<PAGE>

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   FORM 10-KSB

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

                        Commission file number: 000-27305

                                 TELKONET, INC.
        (Exact name of small business issuer as specified in its charter)


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

                               902 A Commerce Road
                               Annapolis, MD 21401
                    (Address of principal executive offices)

                                (410) - 897-5900
                           (Issuer's telephone number)

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

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.

Yes    X        No
     -----         -----
Check if disclosure of delinquent filers pursuant to Item 405 of Regulation S-B
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-KSB or any amendment to
this Form 10-KSB.

  X
-----
State issuer's revenues for its most recent fiscal year:   $93,660

Aggregate market value of the voting stock held by non-affiliates of the
registrant as of March 24, 2004: $143,269,831 Number of outstanding shares of
the registrant's par value $0.001 common stock as of March 24, 2004: 38,704,941
(1).

(1) Number of outstanding shares as of March 24, 2004 does not include 4,559,007
shares to be issued by the company related to the exercise of warrants and
conversion of debentures as of March 24, 2004.

<PAGE>

                                 TELKONET, INC.
                                   FORM 10-KSB
                                      INDEX

                                                                            Page
                                                                            ----
                                     Part I


Item 1.  Description of Business..............................................3

Item 2.  Description of Property..............................................7

Item 3.  Legal Proceedings....................................................7

Item 4.  Submission of Matters to a Vote of Security Holders..................7


                                     Part II

Item 5.  Market for Registrant's Common Equity, Related Stockholder
         Matters and Small Business Issuer Purchases of Securities............8

Item 6.  Management's Discussion and Analysis of Financial
         Condition and Results of Operations..................................9

Item 7.  Financial Statements.................................................18

Item 8.  Changes in and Disagreements with Accountants on
         Accounting and Financial Disclosure..................................18

Item 8A. Controls and Procedures..............................................18


                                    Part III

Item 9.  Directors and Executive Officers of the Registrant...................19

Item 10. Executive Compensation...............................................22

Item 11. Security Ownership of Certain Beneficial Owners and Management
         and Related Stockholder Matters......................................25

Item 12. Certain Relationships and Related Transactions.......................27


                                     Part IV

Item 13. Exhibits and Reports on Form 8-K.....................................30

Item 14. Principal Accounting Fees and Services...............................31

<PAGE>


                                     PART I

ITEM 1.  DESCRIPTION OF BUSINESS.

         GENERAL
         -------

         Telkonet, Inc. ("Telkonet" or the "Company") was formed in 1999 to
develop 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. Since
the Company's formation, it has worked on the development and marketing of its
PLC technology.

         The Company's PLC technology, the "PlugPlus(TM)" product suite,
consists of three separate components, the Gateway, the Coupler and the iBridge.
The Gateway, the hub of the PlugPlus(TM)product suite, is a modular,
self-contained unit that accepts data from an existing network on one port and
distributes it via a second port. The Gateway integrates a communications
processor that runs a series of proprietary applications under Linux. The signal
generated by the Gateway can be directly coupled into low voltage wiring via the
Coupler, which interfaces directly between the Gateway and the building's
electrical panel. Multi-panel buildings typically require multiple Couplers,
which are connected to the Gateway via inexpensive coaxial cable and
concentrated using standard radio frequency splitters. A suite of software
applications running on the Gateway can perform communications functions or
system management functions. The iBridge serves as the user's network access
device and connects to a user's personal computer through a standard Ethernet
cable. The iBridge's AC line cord serves as its power source as well as its
network interface. The Company also offers the eXtender, a fourth optional
device, as part of its PlugPlus(TM)product suite. The eXtender is used to extend
the reach of the Gateway in larger buildings or campus environments.

         The PlugPlus(TM)product suite delivers data to the user at speeds in
excess of 7 Mega bits per second (Mbps), with burst speeds of 12.6 Mbps. The
PlugPlus(TM)product suite is installed by connecting an incoming broadband
signal (DSL, TL, satellite or cable modem) into the Gateway and connecting the
Gateway to a building's electrical panel using one or more Couplers. Once
installed, the Gateway distributes the high-speed Internet signal throughout the
entire existing network of electrical wires within the building. The user may
access a high-speed Internet signal by plugging the iBridge into any electrical
outlet and connecting a personal computer to the iBridge using the computer's
built-in Ethernet port. Multiple personal computers connected to the iBridge can
communicate with one another and can share a single broadband resource via the
Gateway.

         The Company 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 Company's principal executive offices are located at 902 A Commerce
Road, Annapolis, Maryland 21401

         BUSINESS HISTORY
         ----------------

         In January 2002, the Company announced that it had shifted its
management emphasis from research and development to product sales and marketing
in order to move its initial proprietary products into the commercial market. In
January 2002, the Board of Directors, Founders and executive management of the
Company also reassessed the Company's capital structure. In order to attract
additional management and marketing expertise, and to raise the necessary
capital for manufacturing, sales, and marketing, the Board of Directors approved
a plan authorizing the repurchase of certain shares of, and options to purchase,
Telkonet common stock held by each of David Grimes, L. Peter Larson and Stephen
Sadle who, at the time of the stock repurchase, each owned in excess of five
percent of the issued and outstanding capital stock and were directors and
executive officers of Telkonet. The net effect of the recapitalization was to
reduce the number of shares of issued and outstanding common stock from

                                       3
<PAGE>

approximately 22,100,000 shares to 13,900,000 shares. For a more complete
discussion of the repurchase, see "Certain Relationships and Related
Transactions."

         In May 2002, the Company concluded an offering of Series A convertible
debentures pursuant to which the Company raised approximately $1.7 million
dollars for working capital purposes. The Series A convertible debentures accrue
interest at 8.0% per annum and mature three years from the date of issuance.
Each Series A debenture is convertible into shares of Telkonet common stock at
any time following the six month anniversary of the date of issuance at a
conversion price equal to $0.50 per share for each $10,000 principal amount plus
accrued but unpaid interest on the Series A debenture converted. In connection
with the placement of the Series A debentures, Telkonet issued non-detachable
warrants to purchase 1,689,100 shares of Telkonet common stock at a price of
$1.00 per share. As of December 31, 2003, $63,440, including principal and
accrued but unpaid interest, was outstanding on the Series A debentures.

         In September 2002, the Company confirmed through an independent,
Federal Communications Commission ("FCC") certified testing lab that its PLC
product line meets the FCC technical requirements for Class A digital devices.
In June 2003, the Company confirmed that its PLC product line also meets the
requirements for Class B digital devices. As a result, no further testing of
these products is required and the devices may be manufactured and marketed for
commercial or residential use. The FCC permits 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.

         In November 2002, the Company announced the successful installation of
its PlugPlusTM product suite at the historic Partridge Inn in Augusta, Georgia.
The installation provided high-speed Internet connectivity to guest rooms,
meeting rooms and a lobby kiosk.

         In December 2002, the Company announced the installation of a product
field trial at the Marriott Residence Inn-Landfall in Wilmington, NC. Telkonet
implemented a hotel-wide PLC system that provided connectivity to the hotels 90
guest rooms, meeting rooms, common areas and a lobby kiosk.

         In February 2003, the Company concluded an offering of Series B
convertible debentures pursuant to which the Company raised approximately $2.5
million dollars for working capital purposes. The Series B convertible
debentures accrue interest at 8.0% per annum and mature three years from the
date of issuance. Each Series B debenture is convertible into shares of Telkonet
common stock at any time following the six month anniversary of the date of
issuance at a conversion price equal to $0.55 per share for each $10,000
principal amount plus interest of the Series B debenture converted. In
connection with the placement of the Series B debentures, Telkonet issued
non-detachable warrants to purchase 2,500,000 shares of Telkonet common stock at
a price of $1.00 per share. As of December 31, 2003, $326,400, including
principal and accrued but unpaid interest, was outstanding on the Series B
debentures.

         In March 2003, the Company announced that it had executed a strategic
alliance agreement with Choice Hotels International (NYSE: CHH), one of the
largest hotel franchise companies in the world with more than 3,500 hotels,
inns, all-suite hotels and resorts open and under development in 46 countries
under the Comfort Inn, Comfort Suites, Quality, Clarion, Sleep Inn, Rodeway Inn,
EconoLodge and MainStay Suites brand names. The strategic alliance agreement is
an initial two-year contract, pursuant to which Telkonet will become a Choice
Hotels-endorsed vendor offering the PlugPlus(TM) product suite to Choice Hotels'
franchisees in the United States. Under the strategic alliance agreement,
Telkonet and Choice Hotels have agreed to undertake cooperative efforts for the
marketing, advertising and promotion of Telkonet's PlugPlus(TM) product suite to
Choice Hotels' franchisees.

         In the second quarter of 2003, the Company concluded an offering of
Senior Notes pursuant to which the Company raised approximately $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 being June 2006. In connection


                                       4
<PAGE>

with the Senior Note offering the Company also issued non-detachable warrants to
purchase 125,000 shares of the Company's common stock. The warrants have a
three-year contractual life and are exercisable immediately following the
issuance of the Senior Notes at an 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.

         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 shares of common in this transaction. As of December 31, 2003, the
aggregate outstanding balance on the Senior Notes, including principal and
accrued but unpaid interest, was $2,989,000.

         In January 2004, the Board of Directors determined to permit the Senior
Noteholders, for a limited period of time, to convert their Senior Notes into
the Company's common stock at a conversion price of $2.10 per share. In
connection with this transaction, Senior Noteholders converted Senior Notes
having an aggregate principal value of $2,539,000. As of January 31, 2004, the
aggregate outstanding balance on the Senior Notes, including principal and
accrued but unpaid interest, was $450,000.

         COMPETITION
         -----------

         Several established networking vendors, including Linksys and Netgear,
have planned and/or announced powerline communications products that are
compliant with the HomePlug(TM) Alliance. Both Linksys and Netgear are focused
on products for the home and residential marketplace. Telkonet finds potential
competitors to actually be complementary in nature and a validation of the
viability of the powerline communications market overall. While these companies
may choose to move into the commercial market at a future date, at this time
they do not represent a direct competitive threat to Telkonet.

         Notwithstanding the present absence of direct competitors, there can be
no assurance that Linksys Group, Netgear or any other company will not develop
PLC products that compete with Telkonet's products in the future. These
potential competitors 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, initially targeting the hospitality markets with a direct
sales effort at the regional and national level. The Company anticipates that it
will soon focus its efforts on the multi-unit dwelling, government, and
international markets, which it hopes to access through network administrator
and systems administrator partners. Target markets for Telkonet include office
buildings, hotels, schools, shopping malls, commercial buildings, and
multi-dwelling units, government facilities, and any other commercial facilities
that have a need for Internet access and network connectivity. Telkonet will
continue to examine, select and approach entities with existing distribution
channels that will be enhanced by the Company's offerings. The Company also
intends to focus future sales and marketing efforts in Europe, South America,
Asia and the Pacific Rim where the Internet is available.

         RAW MATERIALS
         -------------

         The Company has not experienced any significant or unusual problems in
the purchase of raw materials or commodities. While the Company 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
procuring any essential materials, parts or components. The Company obtains the
majority of its raw materials from the following suppliers: Arrow Electronics,
Inc., Avnet Electronics Marketing, Digi-Key Corporation, Intellon Corporation
and Superior Manufacturing Services.

                                       5
<PAGE>

         CUSTOMERS
         ---------

         The Company is neither limited to, nor reliant upon, a single or
narrowly segmented consumer base from which it derives its revenues. The Company
also is not dependent on any single customer or small group of customers. The
Company's primary focus is in the Hospitality, Multi-Dwelling Units, Government
and International markets.

         INTELLECTUAL PROPERTY
         ---------------------

         The Company has applied for patents that cover its unique technology,
and has utilized the recently announced advancements in transmission speeds to
build its next generation of products that will be launched into the hospitality
market. The Company 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. It
is the intent of the Company to protect this intellectual property by filing
additional patent applications. The Company also has multiple registered and
common law trademarks that it uses in the conduct of its business. The Company
is presently not a party to any intellectual property licensing agreements.

         In September 2003, the Company received approval from the U.S. Patent
and Trademark Office for its "Method and Apparatus for Providing Telephonic
Communication Services" patent. Notwithstanding the issuance of this patent,
there can be no assurance that any of the Company'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 their 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
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 more stringent standards apply to
"Class B" devices intended for residential use. An independent, FCC-certified
testing lab has verified that our PLC product line 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 us
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.

         RESEARCH AND DEVELOPMENT
         ------------------------

         During the years ended December 31, 2003 and 2002, the Company spent
$1,370,785 and $1,279,145 on research and development activities, respectively.
The primary developments arising from these research and development efforts
included an improved network reach with the introduction of the Company's
secondary gateway, the introduction of an encrypted key-change-over-powerline
feature to ease security management, an improved ability to remotely monitor
network status and the addition of a VLAN support function for enhanced
integration with subscriber management and billing systems. The Company's focus
currently is directed toward a reduced total solution cost with improved
performance, streamlined installation and a reduction in the time and cost of
installation and developing a low-cost "plug and play" system for home
networking applications.

                                       6
<PAGE>

         ENVIRONMENTAL MATTERS
         ---------------------

         We do not anticipate any material effect on our capital expenditures,
earnings or competitive position due to compliance with government regulations
involving environmental matters.

         EMPLOYEES
         ---------

         As of March 24, 2004, the Company had 26 full time employees.
Additional key staff is planned in the areas of business development, sales and
marketing, and engineering.

ITEM 2.  DESCRIPTION OF PROPERTY.

         The Company currently leases approximately 3,000 square feet of office
space at 902A Commerce Drive, Annapolis, MD 21401 for all of its corporate
operations pursuant to a month-to-month lease agreement. The Company expects to
terminate this lease in the second quarter of 2004 in anticipation of the
Company's relocation of its operations to Germantown, Maryland as described more
fully below.

         The Company has executed a sub-lease agreement through November 2010
for approximately 11,600 square feet of commercial office space in Germantown,
Maryland. The Company intends to relocate its operations to the Germantown
facility in April 2004. The Company is responsible for an allocated portion of
the build-out cost of the Germantown facility. The Company anticipates that it
will spend approximately $400,000 in connection with this relocation, which
includes aggregate build-out costs, security deposit, office furniture and
telephone equipment. As of December 31, 2003, the Company has incurred
approximately $50,000 in build-out costs and has paid to the landlord
approximately $70,000 as a security deposit for the Germantown facility.

ITEM 3.  LEGAL PROCEEDINGS.

         In March 2003, Jenson Services, Inc. and James P. Doolin filed an
action against the Company in the Third Judicial District Court in and for Salt
Lake County, State of Utah. The action sets forth various counts all based on
allegations that the Company, through its agents, promised to undertake a
registration of the Company's common stock and thereby allow the plaintiffs to
exercise piggy-back registration rights under a registration rights agreement.
The action seeks damages from the Company in unspecified amounts. On February
23, 2004, the litigation was settled by the parties under the terms of a
Settlement and Release Agreement, pursuant to which the parties agreed to
release each other and execute a Lockup Agreement providing that the plaintiffs'
shares of the Company's common stock may only be sold ratably over a ten (10)
month period, and the Company agreed to accept an opinion of plaintiffs' counsel
that plaintiffs' shares of the Company's common stock may be sold under Rule 144
promulgated under the Securities Act of 1933. Under the terms of the settlement
neither party was required to make any monetary payments.

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

         None.

                                       7
<PAGE>

                                     PART II

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

         On January 24, 2004, the Company's common stock was listed for trading
on the American Stock Exchange under the ticker symbol "TKO." Prior to January
24, 2004, the Company's common stock was quoted on the OTC Bulletin Board
(OTCBB) under the symbol "TLKO.OB." As of March 24, 2004, the Company had 353
stockholders of record and 38,704,941 shares of its common stock issued and
outstanding, which does not include 4,559,007 shares to be issued pursuant to
warrants that were exercised on March 24, 2004. For a more complete description
of the warrant exercises and the effect of the issuance of the shares of the
Company's common stock upon exercise of these warrants, see "Subsequent Events
(Note O)" in the notes to the audited financial statements.

         The following table documents the high and low sales prices for the
Company's common stock as quoted on Bloomberg Reporting Service for the periods
indicated.

                                                         HIGH             LOW
                                                       ---------       ---------
YEAR ENDED DECEMBER 31, 2003
         First  Quarter ........................       $   1.90        $   0.41
         Second Quarter ........................       $   4.65        $   1.41
         Third Quarter .........................       $   3.69        $   1.55
         Fourth Quarter ........................       $   2.77        $   1.70
YEAR ENDED DECEMBER 31, 2002
         First Quarter .........................       $   0.87        $   0.87
         Second Quarter ........................       $   1.53        $   1.40
         Third Quarter .........................       $   1.08        $   0.98
         Fourth Quarter ........................       $   0.62        $   0.56

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

         During the last two years, the Company sold shares of its common stock
in the following transactions, each of which was effected in reliance on the
exemption from registration provided by Section 4(2) of the Securities Act of
1933 and/or Rule 506 of Regulation D promulgated thereunder. Each of the
following sales was made to one or more "accredited investors," as such term is
defined in the Securities Act of 1933.

         On January 1, 2003, the Company granted options to purchase 200,000
shares of its common stock to John Vasilj as consideration for certain general
business services provided by Mr. Vasilj.

         On January 1, 2003, the Company granted options to purchase 200,000
shares of its common stock to John Cosper as consideration for certain general
business services provided by Mr. Cosper.

         On January 30, 2003, the Company entered into an employment agreement
with Ronald W. Pickett, the Company's President, pursuant to which the Company
agreed to issue 3,000 shares of its common stock per month for each month during
the term of the employment agreement. These shares were issued to Mr. Pickett on
March 17, 2004.

         On February 1, 2003, the Company granted options to purchase 375,000
shares of its common stock to David L. Jordan as consideration for certain
general business services provided by Mr. Jordan.

                                       8
<PAGE>

         On February 1, 2003, the Company granted options to purchase 375,000
shares of its common stock to Barry W. Zelin as consideration for certain
general business services provided by Mr. Zelin.

         On February 1, 2003, the Company granted options to purchase 250,000
shares of its common stock to Axiom Capital Management, Inc. as consideration
for certain general business services provided by Axiom Capital Management, Inc.

