<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)

                          20374 Seneca Meadows Parkway
                              Germantown, MD 20876
                    (Address of principal executive offices)

                                 (240) 912-1800
                           (Issuer's telephone number)

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

Indicate by check mark 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:   $698,652

Aggregate market value of the voting stock held by non-affiliates of the
registrant as of March 8 2005: $164,590,450

Number of outstanding shares of the registrant's par value $0.001 common stock
as of March 8, 2005: 44,496,755

<PAGE>

                                 TELKONET, INC.
                                   FORM 10-KSB
                                      INDEX

                                                                            Page
                                                                            ----
                                     Part I


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

Item 2.       Description of Property........................................  6

Item 3.       Legal Proceedings..............................................  6

Item 4.       Submission of Matters to a Vote of Security Holders............  6


                                     Part II

Item 5.       Market for Registrant's Common Equity, Related Stockholder
              Matters and Small Business Issuer Purchases of Securities......  7

Item 6.       Management's Discussion and Analysis of Financial
              Condition and Results of Operations............................  7

Item 7.       Financial Statements........................................... 14

Item 8.       Changes in and Disagreements with Accountants on
              Accounting and Financial Disclosure............................ 14

Item 8A.      Controls and Procedures........................................ 14

Item 8B.      Other Information.............................................. 14


                                    Part III

Item 9.       Directors and Executive Officers of the Registrant............. 14

Item 10.      Executive Compensation......................................... 17

Item 11.      Security Ownership of Certain Beneficial Owners and Management
              and Related Stockholder Matters................................ 20

Item 12.      Certain Relationships and Related Transactions................. 22


                                     Part IV

Item 13.      Exhibits and Reports on Form 8-K............................... 22

Item 14.      Principal Accounting Fees and Services......................... 23


<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 focused on development and marketing of its PLC
technology.

         The Company's PLC technology, the "PlugPlus(TM)" product suite,
consists of four primary components, the Gateway, the eXtender, 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 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, T-1/T-3, 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 20374 Seneca
Meadows Parkway, Germantown, MD 20876

         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
approximately 22,100,000 shares to 13,900,000 shares.

         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. In the fourth quarter of 2002, the Company
announced the successful installation of its PlugPlus(TM) product suite at an
historic inn in Augusta, Georgia and installation of a product field trial in
Wilmington, North Carolina.

         In the first quarter of 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 Company


                                       3
<PAGE>

also executed a strategic alliance agreement with Choice Hotels International
(NYSE: CHH), one of the largest hotel franchise companies in the world, pursuant
to which Telkonet agreed to become a Choice Hotels-endorsed vendor. 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 proceeds of the Note offering were designated for
working capital purposes.

         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 December 31, 2004, the
aggregate outstanding balance on the Senior Notes, including principal and
accrued but unpaid interest, was $450,000.

         In February 2004, the Company completed a private offering of its
common stock resulting in net proceeds of $12.8 million. The Company sold
6,387,600 shares of its common stock in the private offering. The proceeds of
the private placement were designated for working capital purposes.

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

         Several established networking vendors, including the Linksys Division
of Cisco Systems (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 residential marketplace.
While these companies may choose to move into the commercial market at a future
date, Linksys and Netgear do not presently represent a direct competitive threat
to Telkonet since they only market and sell their products in the residential
sector.

         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. Linksys and
Netgear have longer operating histories, greater name recognition and
substantially greater financial, technical, sales, marketing and other resources
than Telkonet. These potential competitors may, among other things, undertake
more extensive marketing campaigns, adopt more aggressive pricing policies,
obtain more favorable pricing from suppliers and manufacturers and exert more
influence on the sales channel than Telkonet can. As a result, Telkonet may not
be able to compete successfully with these potential competitors and these
potential competitors may develop or market technologies and products that are
more widely accepted than those being developed by Telkonet or that would render
Telkonet's products obsolete or noncompetitive.

         Management has focused its sales and marketing efforts primarily on the
commercial sector, which includes office buildings, hotels, schools, shopping
malls, commercial buildings, and multi-dwelling units, government facilities,
and any other commercial facilities that have a need for Internet access and
network connectivity. The Company has also focused on establishing relationships
with network administrator and systems administrator partners. Telkonet
continues 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.

         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
purchasing 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.

