UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549





FORM
10-K/A


(Amendment
No. 1)





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 X No





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 X No





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. X Yes __ 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, 2007: $136,993,170.


Number of
outstanding shares of the registrant’s par value $0.001 common stock as of March
1, 2007: 57,002,301.









TELKONET,
INC.


FORM
10-K/A


INDEX





PageExplanatory
      Note
            3Part
      IItem
      1.
            Description
      of Business
            4Item
      1A.
            Risk
      Factors
            13Item
      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
            20Item
      6.
            Selected
      Financial Data
            21Item
      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
            33Item
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
            34Item
      9A.
            Controls
      and Procedures
            34Item
      9B.
            Other
      Information
            36Part
      IIIItem
      10.
            Directors
      and Executive Officers of the Registrant
            36Item
      11.
            Executive
      Compensation
            39Item
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
            48Item
      13.
            Certain
      Relationships and Related Transactions
            49Item
      14.
            Principal
      Accounting Fees and Services
            50Part
      IVItem
      15.
            Exhibits
      and Financial Statement Schedules
            50




2




EXPLANATORY
NOTE




This
Amendment No. 1 on Form 10-K/A (the “Amendment”) amends our
annual  report on Form 10-K for the fiscal year ended December 31,
2006 as filed with the Securities and Exchange Commission on March 16, 2007 (the
“Original Report”).  The Company is filing this Amendment in response
to comments received from the SEC. This Amendment corrects errors and provides
additional disclosure information in Item 7, Note B Acquisition of Subsidiary,
Note H Convertible Promissory Note Payable, and Note K Stock Options and
Warrants, of the audited financial statements for the year-ended December 31,
2006 included in Item 8 of Part II, and Item 15 of Part IV as permitted by the
rules and regulations of the SEC. The amendment did not have any material impact
on our financial results.





For
convenience and ease of reference, we are filing the annual report in its
entirety with the applicable changes.  Except for the amendments above
and the updated certifications, this Amendment continues to speak as of the date
of our Original Report, and we have not updated the disclosures contained herein
to reflect any events that have occurred thereafter. For a discussion of events
and developments thereafter, please see our reports filed with the Securities
and Exchange Commission since March 16, 2007.





3




PART
I





ITEM
1.DESCRIPTION OF
BUSINESS.





GENERAL





Business





Telkonet,
Inc., formed in 1999, develops and markets technology for the transmission of
high-speed voice, video and data communications over the existing electrical
wiring within a building. Telkonet has made definitive inroads into the
Powerline communication (PLC) market and established the “leading” position for
in-building commercial communication solutions.





Through
the Company’s majority-owned subsidiary Microwave Satellite Technologies (MST),
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 recent acquisition of Ethostream, LLC, a leading high speed wireless
internet and technology provider for the hospitality industry (as
described in greater detail below under “Segment Reporting”), will enable
Telkonet to provide installation and support for PLC 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”)
will permit 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 iWire SystemTM platform to support wired and wireless
Internet access and, in the future, to support a networked energy management
system. With the synergy of Ethostream, LLC’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 offices 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.





Segment
Reporting





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





Telkonet
Segment (“Telkonet”)





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
Telkonet iWire SystemTM offers 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 commercial and residential applications,
including multi-dwelling units and the hospitality and government 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 and a host of other
information services.




4




Telkonet’s
Product has been installed in all present target market segments. Government and
regulatory certifications have been obtained to sell the product
internationally. Telkonet has been shipping PLC products since 2003, initially
targeting the multi-hospitality unit (MHU) market followed by the multi-dwelling
unit (MDU) market as well as the Government and Public Sector markets. Telkonet
employs both direct and indirect sales model to distribute and support product
on a worldwide basis.





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. The Company is obligated to register the stock portion of the purchase
price on or before May 15, 2007 and 1,090,000 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
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 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. The aggregate number of shares issuable to the sellers is subject to
downward adjustment in the event the Company’s common stock trades at or above a
price of $4.50 per share for twenty consecutive trading days during the one year
period following the closing.





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, who 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. They all 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 sector,
which includes office buildings, hotels, schools, shopping malls, commercial
buildings, multi-dwelling units, government facilities, 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.
Telkonet also intends to focus future sales and marketing efforts in Europe,
South America, Asia and the Pacific Rim.





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: Avnet Electronics Marketing, Digi-Key
Corporation, Intellon Corporation, and Parkview Metal Products. In addition,
Superior Manufacturing Services, a U.S. based company, provides substantially
all the manufacturing and assembly requirements for Telkonet.




5




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. However, Telkonet’s sale of certain
rental contract agreements to Hospitality Leasing Corporation represented
approximately 18.0% of total revenues in each of 2005 and 2006. Telkonet’s
primary focus is in the commercial, government and international
markets.





Intellectual
Property





Telkonet
has applied for patents that cover the unique technology integrated into the
Telkonet iWire SystemTM 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 SystemTMproduct
suite.





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
products in EU countries. As a result of the certification, Telkonet products
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.





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 SystemTMproduct
suite.




6




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.





Assumed
through the acquisition of SSI, the United States Patent and Trademark Office
issued Patent No: 5,395,042 in March 1995 titled “Apparatus and Method for
automatic climate control” 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 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 infrastructures.





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. An independent, FCC-certified testing lab has verified that the
Company’s our PLC product line complies with the FCC technical requirements for
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.





In Europe
and other overseas markets, Telkonet’s products are subject to safety and RF
emissions regulations adopted by the European Union (EU) for Information
Technology Equipment. In March 2005, the Company received final Conformite
Europeene (CE) certification, which is required for the Company to freely market
and sell its products within the EU. As a result of the certification,
Telkonet’s products sold and installed in EU countries will bear the CE marking,
a symbol that demonstrates that the product has met the EU’s regulatory
standards and is approved for sale in the EU. The Restriction of Hazardous
Substances Directive (RoHS) directive took effect in the EU on July 1, 2006.
This directive restricts the use of six hazardous materials in the manufacture
of various types of electronic and electrical equipment. It is closely linked
with the Waste
Electrical and Electronic Equipment Directive (WEEE) which sets
collection, recycling and recovery targets for electrical goods and is part of a
legislative initiative to solve the problem of huge amounts of toxic e-waste. Telkonet has
taken the appropriate measures to be fully compliant with both of these
directives.





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, 2006, 2005 and 2004, Telkonet spent $1,925,746,
$2,096,104, and $1,852,309, respectively, on research and development
activities. In 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. In 2004, research and development activities included (a)
development of a further cost-reduced (“G3”) iBridge/eXtender, (b) router
software development, and (c) advanced encryption support.




7




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 and $100,000 at December 31, 2006 and 2005, respectively, and
the amount at December 31, 2006, 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. Telkonet 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. 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.
Telkonet reviewed the assumptions underlying the operating performance and cash
flow forecasts in assessing the carrying values of the investment. The fair
value of Telkonet's investment in BPL Global, Ltd. amounted $131,044 and
$131,000 as of December 31, 2006 and 2005, respectively.





Backlog





As of
March 1, 2007 and 2006, revenues to be recognized under non-cancelable leases
and service contracts in the hospitality market of approximately $1,331,000 and
$2,411,000, respectively. Additionally, Telkonet has a commitment to deploy the
Telkonet iWire SystemTM at 50
properties for a major resort company which deployment represents revenue of
approximately $1,100,000 over a 3 year term.





In
conjunction with the acquisition of Smart Systems International on March 9,
2007, Telkonet assumed certain purchase orders relating to a major utilities
energy management initiative provided through the two selected providers. The
current order backlog amounts to approximately $500,000 and the estimated
remaining program value amounts to $3,000,000 for products and services to be
provided through 2008.





In
conjunction with the acquisition of Ethostream, LLC on March 15, 2007, Telkonet
acquired support contracts and monthly services for more than 1500 hotels which
is expected to generate approximately $2,000,000 annual recurring support and
internet advertising revenue.





MST
Segment (“MST”)





MST 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,
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.




8




NuVisionsTM




MST
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. MST also offers its NuVisions Broadband high speed internet
service and NuVisions Digital Voice telephone service to multi-family residences
and commercial properties. MST 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





MST 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, MST
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. MST
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, MST invested in an IPTV platform to deploy in 2007. 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.





Competition




The home
entertainment and video programming industry is competitive, and MST expects
competition to intensify in the future. MST faces its most significant
competition from the franchised cable operators. In addition, MST’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 MST
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





MST’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. MST
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.




9




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





MST’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.




MST
currently maintains service agreements with approximately 20 MDU and MTU
properties. Generally, under the terms of a service agreement, MST 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 MST charges residents
for its services. MST believes that its complementary products and services
allows for future growth and as such are designed and integrated with
scalability in mind.





Governmental
Regulation





Federal
Regulation




MST’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, MST has greater pricing
freedom and is not required to serve any customer whom it does not choose to
serve, and management believes that MST has significantly more competitive
flexibility than do the franchised cable systems. Management believes that these
regulatory advantages help to make MSTs’ 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 MST 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 MST, 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 MST’s business.




10




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 MST will be able to obtain
requisite broadcaster consents, management believes, in most cases, MST 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.





MST 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, MST 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.





State
and Local Cable System Regulation




MST 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 MST 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 MST’s business.





Preferential
Access Right




MST
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. The FCC has recently issued an order
prohibiting telecommunications service providers from negotiating exclusive
contracts with owners of commercial MDU properties, although it deferred
determination in a pending rulemaking whether to render existing exclusive
access agreements unenforceable, or to extend this prohibition to residential
MDUs due to an inadequate administrative record. Although it is open to question
whether the FCC has statutory and constitutional authority to compel mandatory
access, there can be no assurance that it will not attempt to do so. Any such
action may undermine the exclusivity provisions of MST’s rights of entry on the
one hand, but would also open up many other properties to which MST could
provide a competing service. There can be no assurance that future state or
federal laws or regulations will not restrict MST’s ability to offer access
payments, limit MDU owners' ability to receive access payments or prohibit MDU
owners from entering into exclusive agreements, any of which could have a
material adverse effect on MST’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 MST’s
business.




11




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





MST
maintains an investment in Interactivewifi.com, LLC a privately held company.
This investment represents an equity interest of approximately 50% at December
31, 2006. 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,
2006.





Backlog





The MST
subscriber portfolio includes approximately 20 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 MST
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 $1,800,000 in revenue through 2013.





Other
information





Employees





As of
March 1, 2007, the Company had 104 full time employees comprised of 69 full time
employees of Telkonet and 27 employees of MST. The Company anticipates that it
will hire additional key staff throughout 2007 in the areas of business
development, sales and marketing, and engineering.





Following
the acquisition of SSI and Ethostream, LLC on March 9, 2007 and March 15, 2007,
respectively, the Company had 177 full time employees.





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 expand a growing portion of our revenue from
international sales. International sales as a percentage of total revenue
represented 19% and 25% in 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.




12




Year
      Ended December 31,2006
            
            Percentage
              Change
            
            2005
            
            Percentage
              Change
            
            2004United
      States
            
            $
            4,508,478
            
            141%
            
            $
            1,871,241
            
            197%
            
            $
            630,957Worldwide
            
            
            672,850
            
            9%
            
            
            617,082
            
            812%
            
            
            67,695Total
            
            $
            5,181,328
            
            108%
            
            $
            2,488,323
            
            256%
            
            $
            698,652




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, 2006, the Company has incurred cumulative losses
of $70,424,669 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.




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.





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;




13




·
            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, 2007, the Company’s officers and directors owned 17.8% 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.





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, 2006, the Company had outstanding employee options to purchase a
total of 8,520,929 shares of common stock at exercise prices ranging from $1.00
to $5.97 per share, with a weighted average exercise price of $2.06. As of
December 31, 2006, 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, 2006, the Company had warrants outstanding to purchase
a total of 4,557,850 shares of common stock at exercise prices ranging from
$2.59 to $4.87 per share, with a weighted average exercise price of $4.20. 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.




14


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
industry 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 also have to
compete with such companies.





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
operatores and direct broadcast satallite (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
operatores 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.





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 Telkonet’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.




15




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.




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.




16




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.





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.




17




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





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 its business, results of operations, or
financial condition.





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 is currently planning to increase the
office space of its Germantown headquarters by approximately 6,000 square feet
in April 2007 in conjunction with a corporate initiative to consolidate office
space.





The
Company also leases 1,800 square feet of office space in White Marsh, Maryland,
where it operates a portion of its sales and marketing activities. The White
Marsh lease expires in May 2007.





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.





In
conjunction with the January 2006 acquisition of MST, 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.




18




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 and this lease expires in May 2011.




ITEM
3.LEGAL
PROCEEDINGS.





None.





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





On
December 8, 2006, 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
            45,352,150
            0
            1,520,291
            0Ronald
      W. Pickett
            45,343,879
            0
            1,526,562
            0Stephen
      L. Sadle
            45,399,903
            0
            1,472,538
            0Thomas
      C. Lynch
            46,385,473
            0
            486,968
            0James
      L. Peeler
            46,376,673
            0
            495,768
            0Thomas
      M. Hall
            46,423,873
            0
            448,568
            0Seth
      D. Blumenfeld
            45,392,739
            0
            1,479,702
            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 Telkonet’s Amended and Restated Stock Incentive Plan
            12,119,456
            2,641,084
            222,197
            31,889,704Ratification
      of Independent Accountants
            46,555,175
            142,308
            174,958
            0




19


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, 2007, the Company had 216 stockholders of
record and 57,002,301 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, 2005 through December 31,
2006. The information provided for the periods listed below was obtained from
the Yahoo! Finance web site.





High
            
            LowYear
      Ended December 31, 2006First
      Quarter
            
            $
            4.51
            
            $
            3.35Second
      Quarter
            
            $
            4.49
            
            $
            2.46Third
      Quarter
            
            $
            3.50
            
            $
            1.65Fourth
      Quarter
            
            $
            3.27
            
            $
            2.32Year
      Ended December 31, 2005First
      Quarter
            
            $
            6.85
            
            $
            3.66Second
      Quarter
            
            $
            5.34
            
            $
            2.61Third
      Quarter
            
            $
            5.60
            
            $
            3.11Fourth
      Quarter
            
            $
            5.23
            
            $
            3.51





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 August 15, 2002 and each fiscal year ending December 31
thereafter through the fiscal year ended December 31, 2006. Because Telkonet’s
common stock was not widely traded prior to August 15, 2002, the graph does not
show the total return on Telkonet’s common stock prior to August 15, 2002. The
total returns assume $100 invested on August 15, 2002 with reinvestment of
dividends.









20




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)
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003
            
            
            2002Total
      revenues
            
            $
            5,181
            
            
            $
            2,488
            
            
            $
            698
            
            
            $
            94
            
            
            $
            —Operating
      loss
            
            
            (17,563
            )
            
            
            (15,307
            )
            
            
            (13,112
            )
            
            
            (6,564
            )
            
            
            (3,155
            )Net
      loss
            
            
            (27,437
            )
            
            
            (15,778
            )
            
            
            (13,093
            )
            
            
            (7,657
            )
            
            
            (3,778
            )Loss
      per share - basic
            
            
            (0.54
            )
            
            
            (0.35
            )
            
            
            (0.32
            )
            
            
            (0.37
            )
            
            
            (.22
            )Loss
      per share - diluted
            
            
            (0.54
            )
            
            
            (0.35
            )
            
            
            (0.32
            )
            
            
            (0.37
            )
            
            
            (.22
            )Basic
      weighted average common shares outstanding
            
            
            50,824
            
            
            
            44,743
            
            
            
            41,384
            
            
            
            20,702
            
            
            
            17,120Diluted
      weighted average common shares outstanding
            
            
            50,824
            
            
            
            44,743
            
            
            
            41,384
            
            
            
            20,702
            
            
            
            17,120Working
      capital
            
            
            (531
            )
            
            
            12,061
            
            
            
            12,672
            
            
            
            5,296
            
            
            
            (894
            )Total
      assets
            
            
            12,517
            
            
            
            23,291
            
            
            
            15,493
            
            
            
            6,176
            
            
            
            295Short-term
      borrowings and current portion of long-term debt
            
            
            —
            
            
            
            6,350
            
            
            
            —
            
            
            
            15
            
            
            
            310Long-term
      debt, net of current portion
            
            
            —
            
            
            
            9,617
            
            
            
            588
            
            
            
            3,132
            
            
            
            863Stockholders’
      equity (deficiency)
            
            
            8,135
            
            
            
            5,315
            
            
            
            13,646
            
            
            
            2,388
            
            
            
            (1,527
            )





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





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 2006 were $3,425,525, representing 66% of
the Company’s consolidated net sales.