         On February 3, 2003, the Company issued 49,998 shares of its common
stock to Investor Stock Daily, Inc. as consideration for certain public
relations services provided by Investor Stock Daily, Inc.

         During the second quarter of 2003, the Company commenced an offering of
up to $5,000,000 principal amount of Senior Notes. In connection with the
placement of the Senior Notes, the Company also issued non-detachable warrants
granting holders the right to acquire 6,250,000 shares of the Company's common
stock at $1.00 per share.

         On May 21, 2003, the Company issued 35,000 shares of its common stock
and warrants to purchase 35,000 shares of its common stock at $2.97 per share to
vFinance Investments, Inc. as consideration for certain investment banking and
investment advisory services provided by vFinance Investments, Inc.

         On May 21, 2003, the Company issued warrants to purchase 50,000 shares
of its common stock at $2.54 per share to First Montauk Securities Corp. as
consideration for certain financial services provided by First Montauk
Securities Corp.

         On January 26, 2004, the Company issued 1,209,048 shares of its common
stock to holders of its Senior Notes in exchange for forgiveness of
approximately $2,500,000 aggregate outstanding principal amount on such Senior
Notes.

         On February 16, 2004, the Company commenced an offering of up to
$14,056,240 of the Company's common stock. This offering was concluded on
February 18, 2004, and resulted in net proceeds to the Company of $12,787,855
and the issuance of 6,387,600 shares of common stock. CDC Securities, Inc. acted
as the Company's placement agent in connection with this offering.

         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, 2003.

<TABLE>
<CAPTION>
                                              NUMBER OF SECURITIES TO      WEIGHTED -AVERAGE        NUMBER OF SECURITIES
                                              BE ISSUED UPON EXERCISE      EXERCISE PRICE OF       REMAINING AVAILABLE FOR
                                              OF OUTSTANDING OPTIONS,    OUTSTANDING OPTIONS,       FUTURE ISSUANCE UNDER
                                                WARRANTS AND RIGHTS       WARRANTS AND RIGHTS     EQUITY COMPENSATION PLANS
                                                                                                    (EXCLUDING SECURITIES
                                                                                                  REFLECTED IN COLUMN (a))
                                                         (a)                     (b)                         (c)
        ----------------------------------    -----------------------    --------------------     -------------------------
        <S>                                          <C>                       <C>                        <C>
        EQUITY COMPENSATION PLANS APPROVED
                BY SECURITY HOLDERS                  15,000,000                $1.19                      3,439,500
        ----------------------------------    -----------------------    --------------------     -------------------------
           EQUITY COMPENSATION PLANS NOT
           APPROVED BY SECURITY HOLDERS                 n/a                     n/a                          n/a
        ----------------------------------    -----------------------    --------------------     -------------------------
                       TOTAL                         15,000,000                $1.19                      3,439,500
        ----------------------------------    -----------------------    --------------------     -------------------------
</TABLE>

ITEM 6.  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.

                                       9
<PAGE>

         PLAN OF OPERATION
         -----------------

         The Company is emerging from a development stage and has began
generating revenues from operations late in the fourth quarter. The Company may
experience fluctuations in operating results in future periods due to a variety
of factors, including, but not limited to, market acceptance of the Internet and
power line communication technologies as a medium for customers requiring
high-speed Internet access, the Company's ability to acquire and deliver high
quality products at a price lower than those currently available to consumers,
the Company's ability to obtain additional financing in a timely manner and on
terms favorable to the Company, the Company's ability to successfully attract
customers at a steady rate and maintain customer satisfaction, Company
promotions, branding and sales programs, the amount and timing of operating
costs and capital expenditures relating to the expansion of the Company's
business, operations and infrastructure and the implementation of marketing
programs, key agreements and strategic alliances, the number of products offered
by the Company, the number of returns experienced by the Company, and general
economic conditions specific to the Internet, power-line communications, and the
communications industry.

         REVENUES
         --------

         In March 2003, the Company executed a strategic alliance agreement with
Choice Hotels International pursuant to which Telkonet became a Choice
Hotels'-endorsed vendor offering its high-speed Internet access solution to
Choice Hotels' hotel franchisees in the United States. Other strategic alliance
agreements are in various stages of negotiations. It is anticipated that these
alliances will enable Telkonet to leverage the alliance partner's brand,
customer relationships, sales, support and delivery infrastructure.

         During the fourth quarter, following the release of the iBridge, the
Company commenced generating revenues. Initially, the Company extended discounts
to its customers in order to gain sales traction in selected strategic markets.
As a result, the associated gross margins were nominal. Revenue from product
sales was approximately $88,000 and revenue from operating leases was
approximately $5,000. The Company launched its new pricing model in the first
quarter of 2004, which provides for a subscriber-based pricing that is intended
to yield a recurring revenue stream over a three to five year term.

         COSTS AND EXPENSES
         ------------------

         From its inception on November 3, 1999 through December 31, 2003, the
Company has not generated any significant revenues. The Company has incurred
operating expenses of $12,233,922 since inception. These expenses were
associated principally with compensation to employees, product development
costs, costs related to the Company's convertible debentures and equity fund
raising, and compensation for professional services.

         LIQUIDITY AND CAPITAL RESOURCES
         -------------------------------

         To date, Telkonet has not generated any significant revenues to offset
its development and organizational expenses. As a result of Telkonet's operating
losses from its inception through December 31, 2003, Telkonet generated a cash
flow deficit of $9,696,710 from operating activities. As of December 31, 2003,
Telkonet's current assets exceeded its current liabilities by $5,296,570. Of the
total current assets of $5,952,621, cash represented $5,177,918 of this amount
as of December 31, 2003. For the period from inception through December 31,
2003, Telkonet has accumulated losses of $14,116,612. Consequently, its
operations are subject to all risks inherent in the establishment of a new
business enterprise.

         While Telkonet has raised sufficient capital to meet its working
capital and financing needs to date, additional financing may be required in
order to meet Telkonet's current and projected cash flow deficits from
operations and development during the next twelve months. Management believes it
has sufficient capital resources, including the net proceeds equal to $12.8
million arising from its private placement of common stock in February 2004 and
the approximate $3.9 million cash generated from the warrant exercises in March
2004. See footnote O to the audited financial statements for the effect the
additional capital raises subsequent to December 31, 2003. However, if
thereafter, 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.

                                       10
<PAGE>

         During the year ended December 31, 2003, the Series A Debenture holders
demanded registration of shares of Telkonet common stock sufficient to cover
conversion of their debentures and exercise of the attached stock purchase
warrants. Following this demand for registration, Telkonet notified the Series B
Debenture holders, Senior Noteholders and warrant holders with piggy-back
registration rights of their right to participate in the registration.
Approximately 11.7 million shares of Telkonet common stock were registered in
this registration. The registration statement was declared effective by the
Securities and Exchange Commission on September 24, 2003.

         In connection with the registration, certain Series A Debenture
holders, Series B Debenture holders and Senior Noteholders exercised their
non-detachable stock purchase warrants. Telkonet received approximately $3.8
million in cash as a result of the exercise of warrants and converted
approximately $6.3 million of debt into equity as a result of the conversion of
Series A Debentures, Series B Debentures and Senior Notes by the holders thereof
into shares of Telkonet common stock. Moreover, on September 30, 2003, certain
Senior Noteholders elected to use their Senior Notes as consideration for the
exercise of certain warrants held by them. As a result, approximately $2.0
million of the Company's indebtedness represented by the Senior Notes was
converted to equity upon exercise of the warrants and issuance of the underlying
Telkonet common stock.

         In February 2004, Telkonet completed a private offering of its common
stock resulting in net proceeds to the Company of approximately $12.8 million.
The Company sold 6,387,600 shares of its common stock at a discount of 18% to
the average market price of the Company's common stock for the preceding 30
days. The Company has agreed to file a registration statement with the
Securities and Exchange Commission to register the shares of its common stock
sold in this offering on or before May 31, 2004. Additionally, the Company will
include in the registration those shareholders with piggy-back registration
rights who have converted their debentures and exercised their warrants, and
have elected to have the shares of common stock received upon such conversion or
exercise included in such registration.

         In March 2004, the Company received $3.9 million as a result of the
exercise of 4,235,007 warrants to purchase the Company's common stock.
Additionally, $.2 million of debentures were converted into 324,000 shares of
the Company's common stock.

         PRODUCT RESEARCH AND DEVELOPMENT
         --------------------------------

         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 the period November 3, 1999
(date of inception) through December 31, 2003 were approximately $3,702,745. The
Company anticipates that it will incur approximately $500,000 in research and
development costs in 2004 in connection with the further development of its
PlugPlus(TM) product suite.

         These projected expenditures are dependent upon the Company generating
revenues and obtaining sources of financing in excess of the Company's existing
capital resources. There is no guarantee that the Company will be successful in
raising the funds required or generating revenues sufficient to fund the
projected costs of research and development during the next twelve months.

         ACQUISITION OR DISPOSITION OF PLANT AND EQUIPMENT
         -------------------------------------------------

         The Company does not anticipate the sale of any significant property,
plant or equipment during the next twelve months. The Company does not
anticipate the acquisition of any significant property, plant or equipment
during the next 12 months, other than the leasehold improvements, furniture and
equipment associated with the new Germantown, Maryland facility as described
below.

                                       11
<PAGE>

         The Company has executed a sub-lease agreement through November 2010
for approximately 11,600 square feet of commercial office space in Germantown,
Maryland. The Company intends to relocate its operations to the Germantown
facility in April 2004. The Company is responsible for an allocated portion of
the build-out cost for the Germantown facility. The Company anticipates that it
will spend approximately $400,000 in connection with this relocation, which
amount includes aggregate build-out costs, security deposit, office furniture
and telephone equipment. As of December 31, 2003, the Company has incurred
approximately $50,000 in build-out costs and has paid to the landlord
approximately $70,000 as a security deposit for the Germantown facility. The
Company believes it has sufficient resources available to meet these acquisition
needs.

         NUMBER OF EMPLOYEES
         -------------------

         As of March 24, 2004, the Company had twenty-six (26) full time
employees. In order for the Company to attract and retain quality personnel, the
Company anticipates it will continue to offer competitive salaries to current
and future employees. The Company anticipates that it will increase its
employment base to meet the needs outlined in its business plan.

         As the Company continues to expand, the Company will incur additional
costs for personnel. This projected increase in personnel is dependent upon the
Company generating revenues and obtaining sources of financing in excess of its
existing capital resources. Although the Company believes it has sufficient
capital as of March 24, 2004 to support the anticipated growth in operations,
there can be no assurance that the Company will be successful in raising the
funds required or generating revenues sufficient to fund the projected increase
in the number of employees.

         NEW ACCOUNTING PRONOUNCEMENTS
         -----------------------------

         In January 2003, the FASB issued Interpretation No. 46, "Consolidation
of Variable Interest Entities." Interpretation 46 changes the criteria by which
one company includes another entity in its consolidated financial statements.
Previously, the criteria were based on control through voting interest.
Interpretation 46 requires a variable interest entity to be consolidated by a
company if that company is subject to a majority of the risk of loss from the
variable interest entity's activities or entitled to receive a majority of the
entity's residual returns or both. A company that consolidates a variable
interest entity is called the primary beneficiary of that entity. The
consolidation requirements of Interpretation 46 apply immediately to variable
interest entities created after January 31, 2003. The consolidation requirements
apply to older entities in the first fiscal year or interim period beginning
after June 15, 2003. Certain of the disclosure requirements apply in all
financial statements issued after January 31, 2003, regardless of when the
variable interest entity was established. The Company does not expect the
adoption to have a material impact to the Company's financial position or
results of operations.

         In April 2003, the FASB issued Statement of Financial Accounting
Standards (SFAS) No. 149, "Amendment of Statement 133 on Derivative Instruments
and Hedging Activities." SFAS 149 amends SFAS No. 133 to provide clarification
on the financial accounting and reporting of derivative instruments and hedging
activities and requires that contracts with similar characteristics be accounted
for on a comparable basis. The provisions of SFAS 149 are effective for
contracts entered into or modified after June 30, 2003, and for hedging
relationships designated after June 30, 2003. The adoption of SFAS 149 will not
have a material impact on the Company's results of operations or financial
position.

         In May 2003, the FASB issued SFAS No. 150, "Accounting For Certain
Financial Instruments With Characteristics of Both Liabilities and Equity." SFAS
150 establishes standards on the classification and measurement of certain
financial instruments with characteristics of both liabilities and equity. The
provisions of SFAS 150 are effective for financial instruments entered into or
modified after May 31, 2003 and to all other instruments that exist as of the
beginning of the first interim financial reporting period beginning after June
15, 2003. The adoption of SFAS 150 will not have a material impact on the
Company's results of operations or financial position.

                                       12
<PAGE>

         In December 2003, the FASB issued SFAS No. 132 (revised), "Employers'
Disclosures About Pensions and Other Postretirement Benefits - an Amendment of
FASB Statements No. 87, 88, and 106." This statement retains the disclosure
requirements contained in FASB statement no. 132, Employers' Disclosures about
Pensions and Other Postretirement Benefits, which it replaces. It requires
additional disclosures to those in the original statement 132 about the assets,
obligations, cash flows, and net periodic benefit cost of defined benefit
pension plans and other defined benefit postretirement plans. The required
information should be provided separately for pension plans and for other
postretirement benefit plans. The revision applies for the first fiscal or
annual interim period ending after December 15, 2003 for domestic pension plans
and June 15, 2004 for foreign pension plans and requires certain new disclosures
related to such plans. The adoption of this statement will not have a material
impact on the Company's results of operations or financial positions.

         FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS
         -----------------------------------------------

         This Annual Report on Form 10-KSB contains forward-looking statements.
These statements are based on current expectations and assumptions that are
subject to risks and uncertainties. Actual results could differ materially
because of issues and uncertainties such as those listed below and elsewhere in
this report, which, among others, should be considered in evaluating the
Company's financial outlook.

         TELKONET IS EMERGING FROM ITS DEVELOPMENT STAGE AND HAS NO OPERATING
HISTORY ON WHICH TO BASE AN EVALUATION OF ITS CURRENT BUSINESS AND FUTURE
PROSPECTS

         Telkonet is emerging from its development stage. As a result, it has no
operating history upon which to base an evaluation of its current business and
future prospects. The first PlugPlus(TM) product was introduced in July 2001.
The Company has not generated substantial revenues since its inception.
Moreover, the Company does not currently have any contracts in place that will
provide any significant revenue. Because of the Company's lack of an operating
history, management has limited insight into trends that may emerge and could
materially adversely affect the Company's business. Prospective investors should
consider the risks and difficulties our company may encounter in its new and
rapidly evolving market, especially given the Company's lack of operating
history. These risks include the Company's ability to:

         o        market the PlugPlus(TM)product suite;

         o        build a customer base;

         o        generate revenues;

         o        compete favorably in a highly competitive market;

         o        access sufficient capital to support growth;

         o        recruit and retain qualified employees;

         o        introduce new products and services; and

         o        build technology and support systems.

         THE COMPANY HAS A HISTORY OF OPERATING LOSSES AND AN ACCUMULATED
DEFICIT AND EXPECTS TO CONTINUE TO INCUR LOSSES FOR THE FORESEEABLE FUTURE.

                                       13
<PAGE>

         Since inception through December 31, 2003, the Company has incurred
cumulative losses of $14,116,612 and has never generated enough funds through
operations to support its business. The Company expects to continue to incur
substantial operating losses through 2004. The Company's losses to date have
resulted principally from:

         o    research and development costs relating to the development of the
              PlugPlus(TM) product suite;

         o    costs and expenses associated with manufacturing, distribution and
              marketing of the Company's products;

         o    general and administrative costs relating to the Company's
              operations; and

         o    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 PlugPlus(TM) product suite.

         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:

         o    the level of use of the Internet;

         o    the demand for high-tech goods;

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

         o    price competition or pricing changes in the industry;

         o    technical difficulties or system downtime;

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

         o    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 December 31, 2003, the Company's officers and directors owned
24.6% 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.

                                       14
<PAGE>

         FURTHER ISSUANCES OF EQUITY SECURITIES MAY BE DILUTIVE TO CURRENT
STOCKHOLDERS.

         Although the funds raised in the Company's debenture offerings, the
note offering 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, 2003, the Company had outstanding employee options
to purchase a total of 8,293,000 shares of common stock at exercise prices
ranging from $1.00 to $3.68 per share, with a weighted average exercise price of
$1.19. As of December 31, 2003, the Company had outstanding non-employee options
to purchase a total of 3,267,500 shares of common stock at exercise prices of
$1.00 per share. As of December 31, 2003, the Company had warrants outstanding
to purchase a total of 5,159,490 shares of common stock at exercise prices
ranging from $.53 to $2.97 per share, with a weighted average exercise price of
$1.01. In addition, as of December 31, 2003, the Company had 3,439,500
additional shares of common stock which may be issued in the future under the
Telkonet, Inc. Stock Incentive Plan. 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.


                                       15
<PAGE>

         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:

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

         o    negative publicity and damage to the Company's reputation and
              brand; and

         o    decline in the average selling price of the Company's products.

         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
PlugPlus(TM) product suite complies with the FCC technical requirements for
Class A and Class B digital devices. No further testing of these devices is
required and the devices may be manufactured and marketed for commercial and
residential use. Additional devices designed by the Company for commercial and
residential use will be subject to the FCC rules for unlicensed digital devices.
Moreover, if in the future, the FCC changes its technical requirements for
unlicensed digital devices, further testing and/or modifications of devices may
be necessary. Failure to comply with any FCC technical requirements could impair
the Company's ability to sell its products in certain markets and could have a
negative impact on its business and results of operations.

         PRODUCTS SOLD BY THE COMPANY'S COMPETITORS COULD BECOME MORE POPULAR
THAN THE COMPANY'S PRODUCTS OR RENDER THE COMPANY'S PRODUCTS OBSOLETE.

         The market for powerline communications products is highly competitive.
Although the Company is presently the only company marketing PLC products to the
commercial segment, Linksys Group, Inc. and Netgear, Inc. offer similar PLC
solutions for the residential market. There can be no assurance that Linksys
Group, Netgear or any other company will not develop PLC products that compete
with the Company's products in the future. 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


                                       16
<PAGE>

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.

