals, including the internet.
 
 Microwave
Satellite Technologies (MST) (Note B), offers complete sales, installation,
and service of VSAT and business television networks, and became a
full-service national Internet Service Provider (ISP). The MST solution offers a
complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
Broadband Internet access and wireless fidelity (“Wi-Fi”) access, to commercial
multi-dwelling units and hotels.
 
 The
measurement of losses and assets of the reportable segments is based on the same
accounting principles applied in the consolidated financial
statements.
 
 Financial
data relating to reportable operating segments is as follows:
  Year
      ended December 31,2007
              
              
              2006
              
              
              2005(In
      thousands of U.S. $)Revenues:Telkonet
              
              
              11,477
              
              
              
              3,425
              
              
              
              2,488MST
              
              
              2,676
              
              
              
              1,756
              
              
              
              -Total
      revenue
              
              $
              14,153
              
              
              $
              5,181
              
              
              $
              2,488Gross
      ProfitTelkonet
              
              
              3,212
              
              
              
              1,155
              
              
              
              771MST
              
              
              (730
              )
              
              
              (455
              )
              
              
              -Total
      gross profit
              
              $
              2,482
              
              
              $
              700
              
              
              $
              771Operating (loss):Telkonet
              
              
              (14,996
              )
              
              
              (14,476
              )
              
              
              (15,307
              )MST
              
              
              (8,462
              )
              
              
              (3,087
              )
              
              
              -Total
      operating (loss)
              
              $
              (23,458
              )
              
              $
              (17,563
              )
              
              $
              (15,307
              )Interest
      IncomeTelkonet
              
              
              45
              
              
              
              327
              
              
              
              166MST
              
              
              72
              
              
              
              -
              
              
              
              -Total
      interest income
              
              $
              117
              
              
              $
              327
              
              
              $
              166Interest
      ExpensesTelkonet
              
              
              189
              
              
              
              5,594
              
              
              
              646MST
              
              
              1,140
              
              
              
              1
              
              
              
              -Total
      interest expense
              
              $
              1,329
              
              
              $
              5,595
              
              
              $
              646
  F-36
  Year
      ended December 31,2007
              
              
              2006
              
              
              2005(In
      thousands of U.S. $)AssetsTelkonet
              
              
              29,492
              
              
              
              4,137
              
              
              
              23,291MST
              
              
              9,249
              
              
              
              8,379
              
              
              
              -Total
      asset
              
              $
              38,741
              
              
              $
              12,516
              
              
              $
              23,291Capital
      ExpendituresTelkonet
              
              
              224
              
              
              
              94
              
              
              
              794MST
              
              
              1,655
              
              
              
              2,581
              
              
              
              -Total
      capital expenditures
              
              $
              1,879
              
              
              $
              2,675
              
              
              $
              794Operating
      ExpensesTelkonet
              
              
              18,208
              
              
              
              15,632
              
              
              
              16,078MST
              
              
              7,732
              
              
              
              2,633
              
              
              
              -Total
      operating expenses
              
              $
              25,940
              
              
              $
              18,265
              
              
              $
              16,078Depreciation
      and AmortizationTelkonet
              
              
              410
              
              
              
              221
              
              
              
              186MST
              
              
              469
              
              
              
              320
              
              
              
              -Total
      depreciation and amortization
              
              $
              879
              
              
              $
              541
              
              
              $
              186
 
 All of
the Company’s assets as of December 31, 2007, 2006, and 2005 were attributable
to U.S. operations.
  The
following is a summary of operations within geographic areas, classified by the
Company's country of domicile and by foreign countries:
  Year
      ended December 31,2007
              
              
              2006
              
              
              2005(In
      thousands of U.S. $)Revenues
      from sales to unaffiliatedcustomers
      from continuing operationsin
      Telkonet and MST segments:United
      States
              
              
              13,851
              
              
              
              4,509
              
              
              
              1,871Worldwide
              
              
              302
              
              
              
              673
              
              
              
              617$
              14,153
              
              
              $
              5,182
              
              
              $
              2,488
  Sales to
major customers in the Telkonet and MST segments out of total revenues are as
follows:
  Year
      ended December 31,2007
              
              2006
              
              
              2005Honeywell
      Utility Solutions
              10%
              
              -
              
              
              -Hospitality
      Leasing Corporation
              2%
              
              18%
              
              
              18%
 
 NOTE
N - INCOME TAXES
 
 The
Company has adopted Financial Accounting Standard No. 109 which requires the
recognition of deferred tax liabilities and assets for the expected future tax
consequences of events that have been included in the financial statement or tax
returns. Under this method, deferred tax liabilities and assets are determined
based on the difference between financial statements and tax bases of assets and
liabilities using enacted tax rates in effect for the year in which the
differences are expected to reverse.
 