MST





MST 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 wireless fidelity (“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 upon
acquisition for the period February 1 through December 31, 2006 were $1,755,803,
representing 34% of the Company’s consolidated net sales.




21




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 superceded 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.





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 payments status of an
outstanding invoice, generally greater than 30 days past the 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 both orally and in writing, by the billing department and
management.





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, 2006 and 2005 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, 2006, the Company
experienced approximately 3% percent of units returned. Using this experience
factor a reserve of $23,300 was accrued. Prior to the fiscal year of 2005, the
Company had not established historical ratio of claims, and the cost of
replacing defective products and product returns were immaterial and within
management's expectations, accordingly there were no warranties provided with
the purchase of the Company's products during the year ended December 31,
2004.




22




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 year ended
December 31, 2006 was $1,080,895, 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 December 31, 2005 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.




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:




23




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%





Product
Revenue





Product
revenue in the Telkonet Segment increased approximately $800,000, excluding the
sale of certain rental contract agreements to HLC, 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.  TheTelkonet 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 in includes approximately 20 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 (HLC) 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%




24




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 competitve 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.




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 (HLC) 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 develops the infrastructure and continues 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 2007 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.




25




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
            %





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.





Year
Ended December 31, 2005 Compared to Year Ended December 31,
2004





Revenues





Telkonet’s
revenue consists of direct product sales and a rental (lease) model in the
commercial, government and international markets. The table below outlines
product versus rental (lease) revenues for comparable periods:





Year
      ended December 31,Revenue:
            
            2005
            
            2004
            
            VarianceProduct
            
            $
            1,769,727
            
            71%
            
            $
            477,555
            
            68%
            
            $
            1,292,172
            
            271%Rental
      (lease)
            
            
            718,596
            
            29%
            
            
            221,097
            
            32%
            
            
            497,499
            
            225%Total
            
            $
            2,488,323
            
            100%
            
            $
            698,652
            
            100%
            
            $
            1,789,671
            
            256%




Product
revenue





Product
revenue principally arises from the sale of iBridges and other Telkonet iWire
SystemTM
components directly to customers. Revenues to date have been principally derived
from the Commercial (Hospitality and Multi-Dwelling) and International business
units. The Company anticipates continued growth in Commercial and International
product revenue in the Value Added Reseller purchase programs. The Company
expanded its international sales and marketing efforts upon receiving its
European certification (CE) in March 2005. The Company expanded its sales and
marketing efforts in the government sector in connection with the receipt of the
FIPS 140-2 certification received in July 2005.





In
December 2005, 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 $732,000,
including the customer support component of approximately $205,000 which the
Company will retain and continue to receive monthly customer support payments
over the remaining average unexpired lease term of 26 months. In December 2005,
the Company recognized revenue of approximately $439,000 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 $267,000 and expensed associated taxes of approximately
$40,000.




26




Rental
(lease) revenue





The
increase in rental (lease) revenue was primarily due to the increase in
non-cancelable leases. Accordingly, revenues associated with these leases are
recognized ratably over a three to five year lease term. Revenues to be
recognized under these non-cancelable leases (backlog) was approximately
$2,411,000 including a non-recourse sale of $918,000 certain rental
contract agreements in January 2006. The weighted average remaining lease
term was approximately 31 months as of December 31, 2005. The associated
unamortized capitalized costs in connection with these leases was approximately
$664,000 or 26% of revenue backlog.





Cost of
Sales





Year
      ended December 31,Cost
      of Sales:
            
            2005
            
            2004
            
            VarianceProduct
            
            $
            1,183,574
            
            67%
            
            $
            459,225
            
            96%
            
            $
            724,349
            
            158%Rental
      (lease)
            
            
            533,605
            
            74%
            
            
            83,634
            
            38%
            
            
            449,971
            
            538%Total
            
            $
            1,717,179
            
            695
            
            $
            542,859
            
            78%
            
            $
            1,174,320
            
            216%





Product
Costs




Product
cost primarily includes Telkonet iWire SystemTM product
suite equipment cost and installation labor. The related product cost in
connection with the non-recourse sale of approximately $766,000 of rental
contract agreements amounted to approximately $267,000 of previously capitalized
equipment cost and other related cost.




Rental
(lease) Costs





Lease
Cost primarily represents the amortization of the capitalized costs which are
amortized over the lease term and include Telkonet equipment, installation labor
and customer support. This increase compared to the prior year quarter is
commensurate with the increase in leases.





Gross
Profit




Year
      ended December 31,Gross
      Profit:
            
            2005
            
            2004
            
            VarianceProduct
            
            $
            586,153
            
            33%
            
            $
            18,330
            
            4%
            
            $
            567,823
            
            3,098%Rental
      (lease)
            
            
            184,991
            
            26%
            
            
            137,463
            
            62%
            
            
            47,528
            
            -35%Total
            
            $
            771,144
            
            31%
            
            $
            155,793
            
            22%
            
            $
            615,351
            
            395%




Product
Costs





Gross
profit associated with the product revenues for the year ended December 31, 2005
improved over the prior year primarily as a result of reduction of equipment
costs and of improved installation processes, including upfront site surveys and
standardized training.





Rental
(lease) Costs





Gross
profit associated with the rental (lease) revenue decreased as a result of the
build-out of the customer support services.





Operating
Expenses





Year
      ended December 31,2005
            
            
            2004
            
            
            VarianceTotal
            
            $
            16,077,912
            
            
            $
            13,268,067
            
            
            $
            2,809,845
            
            
            
            21
            %




Overall
expenses increased for the year ended December 31, 2005 over the comparable
period in 2004 by $2,809,845 or 21%. Excluding the fee paid pursuant to certain
agreements with consultants of $2,500,000 expensed in the year end December 31,
2004, the increase for the year ended December 31, 2005 over the prior year
amounted to $5,309,845 or 49%. This increase was principally due to salary and
travel costs related to increased sales and marketing functions and office rent
related to the Germantown, MD and Crystal City, VA leases. The number of
employees increased from 48 at December 31, 2004 to 66 at December 31, 2005. In
addition, the Company wrote-off $400,000 of the carrying value of its investment
in Amperion through a charge to operations during the year end December 31,
2005.




27




Product Research and
Development





Year
      ended December 31,2005
            
            
            2004
            
            
            VarianceTotal
            
            $
            2,096,104
            
            
            $
            1,852,309
            
            
            $
            243,795
            
            
            
            13
            %




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, 2005
increased over the comparable prior year by $243,795 or 13%. This increase was
primarily related to an increase in salaries and related costs associated with
the addition of employees and costs related to CE, FIPS 140-2 and other required
certifications of the Company’s product.





Selling, General and
Administrative





Year
      ended December 31,2005
            
            
            2004
            
            
            VarianceTotal
            
            $
            12,041,661
            
            
            $
            7,663,369
            
            
            $
            4,378,292
            
            
            
            57
            %




Selling,
general and administrative expenses increased for the year ended December 31,
2005 over the comparable prior year by $4,378,292 or 57%. This increase is
related to an increase in payroll and associated costs for sales and marketing
resources, advertising, trade shows, and office rent and related facility
costs.




Liquidity and Capital
Resources





Working
Capital





Our
working capital surplus decreased by $12,591,438 during the twelve months ended
December 31, 2006 from a working capital surplus of $12,060,807 at December
31, 2005 to a working capital deficit of $(530,631) at December 31, 2006.
The decrease in working capital for the twelve months ended December 31, 2006,
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 $6,778,042 for the period ended
      December 31, 2006. The most significant uses of cash are as
      follows:





o
            Approximately
      $13,972,000 of cash consumed directly in operating activities, including
      interest paid of $991,000





o
            Principal
      repayments, in cash, of Senior Convertible Debentures and Senior notes
      amounted to $7,750,000 and $100,000,
  respectively





o
            The
      cash payments in the acquisition of MST amounted to approximately
      $958,000, net of acquired cash, and as part of the acquisition the MST
      debt payoff amounted to approximately $410,000—see discussion of MST
      acquisition below;





o
            An
      offsetting amount of approximately $2,740,000 related to the impact of
      proceeds from stock options and warrant
  exercises





o
            An
      additional offsetting amount from the sale of 2,400,000 shares of common
      stock at $2.50 per share for an aggregate purchase price of
      $6,000,000





o
            Approximately
      $2,324,000 was expended on net purchases of capitalized cost and fixed
      assets.





·
            The
      acquisition of MST included a second installment of $900,000 payable in
      January 2007 and at acquisition $400,000 of potential income tax exposure
      was accrued in accounts payable and accrued
  liabilities.




28




Of the
total $3,766,079 in current assets as of December 31, 2006, cash represented
$1,644,037. Of the total $20,377,956 in current assets as of December 31, 2005,
cash represented $8,422,079, and Restricted Certificate of Deposit represented
$10,000,000.




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.





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 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 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 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.




29




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 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 15, 2007, no legal
claim has been filed by the noteholder.





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 which will be 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. In the period 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. The Company is obligated to register the stock portion of the purchase
price on or before May 15, 2007 and 1,090,000 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.





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. The aggregate number of shares issuable to the sellers is subject to
downward adjustment in the event the Company’s common stock trades at or above a
price of $4.50 per share for twenty consecutive trading days during the one year
period following the closing.




30




Proceeds
from the issuance of common stock





During
the twelve months ended December 31, 2006, the Company received $2,684,663 from
the exercise of employee and non-employee stock options and $55,138 from the
exercise of warrants.





During
the twelve months 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 issued to this investor warrants to purchase 1.56
million shares of its common stock at an exercise price of $4.17 per
share.




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.





Cash
flow analysis





Cash
utilized in operating activities was $13,971,529 during the year ended December
31, 2006 compared to $12,086,032 and $9,583,560 during the years ended December
31, 2005 and 2004, respectively. The primary use of cash during the twelve
months ended December 31, 2006 was net operating expenses of the Company of
$12,980,683 and interest expense payments of $990,846.




The
Company was provided and utilized cash for investing activities $6,717,442 and
$10,925,719 during the twelve months ended December 31, 2006 and 2005,
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 sale of certain equipment under operating
lease 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 in financing activities of $476,045 and $19,595,128
during the year ended December 31, 2006 and 2005, respectively. The financing
activities represent proceeds from the sale of 2,400,000 shares of common stock
at $2.50 per share for an aggregate purchase price of $6,000,000 during the
twelve months ended December 31, 2006. Additionally, the financing activities
represent proceeds from the exercise of stock options and warrants of $2,739,801
and $1,174,538 during the years ended December 31, 2006 and 2005, respectively.
The proceeds of the financing activities were offset by repayment of debt
principal of $8,263,756 in 2006, including $7,750,000 of principal payments in
conjunction with the conversion and settlement agreement with the lenders under
the Company’s Convertible Senior Notes and approximately $410,000 in conjunction
with the acquisition of MST.





The
Company believes it has sufficient access to capital to meet its working capital
requirements through the remainder of 2007 in available cash and in cash
generated from operations. Additional financing may be required in order to meet
growth opportunities in financing and/or investing activities. If additional
capital is required and 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.





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.




31




Acquisition or Disposition
of Plant and Equipment





During
the year ended December 31, 2006, fixed assets increased $1,169,899 or 112%
primarily from the addition of the MST Segment assets acquired on January 31,
2006 of approximately $435,000 and approximately $674,000 of equipment purchase
for the MST build-out. The remainder 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.





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





MST
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 and this lease expires in May 2011.





New Accounting
Pronouncements





On
February 16, 2006 the Financial Accounting Standards Board (FASB) issued
SFAS 155, “Accounting for Certain Hybrid Instruments,” which amends SFAS 133,
“Accounting for Derivative Instruments and Hedging Activities,” and SFAS 140,
“Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities.” SFAS 155 allows financial instruments that have embedded
derivatives to be accounted for as a whole (eliminating the need to bifurcate
the derivative from its host) if the holder elects to account for the whole
instrument on a fair value basis. SFAS 155 also clarifies and amends certain
other provisions of SFAS 133 and SFAS 140. This statement is effective for all
financial instruments acquired or issued in fiscal years beginning after
September 15, 2006. The Company does not expect its adoption of this new
standard to have a material impact on its financial position, results of
operations or cash flows.





In
September 2006, the FASB issued SFAS 157, Fair Value Measurements, which
defines fair value, establishes a framework for measuring fair value in
generally accepted accounting principles (“GAAP”), and expands disclosures about
fair value measurements. The Company will be required to adopt SFAS 157
effective for the fiscal year beginning January 1, 2008. The requirements
of SFAS 157 will be applied prospectively except for certain derivative
instruments that would be adjusted through the opening balance of retained
earnings in the period of adoption. The Company is currently evaluating the
impact of the adoption of SFAS 157 on the Company’s consolidated financial
statements and management believes that the adoption of SFAS 157 will not have a
significant impact on its consolidated results of operations or financial
position.





In
September 2006, the FASB issued Statement of Financial Accounting Standards No.
158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement
Plans - an amendment of FASB Statements No. 87, 88, 106, and 132R (‘SFAS
158’).  SFAS 158 changes current practice by requiring employers to
recognize the overfunded or underfunded positions of defined benefit
postretirement plans, including pension plans, on the balance sheet.  The
funded status is defined as the difference between the projected benefit
obligation and the fair value of plan assets.  SFAS 158 also requires
employers to recognize the change in funded status in other comprehensive income
(a component of shareholders’ equity).  SFAS 158 does not change the
requirements for the measurement and recognition of pension expense in the
statement of income.  SFAS 158 is effective for fiscal years ending after
December 15, 2006.  The Company does not anticipate any material impact to
its financial condition or results of operations as a result of the adoption of
SFAS 158.




In
September 2006, the SEC issued Staff Accounting Bulletin 108, Considering the Effects of Prior
Year Misstatements When Quantifying Misstatements in Current Year Financial
Statements (‘SAB 108’).  SAB 108 provides interpretive guidance on
how the effects of the carryover or reversal of prior year financial statement
misstatements should be considered in quantifying a current year
misstatement.  SAB 108 is effective for financial statements covering the
first fiscal year ending after November 15, 2006.  The Company does not
anticipate any material impact to its financial condition or results of
operations as a result of the adoption of SAB 108.




32




In
December 2006, the FASB issued FSP EITF 00-19-2, Accounting for Registration
Payment Arrangements ("FSP 00-19-2") which addresses accounting for registration
payment arrangements. FSP 00-19-2 specifies that the contingent obligation to
make future payments or otherwise transfer consideration under a registration
payment arrangement, whether issued as a separate agreement or included as a
provision of a financial instrument or other agreement, should be separately
recognized and measured in accordance with FASB Statement No. 5, Accounting for
Contingencies. FSP 00-19-2 further clarifies that a financial instrument subject
to a registration payment arrangement should be accounted for in accordance with
other applicable generally accepted accounting principles without regard to the
contingent obligation to transfer consideration pursuant to the registration
payment arrangement. For registration payment arrangements and financial
instruments subject to those arrangements that were entered into prior to the
issuance of EITF 00-19-2, this guidance is effective for financial statements
issued for fiscal years beginning after December 15, 2006 and interim periods
within those fiscal years. The Company has not yet determined the impact that
the adoption of FSP 00-19-2 will have on its financial statements.





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.