         FAILURE OF THE COMPANY'S SERVICES AND PRODUCTS TO BE SUCCESSFUL IN THE
MARKETPLACE COULD HAVE A NEGATIVE EFFECT ON THE COMPANY'S RESULTS OF OPERATIONS.

         Since the Company is just emerging from its development stage, it does
not know with any certainty whether its services and/or products will be
accepted within the business marketplace. If the Company's services and/or
products prove to be unsuccessful within the marketplace, or if the Company
fails to attain market acceptance, it could have a negative effect 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 PlugPlus(TM) 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


                                       17
<PAGE>

validity of patents, to assert infringement claims against others, and to defend
against patent infringement claims can be expensive and time-consuming, even if
the outcome is in the Company's favor. The Company also relies to a lesser
extent on unpatented proprietary technology, and no assurance can be given that
others will not independently develop substantially equivalent proprietary
information, techniques or processes or that the Company can meaningfully
protect its rights to such unpatented proprietary technology. Development of
substantially equivalent technology by the Company's competitors could
negatively impact its business.

         THE COMPANY DEPENDS ON A SMALL TEAM OF SENIOR MANAGEMENT, AND IT MAY
HAVE DIFFICULTY ATTRACTING AND RETAINING ADDITIONAL PERSONNEL.

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

ITEM 7.  FINANCIAL STATEMENTS.

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

ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

         None.

ITEM 8A. CONTROLS AND PROCEDURES.

         As of December 31, 2003, Telkonet performed an evaluation, under the
supervision and with the participation of management, including its Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of its disclosure controls and procedures as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended. Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that Telkonet's disclosure controls and procedures
are effective in timely alerting them to material information required to be
included in Telkonet's periodic filings with the U.S. Securities and Exchange
Commission. There were no significant changes in Telkonet's internal controls or
in other factors that could significantly affect these internal controls
subsequent to the date of the most recent evaluation.

                                       18
<PAGE>

                                    PART III

ITEM 9.  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, 2003. The
directors of the Company are elected every year and serve until their successors
are duly elected and qualified.

     Name                       Age             Title
     ----                       ---             -----
     Ronald W. Pickett          56              President, Director &
                                                Chief Executive Officer

     David Powell               52              Chief Operating Officer

     Robert P. Crabb            56              Secretary

     E. Barry Smith             53              Chief Financial Officer

     Stephen Sadle              58              Senior Vice President & Director

     James Landry               48              Vice President--Engineering

     Warren V. Musser           77              Chairman of the Board

     Hugo DeCesaris             45              Director

     David Grimes               66              Director

     Thomas C. Lynch            61              Director

     Daniel L. McGinnis(1)      65              Director
_____________________________
(1) Mr. McGinnis resigned from the Board of Directors effective March 5, 2004.

RONALD W. PICKETT--PRESIDENT, CHIEF EXECUTIVE OFFICER & DIRECTOR

Mr. Pickett fostered the development of Telkonet since 1999 as the Company's
principle investor and Co-Founder of the Company. He was the Founder, and for
twenty years served as the Chairman of the Board and President of Medical
Advisory Systems, Inc., 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.

DAVID POWELL--CHIEF OPERATING OFFICER

Mr. Powell is the Chief Operating Officer of Telkonet and is responsible for
growing Telkonet's business by developing, marketing and selling the Company's
high-speed Internet access systems worldwide. From 1999 until he joined Telkonet
in 2003, Mr. Powell served as the Senior Vice President of the Network Enhancing
Technologies Solutions division of Tellabs where he developed leading-edge
voice-enhancement and echo cancellation solutions for telecommunications
networks worldwide. From 1990 to 1998, Mr. Powell served in various management
positions at Coherent Communications Systems Corporation before it was acquired
by Tellabs in 1998, including President and Chief Operating Officer, and Vice
President and Managing Director of Coherent's European subsidiary, Coherent
Communications Systems Limited.

                                       19
<PAGE>

E. BARRY SMITH--CHIEF FINANCIAL OFFICER

Mr. Smith is a CPA and senior financial executive with diverse experience in
both public and private companies, which includes big-four public accounting
experience with the firm of Deloitte & Touche. Mr. Smith also served as Senior
Financial Partner and in other executive management positions with Safeguard
Scientifics, Inc. and certain of its affiliates, including ThinAirApps, Inc.
(wireless application provider-sold to Palm, Inc.), Interactive Marketing
Venture (database marketing) and Tangram Enterprise Solutions (software/hardware
for PC/LAN mainframe connectivity and enterprise software management). Prior to
his employment with Telkonet, Mr. Smith also served as Vice President of Finance
& Administration for US Golf Management, a golf course and restaurant management
company, Vice President of Finance for International Communications Research, a
market research and database services company, and Treasurer for The Chilton
Company, a publishing company.

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--VICE PRESIDENT OF ENGINEERING

Mr. Landry has over 18 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 singularly 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.
He holds four US patents.

ROBERT P. CRABB--SECRETARY

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

DAVID W. GRIMES--CO-FOUNDER & DIRECTOR

From 1992 until he joined Telkonet in 1999, Mr. Grimes served as Chief Engineer
for Final Analysis, Inc. and led the design and development of the Low Earth
Orbit constellation of 38 satellites for use in global store and forward
communications. From 1989 to 1992 he was the Engineering Division Director at
EER Inc. and supervised over 100 engineers and technicians on electrical
mechanical and thermal tasks for Goddard Space Flight Center. From 1982 to 1989
Mr. Grimes served as Chief Executive Officer of Transpace Carriers Inc., a
venture to commercialize the Delta launch vehicle. From 1963 to 1982, Mr. Grimes
was a Senior Executive with NASA, heading the $200 million per year Delta
Program. Mr. Grimes is a recognized expert in space and ground communications
systems and brings this expertise to bear on the implementation of the hybrid
telephony and high speed Internet technology. Mr. Grimes has been a director of
the Company since November 1999.


                                       20
<PAGE>

WARREN V. MUSSER--CHAIRMAN OF THE BOARD OF DIRECTORS

Mr. Musser has had extensive experience with public companies during his
distinguished and successful career as an entrepreneur. A partial list of his
accomplishments includes: Chairman Emeritus, Safeguard Scientifics, Inc.
(formerly Safeguard Industries, Inc.), Chairman of the Board and Chief Executive
Officer, Safeguard Scientifics, Inc., Founder, Chairman of the Board and
President, Lancaster Corporation (became Safeguard Industries, Inc.), Founder &
President, Musser and Company, Inc. (Investment Banking Firm). In addition, Mr.
Musser is a Director of CompuCom Systems, Inc. and Internet Capital Group, Inc.,
Vice Chairman of Nutri/System, Inc. and Eastern Technology Council and Chairman
of Economics, PA. He also serves as the Vice President/Development, Cradle of
Liberty Council of the Boy Scouts of America. Mr. Musser has been a director of
the Company since January 2003.

A. HUGO DECESARIS--DIRECTOR

Mr. DeCesaris has over 25 years experience in the homebuilding industry with
Washington Homes, Inc., where he served as Vice President and a member of the
Board of Directors. In January of 2001, Washington Homes, Inc. became a
wholly-owned subsidiary of K. Hovnanian Enterprises, Inc. and is now one of the
top ten homebuilders in the nation. Mr. DeCesaris is currently the Regional Vice
President for the Maryland Division of Washington Homes, Inc., President and
owner of Southern Maryland's largest Marina and a member of the Board of
Directors of MNCBIA Volume Builders Council. Mr. DeCesaris has been a director
of the Company since March 2001.

THOMAS C. LYNCH--DIRECTOR

Mr. Lynch is Senior Vice President, Director of The Staubach Company's Federal
Sector 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). 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, Sanchez Computer Associates, 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 2003.

DANIEL L. MCGINNIS--DIRECTOR

From 1999 to 2002, Mr. McGinnis has served as President and Chief Executive
Officer of SOTAS, Inc. an international developer and seller of operational
support systems for telephone companies. From 1998 to 1999, Mr. McGinnis served
as Senior Vice President for the Network Enhancing Technologies Solutions
division of Tellabs, Inc., an international developer of network transport
equipment for the telephone companies. From 1992 to 1998, he served as Chief
Executive Officer, President and Chief Operating Officer of Coherent
Communications Systems Corp., an international developer and seller of echo
cancellation equipment for telephone companies. Mr. McGinnis has served on the
Board of Directors of Atlantic Coast Airlines Holdings, Inc., SOTAS, Inc.,
Western Loudon Hospital Center Development Team, Northern Virginia Roundtable,
George Washington University- VA Campus, Baird Venture Partners, Washington
Airports Task Force, The George C. Marshall International Center, Loudon
HealthCare, Inc., COHPAC (Australia), and Coherent Communications Systems, Ltd.
Mr. McGinnis has been a director of the Company since 2003. Mr. McGinnis
resigned from the Telkonet Board of Directors effective March 5, 2004.

                                       21
<PAGE>

         The Company maintains an Audit Committee of the Board of Directors. For
the year ended December 31, 2003, Messrs. Sadle, Lynch and McGinnis served on
the Audit Committee. The Company's Board of Directors has determined that each
of Messrs. McGinnis and Lynch is a "financial expert" as defined by Item 401 of
Regulation S-B 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. McGinnis and Lynch are "independent" as such term is defined in
Item 7(d)(3)(iv) of Schedule 14A promulgated under the Securities Exchange Act
of 1934. Effective March 5, 2004, Mr. McGinnis resigned from the Telkonet Board
of Directors and Mr. Musser agreed to serve on the Audit Committee until Mr.
McGinnis' replacement is appointed. The Company's Board of Directors has
determined that Mr. Musser is both a "financial expert" and "independent" as
such terms are defined under the relevant provisions of the Securities Act of
1933 and Securities Exchange Act of 1934. The Board of Directors has adopted an
audit committee charter, which it intends to present to the Company's
stockholders for ratification at the next annual meeting.

         The Company has adopted a Code of Ethics that applies to the Company's
principal executive officer, principal financial officer and those persons
performing similar functions, including those employees of the Company with
senior financial roles. A copy of the Company's Code of Ethics has been filed as
an exhibit to this Annual Report on Form 10-KSB.

ITEM 10. EXECUTIVE COMPENSATION.

         The following table sets forth all compensation actually paid or
accrued by the Company for services rendered to the Company for the years ended
December 31, 2003, 2002 and 2001 to the Company's Chief Executive Officer, the
Company's four most highly compensated executive officers other than the Chief
Executive Officer who were serving as executive officers of the Company as of
December 31, 2003, and those persons for whom disclosure would have been
required but for the fact that they were not serving as an executive officer of
the Company as of December 31, 2003.

<TABLE>
<CAPTION>
                                               SUMMARY COMPENSATION TABLE

 ----------------------------------------------------------------------------------------------------------------------------------
                                         ANNUAL COMPENSATION                         LONG TERM COMPENSATION
                          -------------------------------------------------- ----------------------------------------
                                                                                      AWARDS             PAYOUTS
 ------------------------ -------------------------------------------------- ------------------------- -------------- -------------
           (a)             (b)        (c)          (d)            (e)            (f)          (g)           (h)           (i)
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
   NAME AND PRINCIPAL      YEAR    SALARY ($)   BONUS ($)    OTHER ANNUAL    RESTRICTED   SECURITIES   LTIP PAYOUTS    ALL OTHER
        POSITION                                             COMPENSATION       STOCK     UNDERLYING/                    COMPEN-
                                                                                            OPTIONS                      SATION
                                                                                             SARS
                                                                                              (#)
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
<S>                       <C>       <C>                 <C>              <C>   <C>          <C>                    <C>           <C>
 L. Peter Larson          2001         160,484           -                -    1,455,285      200,000              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
                          2002           4,000           -                -    1,455,285    1,000,000              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
 David Grimes             2001          57,041           -                -    4,971,918      200,000              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
                          2002               -           -                -    1,298,000            -              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
                          2003               -           -                -    1,070,514      375,000              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
 Ronald W. Pickett        2003          91,538                                 2,175,049                           -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
 Robert Crabb             2002           8,500           -                -            -            -              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
                          2003         120,000           -                -       13,109      208,333              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
 Howard Lubert            2003      292,083(2)                                                                     -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
 Stephen L. Sadle         2001         160,484           -                -    5,722,695      200,000              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
                          2002         130,000           -                -    3,721,600            -              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
                          2003         130,000           -                -    3,350,514      375,000              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
 Greg Fowler              2002         114,000           -                -            -      200,000              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------

                                       22
<PAGE>

 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
 David Powell             2003          54,269           -                -            -      133,333              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
 Jim Landry               2001          29,000           -                -            -      125,000              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
                          2002         116,000           -                -            -      225,000              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
                          2003         160,000      10,000                -            -      208,333              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
 E. Barry Smith           2003         115,539           -                -        2,215      208,333              -             -
 ------------------------ ------- ------------- ----------- ---------------- ------------ ------------ -------------- -------------
</TABLE>

(1) In the year ending December 31, 2003, Mr. Pickett received 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 $64,460.

(2) Mr. Lubert's compensation includes $177,083 of the Company's common stock
acquired by Mr. Lubert upon the exercise of options exercised in conjunction his
resignation in June 2003. Additionally, the Company has agreed to pay Mr.
Lubert's salary through December 14, 2004 at an annual rate of $130,000.

                      OPTION/SAR GRANTS IN LAST FISCAL YEAR
                               (Individual Grants)

         The following table sets forth information concerning stock options
granted in the fiscal year ended December 31, 2003, to the persons listed on the
Summary Compensation Table.

<TABLE>
<CAPTION>
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
                                                                             PERCENT OF
                                                                                TOTAL
                                                  NUMBER OF SECURITIES      OPTIONS/SARS
                                                UNDERLYING OPTIONS/SARS      GRANTED TO       EXERCISE OR
                                                        GRANTED             EMPLOYEES IN      BASE PRICE        EXPIRATION
                        NAME                              (#)                FISCAL YEAR        ($/SH)              DATE
                        (a)                               (b)                    (c)              (d)               (e)
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
       <S>                                                        <C>                <C>               <C>           <C>
       L. Peter Larson                                                  -                -                -                -
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
       David Grimes                                               900,000            12.5%             1.00          01/2013
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
       Ronald W. Pickett                                                -                -                -                -
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
       Robert Crabb                                               500,000             6.9%             1.00          01/2013
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
       Howard Lubert                                               83,333             1.2%             1.00          01/2013
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
       Stephen L. Sadle                                           900,000            12.5%             1.00          01/2013
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
       Greg Fowler                                                      -                -                -                -
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
       David Powell                                               800,000            11.1%             2.62          09/2013
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
       James Landry                                               125,000             1.7%             1.00          01/2013
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
       E. Barry Smith                                             500,000             6.9%             1.00          02/2013
       --------------------------------------- --------------------------- ---------------- ---------------- ----------------
</TABLE>


                                       23
<PAGE>

               AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR
                      AND FISCAL YEAR END OPTION/SAR VALUES

         The following table summarizes information relating to stock option
exercises during the year ended December 31, 2003 by those persons listed on the
Summary Compensation Table.


<TABLE>
<CAPTION>
                                                                           NUMBER OF
                                                                          UNEXERCISED          VALUE OF
                                                                          SECURITIES         UNEXERCISED
                                                                          UNDERLYING         IN-THE-MONEY
                                                                        OPTIONS/SARS AT    OPTIONS/SARS AT
                                SHARES ACQUIRED                           FY-END (#)          FY-END ($)
                                  ON EXERCISE        VALUE REALIZED      EXERCISEABLE/      EXERCISEABLE/
               NAME                   (#)                 ($)           UNEXERCISEABLE      UNEXERCISEABLE
               (a)                    (b)                 (c)                 (d)                (e)
       ----------------------- ------------------- ------------------- ------------------ -------------------
       <S>                     <C>                 <C>                 <C>                <C>
       L. Peter Larson         -                   -                   1,000,000/         1,430,000/
                                                                       -0-                -0-
       ----------------------- ------------------- ------------------- ------------------ -------------------
       David Grimes            -                   -                   300,000/           429,000/
                                                                       600,000            858,000
       ----------------------- ------------------- ------------------- ------------------ -------------------
       Ronald W. Pickett       -                   -                   -0-                -0-
                                                                       -0-                -0-
       ----------------------- ------------------- ------------------- ------------------ -------------------
       Robert Crabb            -                   -                   166,667/           238,334/
                                                                       333,333            476,666
       ----------------------- ------------------- ------------------- ------------------ -------------------
       Howard Lubert           $83,333             $177,083            -0-                -0-
                                                                       -0-                -0-
       ----------------------- ------------------- ------------------- ------------------ -------------------
       Stephen L. Sadle        -                   -                   300,000/           429,000/
                                                                       600,000            858,000
       ----------------------- ------------------- ------------------- ------------------ -------------------
       Greg Fowler             -                   -                   200,000/           286,000/
                                                                       -0-                -0-
       ----------------------- ------------------- ------------------- ------------------ -------------------
       David Powell            -                   -                   66,667/            -0-
                                                                       733,333            -0-
       ----------------------- ------------------- ------------------- ------------------ -------------------
       James Landry            -                   -                   181,249/           259,186/
                                                                       168,751            241,314
       ----------------------- ------------------- ------------------- ------------------ -------------------
       E. Barry Smith          -                   -                   166,667/           238,334/
                                                                       333,333            476,666
       ----------------------- ------------------- ------------------- ------------------ -------------------
</TABLE>

         DIRECTOR COMPENSATION
         ---------------------

         Telkonet reimburses directors for costs and expenses in connection with
their attendance and participation at Board of Directors meetings and for other
travel expenses incurred on Telkonet's behalf. Telkonet has the authority to
compensate each non-management director up to $25,000 annually and $1,000 for
each meeting of the Board of Directors. As of December 31, 2003, no such cash
payments have been made. Notwithstanding, upon each director's appointment to
the Board of Directors, each director was granted options to purchase 40,000
shares of the Company's common stock that vest ratably over twelve months with
an exercise price of $2.00 per share.