 A
reconciliation of tax expense computed at the statutory federal tax rate on loss
from operations before income taxes to the actual income tax expense is as
follows:
  F-37
  2007
              
              
              2006
              
              
              2005Tax
      provision computed at the statutory rate
              
              $
              (7,137,000
              )
              
              $
              (9,564,000
              )
              
              $
              (5,522,000
              )Deferred
      state income taxes, net of federal income tax benefit
              
              
              -
              
              
              
              -
              
              
              
              (525,000
              )Stock-based
      compensation
              
              
              563,000
              
              
              
              333,000
              
              
              
              -Goodwill
      impairment
              
              
              692,000
              
              
              
              -
              
              
              
              -Book
      expenses not deductible for tax purposes
              
              
              135,000
              
              
              
              526,000
              
              
              
              19,000U.S.
      NOL created from stock option exercise
              
              
              -
              
              
              
              -
              
              
              
              (463,000
              )U.S.
      deferred tax liability for beneficial conversion feature
              
              
              -
              
              
              
              -
              
              
              
              518,000Minority
      Interest
              
              
              (1,019,000
              )
              
              
              -
              
              
              
              -Change
      in valuation allowance for deferred tax assets
              
              
              6,766,000
              
              
              
              9,038,000
              
              
              
              5,973,000Income
      tax expense
              
              $
              --
              
              
              $
              --
              
              
              $
              --
 
 Deferred
income taxes include the net tax effects of net operating loss (NOL)
carryforwards and the temporary differences between the carrying amounts of
assets and liabilities for financial reporting purposes and the amounts used for
income tax purposes. Significant components of the Company's deferred tax assets
are as follows:
 
 2007
              
              
              2006Deferred
      Tax Assets:Net
      operating loss carryforwards
              
              $
              32,231,000
              
              
              $
              24,273,000Property
      and equipment, principally due to differences in
    depreciation
              
              
              259,000
              
              
              
              (13,000
              )Warrants
      and non-employee stock options
              
              
              1,031,000
              
              
              
              774,000Investment
      in Amperion
              
              
              188,000
              
              
              
              189,000Other
              
              
              915,000
              
              
              
              403,000Total
      deferred tax assets
              
              
              34,624,000
              
              
              
              25,626,000Deferred
      Tax Liabilities:Beneficial
      Conversion Feature of Convertible Debentures
              
              
              (513,000
              )
              
              
              -Acquired
      Intangibles
              
              
              (984,000
              )
              
              
              (1,050,000
              )Outside
      stock basis
              
              
              (816,000
              )
              
              
              -Other
              
              
              (19,000
              )
              
              
              (19,000Total
      deferred tax liabilities
              
              
              (2,332,000
              )
              
              
              (1,069,000
              )Valuation
      allowance
              
              
              (32,292,000
              )
              
              
              (24,557,000
              )Net
      deferred tax assets
              
              $
              --
              
              
              $
              --
 
 The
Company has provided a valuation reserve against the full amount of the net
deferred tax assets, because in the opinion of management, it is more likely
than not that these tax assets will not be realized.
 
 At
December 31, 2007 and 2006, the Company has net operating loss carryforwards of
approximately $87 million and $66 million, respectively, for federal income tax
purposes which will expire at various dates from 2020 through 2027.
 