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
            
            $
            900,000
            
            
            $
            900,000
            
            
            
            -
            
            
            
            -
            
            
            
            -Capital
      Lease Obligations
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Operating
      Lease Obligations
            
            $
            1,117,663
            
            
            $
            421,804
            
            
            $
            518,909
            
            
            $
            176,950
            
            
            
            -Purchase
      Obligations
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Other
      Long-Term Liabilities Reflected on the Registrant’s Balance Sheet Under
      GAAP
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            $
            2,017,663
            
            
            $
            1,321,804
            
            
            $
            518,909
            
            
            $
            176,950
            
            
            
            -





(1)
Operating lease obligations includes approximately $266,872 of future lease
obligations, primarily related to office and warehouse space, in conjunction
with the January 2006 acquisition of Microwave Satellite Technologies,
Inc.





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





Short Term
Investments





We held
no marketable securities as of December 31, 2006. 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.





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, 2007 was $131,044 and
$8,000 in BPL Global and Amperion, respectively, and at December 31, 2006, 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 80%, or $400,000 and
92%, or $92,000, of the carrying value of its investment through a charge to
operations during the years ended December 31, 2005 and 2006, respectively. The
fair value of the Company’s investment in BPL Global, remained at $131,044 as of
December 31, 2006.





ITEM
8.FINANCIAL
STATEMENTS.





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





33


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 Vice President of Finance (principal accounting 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”)). 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 Vice President of Finance
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
2006, 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:




·
            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.





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, 2006, 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, 2006.




The
Company’s assessment of the effectiveness of its internal control over financial
reporting as of December 31, 2006 has been audited by Russell Bedford Stefanou
Mirchandani LLP, an independent registered public accounting firm, as stated in
their report which is included in this Annual Report on Form 10-K.




34




RUSSELL
BEDFORD STEFANOU MIRCHANDANI LLP


CERTIFIED
PUBLIC ACCOUNTANTS





REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





Board of
Directors


Telkonet,
Inc.


Germantown,
MD




We have
audited management's assessment, included in the accompanying Management's
Report on Internal Control over Financial Reporting, that Telkonet, Inc. and
its subsidiaries (the Company) maintained effective internal control over
financial reporting as of December 31, 2006, based on criteria established
inInternal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). 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.
Our responsibility is to express an opinion on management's assessment and an
opinion on the effectiveness of the Company's internal control over financial
reporting based on our audit.




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




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




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




In our
opinion, management's assessment that Telkonet, Inc. and its wholly-owned
subsidiaries maintained effective internal control over financial reporting as
of December 31, 2006, is fairly stated, in all material respects, based on
criteria established in Internal Control Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). Also, in our opinion, Telkonet, Inc. and
its subsidiaries, maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2006, based on criteria
established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO).




We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated financial statements and
financial statement schedules as of and for the year ended December 31, 2006, of
the Company and our report dated March 15, 2007 expressed an unqualified opinion
on those financial statements and financial statement schedules and included an
explanatory paragraph regarding the Company's adoption of the provisions of
Statement of Financial Accounting Standards No. 123(R), "Share-Based Payment",
effective January 1, 2006.








/s/ RUSSELL BEDFORD
      STEFANOU MIRCHANDANI LLPRussell
      Bedford Stefanou Mirchandani LLP
              Certified
      Public Accountants




McLean,
Virginia


March 15,
2007




35




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 during the fiscal year ended December 31, 2006. The directors of the
Company are elected every year and serve until their successors are duly elected
and qualified.





Name
            Age
            TitleRonald
      W. Pickett
            59
            President,
      Director & Chief Executive OfficerFrank
      T. Matarazzo
            45
            President
      & Chief Executive Officer, Microwave Satellite Technologies,
      Inc.Robert
      P. Crabb
            59
            Chief
      Marketing OfficerStephen
      Sadle
            61
            Senior
      Vice President & DirectorJames
      Landry
            51
            Chief
      Technology OfficerRichard
      J. Leimbach
            38
            Vice
      President of FinanceWarren
      V. Musser
            80
            Chairman
      of the BoardThomas
      C. Lynch
            64
            Director
      (1), (2)Dr.
      Thomas M. Hall
            55
            Director
      (1), (2)James
      L. “Lou” Peeler
            73
            Director
      (1), (2)Seth
      Blumenfeld
            66
            Director


_________________________


(1)
            Member
      of the Audit Committee


(2)
            Member
      of the Compensation Committee





Ronald
W. Pickett—President, Chief Executive Officer & Director





Mr.
Pickett has served as the Company’s Chief Executive Officer 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.





Frank
T. Matarazzo—President & Chief Executive Officer, Microwave Satellite
Technologies, Inc. (MST)





Mr.
Matarazzo has been the President and Chief Executive Officer of Microwave
Satellite Technologies, Inc. since its inception in 1982. Mr. Matarazzo has
directed the growth and development of the Microwave Satellite Technologies,
Inc. (MST) and designed and constructed the first private cable television
systems operated by MST and continues to be involved in all technology deployed
at MST. Mr. Matarazzo’s experience includes employment for Conrac Avionics, as a
prototype design engineer, working on the development of the guidance/navigation
systems for military fighter planes as well as the development and construction
of the FM communication systems and engine interface units for the Space Shuttle
Columbia. He is known in the private cable television industry, having both
written articles for trade publications and served as a technical consultant to
municipalities on the subject of satellite delivered information
systems.




36




Robert
P. Crabb—Chief Marketing Officer





Mr. Crabb
has over 35 years of sales, marketing and corporate management experience,
including 15 years in the insurance industry in property and casualty brokerage
and sales and sales management with the Metropolitan Life Insurance Company. His
entrepreneurial expertise also includes public company administration, financial
consulting, corporate management and commercial/residential real estate
development. Mr. Crabb is a former director of Telkonet and has been involved
with the Company since 1999.





Stephen
L. Sadle—Senior Vice President, Co-Founder & Director





From 1999
until he joined Telkonet in 2000, Mr. Sadle served as Senior Vice President and
General Sales Manager of Internos (a provider of web-based vertical extranet
applications). From 1986 until 1999, Mr. Sadle was Vice President of Business
Development and Sales for the Driggs Corporation, a major heavy and
infrastructure contracting firm interfacing with government and the private
sectors. From 1970 until 1986, Mr. Sadle was President of a successful
infrastructure construction and development company in the Washington, D.C.
metropolitan area. Mr. Sadle has been a director of the Company since November
1999.





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.





Richard
J. Leimbach—Vice President of Finance




Mr.
Leimbach has served as the Vice President of Finance since June 2006, also
served as Controller from January 2004 until June 2006. Mr. Leimbach is a
certified public accountant with over thirteen 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.





Warren
V. Musser—Chairman of the Board of Directors





Mr.
Musser, has taken over 50 companies public during his distinguished and
successful career as an entrepreneur, and is the founder and Chairman Emeritus
of Safeguard Scientifics, Inc. (a high-tech venture capital company, formerly
Safeguard Industries, Inc.). Mr. Musser is currently the Managing Director, The
Musser Group (a business consulting firm) and Founder & President, Musser
and Company, Inc. (an investment banking firm). In addition, Mr. Musser is a
Director of Internet Capital Group, Inc. (a business-to-business venture capital
company), and Mr. Musser is a Director and Vice Chairman of Nutri/System, Inc
(Nasdaq:NRTI). (a weight management company) and Co-Chairman of Eastern
Technology Council (a business advisory firm). Mr. Musser serves on a variety of
civic, educational and charitable boards of directors, and serves as vice
president of development, Cradle of Liberty Council, Boy Scouts of America; vice
chairman of The Eastern Technology Council; and chairman of the Pennsylvania
Partnership on Economic Education. Mr. Musser has been a director of the Company
since January 2003.





Thomas
C. Lynch—Director





Mr. Lynch
is Senior Vice President and Director 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 a Director of Pennsylvania Eastern Technology Council, Armed Forces Benefit
Association, Catholic Leadership Institute, National Center for the American
Revolution at Valley Forge and Mikros Systems. Mr. Lynch has been a director of
the Company since October 2003.




37




Dr.
Thomas M. Hall—Director





Dr. Hall
is the Managing Member of Marrell Enterprises, LLC (a company that specializes
in international business development).Dr. Hall also serves on the board of
directors of Coris International SA (a Paris-based insurance services company
with subsidiaries in 36 countries). 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 is presently 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.





Audit
Committee





The
Company maintains an Audit Committee of the Board of Directors. For the year
ended December 31, 2006, 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, 2006, Dr. Hall ad Messrs. Lynch and Peeler served on the
Compensation Committee. The committee held 1 meeting during 2006.




38




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.





Beneficial
Ownership 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 2006 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, 2006.





Thomas M.
Hall


Thomas C.
Lynch


James L.
Peeler





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 executives 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.





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.




39




·
            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.




Compensation Elements and
Rationale





Compensation
for Named Executive Officers Other than the CEO





Compensation
for the named executive officers, other than the CEO, are 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.




40




(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.





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.




41




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 ratably vest 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 purchase 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.





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.





MST
maintains a defined contribution profit sharing plan for employees (the “MST
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 MST 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 MST 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.




42




Perquisites





The
Company leases a vehicle for the use of Telkonet's CEO. The operating
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 MST 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, 2006, 2005 and
2004 paid to our Chief Executive Officer, Vice President of Finance (principal
financial officer) and the three other most highly compensated executive
officers who were serving as such as of December 31, 2006.





Summary
Compensation Table





Name
      and Principal Position
            Year
            Salary
              ($)
            Bonus
              ($)
            Stock
              Awards
              ($)
            Option
      Awards
              ($)
              (3)(4)(5)
            Non-Equity
              Incentive
      Plan Compensation
              ($)
            Change
      in
              Pension
      Value
              and
              Nonqualified
      Deferred Compensation Earnings
              ($)
            All
      Other
              Compen-sation
              ($)
            Total
              ($)Ronald
      W. Pickett
            2006
            $245,423
            $0
            $0
            $0
            $0
            $0
            $4,593
      (3)
            $250,016President
      and Chief
            2005
            $102,340
            $200,000
            $163,319
      (1)
            $0
            $0
            $0
            $0
            $465,659Executive
      Officer
            2004
            $100,089
            $0
            $107,779
      (1)
            $0
            $0
            $0
            $0
            $207,868Frank
      T. Matarazzo
            2006
            $244,539
            $9,615
            $0
            $0
            $0
            $0
            $0
            $254,154President
      and Chief
            2005
            $0
      (2)
            $0
            $0
            $0
            $0
            $0
            $0
            $0
      (2)Executive
      Officer, MST
            2004
            $0
      (2)
            $0
            $0
            $0
            $0
            $0
            $0
            $0
      (2)Stephen
      L. Sadle
            2006
            $168,154
            $6,610
            $0
            $0
            $0
            $0
            $0
            $174,764Senior
      Vice President
            2005
            $171,872
            $10,000
            $0
            $124,770
            $0
            $0
            $0
            $306,6422004
            $171,983
            $6,538
            $0
            $124,770
            $0
            $0
            $0
            $303,291Richard
      J. Leimbach
            2006
            $111,231
            $5,000
            $0
            $36,312
            $0
            $0
            $0
            $152,543Vice
      President, Finance
            2005
            $102,340
            $3,936
            $0
            $36,312
            $0
            $0
            $0
            $142,5882004
            $76,147
            $3,269
            $0
            $5,825
            $0
            $0
            $0
            $85,241James
      F. Landry
            2006
            $174,886
            $6,789
            $0
            $104,500
            $0
            $0
            $0
            $286,176Chief
      Technology
            2005
            $176,508
            $15,000
            $0
            $38,124
            $0
            $0
            $0
            $229,632Officer
            2004
            $172,514
            $15,000
            $0
            $44,958
            $0
            $0
            $0
            $232,499


____________________


(1)
            In
      each year ending December 31, 2005 and 2004, 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, and $107,779,
      respectively.


(2)
            In
      January 2006, the Company acquired a 90% interest in MST, a corporation
      wholly owned by Frank T. Matarazzo, prior to the acquisition. No
      compensation was paid by Telkonet to Mr. Matarazzo for the years ended
      December 31, 2005, and 2004.


(3)
            In
      2004 the following assumptions were used to determine the fair value of
      stock option awards granted: historical volatility of 76% expected option
      life of 5.0 years and a risk-free interest rate of
  1.35%.


(4)
            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
  4.50%.


(5)
            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%.




43




Employment
Agreements





Ronald W.
Pickett, President and Chief Executive Officer, is employed pursuant to an
employment agreement for an unspecified term that commenced January 30, 2003 and
provides for an annual salary $100,000, 3,000 shares of the Company’s common
stock per month for each month of his employment and bonuses and benefits based
upon Telkonet’s internal policies. Mr. Pickett’s annual salary was increased to
$102,340 on August 1, 2004 and he received a bonus of $200,000 for the year
ended December 31, 2005. In January 2006, Mr. Pickett’s salary was increased to
$250,000 with an incentive bonus up to $150,000. The incentive portion of the
salary would be awarded based on the successful achievement of certain
performance metrics aligned with the Company’s 2006 operating plan.





Frank T.
Matarazzo, President and Chief Executive Officer, MST, is employed pursuant to
an employment agreement for a three-year term that commenced February 1, 2006
and provides for an annual salary of $250,000 and bonuses and benefits based
upon MST’s internal policies.





Robert P.
Crabb, Chief Marketing Officer, is employed pursuant to an employment agreement
for a three year term that commenced January 18, 2003 and provides for an annual
salary of $120,000 and bonuses and benefits based upon Telkonet’s internal
policies. Mr. Crabb’s annual salary was increased to $172,340 in
2004.





Stephen
L. Sadle, Senior Vice President, is employed pursuant to an employment agreement
for a three-year term that commenced January 18, 2003 and renewed for a one-year
term through January 17, 2007 and provides for an annual salary of $130,000 and
bonuses and benefits based upon Telkonet’s internal policies. Mr. Sadle’s annual
salary was increased to $171,872 in 2004.





Richard
J. Leimbach, Vice President of Finance, has been employed since January 26, 2004
with an annual salary of $102,340 and bonuses and benefits based upon Telkonet’s
internal policies. Mr. Leimbach’s annual salary was increased to $130,000 in
2006.




James F.
Landry, Chief Technology Officer, has been employed since September 24, 2001
with an annual salary of $160,000 with bonuses and benefits based upon
Telkonet’s internal policies. Mr. Landry’s annual salary was increased to
$176,508 in 2004.





Bill
Dukes, President and CEO of Smart Systems International (an operating division
of Telkonet), is employed pursuant to an employment agreement, dated March 9,
2007. Mr. Dukes’ employment agreement has a term of [one year] and provides for
a base salary of [$250,000] per year and bonuses and benefits based upon
Telkonet’s internal policies.





Robert
Zirpoli, [Senior Engineer] of Smart Systems International (an operating division
of Telkonet), is employed pursuant to an employment agreement, dated March 9,
2007. Mr. Zirpoli’s employment agreement has a term of [one year] and provides
for a base salary of [$100,000] per year and bonuses and benefits based upon
Telkonet’s internal policies.





Jason
Tienor, Chief Executive Officer of Ethostream, LLC, 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 a base salary of $148,000.00 per year and
bonuses and benefits based upon Telkonet’s internal policies.





Jeff
Sobieski, Chief Financial Officer of Ethostream, LLC, 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 $148,000.00 per year and
bonuses and benefits based upon Telkonet’s internal policies.





44


GRANT
OF PLAN BASED AWARDS





There
were no stock options or restricted stock awards granted in 2006.





OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END TABLE





The
following table shows outstanding stock option awards classified as exercisable
and unexercisable as of December 29, 2006 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 $2.67 a share (the
closing market price of the Company’s stock on December 29,
2006).