         In January 2003, options to purchase the following number of shares
were granted to the following non-employee directors of Telkonet under the Stock
Incentive Plan: David Grimes (900,000 shares) and Warren Musser (2,000,000
shares). These options entitle the holder to purchase shares of Telkonet common
stock at $1.00 per share and vest ratably over twelve quarters beginning January
1, 2003. These options are not "incentive stock options" within the meaning of
Section 422 of the Internal Revenue Code of 1986. The grant of these options was
approved by Telkonet's stockholders at the 2003 annual meeting.

                                       24
<PAGE>

         EMPLOYMENT AGREEMENTS
         ---------------------

         L. Peter Larson, former Chief Executive Officer, was employed pursuant
to an employment agreement for a three-year term that commenced June 19, 2000
and provided for an annual salary of $130,000 and bonuses and benefits based
upon Telkonet's internal policies. Mr. Larson resigned from his employment on
January 12, 2002.

         Stephen L. Sadle, Senior Vice President, is employed pursuant to an
employment agreement for a three-year term that commenced June 19, 2000 and
provides for an annual salary of $130,000 and bonuses and benefits based upon
Telkonet's internal policies. On April 24, 2002, Mr. Sadle's employment
agreement was amended to, among other things, extend the term through December
31, 2004. On January 18, 2003, Telkonet and Mr. Sadle executed a new employment
agreement, the terms of which superceded the terms of the April 24, 2002 amended
employment agreement. The January 18, 2003 employment agreement has a term of
three years 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 $170,000 on January 1, 2004.

         Greg Fowler, former Chief Executive Officer, was employed pursuant to
an employment agreement for a three-year term that commenced January 30, 2002
and provided for an annual salary of $130,000 and bonuses and benefits based
upon Telkonet's internal policies. Mr. Fowler resigned effective December 12,
2002.

         James Landry, Vice President of Engineering, 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 received a bonus of $10,000
for the year ended December 31, 2003.

         Robert Crabb, Corporate Secretary, 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
$170,000 on January 1, 2004.

         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 our
common stock per month for each month of his employment and bonuses and benefits
based upon Telkonet's internal policies.

         E. Barry Smith, Chief Financial Officer, is employed pursuant to an
employment agreement for a one-year term that commenced February 17, 2003 and
provides for an annual salary of $130,000 and bonuses and benefits based upon
Telkonet's internal policies. Mr. Smith's annual salary was increased to
$170,000 on January 1, 2004.

         Howard Lubert, former Chief Executive Officer, was employed pursuant to
an employment agreement for a two-year term that commenced January 1, 2003 and
provided for an annual salary of $130,000 and bonuses and benefits based upon
Telkonet's internal policies. Mr. Lubert resigned effective June 16, 2003,
however, Telkonet has agreed to pay Mr. Lubert's salary through December 14,
2004.

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

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

         The following table sets forth, as of March 24, 2004, 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 outstanding common stock. As of March 24, 2004, there were no issued
and outstanding shares of any other class of the Company's equity securities.

                                       25
<PAGE>

<TABLE>
<CAPTION>
----------------------------------------------------- ------------------------------------- --------------------------
NAME AND ADDRESS OF BENEFICIAL OWNER                       SHARES BENEFICIALLY OWNED           PERCENTAGE OF CLASS
----------------------------------------------------- ------------------------------------- --------------------------

OFFICERS AND DIRECTORS
----------------------
<S>                                                             <C>                                    <C>
Ronald W. Pickett, President and CEO
902-A Commerce Road
Annapolis, Maryland 21401                                        2,175,049                             5.6%
----------------------------------------------------- ------------------------------------- --------------------------
David Powell, Chief Operating Officer
902-A Commerce Road
Annapolis, Maryland 21401                                          133,333 (1)                         0.3%
----------------------------------------------------- ------------------------------------- --------------------------
E. Barry Smith, Chief Financial Officer
902-A Commerce Road
Annapolis, Maryland 21401                                          210,548 (2)                         0.5%
----------------------------------------------------- ------------------------------------- --------------------------
Stephen L. Sadle, Senior Vice President
902-A Commerce Road
Annapolis, Maryland 21401                                        3,725,514 (3)                         9.5%
----------------------------------------------------- ------------------------------------- --------------------------
James Landry, Vice President of Engineering
902-A Commerce Road
Annapolis, Maryland 21401                                          208,333 (4)                         0.5%
----------------------------------------------------- ------------------------------------- --------------------------
Robert P. Crabb, Corporate Secretary
902-A Commerce Road
Annapolis, Maryland 21401                                          221,442 (5)                         0.6%
----------------------------------------------------- ------------------------------------- --------------------------
Warren V. Musser, Chairman
902-A Commerce Road
Annapolis, Maryland 21401                                          841,087 (6)                         2.1%
----------------------------------------------------- ------------------------------------- --------------------------
David Grimes, Director
902-A Commerce Road
Annapolis, Maryland 21401                                        1,445,514 (7)                         3.7%
----------------------------------------------------- ------------------------------------- --------------------------
Hugo DeCesaris, Director
902-A Commerce Road
Annapolis, Maryland 21401                                        1,015,000                             2.8%
----------------------------------------------------- ------------------------------------- --------------------------
Thomas C. Lynch, Director
902-A Commerce Road
Annapolis, Maryland 21401                                           20,000 (8)                         0.1%
----------------------------------------------------- ------------------------------------- --------------------------
Daniel L. McGinnis, Director (9)
902-A Commerce Road
Annapolis, Maryland 21401                                           20,000 (10)                        0.1%
----------------------------------------------------- ------------------------------------- --------------------------
All Directors and Executive Officers as a Group                 10,075,821                            24.6%
----------------------------------------------------- ------------------------------------- --------------------------

                                       26
<PAGE>

5.0% BENEFICIAL OWNERS
----------------------

Stephen L. Sadle
902-A Commerce Road
Annapolis, Maryland 21401                                        3,725,514                             9.5%
----------------------------------------------------- ------------------------------------- --------------------------
Ronald W. Pickett
902-A Commerce Road
Annapolis, Maryland 21401                                        2,175,049                             5.6%
----------------------------------------------------- ------------------------------------- --------------------------
</TABLE>
_____________________
(1)      Includes options exerciseable within 60 days to purchase 133,333 shares
         of the Company's common stock at $2.62 per share.
(2)      Includes options exerciseable within 60 days to purchase 208,333 shares
         of the Company's common stock at $1.00 per share.
(3)      Includes options exerciseable within 60 days to purchase 375,000 shares
         of the Company's common stock at $1.00 per share.
(4)      Includes options exerciseable within 60 days to purchase 208,333 shares
         of the Company's common stock at $1.00 per share.
(5)      Includes options exerciseable within 60 days to purchase 208,333 shares
         of the Company's common stock at $1.00 per share.
(6)      Includes options exerciseable within 60 days to purchase 833,333 shares
         of the Company's common stock at $1.00 per share.
(7)      Includes options exerciseable within 60 days to purchase 375,000 shares
         of the Company's common stock at $1.00 per share.
(8)      Includes options exerciseable within 60 days to purchase 20,000 shares
         of the Company's common stock at $2.00 per share.
(9)      Mr. McGinnis resigned from the Board of Directors effective March 5,
         2004.
(10)     Includes options exerciseable within 60 days to purchase 20,000 shares
         of the Company's common stock at $2.00 per share.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

         STOCK REPURCHASES
         -----------------

         On January 12, 2002, the Board of Directors approved a plan authorizing
the repurchase of certain shares of, and options to purchase, Telkonet common
stock owned by Messrs. Grimes, Larson and Sadle. Each of Messrs. Grimes, Larson
and Sadle, at the time of the stock repurchase, owned in excess of five percent
of the issued and outstanding shares of Telkonet common stock and were directors
and executive officers of Telkonet.

         As part of the stock repurchase, Mr. Grimes surrendered 3,721,918
shares of Telkonet common stock and options to purchase 160,000 shares of
Telkonet common stock owned by him. In consideration of the surrender of these
shares and options, Telkonet retained Mr. Grimes as a consultant for a period of
three years and issued to Mr. Grimes fully vested options to purchase 1,000,000
shares of Telkonet common stock at fair market value on the date of exercise,
but not less than $1.00 per share. In addition, Mr. Grimes agreed that certain
shares of Telkonet common stock owned by him would be subject to a 36-month
lock-up agreement under which 50,000 shares would be released on each of
December 1, 2002 and December 1, 2003 and the remaining shares would be released
on January 1, 2005. On April 24, 2002, the terms of Mr. Grimes' lock-up
agreement were amended to permit the immediate release of 139,280 shares of
Telkonet common stock, the release of 50,000 shares of Telkonet common stock on
December 1, 2002, the release of 50,000 shares of Telkonet common stock on
December 1, 2003 and the release of the remaining Telkonet common stock on


                                       27
<PAGE>

January 1, 2005. The revised lock-up agreement also provided for the release of
common stock in proportion to the number of options to purchase Telkonet common
stock exercised by Mr. Grimes from time to time during the term of the lock-up
agreement. As of December 31, 2002, Mr. Grimes had exercised all of the options
issued to Mr. Grimes in the repurchase. Consequently, all of the shares subject
to Mr. Grimes' revised lock-up agreement were released as of December 31, 2002.

         Mr. Larson surrendered 705,000 shares of Telkonet common stock and
options to purchase 200,000 shares of Telkonet common stock owned by him. In
consideration of the surrender of these shares and options, Telkonet retained
Mr. Larson as a consultant for a period of three years and issued to Mr. Larson
fully vested options to purchase 1,000,000 shares of Telkonet common stock at
fair market value on the date of exercise, but not less than $1.00 per share. In
addition, Mr. Larson agreed that certain shares of Telkonet common stock owned
by him would be subject to a 36-month lock-up agreement under which 50,000
shares would be released on each of December 1, 2002 and December 1, 2003 and
the remaining shares would be released on January 1, 2005. On April 24, 2002,
the terms of Mr. Larson's lock-up agreement were amended to permit the immediate
release of 139,280 shares of Telkonet common stock, the release of 50,000 shares
of Telkonet common stock on December 1, 2002, the release of 50,000 shares of
Telkonet common stock on December 1, 2003 and the release of the remaining
Telkonet common stock on January 1, 2005. The revised lock-up agreement also
provides for the release of common stock in proportion to the number of options
to purchase Telkonet common stock exercised by Mr. Larson from time to time
during the term of the lock-up agreement.

         Mr. Sadle surrendered 2,147,694 shares of Telkonet common stock and
options to purchase 200,000 shares of Telkonet common stock owned by him. In
consideration of the surrender of these shares and options, the Board of
Directors granted Mr. Sadle options to purchase 1,000,000 shares of Telkonet
common stock at fair market value on the date of exercise, but not less than
$1.00 per share. In addition, Mr. Sadle agreed that certain shares of Telkonet
common stock owned by him would be subject to a 36-month lock-up agreement under
which 50,000 shares would be released on each of December 1, 2002 and December
1, 2003 and the remaining shares would be released on January 1, 2005. On April
24, 2002, the terms of Mr. Sadle's lock-up agreement were amended to permit the
immediate release of 139,280 shares of Telkonet common stock, the release of
50,000 shares of Telkonet common stock on December 1, 2002, the release of
50,000 shares of Telkonet common stock on December 1, 2003 and the release of
the remaining Telkonet common stock on January 1, 2005. The revised lock-up
agreement also provides for the release of common stock in proportion to the
number of options to purchase Telkonet common stock exercised by Mr. Sadle from
time to time during the term of the lock-up agreement. As of December 31, 2002,
Mr. Sadle had exercised all of the options issued to Mr. Sadle in the
repurchase. Consequently, all of the shares subject to Mr. Sadle's revised
lock-up agreement were released as of December 31, 2002.

         Mr. Sadle's employment agreement was also amended to include a
provision pursuant to which Mr. Sadle would be required to forfeit shares of
Telkonet common stock owned by him, up to an aggregate of 1,500,000 shares of
common stock, in the event he voluntarily terminated his employment prior to the
end of its 36-month term. Pursuant to the amended employment agreement, Mr.
Sadle was required to forfeit 40,000 shares for each month following the month
in which he resigned until the expiration of the amended employment agreement.
The amended employment agreement also extended the term of Mr. Sadle's
employment until December 31, 2004. On January 30, 2003, the Board of Directors
approved an amendment to Mr. Sadle's employment agreement that permits the
release of the 1,500,000 shares of common stock subject to forfeiture upon Mr.
Sadle's resignation in proportion to the number of options to purchase Telkonet
common stock exercised by Mr. Sadle from time to time during the term of the
employment agreement. As of December 31, 2002, Mr. Sadle had exercised all of
the options issued to Mr. Sadle in the repurchase. Consequently, all of the
shares subject to forfeiture pursuant to Mr. Sadle's revised employment
agreement were released from such forfeiture restriction as of January 30, 2003.

         LOANS BY OFFICERS AND SIGNIFICANT STOCKHOLDERS
         ----------------------------------------------

         In 2001, Ronald W. Pickett, a director and officer of Telkonet who owns
in excess of 5.0% of the issued outstanding Telkonet common stock, loaned
$200,000 to Telkonet for working capital purposes. At the time of such loan, no
formal repayment terms or arrangements were agreed to by the parties. On
December 30, 2002, the aggregate remaining principal balance owed by Telkonet to
Mr. Pickett was converted, at Mr. Pickett's election, into Telkonet Series B
Debentures.

                                       28
<PAGE>

         ARRANGEMENT WITH A DIRECTOR AND EXECUTIVE OFFICER
         -------------------------------------------------

         On January 29, 2002, the Company granted Susquehanna Development, LLC
options to purchase 300,000 shares of the Company's common stock at $1.00 per
share as consideration for certain business services provided by Susquehanna
Development to the Company. Robert P. Crabb, the Company's corporate secretary,
is the managing member of Susquehanna Development.

         In September 2003, the Company entered into a consulting agreement,
with The Musser Group for certain services. The consulting agreement provides
for an annual consulting fee of $100,000, which is payable monthly during the
term of the consulting agreement. As of December 31, 2003, $33,333 had been
expensed, of which $8,333 was paid. Warren Musser, Chairman of the Board of
Directors, is a principal of the Musser Group.

                                       29
<PAGE>

                                     PART IV

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K

(a) The following exhibits are included herein or incorporated by reference:

EXHIBIT
NUMBER        DESCRIPTION OF DOCUMENT
------        -----------------------

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)
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 Peter
              Larson, dated as of June 19, 2000 (incorporated by reference to
              our Form 8-K (No. 000-27305), filed on August 30, 2000)
10.3          Employment Agreement by and between Telkonet, Inc. and Stephen L.
              Sadle, dated as of June 19, 2000 (incorporated by reference to our
              Form 8-K (No. 000-27305), filed on August 30, 2000)
10.4          Amendment to Employment Agreement by and between Telkonet, Inc.
              and Stephen L. Sadle, dated as of April 24, 2002 (incorporated by
              reference to our Registration Statement on Form S-1 (No.
              333-108307), filed on August 28, 2003)
10.5          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, 2003)
10.6          Employment Agreement by and between Telkonet, Inc. and J. Gregory
              Fowler, dated as of January 30, 2002 (incorporated by reference to
              our Registration Statement on Form S-1 (No. 333-108307), filed on
              August 28, 2003)
10.7          Employment Agreement by and between Telkonet, Inc. and David S.
              Yaney, dated as of February 15, 2002 (incorporated by reference to
              our Registration Statement on Form S-1 (No. 333-108307), filed on
              August 28, 2003)
10.8          Employment Agreement by and between Telkonet, Inc. and Howard
              Lubert, dated as of January 1, 2003 (incorporated by reference to
              our Registration Statement on Form S-1 (No. 333-108307), filed on
              August 28, 2003)


                                       30
<PAGE>

10.9          Separation Agreement by and between Telkonet, Inc. and Howard
              Lubert, dated as of June 16, 2003 (incorporated by reference to
              our Registration Statement on Form S-1 (No. 333-108307), filed on
              August 28, 2003)
10.10         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)
10.11         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)
10.12         Employment Agreement by and between Telkonet, Inc. and E. Barry
              Smith, dated as of February 17, 2003 (incorporated by reference to
              our Registration Statement on Form S-1 (No. 333-108307), filed on
              August 28, 2003)
14            Code of Ethics
21            Telkonet, Inc. Subsidiaries (incorporated by reference to our
              Registration Statement on Form S-1 (No. 333-108307), filed on
              August 28, 2003)
24            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. Pickett
31.2          Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
              2002 of E. Barry Smith
32.1          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 2002
32.2          Certification of E. Barry Smith pursuant to 18 U.S.C. Section
              1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
              of 2002

(b) The Company filed the following reports on Form 8-K during the last quarter
of the reporting period:

         (i)      On October 3, 2003, the Company filed a Current Report on Form
                  8-K, to report that certain holders of convertible debt chose
                  to convert such debt to common stock. This Current Report on
                  Form 8-K was amended on October 7, 2003.

         (ii)     On October 6, 2003, the Company filed a Current Report on Form
                  8-K, to report the expansion of the Board of Director by two
                  seats and the appointment of Thomas C. Lynch and Daniel L.
                  McGinnis as new directors.

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, 2003 and 2002 for: (i)
services rendered for the audit of our annual financial statements and the
review of our quarterly financial statements, (ii) services by our auditor that
are reasonably related to the performance of the audit or review of our
financial statements and that are not reported as Audit Fees, (iii) services
rendered in connection with tax compliance, tax advice and tax planning, and
(iv) all other fees for services rendered.

       ------------------------ ------------------- ------------------
                                 DECEMBER 31, 2003  DECEMBER 31, 2002
       ------------------------ ------------------- ------------------
       1.  Audit Fees              $  53,925           $  60,200
       ------------------------ ------------------- ------------------
       2.  Audit Related Fees             --                  --
       ------------------------ ------------------- ------------------
       3.  Tax Fees                    3,000              10,613
       ------------------------ ------------------- ------------------
       4.  All Other Fees                 --                  --
       ------------------------ ------------------- ------------------
            Total Fees             $  56,925           $  70,813
       ------------------------ ------------------- ------------------

                                       31
<PAGE>

         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." There were no Audit-Related services provided in fiscal 2003 or
2002.