         CUSTOMERS
         ---------

         The Company is neither limited to, nor reliant upon, a single or
narrowly segmented consumer base from which it derives its revenues. Presently,
the Company is not dependent on any particular customer under contract. However,
the revenues from three major customers approximated 31% of sales for the year
ended December 31, 2004. 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. 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


                                       4
<PAGE>

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 its product offerings, or
be of commercial benefit to the Company.

         GOVERNMENT REGULATION
         ---------------------

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

         In Europe and other overseas markets, the Company's products are
subject to safety and RF emissions regulations adopted by the European Union
(EU) for Information Technology Equipment. In March 2005, the Company received
final Conformite Europeene (CE) certification, which is required for the Company
to freely market and sell its products within the EU. As a result of the
certification, the Company's products that will be sold and installed in EU
countries will bear the CE marking, a symbol that demonstrates that the product
has met the EU's regulatory standards and is approved for sale in the EU.

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

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

         During the years ended December 31, 2004 and 2003, the Company spent
$1,852,308 and $1,370,785 on research and development activities, respectively.
In 2004, research and development activities included (a) development of a
further cost-reduced ("G3") iBridge/eXtender, (b) router software development,
and (c) advanced encryption support. In 2003, research and development
activities included (a) improved network reach with the introduction of the
Company's secondary gateway, (b) the introduction of an encrypted
key-change-over-powerline feature to ease security management, (c) improved
ability to remotely monitor network status and the addition of a VLAN support
function for enhanced integration with subscriber management and billing
systems, and (d) development of the low-cost iBridge/eXtender products.

         LONG TERM INVESTMENT
         --------------------

         On November 30, 2004, the Company entered into a Stock Purchase
Agreement ("Agreement") with Amperion, Inc. ("Amperion"), a privately held
company. Amperion is engaged in the business of developing networking hardware
and software that enables the delivery of high-speed broadband data over
medium-voltage power lines. Pursuant to the Agreement, the Company invested
$500,000 in Amperion in exchange for 11,013,215 shares of Series A Preferred
Stock for an equity interest of approximately 4.7%. The Series A Preferred Stock
has a preferential right to receive dividends and with respect to liquidation.
The Series A Preferred Stock also votes as a single class with the shares of
common stock and Class C common stock, except with respect to certain
extraordinary matters, including an amendment to Amperion's certificate of
incorporation, an increase in the number of authorized shares of Preferred
Stock, the issuance of any class of stock having parity with or rights superior
to those of the Series A Preferred Stock and certain material transactions, in
which case, the Series A Preferred Stock must approve such extraordinary action
voting as a separate class. The Company has the right to designate one member of
Amperion's seven-person board of directors. The board of directors has
designated Warren "Pete" Musser, the Chairman of the board of directors of
Telkonet, to fill this position. Each share of Series A Preferred Stock is
entitled to one vote per share. The Company accounted for this investment under
the cost method, as the Company does not have the ability to exercise
significant influence over Amperion's operating or financial policies.

                                       5
<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 8, 2005, the Company had 57 full time employees. The
Company anticipates that it will hire additional key staff throughout 2005 in
the areas of business development, sales and marketing, and engineering.


ITEM 2.  DESCRIPTION OF PROPERTY.

         The Company presently leases 11,600 square feet of commercial office
space in Germantown, Maryland for its corporate headquarters. The Germantown
lease expires in November 2010. The Company also leases 1,800 square feet of
office space in White Marsh, Maryland where it operates a portion of its sales
and marketing activities. The White Marsh lease expires in May 2007. The Company
also leases a corporate apartment in Germantown, Maryland for an executive
officer. This lease expires in May 2005.

         In March 2005, the Company entered into a lease agreement for 6,742
square feet of commercial office space in Crystal City, Virginia. Pursuant to
this lease, the Company has agreed to assume an allocated portion of the
build-out cost for this facility. The Company intends to relocate majority of
its sales organization to the Crystal City facility on or about March 24, 2005
when the build-out is complete. The Company anticipates that it will spend
approximately $200,000 in connection with this relocation, which expenses
include security deposit, office furniture and telephone equipment. The Crystal
City lease expires in March 2008

ITEM 3.  LEGAL PROCEEDINGS.

         None.