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
              ($)
            Option
              Expiration
              Date
            Number
      of
              Shares
      or
              Units
      of
              StockThat
              Have
      Not
              Vested
              (#)
            Market
              Value
      of
              Shares
      or
              Units
      of
              Stock
      That
              Have
      Not
              Vested
              ($)
            Equity
              Incentive
              PlanAwards:
              Number
      of
              Unearned
              Shares,
              Units
      or
              OtherRights
              That
      Have
              Not
      Vested
              (#)
            Equity
              Incentive
              PlanAwards:
              Market
      or
              PayoutValue
              ofUnearned
              Shares,
              Units
      or
              OtherRights
              That
      Have
              Not
      Vested
              ($)Ronald
      W. Pickett
            -
            -
            -
            N/A
            N/A
            -
            -
            -
            -Frank
      T. Matarazzo
            -
            -
            -
            N/A
            N/A
            -
            -
            -
            -Stephen
      L.Sadle
            900,000
            -
            -
            $1.00
            1/1/2003
            -
            -
            -
            -Richard
      J. Leimbach
            32,500
            55,000
            -
            (1)
            (1)
            -
            -
            -
            -James
      F.Landry
            350,000
            150,000
            -
            (2)
            (2)
            -
            -
            -
            -





_________________





(1)
            Includes
      12,500 and 25,000 vested and unvested options, respectively, exerciseable
      at $2.59 per share with an expiration of 1/26/2014 and 20,000 and 30,000
      vested and unvested options, respectively, exerciseable at $5.08 per share
      with an expiration of 1/1/2015.(2)
            Includes
      250,000 fully vested options, exerciseable at $1.00 per share with
      expirations ranging from 12/3/2011 to 7/1/2013 and 100,000 and 150,000
      vested and unvested options, respectively, exerciseable at $3.45 per share
      with an expiration of 5/1/2014.




OPTION
EXERCISES AND STOCK VESTED





There
were no options exercised by, or stock awards vested for the account of, the
named executive officers during 2006.




45




POTENTIAL
PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL




In
January 2003, the Company entered into an Employment Agreement with Mr. Sadle
pursuant to which, in the event of a change in control, Mr. Sadle will continue
to receive salary and benefits for a period of thirty-six months following
such change in control. All of Mr. Sadle’s options to purchase common stock will
also immediately vest upon a change of control.





For
purposes of Mr. Sadle’s Employment Agreement, the term "change in control" means
the first to occur of the following events (a) any person or group of commonly
controlled persons acquires, directly or indirectly, thirty percent (30%) or
more of the voting control or value of the equity interests in the Company; or
(b) the shareholders of the Company approve an agreement to merge or consolidate
with another corporation or other entity resulting (whether separately or in
connection with a series of transactions) in a change in ownership of twenty
percent (20%) or more of the voting control or value of the equity interests in
the Company, or an agreement to sell or otherwise dispose of all or
substantially all of the Company's assets (including, without limitation, a plan
of liquidation or dissolution), or otherwise approve of a fundamental alteration
in the nature of the Company's business.





Rights
under the Mr. Sadle’s Employment Agreement will be triggered in the event that,
following a change in control, the executive’s employment with the Company is
terminated for any reason or no reason.





If a
change of control had occurred on January 1, 2007, Mr. Sadle would be entitled
to the following as of such date:




$515,616
in salary as well as benefits paid on the employees behalf based upon Telkonet's
internal policies for a period of 36 months.





Each of
Mr. Tienor 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 (ii)
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.





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.





Each of
Mr. Dukes’ and Mr. Zirpoli’s employment agreements obligate the Company to
continue to pay the executive’s base salary and provide continued participation
in each Company benefit plan for a period of three months following the
termination of the executive’s employment without cause. In the event the
executive is terminated “for cause,” or for engaging in any unethical, immoral
or unprofessional conduct or violation of a Company policy, he shall not be
entitled to any payment beyond such termination date, except for accrued leave
and vacation and except as may be required by applicable law. For purposes of
the employment agreements, “cause” includes, but is not be limited to, the
following: (i) theft, fraud, embezzlement, dishonesty or other similar behavior
by the executive; (ii) any material breach by the executive of any provision of
the employment agreement; (iii) any habitual neglect of duty or misconduct of
the executive in discharging any of his duties and responsibilities under the
employment agreement; (iv) any conduct of the executive which is detrimental to
or embarrassing to the Company, including, but not limited to, the executive
being indicated or convicted of a felony or any offense involving moral
turpitude; or (v) any default of the executive’s obligations under the
employment agreement, 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 the Company.




46




Director
Compensation





In 2004,
each non-employee Director elected or appointed to the Board of Directors was
granted an option to purchase forty thousand (40,000) shares of the Company’s
common stock and each Non-Employee Director will be granted an option to
purchase forty thousand (40,000) shares upon his or her re-election at an
annual meeting of the Company’s stockholders. These options vest on a quarterly
basis over a period of one-year.




Compensation
for 2006 to the non-employee directors was earned at the rate of $4,000 per
month plus $1,000 per meeting attended. The Chairman of the Audit Committee
earns compensation at the rate of $4,000 per month, and each non-employee
director earns $1,000 for each meeting of the Audit Committee
attended.





The
following table summarizes all compensation paid to the Company’s directors in
the year ended December 31, 2006.





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
            
            
            52,000
            
            
            
            -
            
            
            
            34,500(2)
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            86,500Thomas
      C. Lynch
            
            
            52,000
            
            
            
            -
            
            
            
            34,500(2)
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            86,500James
      L. Peeler
            
            
            52,000
            
            
            
            -
            
            
            
            34,500(2)
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            86,500Seth
      D. Blumenfeld
            
            
            -
            
            
            
            77,595(3)
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            77,595Ronald
      W. Pickett
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Stephen
      L. Sadle
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -





(1)
            fees
      from annual consulting agreement dated September 2003 for non-director
      services.


(2)
            stock
      options granted in January 2006 pursuant to the non-employee director
      compensation


(3)
            20,000
      shares issued for services performed through June 2006 pursuant to the
      professional services agreement dated July 1,
  2005.





COMPENSATION
COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION





During
the year ended December 31, 2006, Messrs, Hall, Lynch and Peeler 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, 2006 nor has any of them been an officer of the Company. No
executive officer of the Company served during the year ended December 31, 2006
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.




47


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, 2006.





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
            10,336,866
            $1.87
            1,645,423Equity
      compensation plans not approved by security holders
            -
            -
            -Total
            10,336,866
            $1.87
            1,645,423




The
following table sets forth, as of March 1, 2007, 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, 2007, 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 ClassOfficers and
      DirectorsRonald
      W. Pickett, President and CEO
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            2,574,699
            4.5%Frank
      T. Matarazzo, President and CEO, MST
              259-263
      Goffle Road
              Hawthorne,
      NJ 07506
            520,000(1)
            0.9%Stephen
      L. Sadle, Senior Vice President
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            4,284,514(2)
            7.4%James
      Landry, Chief Technology Officer
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            484,200(3)
            0.8%Richard
      Leimbach, Vice President of Finance
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            41,000(4)
            0.1%Warren
      V. Musser, Chairman
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            2,000,000(5)
            3.4%Thomas
      C. Lynch, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            100,000(6)
            0.2%Dr.
      Thomas M. Hall, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            647,790(7)
            1.1%




48




James
      “Lou” L. Peeler, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            84,400(8)
            0.1%Seth
      D. Blumenfeld, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            65,000(9)
            0.1%All
      Directors and Executive Officers as a Group
            10,801,603
            17.8%


_____________________





(1)
            Includes
      600,000 shares of the Company’s common stock issued to Mr. Matarazzo in
      conjunction with the Company’s January 2006 acquisition of a 90% interest
      in Microwave Satellite Technologies, Inc. As part of the purchase price,
      an additional 1,000,000 shares of the Company’s common stock are held in
      escrow, issuable upon the achievement of certain performance targets and
      excluded from this table.(2)
            Includes
      options exercisable within 60 days to purchase 900,000 shares of the
      Company’s common stock at $1.00 per share.(3)
            Includes
      options exercisable within 60 days to purchase 250,000 and 150,000 shares
      of the Company’s common stock at $1.00 and $3.45 per share,
      respectively.(4)
            Includes
      options exercisable within 60 days to purchase 17,500 and 22,500 shares of
      the Company’s common stock at $2.59 and $5.08 per share,
      respectively.(5)
            Includes
      options exercisable within 60 days to purchase 2,000,000 shares of the
      Company’s common stock at $1.00 per share.(6)
            Includes
      options exercisable within 60 days to purchase 20,000 and 80,000 shares of
      the Company’s common stock at $2.00 and $3.45 per share,
      respectively.(7)
            Includes
      options exercisable within 60 days to purchase 80,000 shares of the
      Company’s common stock at $3.45 per share.(8)
            Includes
      options exercisable within 60 days to purchase 80,000 shares of the
      Company’s common stock at $3.45 per share.(9)
            Includes
      15,000 shares of the Company’s common stock to be issued within 60 days
      pursuant to a Professional Services
Agreement.





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, 2006, 2005 and 2004, the
Company paid and expensed $100,000, $100,000 and $100,000,
respectively.





On July
1, 2005, Mr. Blumenfeld was retained as a consultant to Telkonet pursuant to a
Professional Services Agreement between the Company and Mr. Blumenfeld. Pursuant
to the terms of the agreement, Mr. Blumenfeld received 10,000 shares of Company
stock upon execution of the agreement, 10,000 shares of Company 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 plus a five percent (5%)
commission (payable in cash or Company stock) 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. This agreement
expired in June 2006.





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, in
exchange for $200,000 of Series B Debentures held by him. 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 held by Mr. Pickett. In addition,
the Company issued an aggregate of 200,000 shares of common stock upon the
exercise by Mr. Pickett of warrants to purchase shares of the Company’s common
stock at $1.00 per share.




49




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 President
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 President and CEO of the Company and receives an annual base salary of
approximately $150,000 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 and Mr. Peeler. Each of Dr. Hall, Mr. Peeler and Mr. Lynch serve
on, and are the only members of, the Company’s Audit and Compensation
Committees. 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, 2006 and 2005. Additionally, the Company
incurred approximately $320,289, of consulting and internal
resources associated with its Sarbanes-Oxley compliance
review.





December
      31, 2006
            
            
            December
      31, 20051.
      Audit Fees
            
            $
            229,552
            
            
            $
            119,0902.
      Audit Related Fees
            
            
            52,600
            
            
            
            62,8253.
      Tax Fees
            
            
            --
            
            
            
            1,1754.
      All Other Fees
            
            
            --
            
            
            
            --Total
      Fees
            
            $
            282,152
            
            
            $
            183,090





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 Russell Bedford Stefanou Mirchandani 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.”




50




Tax fees
consists 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, 2006, 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, 2006 and 2005.





QUARTERLY
FINANCIAL DATA


(unaudited)





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
            
            
            $
            (170,433
            )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
            )March
      31,
              2005
            
            
            June
      30,
              2005
            
            
            September
      30, 2005
            
            
            December
      31,
              2005Net
      Revenue
            
            $
            246,188
            
            
            $
            472,947
            
            
            $
            621,923
            
            
            $
            1,147,265Gross
      Profit
            
            $
            88,798
            
            
            $
            120,791
            
            
            $
            212,749
            
            
            $
            348,806Provision
      for income taxes
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Net
      loss per share -- basic
            
            $
            (0.07
            )
            
            $
            (0.08
            )
            
            $
            (0.08
            )
            
            $
            (0.12
            )Net
      loss per share -- diluted
            
            $
            (0.07
            )
            
            $
            (0.08
            )
            
            $
            (0.08
            )
            
            $
            (0.12
            )





The
following table sets forth selected unaudited valuation and qualifying account
information for the Company’s year-ended December 31, 2006, 2005 and
2004.




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 31,2006
            
            $
            30,000
            
            
            $
            36,659
            
            
            $
            6,659
            
            
            $
            60,0002005
            
            
            13,000
            
            
            
            39,710
            
            
            
            (22,710
            )
            
            
            30,0002004
            
            
            7,000
            
            
            
            30,637
            
            
            
            (24,637
            )
            
            
            13,000Reserve
      for product returns:Year
      ended December 31,2006
            
            $
            24,000
            
            
            $
            23,300
            
            
            $
            —
            
            
            $
            47,3002005
            
            
            —
            
            
            
            24,000
            
            
            
            —
            
            
            
            24,0002004
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —




51




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.


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, 200710.16
            
            Employment
      Agreement by and between Telkonet, Inc. and Robert Zirpoli, dated as of
      March 9, 200710.17
            
            Employment
      Agreement by and between Telkonet, Inc. and Jason Tienor, dated as of
      March 15, 200710.18
            
            Employment
      Agreement by and between Telkonet, Inc. and Jeff Sobieski, dated as of
      March 15, 200714
            
            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 Russell Bedford Stefanou Mirchandani 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 Ronald W.
      Pickett31.2
            
            Certification
      Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Richard J.
      Leimbach32.1
            
            Certification
      of Ronald W. Pickett 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




52





SIGNATURES





Pursuant
to he 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.By:
              /s/ Jason
      TienorJason
      TienorChief
      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)
            
            March
      3, 2008/s/ Richard J.
      Leimbach
              Richard J. Leimbach
            
            Chief
      Financial Officer
              (principal
      financial officer)
                (principal
      accounting officer)
            
            March
      3, 2008/s/ Warren V.
      Musser
              Warren
      V. Musser
            
            Chairman
      of the Board
            
            March
      3 2008/s/ Ronald
      W.  Pickett
              Ronald
      W.  Pickett
            
            Vice
      Chairman of the Board
            
            March
      3, 2008/s/ Anthony J.
      Paoni
              Anthony
      J. Paoni
            
            Director
            
            March
      3, 2008/s/ Dr. Thomas M.
      Hall
              Dr. Thomas M. Hall
            
            Director
            
            March
      3, 2008/s/ James L.
      Peeler
              James L. Peeler
            
            Director
            
            March
      3, 2008/s/ Seth D.
      Blumenfeld
              Seth D. Blumenfeld
            
            Director
            
            March
      3, 2008/s/ Thomas C.
      Lynch
              Thomas
      C. Lynch
            
            Director
            
            March
      3, 2008




53


SECURITIES
AND EXCHANGE COMMISSION





WASHINGTON,
D.C. 20549











FINANCIAL
STATEMENTS AND SCHEDULES





DECEMBER
31, 2006 AND 2005











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, 2006 and 2005
            F-4Consolidated
      Statements of Losses for the Years ended December 31, 2006, 2005 and
      2004
            F-5Consolidated
      Statements of Stockholders’ Equity for the Years ended December 31, 2006,
      2005 and 2004
            F-6Consolidated
      Statements of Cash Flows for the Years ended December 31, 2006, 2005 and
      2004
            F-9Notes
      to Consolidated Financial Statements
            F-11




F-2





RUSSELL
BEDFORD STEFANOU MIRCHANDANI 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, 2006 and 2005 and the related
consolidated statements of losses, stockholders' equity, and cash flows for each
of the three years in the period ended December 31, 2006. 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, 2006 and 2005, and the results of its operations
and its cash flows for each of the three years in the period ended
December 31, 2006, 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.





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, 2006, 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 15, 2007
expressed an unqualified opinion on management’s assessment of the effectiveness
of the Company’s internal control over financial reporting and an unqualified
opinion on the effectiveness of the Company’s internal control over financial
reporting.






/s/RUSSELL BEDFORD
      STEFANOU MIRCHANDANI LLP
              Russell
      Bedford Stefanou Mirchandani LLP







McLean,
Virginia


March 15,
2007




F-3




TELKONET,
INC.