         Tax fees consists of fees billed for professional services for tax
compliance, tax advice and tax planning.

         All other fees consist of fees for products and services other than the
services reported above. There were no management consulting services provided
in fiscal 2003 or 2002.

         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-related fees, tax fees and other fees incurred by the Company for the year
ended December 31, 2003, were approved by the Company's audit committee.



                                       32
<PAGE>

                                   SIGNATURES

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

                                                  TELKONET, INC.

                                                  /s/ Ronald W. Pickett
                                                  -----------------------
                                                  Ronald W. Pickett
                                                  Chief Executive Officer

         In accordance with the Exchange Act, 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/Warren V. Musser              Chairman of the Board           March 29, 2004
-------------------
Warren V. Musser

/s/ Ronald W.  Pickett           Chief Executive Officer &       March 29, 2004
----------------------           Director
Ronald W.  Pickett

/s/ E. Barry Smith               Chief Financial Officer         March 29, 2004
------------------
E. Barry Smith

/s/ David Powell                 Chief Operating Officer         March 29, 2004
----------------
David Powell

/s/ Stephen L. Sadle             Executive Vice President &      March 29, 2004
--------------------             Director
Stephen L. Sadle

/s/ Hugo DeCesaris               Director                        March 29, 2004
------------------
Hugo DeCesaris

/s/ David Grimes                 Director                        March 29, 2004
----------------
David Grimes

/s/ Thomas C. Lynch              Director                        March 29, 2004
-------------------
Thomas C. Lynch

                                       33
<PAGE>


                       SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549



                       FINANCIAL STATEMENTS AND SCHEDULES

                           DECEMBER 31, 2003 AND 2002



                         FORMING A PART OF ANNUAL REPORT
                 PURSUANT TO THE SECURITIES EXCHANGE ACT OF 1934


                                 TELKONET, INC.


                                      F-1
<PAGE>

                                 TELKONET, INC.

                          INDEX TO FINANCIAL STATEMENTS

--------------------------------------------------------------------------------



Report of Independent Certified Public Accountants                          F-3
Consolidated Balance Sheets at December 31, 2003 and 2002                   F-4
Consolidated Statements of Losses for the Years ended
December 31, 2003 and 2002 and for the Period from November 3,
1999 (Date of Inception) through December 31, 2003                          F-5
Consolidated Statements of  Stockholders' Equity (Deficiency)
for the Period from November 3, 1999 (Date of Inception) through
December 31, 2003                                                     F-6 - F10
Consolidated Statements of Cash Flows for the Years ended
December 31, 2003 and 2002 and for the Period from November 3,
1999 (Date of Inception) through December 31, 2003                   F-11 - F12
Notes to Consolidated Financial Statements                          F-13 - F-32


                                      F-2
<PAGE>

                    RUSSELL BEDFORD STEFANOU MIRCHANDANI LLP
                          CERTIFIED PUBLIC ACCOUNTANTS

               REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
               --------------------------------------------------


Board of Directors
Telkonet, Inc.
Annapolis, MD

         We have audited the accompanying consolidated balance sheets of
Telkonet, Inc. and its wholly-owned subsidiary (the "Company"), a development
stage company, as of December 31, 2003 and 2002 and the related consolidated
statements of losses, (deficiency in) stockholders' equity, and cash flows for
the years ended December 31, 2003 and 2002 and for the period from November 3,
1999 (date of inception) to December 31, 2003. 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 auditing standards generally
accepted in the 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 wholly-owned subsidiary as of December 31, 2003 and 2002, and the
results of its operations and its cash flows for the two years then ended, and
for the period from November 3, 1999 (date of inception) to December 31, 2003,
in conformity with accounting principles generally accepted in the United States
of America.




                                   /s/ RUSSELL BEDFORD STEFANOU MIRCHANDANI LLP
                                   --------------------------------------------
                                        Russell Bedford Stefanou Mirchandani LLP
                                        Certified Public Accountants
McLean, Virginia
March 8, 2004,
except for Note O, which date is March 25, 2004

                                      F-3
<PAGE>

<TABLE>
                                      TELKONET, INC.
                               (A DEVELOPMENT STAGE COMPANY)
                                CONSOLIDATED BALANCE SHEETS
                                DECEMBER 31, 2003 AND 2002

<CAPTION>
ASSETS                                                            2003             2002
                                                              -------------   -------------
<S>                                                           <C>             <C>
CURRENT ASSETS:
Cash and cash equivalents                                     $  5,177,918    $     18,827

Accounts receivable: trade and other                                58,196           1,550

Inventories (Note B)                                               608,516          39,790

Prepaid expenses and deposits                                      107,991           4,625
                                                              -------------   -------------

Total current assets                                             5,952,621          64,792

PROPERTY AND EQUIPMENT, AT COST (Note C):

Furniture and equipment                                            191,248          73,215

Less:  accumulated depreciation                                     67,687          35,252
                                                              -------------   -------------

Total property and equipment, net                                  123,561          37,963

EQUIPMENT UNDER OPERATING LEASES, AT COST (Note  D):
Telecommunications and related equipment, at cost                   33,888              --

Less: accumulated depreciation                                       3,485              --
                                                              -------------   -------------
Total equipment under operating leases, net                         30,403              --

OTHER ASSETS:
Financing costs, less accumulated amortization of
$176,761 and $101,692 at December 31, 2003 and
2002, respectively (Note F)                                             --         192,600

Deposits                                                            70,000              --
                                                              -------------   -------------
Total other assets                                                  70,000         192,600

                                                              $  6,176,585    $    295,355
                                                              =============   =============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY)
CURRENT LIABILITIES:
Accounts payable and accrued liabilities (Note M)             $    629,852    $    518,865
Customer deposits held                                              11,199              --

Notes payable (Note E)                                                  --         310,000

Capital lease obligation- current (Note N)                          15,000              --

Due to shareholders (Note J)                                            --         130,330
                                                              -------------   -------------
Total current liabilities                                          656,051         959,195
Convertible debentures, net of discounts - including
related parties (Note F)                                           143,205         862,682

Senior notes payable (Note G)                                    2,989,000              --

COMMITMENTS AND CONTINGENCIES (Note N)                                  --              --

STOCKHOLDERS' EQUITY (DEFICIENCY) (Note H)
Preferred stock, par value $.001 per
share; 15,000,000 shares authorized;
none issued and outstanding at December 31,
2003 and 2002                                                           --              --
Common stock, par value $.001 per share; 100,000,000 shares
authorized; 30,689,522 and 15,721,131 shares issued and
outstanding at December 31, 2003 and 2002, respectively             30,690          15,721

Additional paid-in-capital                                      16,474,251       4,916,433

Accumulated deficit during development stage                   (14,116,612)     (6,458,676)
                                                              -------------   -------------
Stockholders' equity (Deficiency)                                2,388,329      (1,526,522)
                                                              -------------   -------------
                                                              $  6,176,585    $    295,355
                                                              =============   =============

                See accompanying notes to consolidated financial statements

                                           F-4
</TABLE>
<PAGE>

<TABLE>
                                      TELKONET, INC.
                               (A DEVELOPMENT STAGE COMPANY)
                             CONSOLIDATED STATEMENTS OF LOSSES

<CAPTION>
                                                                     For the period from
                                                                      November 3, 1999
                                                                     (date of inception)
                                     For the year ended December 31,  through December
                                           2003            2002          31, 2003
                                      -------------   -------------   -------------
<S>                                   <C>             <C>             <C>
Product revenues, net                 $     88,403    $         --    $     88,403

Rental revenue, net                          5,257              --           5,257
                                      -------------   -------------   -------------
Total Revenue                               93,660              --          93,660
                                      -------------   -------------   -------------

Cost of Sales                              104,656              --         104,656
                                      -------------   -------------   -------------
Gross Profit (loss)                        (10,996)             --         (10,996)

Costs and Expenses:

Research and Development (Note A)        1,370,785       1,279,145    $  3,702,745

Selling, General and Administrative      4,089,172       1,339,665       6,836,804
Non-Employee Stock Options (Note I)        982,390         452,459       1,446,441

Depreciation and Amortization              110,988          84,067         247,932
                                      -------------   -------------   -------------
Total Operating Expense                  6,553,335       3,155,336      12,233,922


Loss from Operations                    (6,564,331)     (3,155,336)    (12,244,918)


Other Income                                    --           3,322           4,579
Interest income                             20,297              --          20,297

Interest  (Expense)                     (1,113,902)       (626,474)     (1,896,570)

Provision for Income Tax                        --              --              --
                                      -------------   -------------   -------------
                                        (1,093,605)       (623,152)     (1,871,694)

Net Loss                              $ (7,657,936)   $ (3,778,488)   $(14,116,612)
                                      =============   =============   =============

Loss per common share (basic and
assuming dilution) (Note L)           $      (0.37)   $      (0.22)   $      (0.82)
                                      =============   =============   =============

Weighted average common shares
outstanding                             20,702,482      17,119,639      17,191,965


                See accompanying notes to consolidated financial statements

                                           F-5
</TABLE>
<PAGE>

<TABLE>
                                                TELKONET, INC.
                                         (A DEVELOPMENT STAGE COMPANY)
                         CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
                   FOR THE PERIOD NOVEMBER 3, 1999 (DATE OF INCEPTION) TO DECEMBER 31, 2003

<CAPTION>
                                                                                                            Deficit
                                                                                                          Accumulated
                                               Preferred                Common    Additional   Common        During
                                     Preferred  Stock       Common      Stock      Paid in      Stock     Development
                                      Shares    Amount      Shares      Amount     Capital   Subscription    Stage          Total
<S>                                      <C>  <C>         <C>          <C>        <C>         <C>         <C>           <C>
Net Loss                                 --   $     --            --   $     --   $      --   $      --   $   (33,973)  $   (33,973)
                                      ------  ---------  ------------  ---------  ----------  ----------  ------------  ------------
Balance at December 31, 1999                                      --         --          --          --       (33,973)      (33,973)
Shares issued to founders January
2000, in exchange for services and
costs valued at $ 0.60 per share         --         --        19,300        193      11,387          --            --        11,580
Shares issued in June 2000, for
cash in connection with private
placement at $375 per share, net
of costs                                 --         --         1,735         17     644,219          --            --       644,236
Shares issued in July 2000, for
warrants exercised at a price of
$375 per share                           --         --           190         --      71,250          --            --        71,250
Shares issued in August 2000, in
connection with the merger of
Comstock Coal and Telkonet
Communications, Inc                      --         --    21,775,335     21,775          --          --            --        21,775
August 2000, retirement of Telkonet
Communications, Inc shares               --         --       (21,225)      (210)         --          --            --          (210)
Shares issued in October 2000,
in exchange for warrants exercised
at a price of $1 per share               --         --        29,145         29      29,115          --            --        29,144
Shares issued in October 2000,
in exchange for warrants exercised
at a price of $ 0.40 per share           --         --        10,891         11       4,345          --            --         4,356

Net loss                                 --         --            --         --          --          --      (929,720)     (929,720)
                                      ------  ---------  ------------  ---------  ----------  ----------  ------------  ------------

 BALANCE AT DECEMBER 31, 2000            --   $     --    21,815,371   $ 21,815   $ 760,316   $      --   $  (963,693)  $  (181,562)
                                      ======  =========  ============  =========  ==========  ==========  ============  ============


                               See accompanying notes to consolidated financial statements

                                                           F-6
</TABLE>
<PAGE>

<TABLE>
                                                     TELKONET, INC.
                                              (A DEVELOPMENT STAGE COMPANY)
                              CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
                        FOR THE PERIOD NOVEMBER 3, 1999 (DATE OF INCEPTION) TO DECEMBER 31, 2003

<CAPTION>
                                                                                                            Deficit
                                                                                                          Accumulated
                                         Preferred                  Common    Additional     Common         During
                               Preferred  Stock        Common       Stock      Paid in        Stock       Development
                                 Shares   Amount       Shares       Amount     Capital     Subscription      Stage         Total

<S>                                 <C>  <C>         <C>          <C>        <C>           <C>           <C>            <C>
 Balance Forward                    --   $    --     21,815,371   $ 21,815   $   760,316   $        --   $   (963,693)  $  (181,562)
Shares issued in June 2001,
for cash in connection with
a private placement, shares
issued at $.50 a share,
net of costs                        --        --        260,000        260       129,740            --             --       130,000
1,839,378 warrants issued in
June 2001, valued at $0.13
per warrant,  in exchange for
services                            --        --             --         --       237,035            --             --       237,035
72,668 stock options issued
in June 2001, valued at
$0.09 per stock option, in
exchange for services               --        --             --         --         6,375            --             --         6,375
245,287 warrants issued in
July 2001, valued at $0.08
per warrant, in exchange
for services                        --        --             --         --        18,568            --             --        18,568
36,917 stock options issued
in July 2001, valued at $0.08
per warrant, in exchange
for services                        --        --             --         --         2,795            --             --         2,795
Shares issued in August 2001,
for cash in connection with a
private placement, shares
issued at $.50 a share, net
of costs                            --        --         40,000         40        19,960            --             --        20,000
241,000 warrants issued in
August 2001, valued at $0.39
per warrant in exchange for
financing costs                     --        --             --         --        85,818            --            --         85,818
150,000 warrants issued in
August 2001, valued at $0.16
per  warrant, in exchange
for services                        --        --             --         --        23,340            --             --        23,340
36,917 stock options issued
in  August 2001, valued at
$0.06 per stock option, in
exchange for services               --        --             --         --         2,422            --             --         2,422
25,000 warrants issued in
September 2001, valued at
$0.30 per warrant in exchange
for services                        --        --             --         --         7,380            --             --         7,380
95,000 warrants issued in
October 2001, valued at $0.21
per warrant, in exchange for
services                            --        --             --         --        19,558            --             --        19,558
25,000 warrants issued in
November 2001, valued at
$0.33 per warrant,
in exchange for services            --        --             --         --         8,218            --             --         8,218
25,000 warrants issued in
December 2001, valued at $
0.30 per warrant, in exchange
for services                        --        --             --         --         7,380            --             --         7,380
Beneficial conversion feature
of convertible debentures
(Note F)                            --        --             --         --       837,874            --             --       837,874
Value of warrants attached to
convertible debentures
(Note F)                            --        --             --         --        77,254            --             --        77,254

Net loss                            --        --             --         --            --            --     (1,716,495)   (1,716,495)
                                  -----  --------   ------------  ---------  ------------  ------------  -------------  ------------

 BALANCE AT DECEMBER 31, 2001       --   $    --     22,115,371   $ 22,115   $ 2,244,033   $        --   $ (2,680,188)  $  (414,040)
                                  =====  ========   ============  =========  ============  ============  =============  ============

                                    See accompanying notes to consolidated financial statements

                                                          F-7
<PAGE>

                                                     TELKONET, INC.
                                              (A DEVELOPMENT STAGE COMPANY)
                              CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
                        FOR THE PERIOD NOVEMBER 3, 1999 (DATE OF INCEPTION) TO DECEMBER 31, 2003

                                                                                                            Deficit
                                                                                                          Accumulated
                                         Preferred                  Common    Additional     Common         During
                               Preferred  Stock        Common       Stock      Paid in        Stock       Development
                                 Shares   Amount       Shares       Amount     Capital     Subscription      Stage         Total

 Balance Forward                    --   $    --     22,115,371   $ 22,115   $ 2,244,033   $        --   $ (2,680,188)  $  (414,040)
Shares issued in February
2002, in exchange for
convertible debentures
interest, at $.50 per share         --        --         43,586         44        21,749            --             --        21,793
Shares issued in March 2002,
to a founder in exchange for
shares canceled                     --        --      5,250,000      5,250        (5,250)           --             --            --
Shares canceled in March 2002
in connection with capital
restructure                         --        --    (13,480,961)   (13,481)       13,481            --             --            --
Shares issued in June 2002,
for warrants exercised at
$1.00 per share for services
rendered                            --        --         47,906         48        47,857            --             --        47,906
Shares issued in June 2002,
for warrants exercised at
$.40 per share for services
rendered                            --        --         26,443         26        10,551            --             --        10,577
Shares issued in June 2002 to
founders, for options
exercised at $1.00 per share        --        --      1,000,000      1,000       999,000            --             --     1,000,000
Shares issued in June 2002,
for warrants exercised at
$1.0025 per share, for
services rendered                   --        --         80,039         80        80,158            --             --        80,238
Shares issued in June 2002,
for warrants exercised at
$ .41, in connection with
original private placement          --        --        189,327        189        77,720            --             --        77,910
Shares issued in July 2002,
for warrants exercised at
$ .40, in connection with
original private placement          --        --         41,970         42        16,830            --             --        16,872
Shares issued in July 2002 to
founders, for options
exercised at $1.00 per share        --        --      1,000,000      1,000       999,000            --             --     1,000,000
Shares issued in August 2002,
for warrants exercised at
$ .43, in connection with
original private placement          --        --        542,500        543       232,459            --             --       233,001
Shares issued in August 2002,
for warrants exercised at
$ .40, in connection with
original private placement          --        --        193,302        193        77,127            --             --        77,320
Shares issued in October
2002, for warrants exercised
at $ .40, in connection with
original private placement          --        --         77,048         77        30,896            --             --        30,973
Shares issued in October
2002, for warrants exercised
at $0.50 per share in
connection with original
private placement                   --        --        400,000        400       199,600            --             --       200,000
Common stock subscription           --        --             --         --            --    (1,805,400)            --    (1,805,400)
Return of founders shares in
connection with stock
subscription                        --        --     (1,805,400)    (1,805)   (1,803,595)    1,805,400             --            --
Stock based compensation for
the issuance of stock options
to consultants in exchange
for services (Note I)               --        --             --         --       452,459            --             --       452,459
Stock based compensation for
the issuance of warrants to
consultants in exchange for
services (Note I)                   --        --             --         --       170,330            --             --       170,330
Stock based compensation for
the issuance of warrants to
consultants in exchange for
financing costs (Note I)            --        --             --         --        86,474            --             --        86,474

Beneficial conversion feature
of convertible debentures
(Note F)                            --        --             --         --       840,877            --             --       840,877