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

         On October 22, 2004, the Company held its annual meeting of
stockholders at which the Company's stockholders were asked to elect seven (7)
directors to serve on the Company's Board of Directors, ratify certain stock
options granted under the Telkonet, Inc. Amended and Restated Stock Incentive
Plan, ratify the Company's Audit Committee Charter and ratify the appointment of
the Company's independent accountants for 2004. The following directors were
elected at the annual meeting based on the number of votes indicated below. Each
director was elected to serve until the next annual meeting of stockholders or
until his successor is elected and qualified.

<TABLE>
      DIRECTOR NAME                 FOR                  AGAINST                ABSTAIN           BROKER NON-VOTES
      -------------                 ---                  -------                -------           ----------------
<S>                             <C>                         <C>                 <C>                      <C>
Warren V. Musser                31,387,735                  0                   260,762                  0

Ronald W. Pickett               31,291,235                  0                   357,262                  0

David W. Grimes                 31,388,935                  0                   259,562                  0

Stephen L. Sadle                31,292,835                  0                   355,662                  0

Thomas C. Lynch                 31,568,967                  0                   79,530                   0

James L. Peeler                 31,564,467                  0                   84,030                   0

Thomas M. Hall                  31,568,467                  0                   80,030                   0

</TABLE>

                                       6
<PAGE>

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

<TABLE>

      MATTER VOTED UPON                FOR                  AGAINST              ABSTAIN          BROKER NON-VOTES
      -----------------                ---                  -------              -------          ----------------
<S>                                 <C>                     <C>                  <C>                 <C>
Ratification of Stock Options       14,572,463              639,826              277,300             16,158,908

Ratification of Audit
Committee Charter                   31,489,996              84,486                74,015                  0

Ratification of Independent
Accountants                         31,394,774              70,000               183,723                  0

</TABLE>

                                     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 (AMEX) under the ticker symbol "TKO." Prior to
January 24, 2004, the Company's common stock was quoted on the OTC Bulletin
Board under the symbol "TLKO.OB." As of March 8, 2005, the Company had 370
stockholders of record and 44,496,755 shares of its common stock issued and
outstanding.

         The following table documents the high and low sales prices for the
Company's common stock on the AMEX for the period beginning January 24, 2004
through December 31, 2004. The information provided for the period prior to
January 24, 2004 was obtained from the Yahoo! Finance web site.

                                                          HIGH             LOW
                                                          ----             ---
YEAR ENDED DECEMBER 31, 2004
         First  Quarter..............................     $5.48           $2.54
         Second Quarter..............................     $5.32           $3.00
         Third Quarter...............................     $3.50           $2.20
         Fourth Quarter..............................     $5.98           $2.61
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

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

         During the three months ended December 31, 2004, the Company agreed to
issue 9,000 shares of common stock to Ronald W. Pickett, the Company's President
and Chief Executive Officer, pursuant to his employment agreement dated January
20, 2004. This issuance of shares was made 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.

ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OPERATION.

         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.

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

         The Company emerged from its development stage as of December 31, 2003
and began generating revenues from operations late in the fourth quarter of
2003. 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 powerline 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


                                       7
<PAGE>

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 returns experienced by the Company,
and general economic conditions specific to the Internet, powerline
communications and the communications industries generally.

         REVENUES
         --------

         The Company emerged from its development stage as of December 31, 2003.
Therefore, there were no comparable revenues in the prior year. During the year,
the Company changed its sales model in the Hospitality and Multi-Dwelling
markets from principally product sales to a recurring (lease) sales model.
Accordingly, revenues are recognized over a three to five year term. The table
below outlines product versus recurring (lease) revenues for each quarter in
2004:

<TABLE>
                      ------------------------------------------------------------------------------------ --------------------
                                                             2004
                      ------------------------------------------------------------------------------------ --------------------
Revenue:                 1st. Quarter         2nd. Quarter          3rd.Quarter          4th. Quarter         Year-to-Date
<S>                      <C>          <C>     <C>          <C>     <C>           <C>    <C>           <C>   <C>            <C>
Recurring (lease)        20,309       14%     45,880       17%     69,209        87%    85,699        41%   221,097        32%
Product                 119,790       86%    226,022       83%     10,126        13%   121,617        59%   477,555        68%
                      ---------- --------- ---------- --------- ---------- ---------- --------- ---------- --------- ----------
Total                   140,099      100%    271,902      100%     79,335       100%   207,316       100%   698,652       100%
                      ========== ========= ========== ========= ========== ========== ========= ========== ========= ==========
</TABLE>

         RECURRING REVENUE

         As of December 31, 2004, revenues to be recognized under non-cancelable
contracts (backlog) was approximately $933,000 with a weighted average remaining
term of approximately 31 months. The remaining costs to be amortized in
connection with these contracts is approximately $451,000.