CONSOLIDATED
BALANCE SHEETS


DECEMBER
31, 2006 AND 2005







ASSETS
            
            2006
            
            
            2005Current
      Assets:Cash and cash equivalents
            
            $
            1,644,037
            
            
            $
            8,422,079Restricted Certificate of Deposit
            
            
            -
            
            
            
            10,000,000Accounts receivable, net of allowance for doubtful accounts of
      $60,000
              and $30,000 at December 31, 2006 and 2005, respectively
            
            
            295,116
            
            
            
            119,191Income tax receivable (Note L)
            
            
            291,000
            
            
            
            -Inventories (Note D)
            
            
            1,306,593
            
            
            
            1,475,806Prepaid expenses and deposits
            
            
            229,333
            
            
            
            360,880Total current assets
            
            
            3,766,079
            
            
            
            20,377,956Property and equipment,
      at cost (Note E):Furniture and equipment
            
            
            2,211,036
            
            
            
            1,041,137Less: accumulated depreciation
            
            
            582,248
            
            
            
            323,667Total property and equipment, net
            
            
            1,628,788
            
            
            
            717,470Equipment under
      operating leases, at cost (Note F):Telecommunications and related equipment, at cost
            
            
            3,186,000
            
            
            
            789,099Less: accumulated depreciation
            
            
            564,233
            
            
            
            124,669Total equipment under operating leases, net
            
            
            2,621,767
            
            
            
            664,430Other assets:Long-term investments (Note G)
            
            
            193,847
            
            
            
            231,000Intangible assets, net of accumulated amortization of $282,325 and $0
      at
              December 31, 2006 and December 31, 2005, respectively (Note B
      and C)
            
            
            2,181,602
            
            
            
            -Financing Costs, net of accumulated amortization and write-off of
      $1,219,410
              and $73,499 at December 31, 2006 and 2005, respectively (Note
      H)
            
            
            -
            
            
            
            1,145,911Goodwill (Note B and C)
            
            
            1,977,768
            
            
            
            -Deposits
            
            
            146,665
            
            
            
            154,216Total other assets
            
            
            4,499,882
            
            
            
            1,531,127Total
      Assets
            
            $
            12,516,516
            
            
            $
            23,290,983LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts payable and accrued liabilities (Note P)
            
            $
            2,865,144
            
            
            $
            1,821,872Customer deposits held
            
            
            -
            
            
            
            86,257Senior notes payable, current portion (Note I)
            
            
            -
            
            
            
            100,000Note Payable - officer (Note L)
            
            
            80,444
            
            
            
            -Income tax refund due to officer (Note L)
            
            
            291,000
            
            
            
            -Convertible debentures, current portion (Note H)
            
            
            -
            
            
            
            6,250,000Note payable in connection with subsidiary acquisition (Note
      B)
            
            
            900,000
            
            
            
            -Deferred revenue
            
            
            160,125
            
            
            
            59,020Total current liabilities
            
            
            4,296,713
            
            
            
            8,317,149Long-term liabilities:Convertible debentures, net of debt discounts (Note H)
            
            
            -
            
            
            
            9,616,521Deferred revenue
            
            
            42,019
            
            
            
            -Deferred lease liability
            
            
            42,561
            
            
            
            42,317Total long-term liabilities
            
            
            84,580
            
            
            
            9,658,838Commitments and
      contingencies (Note Q)
            
            
            -
            
            
            
            -Minority interest
            
            
            -
            
            
            
            -Stockholders’
      equity (Note J)Preferred stock, par value $.001 per share; 15,000,000 shares
      authorized;
              none issued and outstanding at December 31, 2006 and 2005
            
            
            -
            
            
            
            -Common stock, par value $.001 per share; 100,000,000 shares authorized;
      56,992,301 and
              45,765,171 shares issued and outstanding at December 31, 2006 and 2005,
      respectively
            
            
            56,992
            
            
            
            45,765Additional paid-in-capital
            
            
            78,502,900
            
            
            
            48,256,784Accumulated deficit
            
            
            (70,424,669
            )
            
            
            (42,987,553
            )Stockholders’ equity
            
            
            8,135,223
            
            
            
            5,314,996Total Liabilities and Stockholders’ Equity
            
            $
            12,516,516
            
            
            $
            23,290,983







See
accompanying notes to consolidated financial statements




F-4





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF LOSSES


FOR
THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004







2006
            
            
            2005
            
            
            2004Product
      Revenues, net
            
            $
            3,092,967
            
            
            $
            1,769,727
            
            
            $
            477,555Rental
      Revenue, net
            
            
            2,088,361
            
            
            
            718,596
            
            
            
            221,097Total
      Revenue
            
            
            5,181,328
            
            
            
            2,488,323
            
            
            
            698,652Product
            
            
            2,062,399
            
            
            
            1,183,574
            
            
            
            459,225Rental
            
            
            2,418,260
            
            
            
            533,605
            
            
            
            83,634Total
      Cost of Sales
            
            
            4,480,659
            
            
            
            1,717,179
            
            
            
            542,859Gross
      Profit
            
            
            700,669
            
            
            
            771,144
            
            
            
            155,793Operating
      Expenses:Research
      and Development (Note A)
            
            
            1,925,746
            
            
            
            2,096,104
            
            
            
            1,852,309Selling,
      General and Administrative
            
            
            14,346,364
            
            
            
            12,041,661
            
            
            
            7,663,369Consulting
      Fees (Note J)
            
            
            -
            
            
            
            -
            
            
            
            2,500,000Impairment
      write-down in investment in affiliate (Note G)
            
            
            92,000
            
            
            
            400,000
            
            
            
            -Non-Employee
      Stock Options and Warrants (Note K)
            
            
            277,344
            
            
            
            1,354,219
            
            
            
            1,180,875Employee
      Stock based compensation (Note K)
            
            
            1,080,895
            
            
            
            -
            
            
            
            -Depreciation
      and Amortization
            
            
            540,906
            
            
            
            185,928
            
            
            
            71,514Total
      Operating Expense
            
            
            18,263,255
            
            
            
            16,077,912
            
            
            
            13,268,067Loss
      from Operations
            
            
            (17,562,586
            )
            
            
            (15,306,768
            )
            
            
            (13,112,274
            )Other
      Income (Expense):Other
      Income (Note H)
            
            
            -
            
            
            
            8,600
            
            
            
            -Loss
      on early extinguishment of debt (Note H)
            
            
            (4,626,679
            )Interest
      Income
            
            
            327,184
            
            
            
            166,070
            
            
            
            128,938Interest
      Expense
            
            
            (5,594,604
            )
            
            
            (
      646,183
            )
            
            
            (109,324
            )Total
      Other Income (Expenses)
            
            
            (9,894,099
            )
            
            
            (471,513
            )
            
            
            19,614Loss
      Before Provision for Income Taxes
            
            
            (27,456,685
            )
            
            
            (15,778,281
            )
            
            
            (13,092,660
            )Minority
      interest (Note B)
            
            
            19,569Provision
      for Income Tax (Note N)
            
            
            -
            
            
            
            -
            
            
            
            -Net
      (Loss)
            
            $
            (27,437,116
            )
            
            $
            (15,778,281
            )
            
            $
            (13,092,660
            )Loss
      per common share (basic and assuming dilution) (Note O)
            
            $
            (0.54
            )
            
            $
            (0.35
            )
            
            $
            (0.32
            )Weighted
      average common shares outstanding
            
            
            50,823,652
            
            
            
            44,743,223
            
            
            
            41,384,074







See
accompanying notes to consolidated financial statements




F-5





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY


FOR
THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004






Preferred
      Shares
            
            Preferred
              Stock
              Amount
            
            Common
              Shares
            
            Common
      Stock
              Amount
            
            Additional
              Paid
      in
              Capital
            
            Accumulated
      Deficit
            
            TotalBalance
      at January 1, 2004
            -
            
            $
            -
            
            30,689,522
            
            $
            30,690
            
            $
            16,474,251
            
            $
            (14,116,612
            )
            $
            2,388,329Shares
      issued for employee stock options exercised at approximately $1.08 per
      share
            -
            
            
            -
            
            540,399
            
            
            540
            
            
            582,358
            
            
            -
            
            
            582,898Shares
      issued in exchange for non-employee options exercised at $1.00 per
      share
            -
            
            
            -
            
            328,333
            
            
            328
            
            
            328,005
            
            
            -
            
            
            328,333Shares
      issued to consultants in exchange for services rendered at approximately
      $3.07 per share
            -
            
            
            -
            
            63,566
            
            
            63
            
            
            196,252
            
            
            -
            
            
            196,315Shares
      issued for senior note conversion at $2.10 per share (Note
    I)
            -
            
            
            -
            
            1,209,038
            
            
            1,209
            
            
            2,537,791
            
            
            -
            
            
            2,539,000Shares
      issued in connection with private placement at $2.00 per share, net of
      costs
            -
            
            
            -
            
            6,387,600
            
            
            6,388
            
            
            12,720,455
            
            
            -
            
            
            12,726,843Shares
      issued to consultants for warrants exercised at $2.54 per
      share
            -
            
            
            -
            
            50,000
            
            
            50
            
            
            126,950
            
            
            -
            
            
            127,000Shares
      issued to noteholders for warrants exercised at $1.00 per
      share
            -
            
            
            -
            
            4,000,950
            
            
            4,001
            
            
            3,996,949
            
            
            -
            
            
            4,000,950Shares
      issued to noteholders for cashless warrants exercised
            -
            
            
            -
            
            203,751
            
            
            204
            
            
            (204
            )
            
            -
            
            
            -Shares
      issued for cashless exercise of underwriter warrants
            -
            
            
            -
            
            165,116
            
            
            165
            
            
            (165
            )
            
            -
            
            
            -Shares
      issued in exchange for convertible debentures at $0.50 per
      share
            -
            
            
            -
            
            124,000
            
            
            124
            
            
            61,876
            
            
            -
            
            
            62,000Shares
      issued in exchange for convertible debentures at $0.55 per
      share
            -
            
            
            -
            
            200,000
            
            
            200
            
            
            109,800
            
            
            -
            
            
            110,000Shares
      issued in exchange for accrued interest on convertible
      debentures
            -
            
            
            -
            
            42,999
            
            
            43
            
            
            23,233
            
            
            -
            
            
            23,276Shares
      issued to an employee in exchange for services at approximately $2.99 per
      share
            -
            
            
            -
            
            36,000
            
            
            36
            
            
            107,743
            
            
            -
            
            
            107,779Shares
      issued to consultants in exchange for consulting fees at $2.50 per
      share
            -
            
            
            -
            
            1,000,000
            
            
            1,000
            
            
            2,499,000
            
            
            -
            
            
            2,500,000Founders
      shares returned and canceled in connection with January 2002 capital
      restructure
            -
            
            
            -
            
            (705,285
            )
            
            (705
            )
            
            705
            
            
            -
            
            
            -Write-off
      of beneficial conversion features and warrants attached to convertible
      debentures in connection with conversion of Debenture-1 and Series B
      debentures
            -
            
            
            -
            
            -
            
            
            -
            
            
            (134,666
            )
            
            -
            
            
            (134,666
            )Stock
      options and warrants granted to consultants in exchange for services
      rendered
            -
            
            
            -
            
            -
            
            
            -
            
            
            1,180,875
            
            
            -
            
            
            1,180,875Net
      loss
            -
            
            
            -
            
            -
            
            
            -
            
            
            -
            
            
            (13,092,660
            )
            
            (13,092,660
            )Balance
      at December 31, 2004
            -
            
            $
            -
            
            44,335,989
            
            $
            44,336
            
            $
            40,811,208
            
            $
            (27,209,272
            )
            $
            13,646,272






See
accompanying footnotes to consolidated financial statements




F-6





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)


FOR
THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004






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 H)
            -
            
            
            -
            
            -
            
            
            -
            
            
            1,479,300
            
            
            -
            
            
            1,479,300Value
      of warrants attached to convertible debentures (Note H)
            -
            
            
            -
            
            -
            
            
            -
            
            
            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-7





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)


FOR
THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004






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
            
            
            -
            
            
            2,658,826Shares
      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 H)
            
            
            -
            
            -
            
            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 H)
            
            
            -
            
            -
            
            -
            
            
            -
            
            
            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-8





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR
THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004






2006
            
            
            2005
            
            
            2004Increase
      (Decrease) In Cash and EquivalentsCash
      Flows from Operating Activities:Net
      loss from operating activities
            
            $
            (27,437,116
            )
            
            $
            (15,778,281
            )
            
            $
            (13,092,660
            )Adjustments
      to reconcile net loss from operations to cash used in operating
      activities:Minority
      interest
            
            
            (19,569
            )
            
            
            -
            
            
            
            -Amortization
      and write-off of debt discount - beneficial conversion feature of
      convertible debentures (Note H)
            
            
            1,390,137
            
            
            
            138,406
            
            
            
            21,888Amortization
      and write-off of debt discount - value of warrants attached to convertible
      debentures (Note H)
            
            
            2,743,342
            
            
            
            198,805
            
            
            
            10,152Amortization
      and write-off of financing costs
            
            
            1,145,911
            
            
            
            73,499
            
            
            
            -Other
      income in connection with derivative warrant liabilities (Note
      H)
            
            
            -
            
            
            
            (8,600
            )
            
            
            -Warrants
      issued prepayment of debt
            
            
            3,000,249
            
            
            
            -
            
            
            
            -Common
      stock issued in exchange for and penalty in connection with early
      extinguishment of debt (Note H)
            
            
            2,006,029
            
            
            
            -
            
            
            
            -Stock
      options and warrants issued in exchange for services (Note
    K)
            
            
            1,358,239
            
            
            
            1,354,219
            
            
            
            1,180,875Common
      stock issued in exchange for services rendered (Note J)
            
            
            203,026
            
            
            
            300,117
            
            
            
            304,094Common
      stock issued in exchange for conversion of interest
            
            
            -
            
            
            
            28,131
            
            
            
            23,276Common
      stock issued in exchange for consulting fees (Note J)
            
            
            -
            
            
            
            -
            
            
            
            2,500,000Depreciation,
      including equipment under operating leases
            
            
            980,470
            
            
            
            430,104
            
            
            
            143,358Impairment
      write-down in investment in Amperion (Note G)
            
            
            92,000
            
            
            
            400,000
            
            
            
            -Increase
      / decrease in:Accounts
      receivable, trade and other
            
            
            (143,013
            )
            
            
            (56,044
            )
            
            
            (4,950
            )Inventory
            
            
            169,213
            
            
            
            397,912
            
            
            
            (1,265,202
            )Prepaid
      expenses and deposits
            
            
            405,952
            
            
            
            (313,956
            )
            
            
            (23,150
            )Deferred
      lease liability
            
            
            245
            
            
            
            11,406
            
            
            
            30,911Deferred
      revenue
            
            
            68,801
            
            
            
            59,020
            
            
            
            -Accounts
      payable, accrued expenses, net
            
            
            64,555
            
            
            
            679,230
            
            
            
            587,848Net
      Cash Used In Operating Activities
            
            
            (13,971,529
            )
            
            
            (12,086,032
            )
            
            
            (9,583,560
            )Cash
      Flows From Investing Activities:Costs
      of equipment under operating leases
            
            
            (1,939,759
            )
            
            
            (458,271
            )
            
            
            (491,776
            )Sale
      of equipment under operating lease, net
            
            
            350,571
            
            
            
            -
            
            
            
            -Purchase
      of property and equipment, net
            
            
            (734,888
            )
            
            
            (336,448
            )
            
            
            (514,903
            )Proceeds
      (Investment) in Restricted Certificate of Deposit (Note A)
            
            
            10,000,000
            
            
            
            (10,000,000
            )
            
            
            -Investment
      in MST (Note B)
            
            
            (900,000
            )Net
      cash acquired from MST (Note B)
            
            
            59,384Acquisition
      costs (Note B)
            
            
            (117,822
            )Investment
      in Amperion and BPL Global (Note G)
            
            
            (44
            )
            
            
            (131,000
            )
            
            
            (500,000
            )Net
      Cash Used In Investing Activities
            
            
            6,717,442
            
            
            
            (10,925,719
            )
            
            
            (1,506,679
            )Cash
      Flows From Financing Activities:Proceeds
      from sale of common stock, net of costs and fees (Note J)
            
            
            6,000,000
            
            
            
            -
            
            
            
            12,726,843Proceeds
      from issuance of convertible debentures, net of costs and fees (Note
      H)
            
            
            -
            
            
            
            18,780,590
            
            
            
            -Repayment
      of convertible debenture (Note H)
            
            
            (7,750,000
            )
            
            
            (10,000
            )
            
            
            -Repayment
      of senior notes (Note I)
            
            
            (100,000
            )
            
            
            (350,000
            )
            
            
            -Proceeds
      from exercise of warrants (Note K)
            
            
            55,138
            
            
            
            321,900
            
            
            
            4,127,950Proceeds
      from exercise of employee and non-employee stock options and warrants
      (Note K)
            
            
            2,684,663
            
            
            
            852,638
            
            
            
            911,230Repayments
      of loans
            
            
            (413,756
            )
            
            
            -
            
            
            