Value of warrants attached to
convertible debentures (Note F)     --        --             --         --       124,677            --             --       124,677

Net Loss                            --        --             --         --            --            --     (3,778,488)   (3,778,488)
                                  -----  --------   ------------  ---------  ------------  ------------  -------------  ------------
 BALANCE AT DECEMBER 31, 2002       --   $    --     15,721,131   $ 15,721   $ 4,916,433   $        --   $ (6,458,676)  $(1,526,522)
                                  =====  ========   ============  =========  ============  ============  =============  ============

                                    See accompanying notes to consolidated financial statements

                                                          F-8
<PAGE>

                                                     TELKONET, INC.
                                              (A DEVELOPMENT STAGE COMPANY)
                              CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
                        FOR THE PERIOD NOVEMBER 3, 1999 (DATE OF INCEPTION) TO DECEMBER 31, 2003

                                                                                                            Deficit
                                                                                                          Accumulated
                                         Preferred                  Common    Additional     Common         During
                               Preferred  Stock        Common       Stock      Paid in        Stock       Development
                                 Shares   Amount       Shares       Amount     Capital     Subscription      Stage         Total

Balance Forward                     --        --     15,721,131   $ 15,721   $ 4,916,433            --   $ (6,458,676)  $(1,526,522)
Shares issued in April 2003
in exchange for convertible
debentures at $.50 per share
(Note F)                            --        --         40,000         40        19,960            --             --        20,000
Shares issued in April 2003
in exchange for services at
$1.54 per share                     --        --         49,998         50        76,695            --             --        76,745
Shares issued in June 2003
for employee options
exercised at $1.00 per
share                               --        --         83,333         83        83,250            --             --        83,333
Shares issued in June 2003
for non-employee options
exercised at $1.00 per share        --        --         83,333         84        83,249            --             --        83,333
Stock based compensation for
the issuance of warrants in
exchange for financing costs
(Note I)                            --        --             --         --        87,217            --             --        87,217
Beneficial conversion feature
of convertible debentures
(Note F)                            --        --             --         --     1,761,675            --             --     1,761,675
Value of warrants attached to
convertible debentures (Note F)     --        --             --         --       265,425            --             --       265,425
Shares issued in July 2003
for warrants exercised at
$.66 per share, for services
rendered                            --        --        114,799        115          (115)           --             --            --
Shares issued in July 2003
for warrants exercised at
$.53 per share, for services
rendered                            --        --         64,052         64           (64)           --             --            --
Shares issued in July 2003
for 220,000 warrants
(attached to convertible
debentures) exercised at
$1.00 per share                     --        --        138,388        138          (138)           --             --            --
Shares issued in August 2003
in exchange for convertible
debentures (Note F)                 --        --      7,177,836      7,178     3,779,922            --             --     3,787,100
Shares issued in August 2003
in exchange for accrued
interest on convertible
debentures (Note F)                 --        --        511,143        511       272,114            --             --       272,625
Shares issued in August 2003
for non-employee options
exercised at $1.00 per share        --        --         83,333         84        83,250            --             --        83,334
Shares purchased in August
2003 for cash at $2.00 per
share, net of costs                 --        --            333         --           666            --             --           666
Shares issued in September
2003 for warrants exercised
at $1.00                            --        --      3,597,250      3,597     3,593,653            --             --     3,597,250
Shares issued in September
2003 for warrants exercised
at $.50                             --        --        500,000        500       249,500            --             --       250,000

                                                     (Continued...)

                                                           F-9
<PAGE>

                                                     TELKONET, INC.
                                              (A DEVELOPMENT STAGE COMPANY)
                              CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
                        FOR THE PERIOD NOVEMBER 3, 1999 (DATE OF INCEPTION) TO DECEMBER 31, 2003

                                                                                                            Deficit
                                                                                                          Accumulated
                                         Preferred                  Common    Additional     Common         During
                               Preferred  Stock        Common       Stock      Paid in        Stock       Development
                                 Shares   Amount       Shares       Amount     Capital     Subscription      Stage         Total

(Continued)
Shares issued in September
2003 for warrants exercised
at $1.00, in exchange for
Senior Notes (Note G)               --        --      2,011,000   $  2,011   $ 2,008,989            --             --   $ 2,011,000
Shares issued in September
2003 in exchange for services
at approximately $2.50 per
share                               --        --        114,000        114       285,148            --             --       285,262
Stock based compensation for
the issuance of stock options
to consultants in exchange
for services (Note I)               --        --             --         --       982,390            --             --       982,390
Stock based compensation for
the issuance of warrants to
consultants in exchange for
services (Note I)                   --        --             --         --        30,872            --             --        30,872
Write-off of beneficial
conversion feature in
connection with
conversion of Debenture-1 and
Series B debentures (Note F)        --        --             --         --    (2,046,479)           --             --    (2,046,479)
Write-off of value of
warrants attached to
convertible debentures in
connection with conversion
of Debenture-1 and Series B
debentures (Note F)                 --        --             --         --      (296,470)           --             --      (296,470)
Shares issued in October 2003
in exchange for warrants
exercised at $.50 per share         --        --        315,000        315       157,185            --             --       157,500
Shares issued in October 2003
in exchange for accrued
interest on convertible
debentures (Note F)                 --        --         14,260         14         8,095            --             --         8,109
Shares issued in  November
2003 in exchange for
non-employee options
exercised at $1.00 per share        --        --         20,833         21        20,812            --             --        20,833
Shares issued in November
2003 for warrants exercised
at $1.00 per share                  --        --          2,000          2         1,998            --             --         2,000
Shares issued in November
2003 for employee options
exercised at $1.00 per share        --        --         20,000         20        19,980            --             --        20,000
Shares issued in December
2003 for employee options
exercised at approximately
$1.00 and $1.50 per share           --        --          6,000          6         7,494            --             --         7,500
Shares issued in December
2003 in exchange for services
at approximately $1.01 per
share                               --        --         21,500         22        21,545            --             --        21,567

Net Loss                            --        --             --         --            --            --     (7,657,936)   (7,657,936)
                                  -----  --------   ------------  ---------  ------------  ------------  -------------  ------------

 BALANCE AT DECEMBER 31, 2003       --   $    --     30,689,522   $ 30,690   $16,474,251   $        --   $(14,116,612)  $ 2,388,329
                                  =====  ========   ============  =========  ============  ============  =============  ============

                                    See accompanying notes to consolidated financial statements


                                                          F-10
</TABLE>
<PAGE>

<TABLE>
                                           TELKONET, INC.
                                    (A DEVELOPMENT STAGE COMPANY)
                                CONSOLIDATED STATEMENTS OF CASH FLOWS

<CAPTION>
                                                                                                      For the period
                                                                                                    from November 3,
                                                                                                      1999 (date of
                                                                     For the year Ended December 31,    inception)
                                                                      -----------------------------  through December
                                                                          2003            2002           31, 2003
                                                                      -------------   -------------   -------------
<S>                                                                   <C>             <C>             <C>
INCREASE (DECREASE) IN CASH AND EQUIVALENTS
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss from development stage operations                            $ (7,657,936)   $ (3,778,488)   $(14,116,612)

Adjustments to reconcile net loss from development stage
operations to cash used in operating activities
Amortization of debt discount - beneficial conversion feature of
convertible debentures (Note F)                                            655,261         440,646       1,188,683
Amortization of debt discount - value of warrants attached to
convertible debentures (Note F)                                             89,434          39,390         137,376
Stock options and warrants issued in exchange for services (Note I)      1,013,262         622,790       1,969,124

Common stock issued in exchange for services rendered (Note H)             383,574         138,722         533,876

Common stock issued in exchange for debenture interest (Note F)            280,735          21,793         302,528
Write-off of financing costs in connection with conversion of
convertible debentures (Note F)                                            204,749              --         204,749
Impairment of property and equipment, net                                       --              --          39,287

Depreciation and amortization                                              110,988          84,067         247,932
Increase / decrease in:
Accounts receivable, trade and other                                       (56,646)         (1,550)        (58,196)

Inventory                                                                 (568,726)        (39,790)       (608,516)

Prepaid expenses and deposits                                             (173,366)             --        (177,991)

Accounts payable, accrued liabilities and customer deposits, net           122,186         402,124         641,050
                                                                      -------------   -------------   -------------

NET CASH USED IN OPERATING ACTIVITIES                                   (5,596,485)     (2,070,296)     (9,696,710)

CASH FLOWS FROM INVESTING ACTIVITIES:
Costs of equipment under operating leases                                  (33,888)             --         (33,888)

Purchase of property and equipment, net                                   (103,033)        (18,265)       (215,535)
                                                                      -------------   -------------   -------------

NET CASH USED IN INVESTING ACTIVITIES                                     (136,921)        (18,265)       (249,423)

CASH FLOWS FROM FINANCING ACTIVITIES:

Proceeds from sale of common stock, net of costs                               666         830,673       1,751,890

Proceeds from (repayments to) stockholder advances                        (122,830)        122,830           7,500

Proceeds from issuance of convertible debentures, net of costs           2,027,100       1,222,000       4,067,100

Proceeds from issuance of senior notes, net of costs (Note G)            5,000,000              --       5,000,000

Proceeds from exercise of warrants                                       3,999,250              --       3,999,250

Proceeds from exercise of stock options and warrants                       298,311              --         298,311

Repayment of loans                                                        (310,000)        (90,000)       (400,000)

Proceeds from loans                                                             --              --         400,000
                                                                      -------------   -------------   -------------

NET CASH PROVIDED BY FINANCING ACTIVITIES                               10,892,497       2,085,503      15,124,051

NET (DECREASE) INCREASE IN CASH AND EQUIVALENTS                          5,159,091          (3,058)      5,177,918

Cash and cash equivalents at the beginning of the period                    18,827          21,885              --
                                                                      -------------   -------------   -------------
Cash and cash equivalents at the end of the period                    $  5,177,918    $     18,827    $  5,177,918
                                                                      =============   =============   =============

                     See accompanying notes to consolidated financial statements

                                      F-11
</TABLE>
<PAGE>

<TABLE>
                                           TELKONET, INC.
                                    (A DEVELOPMENT STAGE COMPANY)
                                CONSOLIDATED STATEMENTS OF CASH FLOWS

<CAPTION>
                                                                                         For the period
                                                                                         from November
                                                                                         3, 1999 (date
                                                        For the year Ended December 31,  of inception)
                                                          ----------------------------  through December
                                                             2003           2002           31, 2003
                                                          -------------  -------------  --------------
<S>                                                       <C>            <C>            <C>
Supplemental Disclosures of Cash Flow Information:
Cash transactions:
Cash paid during the period for interest                  $    135,879   $     30,885   $     191,729
Income taxes paid                                                   --             --              --
Non-cash transactions:
Issuance of stock options and warrants in exchange for
services rendered                                            1,013,262        622,790       1,969,124
Issuance of stock warrants in exchange for financing
costs                                                           87,217         86,474         173,691
Common stock issued for services rendered                      383,574        138,722         533,876
Common stock issued in exchange for interest                   280,735         21,793         302,528
Common stock issued in exchange for conversion of
convertible debenture                                        3,807,100             --       3,807,100

Common stock issued in exchange for Senior Note              2,011,000             --       2,011,000
Common stock issued in exchange for notes payable                7,500             --           7,500
Write-off of beneficial conversion feature for
conversion of debenture                                      2,046,479             --       2,046,479
Write-off of value of warrants attached to debenture in
connection with conversion                                     296,470             --         296,470

Notes payable issued in connection with capital lease,
net of repayments (Note N)                                      15,000             --          15,000
Beneficial conversion feature on convertible debentures      1,761,675        693,018       3,440,426
Value of warrants attached to convertible debentures           265,425         56,082         467,356

Acquisition:                                                        --             --              --

   Assets acquired                                                  --             --               1

   Accumulated deficit                                              --             --           2,643

   Liabilities assumed                                              --             --          (2,642)
                                                          -------------  -------------  --------------
                                                          $         --   $         --   $           1
                                                          -------------  -------------  --------------

                     See accompanying notes to consolidated financial statements

                                                F-12
</TABLE>
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


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 is emerging
from its development stage (as defined by Statement of Financial Accounting
Standards No. 7) and has commercialized its technology enabling the transmission
of voice and data over power lines inside existing buildings. The Company will
focus its efforts toward sales and marketing activities through direct and
indirect sales channels. From its inception through the date of these financial
statements, the Company has recognized minimal revenues and has incurred
significant operating expenses.

The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiary, Telkonet Communications, Inc. Significant
intercompany transactions have been eliminated in consolidation.

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.

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.

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 undercounted 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.

Inventories
-----------

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

                                      F-13
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE A-SUMMARY OF ACCOUNTING POLICIES (CONTINUED)

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 2003 and 2002, 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 SEC Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial
Statements" ("SAB 101"). 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.

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, together with the initial direct costs of
installation and support are capitalized, 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 (the "Residual"). Monthly lease payments are
recognized as rental income.

Advertising
-----------

The Company follows the policy of charging the costs of advertising to expenses
incurred. The Company incurred $136,758, $0 and $136,758 in advertising costs
during the years ended December 31, 2003 and 2002, and for the period from
November 3, 1999 (date of inception) to December 31, 2003, respectively.


                                      F-14
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE A-SUMMARY OF ACCOUNTING POLICIES (CONTINUED)

Liquidity
---------

As shown in the accompanying financial statements, the Company has incurred a
net loss of $14,116,612 from its inception through December 31, 2003. The
Company's current assets exceeded its current liabilities by $5,296,570, with
cash and cash equivalents representing $5,177,918 of this amount as of December
31, 2003.

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 2003, 2002, and the period from November 3,
1999 (date of inception) to December 31, 2003 were $1,370,785, $1,279,145, and
$3,702,745, respectively.

Concentrations of Credit Risk
-----------------------------

Financial instruments and related items, which potentially subject the Company
to concentrations of credit risk, consist primarily of cash, cash equivalents
and related party receivables. 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 Company periodically reviews its
trade receivables in determining its allowance for doubtful accounts. There is
no allowance for doubtful accounts established as of December 31, 2003.

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.

Stock Based Compensation
------------------------

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure-an amendment of SFAS 123." This statement
amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide
alternative methods of transition for a voluntary charge to the fair value based
method of accounting for stock-based employee compensation. In addition, this
statement amends the disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial statements about the
method of accounting for stock-based employee compensation and the effect of the
method used on reported results. The Company has chosen to continue to account
for stock-based compensation using the intrinsic value method prescribed in APB
Opinion No. 25 and related interpretations. Accordingly, compensation expense
for stock options is measured as the excess, if any, of the fair market value of
the Company's stock at the date of the grant over the exercise price of the
related option. The Company has adopted the annual disclosure provisions of SFAS
No. 148 in its financial reports for the year ended December 31, 2003 and 2002
and for subsequent periods.


                                      F-15
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE A-SUMMARY OF ACCOUNTING POLICIES (CONTINUED)

Stock Based Compensation (Continued)
------------------------------------

Had compensation costs for the Company's stock options been determined based on
the fair value at the grant dates for the awards, the Company's net loss and
losses per share would have been as follows (transactions involving stock
options issued to employees and Black-Scholes model assumptions are presented in
Note I):

<TABLE>
<CAPTION>
                                                                  2003       2002 (as restated)
                                                             --------------   ----------------
<S>                                                          <C>              <C>
Net loss - as reported                                       $  (7,657,936)   $    (3,778,488)
Add: Total stock based employee compensation expense as
reported under intrinsic value method (APB. No. 25)                     --                 --
Deduct: Total stock based employee compensation expense
as reported under fair value based method (SFAS No. 123)        (5,211,112)          (398,433)
                                                             --------------   ----------------
Net loss - Pro Forma                                         $ (12,869,048)   $    (4,176,921)
Net loss attributable to common stockholders - Pro forma     $ (12,869,048)   $    (4,176,921)
Basic (and assuming dilution) loss per share - as reported   $       (0.37)   $         (0.22)
Basic (and assuming dilution) loss per share - Pro forma     $       (0.62)   $         (0.24)
</TABLE>

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.

New Accounting Pronouncements
-----------------------------

In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities." Interpretation 46 changes the criteria by which one
company includes another entity in its consolidated financial statements.
Previously, the criteria were based on control through voting interest.
Interpretation 46 requires a variable interest entity to be consolidated by a
company if that company is subject to a majority of the risk of loss from the
variable interest entity's activities or entitled to receive a majority of the
entity's residual returns or both. A company that consolidates a variable
interest entity is called the primary beneficiary of that entity. The
consolidation requirements of Interpretation 46 apply immediately to variable
interest entities created after January 31, 2003. The consolidation requirements
apply to older entities in the first fiscal year or interim period beginning
after June 15, 2003. Certain of the disclosure requirements apply in all
financial statements issued after January 31, 2003, regardless of when the
variable interest entity was established. The Company does not expect the
adoption to have a material impact to the Company's financial position or
results of operations.

In April 2003, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 149, AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING
ACTIVITIES. SFAS 149 amends SFAS No. 133 to provide clarification on the
financial accounting and reporting of derivative instruments and hedging
activities and requires that contracts with similar characteristics be accounted
for on a comparable basis. The provisions of SFAS 149 are effective for
contracts entered into or modified after June 30, 2003, and for hedging
relationships designated after June 30, 2003. The adoption of SFAS 149 will not
have a material impact on the Company's results of operations or financial
position.


                                      F-16
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE A-SUMMARY OF ACCOUNTING POLICIES (CONTINUED)

New Accounting Pronouncements (Continued)
-----------------------------------------

In May 2003, the FASB issued SFAS No. 150, ACCOUNTING FOR CERTAIN FINANCIAL
INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY. SFAS 150
establishes standards on the classification and measurement of certain financial
instruments with characteristics of both liabilities and equity. The provisions
of SFAS 150 are effective for financial instruments entered into or modified
after May 31, 2003 and to all other instruments that exist as of the beginning
of the first interim financial reporting period beginning after June 15, 2003.
The adoption of SFAS 150 will not have a material impact on the Company's
results of operations or financial position.