         PRODUCT REVENUE

         Product revenue principally arises from the sale of iBridges and other
PlugPlus(TM) components directly to customers. Revenues to date have primarily
been derived from the Hospitality and Multi-Dwelling business units. The Company
has expanded its marketing efforts in the International and Government markets
and anticipates full deployment of its product upon successful product
certification in each of these respective markets. In March 2005, the Company
received European certification of its products and anticipates the initiation
of revenue opportunities in the second quarter of 2005.

         COST OF SALES
         -------------

         The Company emerged from its development stage as of December 31, 2003.
Therefore, there were no comparable costs of sales in the prior year. During the
year, the Company changed its sales model in the Hospitality and Multi-Dwelling
markets from principally product sales to a recurring (lease) sales model. Total
cost of sales amounted to $542,859 and gross margin approximately 22% of total
revenue for the year ended December 31, 2004.

         OPERATING EXPENSES
         ------------------

         Overall expenses increased for the year ended December 31, 2004 over
the prior year by $6,714,732 or 102%. Excluding the fee paid pursuant to certain
agreements with consultants of $2,500,000 expensed during the second quarter,
the increase for the year was $4,214,732 or 64%. This increase is principally
due to payroll and related costs for administrative sales and marketing,
non-employee compensation for services, advertising and trade show attendance,
and rent and related relocation costs for our corporate and sales offices.

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

         As of December 31, 2004, the Company's current assets exceeded current
liabilities by $12,671,520. Of the total current assets of $13,900,419, cash
represented $11,838,702 of this amount as of December 31, 2004.

         While the Company believes it has sufficient capital to meet its
working capital requirements for the next twelve months, additional financing
may be required in order to meet growth opportunities in financing and/or
investing activities. If additional capital is required and the Company is not
successful in generating sufficient liquidity from operations or in raising
sufficient capital resources on terms acceptable to the Company, this could have
a material adverse effect on the Company's business, results of operations,
liquidity and financial condition.

                                       8
<PAGE>

         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

         In February 2004, Telkonet completed a private placement 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.

         In March 2004, the Company received $3.9 million upon the exercise of
4,235,007 warrants to purchase the Company's common stock. Additionally, $0.2
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 expended in the period incurred. Total expenses
for the year ended December 31, 2004 increased over the comparable prior year by
$481,523, or 35%. This increase was primarily related to an increase in salaries
and related costs associated with the addition of 2 full-time employees and
costs related to independent lab testing and certification of the Company's
product.

         SELLING, GENERAL AND ADMINISTRATIVE
         -----------------------------------

         Selling, general and administrative expenses increased for the year
ended December 31, 2004 over the comparable prior year by $3,574,197 or 87%. The
increase is related to an increase in payroll and associated costs for
management, sales and marketing resources, advertising and trade show attendance
and related relocation costs for corporate and new sales offices.

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

         During the year ended December 31, 2004, fixed assets increased
$513,441, which is primarily related to leasehold improvements associated with
the Company's relocation of its corporate offices to Germantown, Maryland. The
Company does not anticipate the sale or purchase of any significant property,
plant or equipment during the next twelve months, other than purchases of
leasehold improvements, computer equipment and peripherals to be used in the
Company's day-to-day operations.

         In March 2005, the Company entered into a lease agreement for 6,742
square feet of commercial office space in Crystal City, Virginia. Pursuant to
this lease, the Company has agreed to assume a portion of the build-out cost for
this facility. The Company anticipates that it will spend approximately $200,000
in connection with this relocation, which expenses include security deposit,
office furniture and telephone equipment.