            -Repayments
      of capital leases
            
            
            -
            
            
            
            -
            
            
            
            (15,000
            )Net
      Cash Provided By Financing Activities
            
            
            476,045
            
            
            
            19,595,128
            
            
            
            17,751,023Net
      Increase (Decrease) In Cash and Equivalents
            
            
            (6,778,042
            )
            
            
            (3,416,623
            )
            
            
            6,660,784Cash
      and cash equivalents at the beginning of the year
            
            
            8,422,079
            
            
            
            11,838,702
            
            
            
            5,177,918Cash
      and cash equivalents at the end of the year
            
            $
            1,644,037
            
            
            $
            8,422,079
            
            
            $
            11,838,702






See
accompanying notes to consolidated financial statements




F-9


TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS (Continued)


FOR
THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004







2006
            
            
            2005
            
            
            2004Supplemental
      Disclosures of Cash Flow Information:Cash
      transactions:Cash
      paid during the period for interest
            
            $
            990,846
            
            
            $
            40,645
            
            
            $
            100,608Income
      taxes paid
            
            
            -
            
            
            
            -
            
            
            
            -Non-cash
      transactions:Issuance
      of stock options and warrants in exchange for services rendered (Note
      K)
            
            
            1,358,239
            
            
            
            1,354,219
            
            
            
            1,180,875Common
      stock issued for services rendered (Note J)
            
            
            203,026
            
            
            
            300,117
            
            
            
            304,094Common
      stock issued in exchange for interest (Note J)
            
            
            -
            
            
            
            28,131
            
            
            
            23,276Common
      stock issued in exchange for consulting services (Note J)
            
            
            -
            
            
            
            -
            
            
            
            2,500,000Note
      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 H)
            
            
            2,006,030
            
            
            
            -
            
            
            
            -Issuance
      of shares for purchase of subsidiary
            
            
            2,700,000
            
            
            
            -
            
            
            
            -Common
      stock issued in exchange for Senior Note (Note I and K)
            
            
            -
            
            
            
            -
            
            
            
            2,539,000Common
      stock issued in exchange for conversion of convertible debenture (Note H
      and K)
            
            
            12,250,000
            
            
            
            200,000
            
            
            
            172,000Write-off
      of beneficial conversion feature for conversion of
    debenture
            
            
            -
            
            
            
            -
            
            
            
            134,135Write-off
      of value of warrants attached to debenture in connection with
      conversion
            
            
            -
            
            
            
            -
            
            
            
            531Impairment
      write-down in investment in affiliate (Note G)
            
            
            92,000
            
            
            
            400,000
            
            
            
            -Beneficial
      conversion feature on convertible debentures (Note H)
            
            
            -
            
            
            
            1,479,300
            
            
            
            -Value
      of warrants attached to convertible debentures (Note H)
            
            
            -
            
            
            
            2,910,700
            
            
            
            -Acquisition
      of MST (Note B):Assets
      acquired
            
            
            4,120,600
            
            
            
            -
            
            
            
            -Goodwill
      (including purchase price contingency)
            
            
            6,477,767
            
            
            
            -
            
            
            
            -Minority
      Interest
            
            
            (19,569
            )
            
            
            -
            
            
            
            -Liabilities
      assumed
            
            
            (1,460,976
            )
            
            
            -
            
            
            
            -Common
      stock issued
            
            
            (2,700,000
            )
            
            
            -
            
            
            
            -Notes
      payable issued
            
            
            (900,000
            )
            
            
            -
            
            
            
            -Purchase
      price contingency
            
            
            (4,500,000
            )
            
            
            -
            
            
            
            -Direct
      acquisition costs
            
            
            (117,822
            )
            
            
            -
            
            
            
            -Cash
      paid for acquisition
            
            
            900,000
            
            
            
            -
            
            
            
            -







See
accompanying notes to consolidated financial statements




F-10





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2006, 2005 AND 2004






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. (the "Company"), formerly Comstock Coal Company, Inc., was formed on
November 3, 1999 under the laws of the state of Utah. The Company was a
“development stage enterprise” (as defined by Statement of Financial Accounting
Standards No. 7) until December 31, 2003. The Company is engaged in the business
of developing, producing and marketing proprietary equipment enabling the
transmission of voice and data 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.





The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiary, Telkonet Communications, Inc. and 90% owned subsidiary
Microwave Satellite Technologies (MST). 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.





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 $60,000 and $30,000 at December
31, 2006 and December 31, 2005, respectively.





Cash and Cash
Equivalents





For
purposes of the Statements of Cash Flows, the Company considers all highly
liquid debt instruments purchased with a maturity date of three months or less
to be cash equivalents.





Restricted Certificate of
Deposit





In the
year ended December 31, 2006, restricted cash was drawn down to zero upon in
conjunction with the settlement agreements with the lenders of its Convertible
Senior Notes (Note H ). The restricted cash at December 31, 2005 consisted of a
$10,000,000 certificate of deposit pledged as collateral for an irrevocable
letter of credit agreement.  The letter of credit agreement automatically
renewed annually as required in the Convertible Senior Notes loan
covenant.  The certificate of deposit provided for approximately 4%
interest payable at maturity.





Liquidity




As shown
in the accompanying consolidated financial statements, the Company incurred net
loss of $27,437,116, $15,778,281 and $13,092,660 for the years ended December
31, 2006, 2005 and 2004, respectively. Net loss included $5,658,986, $338,620
and $0 of non-cash interest and financing expense in connection with the
convertible debentures, $4,626,769, $0 and $0 of non-cash expense in connection
with the early extinguishment of debt, and $1,358,239, $1,354,219 and $1,180,875
of non-cash compensation to employees and non-employees in connection with stock
options granted and vested and $0, $0 and $2,500,000 of common stock issued in
exchange for consulting services for the years ended December 31, 2006, 2005 and
2004, respectively. The Company's current liabilities, on a consolidated basis,
exceeded its current assets by $530,634 as of December 31, 2006.




F-11




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.





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 an 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. The
company has determined that its investment in Amperion Inc. has been impaired
based upon forecasted discounted cash flow and has written off $92,000 and
$400,000, of its investment based on management assessment during the year ended
December 31, 2006 and 2005, respectively. (Note G).





Inventories





Inventories
consist primarily of Gateways, Extenders, iBridges and Couplers which are the
significant components of the Telkonet solution. Cost is determined by the
first-in, first-out method. (Note D).





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.





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 2006, 2005 and 2004, 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 superceded 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.




F-12




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).





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 payments status of an
outstanding invoice, generally greater than 30 days past the 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.





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, 2006 and 2005. 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, 2006 and 2005, the Company
experienced approximately three percent of units returned. As of December 31,
2006 and 2005, the Company recorded warranty liabilities in the amount of
$47,300 and $24,000, respectively, using this experience factor.  Prior to
the fiscal year of 2005, the Company had not established historical ratio of
claims, and the cost of replacing defective products and product returns were
immaterial and within management's expectations, accordingly there were no
warranties provided with the purchase of the Company's products during the year
ended December 31, 2004.





Advertising





The
Company follows the policy of charging the costs of advertising to expenses
incurred. The Company incurred $663,323, $657,794, and $499,874 in advertising
costs during the years ended December 31, 2006, 2005 and 2004,
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 2006, 2005 and 2004 were $1,925,746,
$2,096,104, and $1,852,309, respectively.




F-13




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.





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 year ended
December 31, 2006 was $1,080,895, 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 December 31, 2005 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.




F-14




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 years ended December 31, 2005 and 2004, in
accordance with SFAS 123, as amended by SFAS No. 148 “Accounting for Stock-Based
Compensation - Transition and Disclosure."




2005
            
            
            2004Net
      loss - as reported
            
            $
            (15,778,281
            )
            
            $
            (13,092,660
            )Deduct:
      stock-based compensation expense, net of tax
            
            
            (2,440,097
            )
            
            
            (7,830,385
            )Net
      loss - pro forma
            
            $
            (18,218,378
            )
            
            $
            (20,923,045
            )Net
      loss per common share — basic (and assuming dilution):As
      reported
            
            $
            (0.35
            )
            
            $
            (0.32
            )Deduct:
      stock-based compensation expense, net of tax
            
            
            (0.06
            )
            
            
            (0.19
            )Pro
      forma
            
            $
            (0.41
            )
            
            $
            (0.51
            )




Disclosure
for the year ended December 31, 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 and 2004:





2005
            
            2004Significant
      assumptions (weighted-average):Risk-free
      interest rate at grant date
            
            
            4.5%
            
            
            1.35%Expected
      stock price volatility
            
            
            71%
            
            
            76%Expected
      dividend payout
            
            
            -
            
            
            -Expected
      option life (in years)
            
            
            5.0
            
            
            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 2006 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.




F-15




New Accounting
Pronouncements





On
February 16, 2006 the FASB issued SFAS 155, “Accounting for Certain Hybrid
Instruments,” which amends SFAS 133, “Accounting for Derivative Instruments and
Hedging Activities,” and SFAS 140, “Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities.” SFAS 155 allows financial
instruments that have embedded derivatives to be accounted for as a whole
(eliminating the need to bifurcate the derivative from its host) if the holder
elects to account for the whole instrument on a fair value basis. SFAS 155 also
clarifies and amends certain other provisions of SFAS 133 and SFAS 140. This
statement is effective for all financial instruments acquired or issued in
fiscal years beginning after September 15, 2006. The Company does not
expect its adoption of this new standard to have a material impact on its
financial position, results of operations or cash flows.





The FASB
issued SFAS No. 156, “Accounting for Servicing of Financial Assets an
amendment of FASB Statement No. 140” (“SFAS No. 156”) in March
2006. SFAS No. 156 requires a company to recognize a servicing asset
or servicing liability each time it undertakes an obligation to service a
financial asset. A company would recognize a servicing asset or servicing
liability initially at fair value. A company will then be permitted to choose to
subsequently recognize servicing assets and liabilities using the amortization
method or fair value measurement method. SFAS No. 156 is effective for
fiscal years beginning after September 15, 2006. The Company does not
expect its adoption of this new standard to have a material impact on its
financial position, results of operations or cash flows.




On
July 13, 2006, the FASB issued FASB Interpretation No. 48, “Accounting
for Uncertainty in Income Taxes-an Interpretation of FASB Statement
No. 109” (“FIN No. 48”). FIN No. 48 clarifies what
criteria must be met prior to recognition of the financial statement benefit of
a position taken in a tax return. FIN No. 48 will require companies to
include additional qualitative and quantitative disclosures within their
financial statements. The disclosures will include potential tax benefits from
positions taken for tax return purposes that have not been recognized for
financial reporting purposes and a tabular presentation of significant changes
during each period. The disclosures will also include a discussion of the nature
of uncertainties, factors which could cause a change, and an estimated range of
reasonably possible changes in tax uncertainties. FIN No. 48 will also
require a company to recognize a financial statement benefit for a position
taken for tax return purposes when it will be more-likely-than-not that the
position will be sustained. FIN No. 48 will be effective for fiscal
years beginning after December 15, 2006.




On
September 15, 2006, the FASB issued SFAS No. 157, “Fair Value
Measurements” (“SFAS No. 157”). SFAS No. 157 addresses how
companies should measure fair value when they are required to use a fair value
measure for recognition and disclosure purposes under generally accepted
accounting principles. SFAS No. 157 will require the fair value of an
asset or liability to be based on a market based measure which will reflect the
credit risk of the company. SFAS No. 157 will also require expanded
disclosure requirements which will include the methods and assumptions used to
measure fair value and the effect of fair value measures on earnings.
SFAS No. 157 will be applied prospectively and will be effective for
fiscal years beginning after November 15, 2007 and to interim periods
within those fiscal years.




In
September 2006, the Financial Accounting Standards Board issued FASB Statement
No. 158, “Employers’ Accounting for Defined Benefit Pension and Other
Postretirement Plans” (“SFAS 158”). SFAS 158 requires the Company to
record the funded status of its defined benefit pension and other postretirement
plans in its financial statements. The Company is required to record an asset in
its financial statements if a plan is overfunded or record a liability in its
financial statements if a plan is underfunded with a corresponding offset to
shareholders’ equity. Previously unrecognized assets and liabilities are
recorded as a component of shareholders’ equity in accumulated other
comprehensive income, net of applicable income taxes. SFAS 158 also
requires the Company to measure the value of its assets and liabilities as of
the end of its fiscal year ending after December 15, 2008. The Company has
implemented SFAS 158 using the required prospective method. The recognition
provisions of SFAS 158 are effective for the fiscal year ending after
December 15, 2006. The Company does not expect its adoption of this new
standard to have a material impact on its financial position, results of
operations or cash flows.




In
December 2006, the FASB issued FSP EITF 00-19-2, Accounting for Registration
Payment Arrangements ("FSP 00-19-2") which addresses accounting for registration
payment arrangements. FSP 00-19-2 specifies that the contingent obligation to
make future payments or otherwise transfer consideration under a registration
payment arrangement, whether issued as a separate agreement or included as a
provision of a financial instrument or other agreement, should be separately
recognized and measured in accordance with FASB Statement No. 5, Accounting for
Contingencies. FSP 00-19-2 further clarifies that a financial instrument subject
to a registration payment arrangement should be accounted for in accordance with
other applicable generally accepted accounting principles without regard to the
contingent obligation to transfer consideration pursuant to the registration
payment arrangement. For registration payment arrangements and financial
instruments subject to those arrangements that were entered into prior to the
issuance of EITF 00-19-2, this guidance is effective for financial statements
issued for fiscal years beginning after December 15, 2006 and interim periods
within those fiscal years. The Company has not yet determined the impact that
the adoption of FSP 00-19-2 will have on its financial statements.




F-16




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.





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.





The
purchase price contingency shares are price protected for the benefit of the
former owner of MST. 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 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. 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.





MST 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 MST 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 MST 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
MST. 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
      and other intangible assets
            
            
            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 independently valued at $2,463,927 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 and MST 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,Proforma
              2006
            
            
            Proforma
              2005Product
      revenue
            
            $
            3,128,120
            
            
            $
            2,393,010Recurring
      revenue
            
            
            2,188,329
            
            
            
            1,918,2005,316,449
            
            
            
            4,311,210Net
      (loss)
            
            $
            (27,578,779
            )
            
            $
            (11,685,089
            )Basic
      (loss) per share
            
            $
            (0.54
            )
            
            $
            (0.26
            )Diluted
      (loss) per share
            
            $
            (0.54
            )
            
            $
            (0.26
            )




The
acquisition of MST resulted in the valuation of MST’s subscriber lists as
intangible assets. The MST 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, 2006, 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, 2006.
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.




F-18




At
December 31, 2006, 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 goodwill and intangibles acquired.