In December 2003, the FASB issued SFAS No. 132 (revised), EMPLOYERS' DISCLOSURES
ABOUT PENSIONS AND OTHER POSTRETIREMENT BENEFITS - AN AMENDMENT OF FASB
STATEMENTS NO. 87, 88, AND 106. This statement retains the disclosure
requirements contained in FASB statement no. 132, Employers' Disclosures about
Pensions and Other Postretirement Benefits, which it replaces. It requires
additional disclosures to those in the original statement 132 about the assets,
obligations, cash flows, and net periodic benefit cost of defined benefit
pension plans and other defined benefit postretirement plans. The required
information should be provided separately for pension plans and for other
postretirement benefit plans. The revision applies for the first fiscal or
annual interim period ending after December 15, 2003 for domestic pension plans
and June 15, 2004 for foreign pension plans and requires certain new disclosures
related to such plans. The adoption of this statement will not have a material
impact on the Company's results of operations or financial positions.

Reclassifications
-----------------

Certain reclassifications have been made in prior year's financial statements to
conform to classifications used in the current year.

NOTE B - 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,
iBridges and Couplers which are the significant components of the Telkonet
solution. Components of inventories as of December 31, 2003 and 2002 are as
follows:

                                                    2003               2002
                                                 ----------         ----------
         Raw Materials                           $ 374,794          $      --
         Finished Goods                            233,722             39,790
                                                 ----------         ----------
                                                 $ 608,516          $  39,790
                                                 ==========         ==========

                                      F-17
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE C - PROPERTY, PLANT AND EQUIPMENT

The Company's property and equipment at December 31, 2003 and 2002 consists of
the following:

                                                        2003              2002
                                                     ----------       ----------
  Development Test Equipment                         $  72,774        $      --
  Office Equipment                                     103,773           58,514
  Office Fixtures and Furniture                         14,701           14,701
                                                     ----------       ----------
     Total                                             191,248           73,215
  Accumulated Depreciation                             (67,687)         (35,252)
                                                     ----------       ----------
                                                     $ 123,561        $  37,963
                                                     ==========       ==========

Depreciation expense included as a charge to income amounted to $32,435, $7,144,
and $67,687 for the year ended December 31, 2003, 2002, and from inception to
December 31, 2003, respectively.

NOTE D - 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 three years. Equipment under operating leases
at December 31, 2003 and 2002 consist of the following:

                                                               2003       2002
                                                             ---------  --------
     Telecommunications and related equipment                $ 33,888   $    --
     Less: accumulated depreciation                            (3,485)       --
                                                             ---------  --------
     Capitalized equipment, net of accumulated depreciation    30,403        --
     Less: estimated reserve for residual values                   --        --
                                                             ---------  --------
     Capitalized equipment under operating leases, net       $ 30,403   $    --
                                                             =========  ========

The following is a schedule by years of minimum future rentals on noncancellable
operating leases as of December 31, 2003:

     Year ending December 31,
     2004                                                       $36,464
     2005                                                        32,907
     2006                                                        23,331
                                                                --------
                                                                $92,702
                                                                ========

NOTE E - NOTES PAYABLE

<TABLE>
<CAPTION>
Notes payable at December 31, 2003 and 2002 consists of the following:
                                                                                          2003            2002
                                                                                      --------------  ------------
  <S>                                                                                 <C>             <C>
  Note payable in monthly installments of interest only at 7.5% per annum,
  unsecured and guaranteed by a Company shareholder. Maturity date is in
  September 2002; the Company paid the debt in full in February 2003.                 $          --   $    60,000
  Note payable in monthly installments of interest only at the prime lending
  rate plus 1%, unsecured and guaranteed by a Company shareholder. The original
  maturity date of the loan was extended from March 2002 to March 2003; the
  Company paid the debt in full in September 2003.                                               --       250,000
                                                                                      --------------  ------------
                                                                                                 --       310,000
  Less: current portion                                                                          --      (310,000)
                                                                                      --------------  ------------
                                                                                      $          --   $        --
                                                                                      ==============  ============


                                      F-18
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE F - CONVERTIBLE PROMISSORY NOTES PAYABLE

A summary of convertible promissory notes payable at December 31, 2003 and
2002is as follows:

                                                                                           2003            2002
                                                                                      --------------  ------------
  Convertible notes payable ("Debenture-1"), in quarterly installments of
  interest only at 8% per annum, unsecured and due three years from the date of
  the note with the latest maturity May 2005; 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 $.50 per share six months after issuance.
  During the year ended December 31, 2003, a total of $1,627,100 of Debenture-1
  was converted to common stock of the Company.                                       $      62,000   $ 1,689,100
  Debt Discount - beneficial conversion feature, net of accumulated
  amortization of $41,411 and $531,858 at December 31, 2003 and 2002,
  respectively.                                                                             (24,718)     (999,034)
  Debt Discount - value attributable to warrants attached to notes, net of
  accumulated amortization of $3,605 and $47,216 at December 31, 2003 and 2002,
  respectively.                                                                              (2,116)      (86,120)
                                                                                      --------------  ------------
                                                                                             35,166       603,946
  Convertible notes payable ("Series B Debenture"), in quarterly installments of
  interest only at 8% per annum, unsecured and due three years from the date of
  the note with the latest maturity February 2006; 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 $.55 per share six months after issuance.
  During the year ended December 31, 2003, a total of $2,180,000 of Series B
  Debenture was converted to common stock of the Company.                                   320,000       472,900
  Debt Discount - beneficial conversion feature, net of accumulated
  amortization of $75,426 and $1,564 at December 31, 2003 and 2002,
  respectively.                                                                            (180,546)     (146,295)
  Debt Discount - value attributable to warrants attached to notes, net of
  accumulated amortization of $13,194 and $726 at December 31, 2003 and 2002,
  respectively.                                                                             (31,415)      (67,869)
                                                                                      --------------  ------------
                                                                                            108,039       258,736
                                                                                      --------------  ------------
  Total                                                                               $     143,205   $   862,682
                                                                                      --------------  ------------
  Less: current portion                                                                          --            --
                                                                                      --------------  ------------
                                                                                      $     143,205   $   862,682
                                                                                      ==============  ============
</TABLE>

Convertible Debentures
----------------------

During the year ended December 31, 2001, the Company issued convertible
promissory notes (the "Debenture-1") to Company officers, shareholders, and
sophisticated investors in exchange for $940,000, exclusive of placement costs
and fees. The Debenture-1 accrues interest at 8% per annum and is payable and
due three years from the date of the note with the latest maturity date of
November 2004. Noteholder has the option to convert any unpaid note principal
together with accrued and unpaid interest to the Company's common stock at a
rate of $.50 per share six months after issuance. 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 Debenture-1 note.

                                      F-19
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE F - CONVERTIBLE PROMISSORY NOTES PAYABLE (CONTINUED)

Convertible Debentures (Continued)
----------------------------------

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 $837,874 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 Debenture-1. The debt discount attributed to the
beneficial conversion feature is amortized over the Debenture-1's maturity
period (three years) as interest expense.

In connection with the placement of the Debenture-1 notes, the Company issued
non-detachable warrants granting the holders the right to acquire 940,000 shares
of the Company's common stock at $1.00 per share. In accordance with EMERGING
ISSUES TASK FORCE ISSUE 00-27, APPLICATION OF ISSUE NO. 98-5 TO CERTAIN
CONVERTIBLE INSTRUMENTS ("EITF - 0027"), the Company recognized the value
attributable to the warrants in the amount of $77,254 to additional paid in
capital and a discount against the Debenture-1. The Company valued the warrants
in accordance with EITF 00-27 using the Black-Scholes pricing model and the
following assumptions: contractual terms of 3 years, an average risk free
interest rate of 4.25%, a dividend yield of 0%, and volatility of 21%. The debt
discount attributed to the value of the warrants issued is amortized over the
Debenture-1's maturity period (three years) as interest expense.

During the year ended December 31, 2002, the Company issued convertible
promissory notes (the "Debenture-1") to Company officers, shareholders, and
sophisticated investors in exchange for $749,100, exclusive of placement costs
and fees. The Debenture-1 accrues interest at 8% per annum and is payable and
due three years from the date of the note with the latest maturity date of May
2005. Noteholders have the option to convert any unpaid note principal together
with accrued and unpaid interest to the Company's common stock at a rate of $.50
per share six months after issuance.

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 Debenture-1 note. 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 $693,018 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 Debenture-1. The debt discount attributed to the beneficial
conversion feature is amortized over the Debenture-1's maturity period (three
years) as interest expense.

In connection with the placement of the Debenture-1 notes in 2002, the Company
issued non-detachable warrants granting the holders the right to acquire 749,100
shares of the Company's common stock at $1.00 per share. In accordance with
EMERGING ISSUES TASK FORCE ISSUE 00-27, APPLICATION OF ISSUE NO. 98-5 TO CERTAIN
CONVERTIBLE INSTRUMENTS ("EITF -0027"), the Company recognized the value
attributable to the warrants in the amount of $56,082 to additional paid in
capital and a discount against the Debenture-1. The Company valued the warrants
in accordance with EITF 00-27 using the Black-Scholes pricing model and the
following assumptions: contractual terms of 3 years, an average risk free
interest rate of 1.67%, a dividend yield of 0%, and volatility of 26%. The debt
discount attributed to the value of the warrants issued is amortized over the
Debenture-1's maturity period (three years) as interest expense.

Series B Debentures
-------------------

In October and December 2002, the Company issued convertible promissory notes
(the "Series B Debenture") to Company officers, shareholders, and sophisticated
investors in exchange for $472,900 , exclusive of placement costs and fees .The
Series B Debenture accrues interest at 8% per annum and is payable and due three
years from the date of the note with the latest maturity date of December 2005.
Noteholders have the option to convert any unpaid note principal together with
accrued and unpaid interest to the Company's common stock at a rate of $.55 per
share six months after issuance.

                                      F-20
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE F - CONVERTIBLE PROMISSORY NOTES PAYABLE (CONTINUED)

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 Series B Debenture note. 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 $147,859 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 Series B Debenture. The debt discount attributed to the
beneficial conversion feature is amortized over the Series B Debenture's
maturity period (three years) as interest expense.

In connection with the placement of the Series B Debenture notes in 2002, the
Company issued non-detachable warrants granting the holders the right to acquire
472,900 shares of the Company's common stock at $1.00 per share. In accordance
with EMERGING ISSUES TASK FORCE ISSUE 00-27, APPLICATION OF ISSUE NO. 98-5 TO
CERTAIN CONVERTIBLE INSTRUMENTS ("EITF -0027"), the Company recognized the value
attributable to the warrants in the amount of $68,595 to additional paid in
capital and a discount against the Series B Debenture. The Company valued the
warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and
the following assumptions: contractual terms of 3 years, an average risk free
interest rate of 1.67%, a dividend yield of 0%, and volatility of 26%. The debt
discount attributed to the value of the warrants issued is amortized over the
Series B Debenture's maturity period (three years) as interest expense.

In January and February 2003, the Company issued convertible Series B Debentures
to Company officers, shareholders, and sophisticated investors in exchange for
$2,027,100, exclusive of placement costs and fees. The Series B Debentures
accrue interest at 8% per annum and are payable and due three years from the
date of the note with the latest maturity date of February 2006. Noteholders
have the option to convert any unpaid note principal together with accrued and
unpaid interest to the Company's common stock at a rate of $.55 per share six
months after issuance.

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 Series B Debenture note. 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 $1,761,675 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 Series B Debentures. The debt discount attributed to the
beneficial conversion feature is amortized over the Series B Debentures maturity
period (three years) as interest expense.

In connection with the placement of the Series B Debenture notes in January and
February 2003, the Company issued non-detachable warrants granting the holders
the right to acquire 2,027,100 shares of the Company's common stock at $1.00 per
share. In accordance with EMERGING ISSUES TASK FORCE ISSUE 00-27, APPLICATION OF
ISSUE NO. 98-5 TO CERTAIN CONVERTIBLE INSTRUMENTS ("EITF -0027"), the Company
recognized the value attributable to the warrants in the amount of $265,425 to
additional paid in capital and a discount against the Series B Debentures. The
Company valued the warrants in accordance with EITF 00-27 using the
Black-Scholes pricing model and the following assumptions: contractual terms of
3 years, an average risk free interest rate of 1.25%, a dividend yield of 0%,
and volatility of 26%. The debt discount attributed to the value of the warrants
issued is amortized over the Series B Debentures maturity period (three years)
as interest expense.

The Company amortized the Debenture 1 and the Series B Debenture debt discount
attributed to the beneficial conversion feature and the value of the attached
warrants and recorded non-cash interest expense of $744,695 and $480,036 for the
years ended December 31, 2003 and 2002, respectively.

                                      F-21
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE F - CONVERTIBLE PROMISSORY NOTES PAYABLE (CONTINUED)

During the year ended December 31, 2003, the Debenture-1 noteholders demanded
registration of that number of common shares of the Company sufficient to cover
the conversion of their debentures and exercise of the attached warrants.
Accordingly, the Company notified the Series B Debenture noteholders, Senior
noteholders (Note G) and warrant holders with piggy-back registration rights of
their right to participate in the registration. During the year ended December
31, 2003, the Company issued an aggregate of 7,217,836 shares of common stock in
connection with the conversion of $1,627,100 aggregate principal amount of the
Debenture-1 and $2,180,000 aggregate principal amount of the Series B
Debentures. The Company also issued an aggregate of 525,403 shares of common
stock in exchange for accrued interest of $195,148 and $85,586 for Debenture-1
and Series B debenture, respectively.

In connection with the conversion of Debenture-1 and Series B debentures, the
Company wrote off the un-amortized debt discount attributed to the beneficial
conversion feature and the value of the attached warrants in the amount of
$2,046,479 and $296,470, respectively. Capitalized financing costs in connection
with the issuance of Debenture-1 and Series B debenture were $381,509 and
$249,292 at December 31, 2003 and 2002, respectively. Un-amortized financing
cost of $204,748 in connection with issuance of Debenture-1 and Series B
Debenture was charged to operations during the year ended December 31, 2003.

NOTE G - 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. The Senior Notes outstanding as of December 31,
2003 is $2,989,000.

In January 2004, certain senior note holders elected to convert $2,539,000 of
their senior notes into equity at a conversion price of $2.10 per share. The
remaining outstanding senior notes as of January 31, 2004 after the conversion
was $450,000. (See Note N)

NOTE H - 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, 2003, 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, 2003, the
Company has 30,689,522 shares of common stock issued and outstanding.

                                      F-22
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE H - CAPITAL STOCK (CONTINUED)

In January 2000, the Company issued 19,300 shares to its founders, in exchange
for costs and services, valued at $11,580.

In June 2000, the Company issued a total of 1,735 shares of common stock in a
private placement to sophisticated investors, primarily in the United States in
exchange for $644,236 net of costs and fees. In July 2000 the Predecessor issued
190 shares of common stock in exchange for exercised warrants at $375 per share,
totaling $71,250

In August 2000, the Company issued 21,775,345 shares of common stock in
conjunction with the merger of Comstock Coal Company, Inc. In connection with
the transaction, the Company retired 21,225 shares of previously issued Telkonet
Communications, Inc common stock.

In October 2000, the Company issued 29,145 and 10,891 shares of common stock in
exchange for exercised warrants with exercise prices of $1.00 and $0.40 per
share, respectively.

In June 2001 and August 2001, the Company issued 260,000 and 40,000 shares of
its common stock, respectively, in a private placement to sophisticated
investors in exchange for $150,000, net of costs and fees.

In January 2002, the Company re-organized its capital structure, whereby the
Company agreed to purchase 8,936,244 shares of the Company's common stock held
by the Founders and cancel certain vested options held by the Founders to
purchase the Company's common stock, in exchange for the issuance of newly
issued options to purchase 3,500,000 shares of the Company's common stock. The
new stock options expire in January 2012, and have an exercise price of $1.00
per share, which is in excess of the weighted average fair value of the
Company's common stock at the grant dates. The canceled options had no intrinsic
value at the award date and as a result, the Company did not incur a
compensation cost in connection with the cancellation of the options. In
connection with this transaction, the Company issued 5,250,000 shares of common
stock to founders and canceled 13,480,961 shares of previously issued common
stock.

In June and July 2002, two of the Founders exercised the stock options to
purchase 2,000,000 shares of the Company's common stock. The Company entered
into four promissory notes with principal amounts of $250,000 each and two
promissory notes with principal amounts of $500,000 each with the two Founders
to ensure payments for issued stock. The notes are due one year from the date of
issuance. Interest will begin to accrue from and after the maturity dates on any
unpaid principal balance at an interest rate of 6% per annum. During the year
2002, the Company received $194,600 proceeds from the stock subscription. In
December 2002, the Founders returned a total of 1,805,400 shares of common stock
to the Company and the unpaid principal amount of the promissory notes was
canceled accordingly.

In February 2002, the Company issued 43,586 shares of common stock to its
convertible debenture holders in exchange for interest of $21,793.

In June 2002, the Company issued 154,388 shares of common stock to consultants
for warrants exercised at prices ranging from $.40 to $1.00 per share in
exchange for services, totaling $138,722, which approximated the fair value of
the shares issued during the period the services were completed and rendered.
Compensation costs of $ 138,722 were charged to income during the year ended
December 31, 2002. In 2002, the Company issued 1,444,147 shares of common stock,
or $636,076 to sophisticated investors for warrants exercised at prices ranging
from $.40 to $.50 per share.

In April 2003, the Company issued 40,000 shares of common stock at $0.50 per
share to one of its convertible debenture holders in exchange for $20,000 of
Debenture-1 due to the noteholder (Note F).

                                      F-23
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE H - CAPITAL STOCK (CONTINUED)

In April 2003, the Company issued 49,998 shares of common stock at approximately
$1.54 per share to consultants for services rendered, which approximated the
fair value of the shares issued during the period the services were completed
and rendered. Compensation costs of $76,745 were charged to operations.

In June 2003, the Company issued 83,333 shares of common stock for an aggregate
purchase price of $83,333 to an employee upon exercise of employee stock options
at $1.00 per share. Additionally, the Company issued 83,333 shares of common
stock for an aggregate purchase price of $83,333 to a consultant upon exercise
of non-employee stock options at $1.00 per share.