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

         As of March 8, 2005, the Company had fifty-seven (57) 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 8, 2005 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 November 2004, the Financial Accounting Standards Board (FASB)
issued SFAS 151, Inventory Costs--an amendment of ARB No. 43, Chapter 4. This
Statement amends the guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to
clarify the accounting for abnormal amounts of idle facility expense, freight,
handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter
4, previously stated that ". . . under some circumstances, items such as idle
facility expense, excessive spoilage, double freight, and rehandling costs may
be so abnormal as to require treatment as current period charges. . . ." This
Statement requires that those items be recognized as current-period charges


                                       9
<PAGE>

regardless of whether they meet the criterion of "so abnormal." In addition,
this Statement requires that allocation of fixed production overheads to the
costs of conversion be based on the normal capacity of the production
facilities. This Statement is effective for inventory costs incurred during
fiscal years beginning after June 15, 2005. Management does not believe the
adoption of this Statement will have any immediate material impact on the
Company.

         In December 2004, FASB issued SFAS No.152, "Accounting for Real Estate
Time-Sharing Transactions--an amendment of FASB Statements No. 66 and 67" (SFAS
152). This Statement amends FASB Statement No. 66, Accounting for Sales of Real
Estate, to reference the financial accounting and reporting guidance for real
estate time-sharing transactions that is provided in AICPA Statement of Position
(SOP) 04-2, Accounting for Real Estate Time-Sharing Transactions. This Statement
also amends FASB Statement No. 67, Accounting for Costs and Initial Rental
Operations of Real Estate Projects, to state that the guidance for (a)
incidental operations, and (b) costs incurred to sell real estate projects does
not apply to real estate time-sharing transactions. The accounting for those
operations and costs is subject to the guidance in SOP 04-2. This Statement is
effective for financial statements for fiscal years beginning after June 15,
2005, with earlier application encouraged. The Company does not anticipate that
the implementation of this standard will have a material impact on its financial
position, results of operations or cash flows.

         On December 16, 2004, FASB published Statement of Financial Accounting
Standards No. 123 (Revised 2004), Share-Based Payment (SFAS 123R). SFAS 123R
requires that compensation cost related to share-based payment transactions be
recognized in the financial statements. Share-based payment transactions within
the scope of SFAS 123R include stock options, restricted stock plans,
performance-based awards, stock appreciation rights, and employee share purchase
plans. The provisions of SFAS 123R are effective as of the first interim period
that begins after June 15, 2005. Accordingly, the Company will implement the
revised standard in the third quarter of fiscal year 2005. Currently, the
Company accounts for its share-based payment transactions under the provisions
of APB 25, which does not necessarily require the recognition of compensation
cost in the financial statements. Management is assessing the implications of
this revised standard, which may materially impact the Company's results of
operations in the third quarter of fiscal year 2005 and thereafter.

         On December 16, 2004, FASB issued Statement of Financial Accounting
Standards No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion
No. 29, Accounting for Nonmonetary Transactions (SFAS 153). This statement
amends APB Opinion 29 to eliminate the exception for nonmonetary exchanges of
similar productive assets and replaces it with a general exception for exchanges
of nonmonetary assets that do not have commercial substance. Under SFAS 153, if
a nonmonetary exchange of similar productive assets meets a commercial-substance
criterion and fair value is determinable, the transaction must be accounted for
at fair value resulting in recognition of any gain or loss. SFAS 153 is
effective for nonmonetary transactions in fiscal periods that begin after June
15, 2005. The Company does not anticipate that the implementation of this
standard will have a material impact on its financial position, results of
operations or cash flows.


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

         Telkonet emerged from its development stage as of December 31, 2003. As
a result, it has a limited operating history upon which to base an evaluation of
its current business and future prospects. The Company has not generated
substantial revenues since its inception. Because of the Company's limited
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 the 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;

                                       10
<PAGE>

         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.

         Since inception through December 31, 2004, the Company has incurred
cumulative losses of $27,209,272 and has never generated enough funds through
operations to support its business. The Company expects to continue to incur
substantial operating losses through 2005. 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.

                                       11
<PAGE>

         As of March 8, 2005, the Company's officers and directors owned 22.6%
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.

         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, 2004, the Company had outstanding employee options
to purchase a total of 9,614,767 shares of common stock at exercise prices
ranging from $1.00 to $4.42 per share, with a weighted average exercise price of
$1.61. As of December 31, 2004, the Company had outstanding non-employee options
to purchase a total of 1,999,169 shares of common stock at exercise prices of
$1.07 per share. As of December 31, 2004, the Company had warrants outstanding
to purchase a total of 575,900 shares of common stock at exercise prices ranging
from $1.00 to $2.97 per share, with a weighted average exercise price of $1.12.
In addition, as of December 31, 2004, the Company had 33,973 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.