 With the
implementation of FAS123R, the amount of the NOL carryforward related to stock
based compensation expense is not recognized until the stock-based compensation
tax deductions reduce taxes payable. Accordingly, the NOL's reported in the
deferred tax asset that were generated in the current year do not include the
component of the NOL related to excess tax deductions over book compensation
cost related to stock based compensation.. The NOL deferred tax asset does
include pre-implementation excess tax deductions over book compensation cost
related to stock based compensation. The NOL related to excess tax deductions
will be recorded directly into Additional Paid-in-Capital at the time they
produce a future current tax benefit. Approximately, $5.6 million and $5.5
million of the NOLs at December 31, 2007 and December 31, 2006, respectively,
relate to stock option expense for which subsequently recognized tax benefits
will be allocated to capital in excess of par value. No tax deduction benefit
from the exercise of stock options was recorded to capital in excess of par
value for the years ended December 31, 2007, 2006 and 2005,
respectively.
 
 During
2006, the Company acquired Microwave Satellite Technologies, Inc.  As
part of the purchase accounting for this acquisition, a deferred tax liability
in the amount of approximately $1.2 million was established.  This
acquired $1.2 million resulted in a release of Telkonet's pre-acquisition
valuation allowance.  The release of this valuation allowance of
approximately $1.2 million was recorded as a reduction of goodwill in connection
with the acquisition purchase accounting.
 
 During
2007, the Company acquired SSI and Ethostream.  As part of the
purchase accounting for these acquisitions, deferred tax assets in the amount of
$3.8 million and $74,000, respectively, were established.  A valuation
allowance against these deferred assets was established as part of purchase
accounting and was recorded to goodwill.
  SFAS 109 requires
recognition of a deferred tax liability for outside basis differences arising in
fiscal years beginning after December 15, 1992.  An outside basis
difference represents the amount by which the basis of an investment in a
domestic subsidiary for financial reporting purposes exceeds the tax basis in
such asset.  If under applicable tax law, the outside basis difference in a
domestic subsidiary can be recovered tax-free and the Company expects to avail
itsself of such law, the outside basis difference is not a temporary difference
since no taxes are expected to result upon its reversal.  Subsequent to the
transaction in May 2007 discussed previously, Telkonet's ownership in Microwave
Satellite Technologies, Inc. is only 63%.  As such, it can no longer
recover the outside tax basis in a tax-free manner and Telkonet does not intend
to modify its ownership to avail itself of a tax-free recovery
alternative.  As such, a deferred liability was established in 2007 for the
outside basis difference in Telkonet's ownership of Microwave Satellite
Technologies, Inc.
 F-38
 The
Company’s NOL and tax credit carryovers may be significantly limited under
Section 382 of the Internal Revenue Code (IRC). NOL and tax credit carryovers
are limited under Section 382 when there is a significant “ownership change” as
defined in the IRC. During 2005 and in prior years, the Company may have
experienced such ownership changes.
  The
limitation imposed by Section 382 would place an annual limitation on the amount
of NOL and tax credit carryovers that can be utilized. When the Company
completes the necessary studies, the amount of NOL carryovers available may be
reduced significantly. However, since the valuation allowance fully reserves for
all available carryovers, the effect of the reduction would be offset by a
reduction in the valuation allowance.
 
 NOTE
O - LOSSES PER COMMON SHARE
 
 The
following table presents the computations of basic and dilutive loss per
share:
 
 2007
              
              
              2006
              
              
              2005Net
      loss available to common shareholders
              
              $
              (20,391,110
              )
              
              $
              (27,437,116
              )
              
              $
              (15,778,281
              )Basic
      and fully diluted loss per share
              
              $
              (0.31
              )
              
              $
              (0.54
              )
              
              $
              (0.35
              )Weighted
      average common shares outstanding
              
              
              65,414,875
              
              
              
              50,823,652
              
              
              
              44,743,223
 
 For the
years ended December 31, 2007, 2006 and 2005, 2,800,950, 4,604,414 and
7,577,208 potential shares, respectively were excluded from shares used to
calculate diluted losses per share as their inclusion would reduce net losses
per share.
 
 NOTE
P - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
 
 Accounts
payable and accrued liabilities at December 31, 2007 and 2006 are as
follows:
 
 2007
              
              
              2006Accounts
      payable and accrued expenses
              
              $
              4,940,472
              
              
              $
              1,625,357Accrued
      interest
              
              
              40,000
              
              
              
              -Accrued
      payroll and payroll taxes
              
              
              913,962
              
              
              
              559,411Accrued
      purchase price contingency
              
              
              400,000
              
              
              
              400,000Warranty
              
              
              102,534
              
              
              
              47,300Other
              
              
              957,209
              
              
              
              233,076Total
              
              $
              7,354,177
              
              
              $
              2,865,144
 
 NOTE
Q - COMMITMENTS AND CONTINGENCIES
 
 Office Leases
Obligations
 
 The
Company leases office space under a sub-lease agreement through November 2010
for office space which occupies approximately 11,600 square feet in Germantown,
MD.  In April 2007, the Company entered into a sub-lease agreement for
an additional 4,800 square feet of adjacent office space through December
2015.
 