In July 2003, the Company issued an aggregate of 178,851 shares of common stock
to consultants for previously issued warrants exercised at $0.66 and $0.33 per
share. Additionally, the Company issued an aggregate of 138,388 shares of common
stock to its convertible debenture holders for 220,000 warrants exercised at
$1.00 per share.

In August 2003, the Company issued an aggregate of 7,688,979 shares of common
stock to its convertible debenture holders in exchange for $3,787,100 of debt
and $272,625 of accrued interest (see Note F). The Company also issued 83,333
shares of common stock to a consultant, for non-employee stock options exercised
at $1.00 per share. Additionally, the Company issued 333 shares of common stock
for $666 of cash, net of costs and fees.

In September 2003, the Company issued an aggregate of 3,597,250 and 500,000
shares of common stock for warrants exercised at $1.00 and $0.50 per share,
respectively. 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 (see Note F). The Company also issued an aggregate of
114,000 shares at approximately average $2.50 per share to consultants for
$285,262 of services rendered, which approximated the fair value of the shares
issued during the period the services were completed and rendered.

In October 2003, the Company issued 315,000 shares of common stock for an
aggregate purchase price of $157,500 to one of the Company's directors upon
exercise of employee stock options exercised at $0.50 per share. The Company
also issued an aggregate of 14,260 shares of common shares to a convertible
debenture noteholder in exchange for accrued interest of $8,109 (Note F).

In November 2003, the Company issued an aggregate of 20,000 shares of common
stock for an aggregate purchase price of $20,000 to employees for employee stock
options exercised at $1.00 per share. Additionally, the Company issued an
aggregate of 20,833 shares of common stock to a consultant for an aggregate
purchase price of $20,833 for non-employee stock options exercised at $1.00 per
share. The Company also issued 2,000 shares of common stock for an aggregate
purchase price of $2,000 to consultants for warrants exercised at $1.00 per
share.

In December 2003, the Company issued 6,000 shares of common stock for an
aggregate purchase price of $7,500 to employees for employee stock options at
$1.00 and $1.50 per share. Additionally, the Company issued an aggregate of
18,500 shares of common stock to consultants in exchange for $21,567 of services
rendered, which approximated the fair value of the shares issued during the
period the services were completed and rendered. Compensation costs of $21,567
were charged to operations.

                                      F-24
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE I - 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 Exercisable
              -------------------                      -------------------
                             Weighted Average    Weighted              Weighted
                                  Remaining      Average               Average
    Exercise     Number        Contractual       Exercise    Number    Exercise
     Prices    Outstanding     Life (Years)       Price    Exercisable   Price
     ------    -----------     ------------       -----    -----------   -----
      $1.00     6,629,000          8.77           $1.00     2,823,518    $1.00
      $1.30       195,000          9.50           $1.30        28,333    $1.30
      $1.98        20,000          9.76           $1.98         1,667    $1.98
      $2.00        80,000          9.75           $2.00        20,000    $2.00
      $2.35       490,000          9.40           $2.35        80,833    $2.35
      $2.46         5,000          9.94           $2.46            --    $2.46
      $2.48         2,000          9.96           $2.48            --    $2.48
      $2.62       820,000          9.69           $2.62        68,333    $2.62
      $3.06         7,000          9.46           $3.06         1,167    $3.06
      $3.43        25,000          9.52           $3.43         4,167    $3.43
      $3.68        20,000          9.52           $3.68         3,333    $3.68
                ----------        ------          ------    ----------   ------
                8,293,000          8.94           $1.19     3,031,351    $1.09
                ==========        ======          ======    ==========   ======

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

                                                                       Weighted
                                                                        Average
                                                           Number      Price Per
                                                          of Shares      Share
                                                         -----------   ---------
       Outstanding at January 1, 2002                     1,055,000    $   1.00
          Granted (as restated)                           3,335,000        1.00
          Exercised                                      (1,000,000)       1.00
          Canceled or expired                            (1,440,000)       1.00
                                                         -----------   ---------
       Outstanding at December 31, 2002 (as restated)     1,950,000        1.00
          Granted                                         7,202,333        1.22
          Exercised                                        (109,333)       1.01
          Canceled or expired                              (750,000)       1.00
                                                         -----------   ---------
       Outstanding at December 31, 2003                   8,293,000    $   1.19
                                                         ===========   =========

The weighted-average fair value of stock options granted to employees during the
years ended December 31, 2003 and 2002 and the weighted-average significant
assumptions used to determine those fair values, using a Black-Scholes option
pricing model are as follows:
                                                            2003        2002
                                                            ----        ----
       Significant assumptions (weighted-average):
           Risk-free interest rate at grant date            1.13%      1.67%
           Expected stock price volatility                   118%        26%
           Expected dividend payout                           --         --
           Expected option life-years (a)                     10         10

       (a)The expected option life is based on contractual expiration dates.


                                      F-25
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE I - STOCK OPTIONS AND WARRANTS (CONTINUED)

Employee Stock Options (Continued)
----------------------------------

If the Company recognized compensation cost for the non-qualified employee stock
option plan in accordance with SFAS No. 123, the Company's pro forma net loss
and net loss per share would have been $(12,869,048) and $(.62) in 2003 and
$(4,176,921) and $(0.24) in 2002 (as restated),respectively.

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 Exercisable
              -------------------                      -------------------
                             Weighted Average    Weighted              Weighted
                                  Remaining      Average               Average
    Exercise     Number        Contractual       Exercise    Number    Exercise
     Prices    Outstanding     Life (Years)       Price    Exercisable   Price
     ------    -----------     ------------       -------  -----------   -------
     $1.00      3,267,500          8.93           $ 1.00    2,280,000    $ 1.00
     ======     ==========        ======          ======    ==========   ======

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

                                                                       Weighted
                                                                        Average
                                                           Number      Price Per
                                                          of Shares      Share
                                                         -----------   ---------
       Outstanding at January 1, 2002                       246,502    $   0.70
          Granted                                         2,455,000        1.00
          Exercised                                      (1,146,502)        .96
          Canceled or expired                                    --          --
                                                         -----------   ---------
       Outstanding at December 31, 2002                   1,555,000        1.00
          Granted                                         1,900,000        1.00
          Exercised                                        (187,500)       0.96
          Canceled or expired                                    --          --
                                                         -----------   ---------
       Outstanding at December 31, 2003                   3,267,500    $   1.00
                                                         ===========   =========

The estimated value of the options granted to consultants during the year ended
December 31, 2003 was determined using the Black-Scholes option pricing model
and the following assumptions: expected term of 3 to 10 years, a risk free
interest rate of 1.13%, a dividend yield of 0% and volatility of 118%. The
amount of the expense charged to operations in connection with granting the
options was $982,390 and $452,459 during the year ended December 31, 2003 and
2002, 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.

                                      F-26
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE I - STOCK OPTIONS AND WARRANTS (CONTINUED)

Warrants (Continued)
--------------------

              Warrants Outstanding                     Warrants Exercisable
              --------------------                     --------------------
                             Weighted Average    Weighted               Weighted
                                Remaining        Average                Average
    Exercise     Number        Contractual       Exercise    Number     Exercise
     Prices    Outstanding     Life (Years)       Price    Exercisable   Price
     ------    -----------     ------------       -------  -----------   -------
     $ .53        186,140         0.75            $  .53      186,140    $  .53
     $ .66         80,000         1.83            $  .66       80,000    $  .66
     $1.00      4,808,350         2.07            $ 1.00    4,808,350    $ 1.00
     $2.54         50,000         2.42            $ 2.54       50,000    $ 2.54
     $2.97         35,000         2.42            $ 2.97       35,000    $ 2.97
               -----------     --------           -------  -----------   -------
                5,159,490         2.03            $ 1.01    5,159,490    $ 1.01
               ===========     ========           =======  ===========   =======

Transactions involving warrants are summarized as follows:

                                                                       Weighted
                                                                        Average
                                                           Number      Price Per
                                                          of Shares      Share
                                                         -----------   ---------
       Outstanding at January 1, 2002                     3,528,665    $    .67
          Granted                                         1,667,460        0.87
          Exercised                                      (1,650,675)        .51
          Canceled or expired                               (13,990)       1.00
                                                         -----------   ---------
       Outstanding at December 31, 2002                   3,531,460    $   0.84
          Granted                                         8,591,800        1.01
          Exercised                                      (6,963,770)       0.92
          Canceled or expired                                    --          --
                                                         -----------   ---------
       Outstanding at December 31, 2003                   5,159,490    $   1.01
                                                         ===========   =========

The estimated value of the compensatory warrants granted to non-employees in
exchange for services and financing expenses was determined using the
Black-Scholes pricing model and the following assumptions: expected term of 3 to
8 years, a risk free interest rate of 1.13%, a dividend yield of 0% and
volatility of 118%. The amount of the expense charged to operations for
compensatory warrants granted in exchange for services was $30,872 and $170,330
during the year ended December 31, 2003 and 2002, respectively. The Company also
capitalized financing costs of $87,217 and $86,474 for compensatory warrants
granted in connection with placement of convertible debentures for the year
ended December 31, 2003 and 2002, respectively. The unamortized financing costs
were written off as of December 31, 2003 commensurate with the conversion of the
debentures (Note F).

NOTE J - RELATED PARTY TRANSACTIONS

A company officer has advanced funds to the Company for working capital
purposes. No formal repayment terms or arrangements exist. The net amount of
advances due the officer at December 31, 2002 was $4,830 and paid in full during
2003.

Significant shareholders of the Company had advanced funds to the Company for
working capital purposes. The amount of the advances at December 31, 2002 was
$125,500 and paid in full during 2003.

                                      F-27
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE J - RELATED PARTY TRANSACTIONS (CONTINUED)

In January 2003, the Company entered into an informal agreement with Warren V.
Musser, Chairman of the Board of Directors, pursuant to which the Company agreed
to pay Mr. Musser a commission equal to 8.0% of the aggregate value of Series B
Debentures purchased by persons referred to Telkonet, Inc. by Mr. Musser.
Pursuant to this agreement, Mr. Musser received $8,000 for the year ended
December 31, 2003.

In January 2003, the Company entered into an informal agreement with Howard
Lubert, Telkonet's formed Chief Executive Officer, pursuant to which we agreed
to pay Mr. Lubert a commission equal to 8.0% of the aggregate value of the
Series B Debentures purchased by persons referred to Telkonet, Inc. by Mr.
Lubert. Pursuant to this agreement, Mr. Lubert received $12,000 for the year
ended December 31, 2003.

In January 2003, the Company entered into an employment agreement with Ronald W.
Pickett, President to provide for an annual compensation of $100,000 and 3,000
shares of stock from the Employee Stock Option Plan for each month that he
serves as President. As of December 31, 2003, the Company has provided for the
issuance of 36,000 shares. These shares were issued in March 2004.

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, 2003, an aggregate of $33,333 of consulting
fees was charged to income pursuant to the agreement.

NOTE K - 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. Temporary differences between taxable
income reported for financial reporting purposes and income tax purposes are
insignificant.

For income tax reporting purposes, the Company's aggregate unused net operating
losses approximate $14,000,000 which expire through 2023, subject to limitations
of Section 382 of the Internal Revenue Code, as amended. The deferred tax asset
related to the carryforward is approximately $4,800,000. The Company has
provided a valuation reserve against the full amount of the net operating loss
benefit, because in the opinion of management based upon the earning history of
the Company, it is more likely than not that the benefits will not be realized.

Components of deferred tax assets as of December 31, 2003 are as follows:

          Non Current:
                 Net operating loss carryforward                    $ 4,800,000
                 Valuation allowance                                 (4,800,000)
                                                                    ------------
                 Net deferred tax asset                             $        --
                                                                    ============

                                      F-28
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE L - LOSSES PER COMMON SHARE

The following table presents the computations of basic and dilutive loss per
share:

<TABLE>
<CAPTION>
                                                                             For the period
                                                                             from November
                                                                              3, 1999 (date
                                                                          of inception) through
                                                 2003            2002      December 31, 2003
                                             -------------   -------------   -------------
<S>                                          <C>             <C>             <C>
Net loss available to common shareholders    $ (7,657,936)   $ (3,778,488)   $(14,116,612)
                                             =============   =============   =============
Basic and fully diluted loss per share       $      (0.37)   $      (0.22)   $      (0.82)
                                             =============   =============   =============
Weighted average common shares outstanding     20,702,482      17,119,639      17,191,965
                                             =============   =============   =============
</TABLE>

NOTE M - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

Accounts payable and accrued liabilities at December 31, 2003 and 2002 are as
follows:

                                                           2003           2002
                                                         ---------     ---------
        Accounts payable                                 $275,987      $360,015
        Accrued interest                                   67,350       115,560
        Accrued payroll and payroll taxes                 283,699        41,210
        Other                                               2,816         2,080
                                                         ---------     ---------
        Total                                            $629,852      $518,865
                                                         =========     =========

NOTE N - COMMITMENTS AND CONTINGENCIES

Office Leases
-------------

The Company leases office space on a month to month basis in Annapolis, Maryland
for its corporate offices. Additionally, the Company has entered into a
sub-lease agreement through November 2010 for office space which occupies
approximately 11,600 square feet in Germantown, MD anticipated to commence in
April 2004. The Company, which is responsible for an allocated portion of the
build-out cost of the office space, and is expected to incur approximately
$400,000 for leasehold improvements, security deposit, office furniture and
telephone equipment. As of December 31, 2003, the Company has prepaid $50,000
for leasehold improvements and $70,000 security deposit with the Landlord.
Commitments for minimum rentals under non cancelable leases at December 31, 2003
are as follows:

                          2004                        $  77,507
                          2005                          118,585
                          2006                          122,151
                          2007                          125,832
                          2008                          129,630
                          Thereafter                    259,541
                                                      ----------
                                                      $ 833,246
                                                      ==========

Rental expenses charged to operations for the year ended December 31, 2003 and
2002 are $74,777 and $69,986, respectively.

                                      F-29
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE N - COMMITMENTS AND CONTINGENCIES (CONTINUED)

Capital Lease Obligations
-------------------------

Computer equipment and software includes the following amounts for capitalized
leases at December 31, 2003 and 2002:

                                                             2003         2002
                                                          ---------     --------
Computer equipment and software                           $ 52,000      $    --

Less: accumulated depreciation and amortization             (5,200)          --
                                                          ---------     --------
                                                          $ 46,800      $    --
                                                          =========     ========

Future minimum lease payments required under the capital leases are as follows:

2004                                                                   $ 19,620
                                                                       ---------
Less: amount representing interest                                       (1,870)
                                                                       ---------
                                                                         17,750
Less: current portion                                                   (17,750)
                                                                       ---------
Long-term portion                                                      $     --
                                                                       =========

The Company had computer equipment and software purchased under non-cancelable
leases with an original cost of $52,000 as of December 31, 2003 and 2002.
Depreciation expense of $5,200 and $0 has been charged to operations as of
December 31, 2003 and 2002, respectively.

Employment and Consulting Agreements
------------------------------------

The Company has employment agreements with all of its employees. In addition to
salary and benefit provisions, the agreements include non-disclosure and
confidentiality provisions for the 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.

Litigation
----------

The Company is subject to other 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.

NOTE O - SUBSEQUENT EVENTS

In January 2004, certain senior note holders (see Note G) elected to convert
$2,539,000 of their senior notes into equity at a conversion price of $2.10 per
share. Additionally, convertible debenture holders (Debenture -1 and Series B)
elected to convert $172,000 of note into equity at a conversion price of $.50
and .55 per share. Warrants and stock option exercises also provided the Company
approximately $3.9 million of cash. In February 2004, the Company completed a
private offering to accredited investors of its common stock resulting in net
proceeds to the Company of approximately $12.8 million. The Company sold
6,387,600 shares of its common stock in this offering at a price equal to the
average closing price per share over the 30 trading day period ending February
5, 2004, discounted by 18%.



                                      F-30
<PAGE>

                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


NOTE O - SUBSEQUENT EVENTS (CONTINUED)

The proforma balance sheet as of December 31, 2003 illustrates the effect of the
equity transactions which occurred subsequent to the December 31, 2003. These
transactions consisted of:

         o        Receipt of approximately $3,900,000 in exchange for exercise
                  of approximately 4,300,000 of previously issued warrants to
                  acquire common stock (see Note I)

         o        Issuance of 300,000 shares of common stock in exchange for
                  approximately $172,000 of previously issued convertible
                  debentures, net of debt discount of approximately $107,000
                  (see Note F)

         o        Receipt of approximately $12,800,000 in exchange for 6,400,000
                  shares of the Company's restricted common stock issued in
                  connection with a private placement

         o        Issuance of 1,200,000 shares of common stock in exchange for $
                  2,500,000 of previously issued Senior Notes (see Note G)


<TABLE>
                                 TELKONET, INC.
                          (A DEVELOPMENT STAGE COMPANY)
                   CONDENSED UNAUDITED PROFORMA BALANCE SHEET
                                DECEMBER 31, 2003

<CAPTION>
                                                      December 31, 2003               December 31, 2003
                                                           Audited       Adjustment   Unaudited Proforma
                                                        -------------   -------------   -------------
<S>                                                     <C>             <C>             <C>
ASSETS
 CURRENT ASSETS:
 Cash and equivalents                                   $  5,177,918    $ 16,718,055    $ 21,895,973
 Other current assets                                        774,703              --         774,703
                                                        -------------   -------------   -------------

 Total current assets                                      5,952,621      16,718,055      22,670,676

 Other Assets                                                223.964              --         223,964
                                                        -------------   -------------   -------------

                                                        $  6,176,585    $ 16,718,055    $ 22,894,640
                                                        =============   =============   =============
LIABILITIES AND STOCKHOLDERS' EQUITY
 Current liabilities                                         656,051              --         656,051
 Convertible debentures, net of discounts -
     including related parties                               143,205         (64,480)         78,725
 Senior Notes Payable                                      2,989,000    $ (2,539,000)        450,000

Stockholders' equity                                       2,388,329      19,321,535      21,709,864
                                                        -------------   -------------   -------------

                                                        $  6,176,585    $ 16,718,055    $ 22,894,640
                                                        =============   =============   =============

                                      F-31


</TABLE>