NOTE
C - INTANGIBLE ASSETS ACQUIRED





Total
identifiable intangible assets acquired and their carrying value at December 31,
2006 are:





Gross
              Carrying
              Amount
            
            Accumulated
      Amortization
            
            Net
            
            Residual
              Value
            
            Weighted
              Average
              Amortization
              Period
              (Years)Amortized
      Identifiable tangible Assets:Subscriber
      lists
            
            $
            2,463,927
            
            (282,325)
            
            2,181,602
            
            $
            -
            
            8.0Total
      Amortized Identifiable Intangible Assets
            
            $
            2,463,927
            
            (282,325)
            
            2,181,602
            
            $
            -Unamortized
      Identifiable Intangible Assets:
            
            
            NoneTotal
            
            $
            2,463,927
            
            (282,325)
            
            2,181,602
            
            $
            -





NOTE
C - INTANGIBLE ASSETS ACQUIRED (continued)





Total
amortization expense charged to operations for the year ended December 31,
2006 was $282,325. Estimated amortization expense as of December 31, 2006 is as
follows:





Fiscal2007
            307,9912008
            307,9912009
            307,9912010
            307,9912011
            307,9912012
      and after
            641,647Total
            2,181,602





NOTE
D - INVENTORIES





Inventories
are stated at the lower of cost or market determined by the first-in, first-out
(FIFO) method. Inventories primarily consist of Gateways, Extenders, iBridges
and Couplers which are the significant components of the Telkonet solution.
Components of inventories as of December 31, 2006 and 2005 are as
follows:





2006
            
            
            2005Raw
      Materials
            
            $
            516,604
            
            
            $
            598,335Finished
      Goods
            
            
            789,989
            
            
            
            877,471$
            1,306,593
            
            
            $
            1,475,806





NOTE
E - PROPERTY, PLANT AND EQUIPMENT





The
Company’s property and equipment at December 31, 2006 and 2005 consists of the
following:





2006
            
            
            2005Development
      Test Equipment
            
            $
            184,575
            
            
            $
            96,967Computer
      Software
            
            
            151,986
            
            
            
            142,894Leasehold
      Improvements
            
            
            394,871
            
            
            
            209,911Office
      Equipment
            
            
            1,137,942
            
            
            
            360,527Office
      Fixtures and Furniture
            
            
            341,662
            
            
            
            230,838Total
            
            
            2,211,036
            
            
            
            1,041,137Accumulated
      Depreciation
            
            
            (582,248
            )
            
            
            (323,667
            )$
            1,628,788
            
            
            $
            717,470




F-19




Depreciation
expense included as a charge to income was $258,581, $185,928, and $71,514 for
the years ended December 31, 2006, 2005 and 2004, 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, 2006 and 2005 consist of the following:





2006
            
            
            2005Telecommunications
      and related equipment
            
            $
            3,186,000
            
            
            $
            789,099Less:
      accumulated depreciation
            
            
            (564,233
            )
            
            
            (124,669
            )Capitalized
      equipment, net of accumulated depreciation
            
            
            2,697,517
            
            
            
            664,430Less:
      estimated reserve for residual values
            
            
            -
            
            
            
            --Capitalized
      equipment under operating leases, net
            
            
            2,621,767
            
            
            
            664,430





In the
year end December 31, 2006 and 2005, 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 and $732,000 including the customer support
component of approximately $370,000 and $205,000 which the Company 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 year
ending December 31, 2006 and 2005, the Company recognized revenue of
approximately $683,000 and $439,000 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
$267,000, and expensed associated taxes of approximately $64,000 and $40,000,
respectively.




The
following is a schedule by years of minimum future rentals on non-cancellable
operating leases as of December 31, 2006:





2007
            
            
            615,3952008
            
            
            488,4002009
            
            
            402,2912010
            
            
            328,9752011
            
            
            289,224$
            2,124,285





NOTE
G - 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.




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 and $100,000 at December 31, 2006
and 2005, respectively, and this amount represents the current fair
value.




F-20




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 and
$131,000 as of December 31, 2006 and 2005, respectively.





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, 2006. 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 $53,000 as of December 31,
2006.





NOTE
H - CONVERTIBLE PROMISSORY NOTES PAYABLE





A summary
of convertible promissory notes payable at December 31, 2006 and 2005 is as
follows:





2006
            
            2005Convertible
      Senior Notes payable (“Convertible Senior Notes”), accrue interest at
      7.25% per annum and provide for equal monthly principal installments
      beginning March 1, 2006. Maturity date is in October 2008. Noteholder has
      the option to convert unpaid note principal together with accrued and
      unpaid interest to the Company’s common stock at a rate of $5.00 per share
      at any time. During the year ended December 31, 2006, the Company paid
      down $7,750,000 of principal in cash and a total of $12,250,000 of
      principal was converted to common stock of the Company.
            -
            
            $
            20,000,000Debt
      Discount - beneficial conversion feature, net of accumulated amortization
      and write-off of $1,479,300 and $89,163 at December 31, 2006 and 2005,
      respectively.
            -
            
            
            (1,390,137
            )Debt
      Discount - value attributable to warrants attached to notes, net of
      accumulated amortization and write-off of $ 2,919,300 and $175,958 at
      December 31, 2006 and 2005, respectively.
            -
            
            
            (2,743,342
            )Total
            -
            
            $
            15,866,521Less:
      current portion
            -
            
            
            (6,250,000
            )-
            
            $
            9,616,521





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 six 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 (Note A). 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.




F-21




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 issues are subject to an 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 J). The Company has
accounted for the additional 53,578 warrants issued, valued at $79,226, as
interest expense during the year ended December 31, 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.





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 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.




F-22




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.





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 the remaining unamortized financing costs of
$354,484.





NOTE
I - SENIOR NOTES PAYABLE





In the
second quarter of 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 Senior Notes are denominated in units of
$100,000, accrue interest at 8% per annum and are due three years from the date
of issuance with the latest maturity date of June 2006. Attached to each Senior
Note are warrants to purchase 125,000 shares of common stock. The warrants have
a three-year contractual life and are exercisable immediately after the issuance
of the Senior Note at exercise price of $1.00 per share. The Senior Notes are
secured by a first priority security interest in all intellectual property
assets of the Company. The Company plans to use the Senior Note proceeds for
expansion of sales, marketing and strategic partnership programs, building
required infrastructure and for working capital.





In
September 2003, certain Senior noteholders elected to surrender their Senior
Notes as consideration for the exercise of warrants to purchase shares of common
stock of the Company. The Company issued an aggregate of 2,011,000 restricted
shares of common stock for warrants exercised at $1.00 per share, in exchange
for $2,011,000 of Senior Notes.




In
January 2004, certain noteholders requested conversion of their senior
notes into Company restricted shares of common stock. The Company’s Board of
Directors approved this request by amending the terms of the Senior Note for a
limited time. The Company immediately notified all of the outstanding Senior
Noteholders of this temporary conversion option, and indicated that it would
accept the surrender of the Senior Notes as consideration for the purchase of
the Company’s common shares at a price of $2.10 per share. The conversion price
represented the current market price of the Company’s common stock. An aggregate
of $2,539,000 of senior notes were converted into 1,209,038 shares of common
stock of the Company in January 2004. On November 3, 2005, the Company paid
$350,000 of these senior notes and obtained a subordination agreement from the
remaining $100,000 noteholder. The remaining outstanding senior note matured and
was repaid in June 2006. The Company issued 20,000 warrants to purchase common
stock of the Company at $5.00 in consideration for the subordination agreement.
These warrants expired on June 15, 2006.




F-23




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, 2006, 2005 and 2004, 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,
2006, 2005 and 2004, the Company has 56,992,301, 45,765,171 and 44,335,989
shares, respectively, of common stock issued and outstanding.





During
the year ended December 31, 2004, the Company issued 540,399 shares of common
stock for an aggregate purchase price of $582,898 to certain employees upon
exercise of employee stock options at approximately $1.08 per share.
Additionally, the Company issued 328,333 shares of common stock for an aggregate
purchase price of $328,333 to consultants upon exercise of non-employee stock
options at approximately $1.00 per share.





During
the year ended December 31, 2004, the Company issued an aggregate of 63,566
shares of common stock, having an aggregate fair market value of $196,315, to
consultants in exchange for services rendered, which approximated the fair value
of the shares issued during the period services were completed and
rendered.





During
the year ended December 31, 2004, the Company issued an aggregate of 1,209,038
of restricted shares of common stock upon the election of certain senior note
holders to convert their senior notes into equity at a conversion price of $2.10
per share.





During
the year ended December 31, 2004, the Company issued 6,387,600 shares of its
common stock for an aggregate purchase price of $12,726,843, net of costs and
fees.





During
the year ended December 31, 2004, the Company issued an aggregate of 4,000,950
shares of common stock upon the exercise of warrants at approximately $1.00 per
share and an aggregate of 368,867 shares of common stock in exchange for 448,407
outstanding warrants.





During
the year ended December 31, 2004, the Company issued an aggregate of 50,000
shares of common stock to consultants pursuant to warrants exercised at $2.54
per share.





During
the year ended December 31, 2004, the Company issued an aggregate of 324,000
shares of common stock in connection with the conversion of $62,000 aggregate
principal amount of the Debenture-1 and $110,000 aggregate principal amount of
the Series B Debentures. The Company also issued an aggregate of 42,999 shares
of common stock in exchange for accrued interest of $23,276 for Debenture 1 and
Series B Debentures.





During
the year ended December 31, 2004, the Company issued an aggregate of 36,000
shares of common stock to an employee in exchange for $107,779 of services
rendered, which approximated the fair value of the shares issued during the
period services were completed and rendered. Compensation costs of $107,779 were
charged to operations.





In March
2004, the Company entered into consulting agreements (the “Agreements”) with
Aware Capital Consultants, Inc. and Scarborough, Ltd. (“Consultants”). Pursuant
to the Agreements, the Company issued an aggregate of 1,000,000 shares of its
restricted common stock to Consultants in exchange for professional services
rendered and to be rendered. In accordance with Emerging Issues Task Force Issue
96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees
for Acquiring, or in Conjunction with Selling, Goods or Services (“EITF 96-18”),
the measurement date to determine fair value was the date at which a commitment
for performance by the counter party to earn the equity instrument was reached.
The Company valued the shares issued for consulting services at the rate which
represents the fair value of the services received which did not differ
materially from the value of the stock issued. Compensation cost of $2,500,000
was charged to operations during the year ended December 31, 2004.




F-24




The
Company reorganized its capital structure in January 2002 whereby the Company
agreed to repurchase common stock held by the founders of the Company. All
founders shares were returned and canceled in March 2002, except for 705,285
shares which remained outstanding, but were subject to repurchase by the Company
pending receipt of the share certificate evidencing those shares. During the
year ended December 31, 2004, the remaining 705,285 shares of founder’s stock
were returned to and canceled by the Company.





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 I).





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.





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 (Note K).




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 H).





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).




F-25




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
            
            4,197,929
            
            5.87
            
            $
            1.00
            
            4,196,262
            
            $
            1.00$2.00
      - $2.99
            
            1,446,000
            
            7.18
            
            $
            2.49
            
            905,800
            
            $
            2.43$3.00
      - $3.99
            
            2,554,000
            
            8.37
            
            $
            3.21
            
            889,167
            
            $
            3.34$4.00
      - $4.99
            
            161,000
            
            8.14
            
            $
            4.44
            
            49,000
            
            $
            4.44$5.00
      - $5.99
            
            162,000
            
            8.02
            
            $
            5.28
            
            62,250
            
            $
            5.258,520,929
            
            6.92
            
            $
            2.06
            
            6,102,479
            
            $
            1.62




Transactions
involving stock options issued to employees are summarized as
follows:





Number
              of
      Shares
            
            
            Weighted
              Average
              Price
              Per
      ShareOutstanding
      at January 1, 2004
            
            
            8,293,000
            
            
            $
            1.19Granted
            
            
            2,108,000
            
            
            
            3.06Exercised
      (Note J)
            
            
            (540,399
            )
            
            
            1.08Cancelled
      or expired
            
            
            (245,834
            )
            
            
            1.74Outstanding
      at December 31, 2004
            
            
            9,614,767
            
            
            $
            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
            
            
            $
            2.06




The
weighted-average fair value of stock options granted to employees during the
years ended December 31, 2006, 2005 and 2004 and the weighted-average
significant assumptions used to determine those fair values, using a
Black-Scholes option pricing model are as follows:




F-26




TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2006, 2005 AND 2004








NOTE
K - STOCK OPTIONS AND WARRANTS (Continued)




2006
            
            
            2005
            
            
            2004Significant
      assumptions (weighted-average):Risk-free
      interest rate at grant date
            
            
            5.0
            %
            
            
            4.5
            %
            
            
            1.35
            %Expected
      stock price volatility
            
            
            65
            %
            
            
            71
            %
            
            
            76
            %Expected
      dividend payout
            
            
            -
            
            
            
            -
            
            
            
            -Expected
      option life (in years)
            
            
            5.0
            
            
            
            5.0
            
            
            
            5.0Fair
      value per share of options granted
            
            $
            1.82
            
            
            $
            2.40
            
            
            $
            1.83





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 12
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 2004, 2005 and 2006 is $2,420,988,
$1,235,487 and $2,810,417, respectively. Additionally, the total fair value of
shares vested during these years is $7,830,385, $2,440,097 and $1,080,095,
respectively.





Total
stock-based compensation expense recognized in the consolidated statement of
earnings for the year ended December 31, 2006 was $1,080,895, net of tax effect.
Additionally, the aggregate intrinsic value of options outstanding and unvested
as of December 31, 2006 is $5,187,394.





The
financial statements for the year ended December 31, 2005 and 2004 have 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; and $(20,923,045) and $(0.51), respectively, for the year ended December
31, 2004.





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
              
              5.34
              
              $
              1.00
              
              1,815,937
              
              $
              1.00
  F-27


Transactions
involving options issued to non-employees are summarized as
follows:





Number
              of
      Shares
            
            
            Weighted
      Average
              Price
      Per ShareOutstanding
      at January 1, 2004
            
            
            3,267,500
            
            
            $
            1.00Granted
            
            
            60,000
            
            
            
            3.45Exercised
      (Note J)
            
            
            (328,331
            )
            
            
            1.00Canceled
      or expired
            
            
            (1,000,000
            )
            
            
            1.00Outstanding
      at December 31, 2004
            
            
            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
            
            
            $
            1.00




The
estimated value of the non-employee stock options vested during the year ended
December 31, 2006 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, $1,191,767 and $1,130,780 during the year ended
December 31, 2006, 2005 and 2004, 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
            
            4.62
            
            $2.59
            
            862,452
            
            $2.59$4.17
            
            1,560,000
            
            4.67
            
            $4.17
            
            1,560,000
            
            $4.17$4.87
            
            2,135,398
            
            4.17
            
            $4.87
            
            2,135,398
            
            $4.874,557,850
            
            4.19
            
            $4.20
            
            4,557,850
            
            $4.20





Transactions
involving warrants are summarized as follows:





Number
              of
      Shares
            
            
            Weighted
              Average
              PricePer
      ShareOutstanding
      at January 1, 2004
            
            
            5,159,490
            
            
            $
            1.01Granted
            
            
            -
            
            
            
            -Exercised
      (Note J)
            
            
            (4,468,590
            )
            
            
            0.99Canceled
      or expired
            
            
            (115,000
            )
            
            
            1.00Outstanding
      at December 31, 2004
            
            
            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
            
            
            $
            4.20




F-28




The
Company granted 2,097,850 and 1,000,000 warrants to Convertible Senior Notes
holders (Note H), 1,560,000 and 0 warrants to private placement investors (Note
J), and 0 and 40,000 compensatory warrants to non-employees during the year
ended December 31, 2006 and 2005, respectively. The Company did not granted any
warrants during the year ended December 31, 2004. The estimated value of
compensatory warrants granted during the period ended December 31, 2006 was
determined using the Black-Scholes option pricing model and the following
assumptions: contractual term of 3 years, a risk free interest rate of
approximately 4.50%, a dividend yield of 0% and volatility of 71%. Compensation
expense of $3,845, $162,453, and $50,096 was charged to operations for the year
ended December 31, 2006, 2005 and 2004, respectively. The purchase price of the
warrants issued to Convertible Senior Notes holders was adjusted from $5.00 to
$4.87 per share and approximately 54,000 additional warrants were issued during
the year ended December 31, 2006 in accordance with the anti-dilution protection
provision of the Convertible Senior Notes Payable Agreement dated October 27,
2005 (Note H), upon the issuance of the 2,400,000 shares of common stock and
1,560,000 warrants to private placement investors (Note J) for a price per share
lower than $5.00.





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, 2005 and 2004, the Company has provided for the issuance of
36,000 shares of its common stock to Mr. Pickett each year.




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, 2006, 2005 and 2004, an aggregate of
$100,000 of consulting fees was charged to income each year pursuant to the
agreement.





In
July 2005, the Company entered into a Professional Services Agreement for
international consulting with Seth Blumenfeld, a member of the board of
directors. Pursuant to the terms of the agreement, Mr. Blumenfeld received
10,000 shares of Company stock upon execution of the agreement, 10,000 shares of
Company stock per quarter for the first year and 5,000 shares of Company stock
per quarter thereafter plus a five percent (5%) commission. 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.
During the year ended December 31, 2006 and 2005, the Company charged to
operations stock-based compensation in aggregate amount of $105,195 and
$127,766, respectively, in connection with this agreement.