         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.

                                       12
<PAGE>

         The market for powerline communications products is highly competitive.
The Company believes it has the only commercial integrated three phase solution
for "in-building" distribution of broadband utilizing the electrical wiring
infrastructure. The Linksys Division of Cisco Systems, Inc. (Linksys) and
Netgear, Inc. offer similar PLC solutions for the residential market. Although
Linksys and Netgear do not presently compete with the Company in the commercial
market, there can be no assurance that Linksys, 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 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


                                       13
<PAGE>

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

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

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

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, 2004, the Company 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 the Company's disclosure controls and
procedures are effective in timely alerting them to material information
required to be included in the Company's periodic filings with the U.S.
Securities and Exchange Commission. There were no significant changes in the
Company's internal controls or in other factors that could materially affected
or are reasonable likely to materially affect, the Company's internal controls
subsequent to the date of the most recent evaluation.

ITEM 8B. OTHER INFORMATION.

         None.

                                    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, 2004. The
directors of the Company are elected every year and serve until their successors
are duly elected and qualified.

<TABLE>

     Name                             Age             Title
     ----                             ---             -----
<S>                                   <C>             <C>
     Ronald W. Pickett                57              President, Director & Chief Executive Officer

     David Powell                     53              Managing Director, International

     Robert P. Crabb                  57              Corporate Secretary

     E. Barry Smith                   54              Chief Financial Officer

     Stephen Sadle                    59              Senior Vice President & Director

     James Landry                     49              Chief Technology Officer


                                       14
<PAGE>

     Name                             Age             Title
     ----                             ---             -----

     Warren V. Musser                 78              Chairman of the Board

     David Grimes                     67              Director

     Thomas C. Lynch                  62              Director

     Dr. Thomas M. Hall               53              Director

     James L. "Lou" Peeler            71              Director

</TABLE>

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

         Mr. Pickett has served as the Company's Chief Executive Officer since
January 2003. In addition, he has fostered the development of Telkonet since
1999 as the Company's principle investor and Co-Founder. He was the Founder, and
for twenty years served as the Chairman of the Board and President of Medical
Advisory Systems, Inc., 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--MANAGING DIRECTOR,  INTERNATIONAL

         Mr. Powell is the Managing Director, International and is responsible
for growing Telkonet's business by developing, marketing and selling the
Company's high-speed Internet access systems outside the United States. 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.

E. BARRY SMITH--CHIEF FINANCIAL OFFICER

         Mr. Smith has served as the Company's Chief Financial Officer since
February 2003. 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.

                                       15
<PAGE>

JAMES F. LANDRY--CHIEF TECHNOLOGY OFFICER

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

ROBERT P. CRABB--CORPORATE SECRETARY

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

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.

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.

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, Armed Forces Benefit
Association, Catholic Leadership Institute, National Center for the American
Revolution at Valley Forge and Mikros Systems. Mr. Lynch has been a director of
the Company since October 2003.

DR. THOMAS M. HALL--DIRECTOR

         Dr. Hall is the Executive Director of Digital Angel Corporation and the
Managing Partner of Marrell Enterprises LLC, a company that specializes in
international business development. Dr. Hall is a consultant to Coris
International SA, a Paris-based insurance services company with subsidiaries in
36 countries. For 12 years, Dr. Hall was the chief executive officer of Medical
Advisory Systems, Inc., a company providing international medical services and
pharmaceutical distribution. Dr. Hall holds a bachelor of science and a medical
degree from the George Washington University and a master of international
management degree from the University of Maryland. Dr. Hall has been a director
of the Company since April 2004.

                                       16
<PAGE>

JAMES L. "LOU" PEELER--DIRECTOR

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

         The Company maintains an Audit Committee of the Board of Directors. For
the year ended December 31, 2004, Messrs. Hall, Lynch and Peeler served on the
Audit Committee. The Company's Board of Directors has determined that each of
Messrs. Hall 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. Hall, Lynch and Peeler are "independent" as such term is defined
in Item 7(d)(3)(iv) of Schedule 14A promulgated under the Securities Exchange
Act of 1934. The Board of Directors has adopted an audit committee charter,
which was ratified by the Company's stockholders.