 In April
2005, the Company entered into a three-year lease agreement for 6,742 square
feet of commercial office space in Crystal City, Virginia. Pursuant to this
lease, the Company agreed to assume a portion of the build-out cost for this
facility.   In February 2007, the Company agreed to sub-lease the
Crystal City, Virginia office through the remaining term of the contract
resulting in a loss of approximately $192,000.  This lease terminates
in March 2008.
 
 Additionally,
the Company leases 2 corporate apartments through August 2008 in Germantown,
MD.
 
 MST,
which was acquired by the Company in January 2006, presently leases 12,600
square feet of commercial office space in Hawthorne, New Jersey for its office
and warehouse spaces. This lease will expire in April 2010.
 
 In the
year ended September 2006, the Company leased a vehicle for the then Chief
Executive Officer and current Vice Chairman of the Board of Directors. The
operating lease will expire in September 2008.
 
 Following
the acquisitions of Smart Systems International and Ethostream, the Company
assumed leases on 9,000 square feet of office space in Las Vegas, NV for
Smart Systems International on a month to month basis and 4,100 square feet of
office space in Milwaukee, WI for Ethostream. The Ethostream lease expires in
May 2011.  The Las Vegas, NV office lease will terminate effective
April 30, 2008.
 
 F-39
 Commitments
for minimum rentals under non cancelable leases at December 31, 2007 are as
follows:
  2008
              
              $
              539,6812009
              
              
              485,2392010
              
              
              366,9032011
              
              
              192,4342012
      and thereafter
              
              
              498,542Total
              
              $
              2,082,799
 
 Rental
expenses charged to operations for the year ended December 31, 2007, 2006 and
2005 are $825,785, $578,022 and $389,935, respectively.
  Capital Lease
Obligations
 
 Development
test equipment (Note E) includes the following amounts for capitalized leases at
December 31, 2007 and 2006:
 
 2007
              
              
              2006Computer
      equipment and software
              
              $
              52,000
              
              
              $
              52,000Less:
      accumulated depreciation and amortization
              
              
              (36,600
              )
              
              
              (25,000
              )$
              15,400
              
              
              $
              27,000
 
 The
Company has computer equipment and software purchased under non-cancelable
leases with an original cost of $52,000. As of December 31, 2007, the Company
has paid in full the lease obligation. Depreciation expense of $11,600, $10,400,
and $10,400 in connection with the capital leased equipment was charged to
operations during the year ended December 31, 2007, 2006 and 2005,
respectively.
 
 Employment and Consulting
Agreements
 
 The
Company has employment agreements with certain of its key employees which
include non-disclosure and confidentiality provisions for protection of the
Company’s proprietary information.
 
 The
Company has consulting agreements with outside contractors to provide marketing
and financial advisory services. The Agreements are generally for a term of 12
months from inception and renewable automatically from year to year unless
either the Company or Consultant terminates such engagement by written
notice.
  The
Company entered into an exclusive financial advisor and consulting agreement in
January 2007. The agreement provides a minimum consideration fee, not less than
$250,000, in the event of an equity or financing transaction where the advisor
is engaged. The agreement may be terminated with sixty days notification by
either party.
 
 On August
1, 2007, the Company entered into an agreement with Barry Honig, President of
GRQ Consultants, Inc. (“GRQ”). Telkonet has agreed to pay Mr. Honig 50,000
shares of common stock per month for six (6) months, to provide the Company with
transaction advisory services. As of December 31, 2007, GRQ held a Senior
Promissory Note issued by Telkonet on July 24, 2007, in the principal amount of
$1,500,000 (Note I).  On February 8, 2008, this note was repaid in
full including $49,750 in accrued but unpaid interest from the issuance date
through the date of repayment (Note V).
 