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 2006, the Company entered into a one-year professional services
agreement with Global Transport Logistics, Inc. (“GTI”), for consulting services
for which GTI is paid a fee of $10,000 per month. GTI is 50% owned by Anthony
Matarazzo, the President of MST’s brother.





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.




F-29




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 31,2006
            
            
            2005
            
            
            2004(In
      thousands of U.S. $)Revenues:Telkonet
            
            
            3,426
            
            
            
            2,488
            
            
            
            699MST
            
            
            1,756
            
            
            
            -
            
            
            
            -Total
      revenue
            
            $
            5,182
            
            
            $
            2,488
            
            
            $
            699Year
      ended December 31,2006
            
            
            2005
            
            
            2004(In
      thousands of U.S. $)Gross
      ProfitTelkonet
            
            
            1,155
            
            
            
            771
            
            
            
            156MST
            
            
            (455
            )
            
            
            -
            
            
            
            -Total
      revenue
            
            $
            700
            
            
            $
            771
            
            
            $
            156Operating (loss):Telkonet
            
            
            (14,477
            )
            
            
            (15,307
            )
            
            
            (13,112
            )MST
            
            
            (3,087
            )
            
            
            -
            
            
            
            -Total
      operatiing (loss)
            
            $
            (17,564
            )
            
            $
            (15,307
            )
            
            $
            (13,112
            )Interest
      IncomeTelkoent
            
            
            327
            
            
            
            166
            
            
            
            129MST
            
            
            -
            
            
            
            -
            
            
            
            -Total
      interest income
            
            $
            327
            
            
            $
            166
            
            
            $
            129Interest
      ExpensesTelkonet
            
            
            5,594
            
            
            
            646
            
            
            
            109MST
            
            
            1
            
            
            
            -
            
            
            
            -Total
      interest expense
            
            $
            5,595
            
            
            $
            646
            
            
            $
            109






Year
      ended December 31,2006
            
            
            2005
            
            
            2004(In
      thousands of U.S. $)AssetsTelkonet
            
            
            4,137
            
            
            
            23,291
            
            
            
            15,494MST
            
            
            8,379
            
            
            
            -
            
            
            
            -Total
      asset
            
            $
            12,516
            
            
            $
            23,291
            
            
            $
            15,494Capital
      ExpendituresTelkonet
            
            
            94
            
            
            
            794
            
            
            
            1,007MST
            
            
            2,581
            
            
            
            -
            
            
            
            -Total
      capital expenditures
            
            $
            2,675
            
            
            $
            794
            
            
            $
            1,007Operating
      ExpensesTelkonet
            
            
            15,632
            
            
            
            16,078
            
            
            
            13,268MST
            
            
            2,633
            
            
            
            -
            
            
            
            -Total
      operating expenses
            
            $
            18,265
            
            
            $
            16,078
            
            
            $
            13,268Depreciation
      and AmortizationTelkonet
            
            
            221
            
            
            
            186
            
            
            
            72MST
            
            
            320
            
            
            
            -
            
            
            
            -Total
      depreciation and amortization
            
            $
            541
            
            
            $
            186
            
            
            $
            72




F-30




All of
the Company’s assets as of December 31, 2006, 2005, and 2004 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 31,2006
            
            
            2005
            
            
            2004(In
      thousands of U.S. $)Revenues
      from sales to unaffiliatedcustomers
      from continuing operationsin
      Telkonet and MST segments:United
      States
            
            
            4,509
            
            
            
            1,871
            
            
            
            631Worldwide
            
            
            673
            
            
            
            617
            
            
            
            68$
            5,182
            
            
            $
            2,488
            
            
            $
            699




Sales to
major customers in the Telkonet and MST segments out of total revenues are as
follows:




Year
      ended December 31,2006
            
            2005
            
            2004Hospitality
      Leasing Corporation
            
            
            18%
            
            18%
            
            
            19%





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:




2006
            
            
            2005
            
            
            2004Tax
      provision computed at the statutory rate
            
            $
            (9,564,000
            )
            
            $
            (5,522,000
            )
            
            $
            (4,583,000
            )Deferred
      state income taxes, net of federal income tax benefit
            
            
            -
            
            
            
            (525,000
            )
            
            
            -Book
      expenses not deductible for tax purposes
            
            
            526,000
            
            
            
            19,000
            
            
            
            15,000U.S.
      NOL created from stock option exercise
            
            
            -
            
            
            
            (463,000
            )
            
            
            (404,000
            )U.S.
      deferred tax liability for beneficial conversion feature
            
            
            -
            
            
            
            518,000
            
            
            
            -Change
      in valuation allowance for deferred tax assets
            
            
            9,038,000
            
            
            
            5,973,000
            
            
            
            4,972,000Income
      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:





2006
            
            
            2005Deferred
      Tax Assets:Net
      operating loss carryforwards
            
            $
            24,273,000
            
            
            $
            15,015,000Warrants
      and non-employee stock options
            
            
            774,000
            
            
            
            684,000Investment
      in Amperion
            
            
            189,000
            
            
            
            152,000Other
            
            
            403,000
            
            
            
            487,000Total
      deferred tax assets
            
            
            25,639,000
            
            
            
            16,338,000Deferred
      Tax Liabilities:Beneficial
      Conversion Feature of Convertible Debentures
            
            
            -
            
            
            
            (527,000
            )Property
      and equipment, principally due to differences in
    depreciation
            
            
            (13,000
            )
            
            
            (66,000
            )Acquired
      Intangibles
            
            
            (1,050,000
            )
            
            
            -Other
            
            
            (19,000
            )
            
            
            -Total
      deferred tax liabilities
            
            
            (1,082,000
            )
            
            
            (593,000
            )Valuation
      allowance
            
            
            (24,557,000
            )
            
            
            (15,745,000
            )Net
      deferred tax assets
            
            $
            --
            
            
            $
            --




F-31




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, 2006, the Company has net operating loss carryforwards of
approximately $66 million for federal income tax purposes which will expire at
various dates from 2020 through 2026.





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, $2.5 million and $5.5
million of the NOLs at December 31, 2005 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, 2006, 2005 and 2004,
respectively.





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:





2006
            
            
            2005
            
            
            2004Net
      loss available to common shareholders
            
            $
            (27,437,116
            )
            
            $
            (15,778,281
            )
            
            $
            (13,092,660
            )Basic
      and fully diluted loss per share
            
            $
            (0.54
            )
            
            $
            (0.35
            )
            
            $
            (0.32
            )Weighted
      average common shares outstanding
            
            
            50,823,652
            
            
            
            44,743,223
            
            
            
            41,384,074





For the
years ended December 31, 2006, 2005 and 2004, 4,604,414, 7,577,208, and
9,198,646 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, 2006 and 2005 are as
follows:





2006
            
            
            2005Accounts
      payable
            
            $
            1,625,357
            
            
            $
            880,802Accrued
      interest
            
            
            -
            
            
            
            263,806Accrued
      payroll and payroll taxes
            
            
            559,411
            
            
            
            594,401Accrued
      purchase price contingency
            
            
            400,000
            
            
            
            -Warranty
            
            
            47,300
            
            
            
            24,000Other
            
            
            233,076
            
            
            
            58,863Total
            
            $
            2,865,144
            
            
            $
            1,821,872





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 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. The Company also leases office space of approximately 1,800
square feet in White Marsh, MD. Additionally, the Company leases two corporate
apartments through May 2006 in Germantown, MD and Crystal City, VA.




F-32




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 chief executive
officer. The operating lease will expire in September 2008.





Commitments
for minimum rentals under non cancelable leases at December 31, 2006 are as
follows:




2007
            
            $
            421,8042008
            
            
            279,6182009
            
            
            239,2912010
            
            
            176,9502011
      and thereafter
            
            
            -Total
            
            $
            1,117,663





Rental
expenses charged to operations for the year ended December 31, 2006, 2005 and
2004 are $578,022, $389,935, and $165,249, respectively.




NOTE
R - COMMITMENTS AND CONTINGENCIES





Capital Lease
Obligations





Development
test equipment (Note E) includes the following amounts for capitalized leases at
December 31, 2006 and 2005:





2006
            
            
            2005Computer
      equipment and software
            
            $
            52,000
            
            
            $
            52,000Less:
      accumulated depreciation and amortization
            
            
            (36,400
            )
            
            
            (26,000
            )$
            15,600
            
            
            $
            26,000





The
Company has computer equipment and software purchased under non-cancelable
leases with an original cost of $52,000. As of December 31, 2006, the Company
has paid in full the lease obligation. Depreciation expense of $10,400, $10,400,
and $10,400 in connection with the capital leased equipment was charged to
operations during the year ended December 31, 2006, 2005 and 2004,
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.




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 H).  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.




F-33




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.





Microwave Satellite
Technology, Inc. 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 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 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. 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.




NOTE
S - BUSINESS CONCENTRATION





Total
sale 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. Revenue from one major customer represented $136,166 or approximately 19%
of 2004 revenues. Total accounts receivable of $8,774, or 2% of total accounts
receivable, was due from Hospitality Leasing Corporation as of December 31,
2006. There were no outstanding accounts receivable from these major customers
as of December 31, 2005 and 2004.





Purchases
from three (3) major suppliers approximated $446,038or 61% of purchase, $598,000
or 48% of purchases, and $885,568 or 40% of purchases for the years ended
December 31, 2006, 2005 and 2004, respectively. Total accounts payable of
approximately $1,871 or 0.3% of total accounts payable was due to these three
suppliers as of December 31, 2006 and approximately $3,000 or .04% of total
accounts payable was due to these three suppliers as of December 31,
2005.





NOTE
T - SUBSEQUENT EVENTS





$10 million Private
Placement





On
February 2, 2007, we completed a private placement of 4.0 million shares of our
common stock to certain accredited investors for gross proceeds of $10 million.
The Company incurred $390,000 in private placement fees in connection with
this transaction. The proceeds of this offering will be used for general working
capital needs and to assist in funding the Company's strategic initiatives.
Telkonet also has issued to the purchasers in the private
placement warrants to purchase 2.6 million shares of common stock at an
exercise price of $4.17 per share. Additionally, the Company agreed to issue to
the placement agent warrants to purchase 79,000 shares of its common stock at an
exercise price of $4.17 per share. These warrants expire five years from
the date of issuance.





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 $7,000,000. 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 1,090,000 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.





The
acquisition was accounted for using the purchase method of accounting under SFAS
No. 141.




F-34




The
following table presents the purchase price allocation, including estimated
professional fees and other related acquisition costs, to the assets acquired
and liabilities assumed, based on their fair values as of December 31, 2006
which is the most recent unaudited financial statements:





Current
      assets
            
            $
            1,477,355Property,
      plant and equipment
            
            
            32,052Other
      assets
            
            
            378,170Goodwill and
      Intangibles
            
            
            5,593,557Total
      assets acquired
            
            
            7,481,134Accounts
      payable and accrued liabilities
            
            
            (231,134
            )Total
      liabilities assumed
            
            
            (231,134
            )Net
      assets acquired
            
            $
            7,250,000





Due to
its recent date of acquisition, the purchase price allocation to Intangibles and
Goodwill is based upon preliminary data that is subject to adjustment and could
change significantly pending the completion of management’s valuation to
accurately evaluate this allocation. The Company recognizes goodwill in
connection with this acquisition as a result of SSI’s historical development of
its subscriber base, high profile customer acquisition, its proprietary suite of
energy management products and strategic industry position. The results of the
acquisition will be included within the consolidated financial statements from
its date of acquisition in 2007.





The
following data presents unaudited pro forma revenues, net loss and basic and
diluted net loss per share of common stock for the Company as if the acquisition
discussed above, had occurred on January 1, 2005. The Company has prepared these
pro forma financial results for comparative purposes only. These pro forma
financial results may not be indicative of the results that would have occurred
if the Company had completed the acquisition at the beginning of the periods
shown below or the results that will be attained in the future:




Year
      Ended December 31, 2006As
      Reported
            
            
            Pro
      Forma Adjustments
            
            
            Pro
      FormaRevenues
            
            $
            5,181,328
            
            
            $
            1,599,935
            
            
            $
            6,781,263Net
      loss
            
            $
            (27,437,116
            )
            
            $
            (1,187,836
            )
            
            $
            (28,624,952
            )Net
      loss per common share outstanding - basic
            
            $
            (0.54
            )
            
            $
            -
            
            
            $
            (0.54
            )Weighted
      average common shares outstanding - basic
            
            
            50,823,652
            
            
            
            -
            
            
            
            53,050,925





Year
      Ended December 31, 2005As
      Reported
            
            
            Pro
      Forma Adjustments
            
            
            Pro
      FormaRevenues
            
            $
            2,488,323
            
            
            $
            661,604
            
            
            $
            3,149,927Net
      loss
            
            $
            (15,778,281
            )
            
            $
            (1,576,771
            )
            
            $
            (17,355,052
            )Net
      loss per common share outstanding - basic
            
            $
            (0.35
            )
            
            $
            (0.02
            )
            
            $
            (0.37
            )Weighted
      average common shares outstanding - basic
            
            
            44,743,223
            
            
            
            
            
            
            
            46,970,496





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. The aggregate number of shares issuable to the sellers is subject to
downward adjustment in the event the Company’s common stock trades at or above a
price of $4.50 per share for twenty consecutive trading days during the one year
period following the closing.





The
acquisition was accounted for using the purchase method of accounting under SFAS
No. 141.




F-35




The
following table presents the purchase price allocation, including estimated
professional fees and other related acquisition costs, to the assets acquired
and liabilities assumed, based on their fair values as of December 31, 2006
which is the most recent unaudited financial statements:





Current
      assets
            
            $
            877,389Property,
      plant and equipment
            
            
            55,793Other
      assets
            
            
            303,828Goodwill &
      Intangibles
            
            
            11,285,895Total
      assets acquired
            
            
            12,522,905Accounts
      payable and accrued liabilities
            
            
            (466,808
            )Total
      liabilities assumed
            
            
            (466,808
            )Net
      assets acquired
            
            $
            12,056,097





Due to
its recent date of acquisition, the purchase price allocation to Intangibles and
Goodwill is based upon preliminary data that is subject to adjustment and could
change significantly pending the completion of management’s valuation to
accurately evaluate this allocation.The Company
recognizes goodwill in connection with this acquisition as a result of
Ethostream’s historical development of its subscriber base, high profile
customer acquisition, and strategic industry position. The results of the
acquisition will be included within the consolidated financial statements from
its date of acquisition in 2007.





The
following data presents unaudited pro forma revenues, net loss and basic and
diluted net loss per share of common stock for the Company as if the acquisition
discussed above, had occurred on January 1, 2005. The Company has prepared these
pro forma financial results for comparative purposes only. These pro forma
financial results may not be indicative of the results that would have occurred
if the Company had completed the acquisition at the beginning of the periods
shown below or the results that will be attained in the future:





Year
      Ended December 31, 2006As
      Reported
            
            
            Pro
      Forma Adjustments
            
            
            Pro
      FormaRevenues
            
            $
            5,181,328
            
            
            $
            3,511,538
            
            
            $
            8,692,866Net
      loss
            
            $
            (27,437,116
            )
            
            $
            (156,623
            )
            
            $
            (27,593,739
            )Net
      loss per common share outstanding - basic
            
            $
            (.54
            )
            
            $
            (0.01
            )
            
            $
            (0.51
            )Weighted
      average common shares outstanding - basic
            
            
            50,823,652
            
            
            
            
            
            
            
            54,283,261




Year
      Ended December 31, 2005As
      Reported
            
            
            Pro
      Forma Adjustments
            
            
            Pro
      FormaRevenues
            
            $
            2,488,323
            
            
            $
            2,752,355
            
            
            $
            5,240,678Net
      loss
            
            $
            (15,778,281
            )
            
            $
            (113,996
            )
            
            $
            (15,892,277
            )Net
      loss per common share outstanding - basic
            
            $
            (.35
            )
            
            $
            0.02
            
            
            $
            (0.33
            )Weighted
      average common shares outstanding - basic
            
            
            44,743,223
            
            
            
            
            
            
            
            48,202,832