 Jason
Tienor, President and Chief Executive Officer, is employed pursuant to an
employment agreement dated March 15, 2007.  Mr. Tienor’s employment
agreement has a term of three years and provides for a base salary of $200,000
per year.
 
 Jeff
Sobieski, Executive Vice President, Energy Management, is employed pursuant to
an employment agreement, dated March 15, 2007. Mr. Sobieski’s employment
agreement has a term of three years for a base salary of $190,000 per
year.
 
 Frank T.
Matarazzo, Chief Executive Officer, MSTI Holdings, Inc, is employed pursuant to
an employment agreement that provides for an annual salary of $300,000 and
expires December 31, 2011.
  F-40
 Litigation
 
 The
Company is subject to legal proceedings and claims which arise in the ordinary
course of its business. Although occasional adverse decisions or settlements may
occur, the Company believes that the final disposition of such matters should
not have a material adverse effect on its financial position, results of
operations or liquidity.
 
 Senior Convertible
Noteholder Claim
 
 The
August 14, 2006 Settlement Agreement with the Senior Convertible Debenture
Noteholders provided that the number of shares issued to the Noteholders shall
be adjusted based upon the arithmetic average of the weighted average price of
the Company’s common stock on the American Stock Exchange for the twenty trading
days immediately following the settlement date (Note I).  The Company has
concluded that, based upon the weighted average of the Company's common stock
between August 16, 2006 and September 13, 2006, the Company is entitled to a
refund from the two Noteholders.  One of the Noteholders has informed the
Company that it does not believe such a refund is required.  As a result,
the Company has declined to deliver to the Noteholders certain stock purchase
warrants issued to them pursuant to the Settlement Agreement pending resolution
of this disagreement. The Noteholder has alleged that the Company has failed to
satisfy its obligations under the Settlement Agreement by failing to deliver the
warrants. In addition, the Noteholder maintains that the Company has breached
certain provisions of the Registration Rights Agreement and, as a result of such
breach, such Noteholder claims that it is entitled to receive liquidated damages
from the Company.
 
 However,
in the Company’s opinion, the ultimate disposition of these matters will not
have a material adverse effect on the Company’s results of operations or
financial position.
 
 Purchase Price
Contingency
 
 In
conjunction with the acquisition of MST on January 31, 2006, the purchase price
contingency shares are price protected for the benefit of the former owner of
MST (Note B). In the event the Company’s common stock price is below $4.50 per
share upon the achievement of thirty three hundred (3,300) subscribers a pro
rata adjustment in the number of shares will be required to support the
aggregate consideration of $5.4 million. The price protection provision provides
a cash benefit to the former owner of MST if the as-defined market price of the
Company’s common stock is less than $4.50 per share at the time of issuance from
the escrow on or before January 31, 2009. The issuance of additional shares or
distribution of other consideration upon resolution of the contingency based on
the Company’s common stock prices will not affect the cost of the acquisition.
When the contingency is resolved or settled, and additional consideration is
distributable, the Company will record the current fair value of the additional
consideration and the amount previously recorded for the common stock issued
will be simultaneously reduced to the lower current value of the Company’s
common stock. In addition, the Company agreed to fully fund the MST three year
business plan, established on January 31, 2006, to satisfy the benchmarks
established to achieve 3,300 subscribers. In the event, for any reason, the
Company materially fails to satisfy its obligations then the former owners of
MST shall be entitled to the release of any and all consideration held in
reserve.
 
 On March 9, 2007, the Company acquired
substantially all of the assets of Smart Systems International (SSI), a leading
provider of energy management products and solutions to customers in the United
States and Canada for cash and Company common stock having an aggregate value of
$6,875,000. The purchase price was comprised of $875,000 in cash and 2,227,273
shares of the Company’s common stock. The Company was obligated to register the
stock portion of the purchase price on or before May 15, 2007. Pursuant to the
registration rights agreement, the registration statement was required to be
effective no later than July 14, 2007.  The registration rights
agreement does not expressly provide for penalties in the event this deadline is
not met.  This registration statement was declared effective on March
14, 2008.
 
 Of the
stock issued in the SSI acquisition, 1,090,909 shares are being held in an
escrow account for a period of one year following the closing from which certain
potential indemnification obligations under the purchase agreement may be
satisfied. The aggregate number of shares held in escrow is subject to
adjustment upward or downward depending upon the trading price of the Company’s
common stock during the one year period following the closing
date.  On March 12, 2008, the Company released these shares from
escrow and plan to issue an additional 1,909,091 shares pursuant to the
adjustment provision in the SSI asset purchase agreement.
 (Note
V).
 
 Senior Convertible
Debentures
 
 On
February 11, 2008, the Purchasers executed a letter agreement with MSTI
containing, among other things, in the event Frank Matarazzo ceases being our
Chief Executive Officer of MSTI, that would be an event of default under the
Debentures.
 
 F-41
 NOTE
R - MINORITY INTEREST IN SUBSIDIARY
  Minority
interest in results of operations of consolidated subsidiaries represents the
minority shareholders' share of the income or loss of the consolidated
subsidiary MST. The minority interest in the consolidated balance sheet reflects
the original investment by these minority shareholders in the consolidated
subsidiaries, along with their proportional share of the earnings or losses of
the subsidiaries.
  On
January 31, 2006, the Company acquired a 90% interest in Microwave Satellite
Technologies, Inc. (“MST”) from Frank Matarazzo, the sole stockholder of MST in
exchange for $1.8 million in cash and 1.6 million unregistered shares of the
Company’s common stock for an aggregate purchase price of $9,000,000 (See Note
B). This transaction resulted in a minority interest of $19,569, which reflects
the original investment by the minority shareholder of MST.
  On May
24, 2007, MST merged with a wholly-owned subsidiary of MSTI Holdings, Inc.
(formerly Fitness Xpress, Inc. ("FXS")). Immediately following the merger, MSTI
Holdings Inc. completed an equity financing of approximately $3.1 million
through the private placement of common stock and warrants and a debt financing
of approximately $6 million through the private placement of debentures and
warrants. These transactions resulted in additional minority interest of
$4,576,740 and increased the minority interest from 10% to 37% of MSTI Holding,
Inc. outstanding common shares.
 
 For
the twelve months ended ended December 31, 2007 and 2006, the minority
shareholder's share of the loss of MST was limited to $2,910,068 and $19,569,
respectively. The minority interest in MST through May 24, 2007 was a deficit
and, in accordance with Accounting Research Bulletin No. 51, subsidiary losses
should not be charged against the minority interest to the extent of reducing it
to a negative amount. As such, any losses will be charged against the Company's
operations, as majority owner. However, if future earnings do materialize, the
majority owner should be credited to the extent of such losses previously
absorbed in the amount of $545,745.
 
 Minority
interest at December 31, 2007 and December 31, 2006 amount to $2,978,918 and $0,
respectively.
  NOTE
S - BUSINESS CONCENTRATION
 
 Revenue
from one (1) major customer approximated $1,436,838 or 10% of total revenues for
the year ending December 31, 2007. Total sales of rental contract agreements
(Note F) and the related capitalized equipment to Hospitality Leasing
Corporation approximated $705,000 and $252,000 in the year ending December 31,
2006, and $439,000 and $0 in the year ending 2005, which constituted
approximately 18% and approximately 18% of total revenue, respectively, and
represented the only major customer for years then ended. Total accounts
receivable of $290,990, or 10% of total accounts receivable, was due from these
customers as of December 31, 2007.  Total accounts receivable of
$8,774, or 2% of total accounts receivable, was due from Hospitality Leasing
Corporation as of December 31, 2006. There was no outstanding accounts
receivable from these major customers as of December 31, 2005.
  Purchases
from two (2) major suppliers approximated $2,126,137 or 36% of purchases,
$446,038 or 61% of purchases, and $598,000 or 48% of purchases for the years
ended December 31, 2007, 2006 and 2005, respectively. Total accounts payable of
approximately $761,033 or 19% of total accounts payable was due to these three
suppliers as of December 31, 2007, and approximately $1,871 or 0.3% of total
accounts payable was due to these three suppliers as of December 31,
2006.
 
 NOTE
T - NET INVESTMENT IN SALES-TYPE LEASES
  Ethostream,
LLC’s net investment in sales-type leases as of December 31, 2007 and 2006
consists of the following:
 
 2007
              
              
              2006Total
      Minimum Lease Payments to be Received
              
              $
              30,000
              
              
              $
              -Less:
      Unearned Interest Income
              
              
              (2,330
              )
              
              
              -Net
      Investment in Sales-Type Leases
              
              
              27,670
              
              
              
              -Less:
      Current Maturities
              
              
              (16,501
              )
              
              
              -Non-Current
      Portion
              
              $
              11,169
              
              
              $
              -
 
 Aggregate
future minimum lease payments to be received under the above leases are as
follows as of December 31, 2007:
 
 2008
              
              $
              18,2912009
              
              
              10,7972010
              
              
              9122011
              
              
              -$
              30,000
  F-42
  NOTE U
- EMPLOYEE BENEFIT PLAN
 
 MSTI
maintains a defined contribution profit sharing plan for employees (the
“401(k)”), that is administered by a committee of trustees appointed by MSTI.
All MSTI employees are eligible to participate upon the completion of
three months of employment, subject to minimum age requirements. Each year
MSTI makes a contribution to the 401(k) without regard to current or
accumulated net profits of MSTI. These contributions are allocated to
participants in amounts of  100% of the participants’ contributions up
to 1% of each participant’s gross pay, then 10% of the next 5% of each
participant’s gross pay (a higher contribution percentage may be determined at
MSTI’s discretion).  In addition, MSTI makes a one-time, annual
contribution of 3% of each participant’s gross pay to each participant’s
contribution account in the 401(k) plan.  Participants become vested
in equal portions of their MSTI contribution account for each year of service
until full vesting occurs upon the completion of six years of service.
Distributions are made upon retirement, death or disability in a lump sum or in
installments. The expense for these benefits was $65,812 for the period ending
December 31, 2007.
  NOTE
V - SUBSEQUENT EVENTS
 
 Amendments to Stock Purchase
Warrants
 
 On
February 1, 2008, the Board of Directors of Telkonet, Inc. approved an amendment
to the stock purchase warrants held by Enable Opportunity Partners, L.P., Pierce
Diversified Strategy Master Fund, LLC, Ena and Enable Growth Partners, L.P. to
reduce the exercise price under such warrants from $4.17 per share to $0.6978258
per share.  The warrants entitled the holders to purchase an aggregate
of up to 3,380,000 shares of Telkonet’s common stock.  These warrants
were originally granted in connection with two private placements that were
completed in September 2006 and February 2007.
 
 On
February 7, 2008, Enable Opportunity Partners, L.P., Pierce Diversified Strategy
Master Fund, LLC, Ena and Enable Growth Partners, L.P. exercised all of their
warrants on a cashless basis using the a five day volume average weighted price
(VWAP) as of January 31, 2008 of $.99 resulting in the issuance of 1,000,000
shares of Company common stock and a return of 2,380,000 to shares
authorized.
 
 As a
result of this amendment to the warrants, Telkonet expects to have a one-time
“non-cash” charge of approximately $1,700,000, which is comprised of
approximately $1,200,000 attributable to the amendment to the foregoing warrants
and approximately $500,000 attributable to anti-dilution provisions of certain
other outstanding stock purchase warrants.
 
 Private
Placement
 
 On
February 8, 2008, Telkonet, Inc. completed a private placement of 2.5 million
shares of its common stock for aggregate gross proceeds of $1.5
million.  The proceeds of this private placement were primarily used
to repay the Senior Promissory Note issued by Telkonet to GRQ Consultants, Inc.
that became due on January 28, 2008.
 
 Financing
Agreement
 
 On
February 13, 2008, Telkonet, Inc. entered into a Factoring and Security
Agreement (the “Agreement”) with Thermo Credit, LLC (“Thermo”), pursuant to
which Thermo has agreed to lend to Telkonet, on a revolving basis, up to
$2,500,000.  The Agreement has a two year term and is secured by
substantially all of the Company’s accounts receivable.  The proceeds
will be used for general working capital needs.
 
 Purchase Price
Contingency
 
 As of
March 9, 2008, Telkonet owed an additional 1,909,091 shares of its common stock
to the sellers of Smart Systems International to satisfy the adjustment
provision for the number of shares held in escrow to satisfy the indemnification
provisions of the purchase agreement.
 
 F-43