         The Company has also 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 was filed as
Exhibit 14 to the Company's Annual Report on Form 10-KSB for the year ended
December 31, 2003. In addition, the Company will provide a copy of its Code of
Ethics free of charge upon request to any person submitting a written request to
the Company's Chief Executive Officer.

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, 2004, 2003 and 2002 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, 2004, 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, 2004.

<TABLE>
                                                     SUMMARY COMPENSATION TABLE

 ------------------------ -------------------------------------------------- -------------------------------------------- ----------
                                         ANNUAL COMPENSATION                           LONG TERM COMPENSATION
 ------------------------ -------------------------------------------------- ------------------------------ ------------- ----------
                                                                                        AWARDS                PAYOUTS
 ------------------------ ------- -------------- -------- ------------------ ---------------- ------------- ------------- ----------
           (a)             (b)         (c)         (d)           (e)               (f)            (g)           (h)          (i)
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------
                                                                                             SECURITIES
                                                                              RESTRICTED   UNDERLYING/OPTION               ALL OTHER
 NAME AND PRINCIPAL                               BONUS      OTHER ANNUAL        STOCK           SARS                       COMPEN-
     POSITION             YEAR    SALARY ($)       ($)       COMPENSATION         ($)            (#)        LTIP PAYOUTS    SATION
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------
<S>                       <C>            <C>      <C>      <C>                 <C>          <C>              <C>           <C>
 Ronald W. Pickett
 President & Chief
 Executive Officer        2003           91,538        -                  -    64,460 (1)                -             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------

                          2004          100,089        -                  -   107,779 (1)                -             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------
 Robert Crabb
 Corporate Secretary      2002            8,500        -                  -             -                -             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------

                          2003          120,000        -                  -             -          500,000             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------

                          2004          172,167    6,538                  -             -                -             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------
 Howard Lubert
 Former Chief Executive
 Officer                  2003          162,083(2)     -                  -             -                -             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------

                          2004          130,000(2)
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------


                                       17
<PAGE>

 ------------------------ -------------------------------------------------- -------------------------------------------- ----------
                                         ANNUAL COMPENSATION                           LONG TERM COMPENSATION
 ------------------------ -------------------------------------------------- ------------------------------ ------------- ----------
                                                                                        AWARDS                PAYOUTS
 ------------------------ ------- -------------- -------- ------------------ ---------------- ------------- ------------- ----------
           (a)             (b)         (c)         (d)           (e)               (f)            (g)           (h)          (i)
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------
                                                                                             SECURITIES
                                                                              RESTRICTED   UNDERLYING/OPTION               ALL OTHER
 NAME AND PRINCIPAL                               BONUS      OTHER ANNUAL        STOCK           SARS                       COMPEN-
     POSITION             YEAR    SALARY ($)       ($)       COMPENSATION         ($)            (#)        LTIP PAYOUTS    SATION
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------

 Stephen L. Sadle
 Sr. Vice President       2002          130,000        -                  -             -                -             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------

                          2003          130,000        -                  -                        900,000             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------
                          2004          171,983    6,538                  -                              -             -           -

 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------
 Jim Landry
 Chief Technology
 Officer                  2002          116,000        -                  -                        225,000             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------

                          2003          160,000   10,000                  -                        100,000             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------

                          2004          172,514   15,000                  -                        250,000             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------

 E. Barry Smith
 Chief Financial Officer  2003          115,539        -                  -                        500,000             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------

                          2004          171,983   15,000                  -                              -             -           -
 ------------------------ ------- -------------- -------- ------------------ ------------- ---------------- ------------- ----------
</TABLE>

(1) In each year ending December 31, 2004 and 2003, Mr. Pickett earned 36,000
shares issued under the Company's Employee Stock Incentive Plan as additional
compensation pursuant to his employment agreement. The fair market value of
these shares upon issuance was $64,460 and $107,779, respectively.

(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. The Company paid Mr. Lubert's salary through December
14, 2004 at an annual rate of $130,000. Mr. Lubert's salary of $130,000 was paid
in 2004, but accrued in 2003.

                      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, 2004, to the persons listed on the
Summary Compensation Table.

<TABLE>
                                                                   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>
       James Landry                          250,000                 11.9%             $3.45          04/2014
       ---------------------------- --------------------------- ----------------- ---------------- ---------------
       Ronald W. Pickett                        0                      0%               n/a             n/a
       ---------------------------- --------------------------- ----------------- ---------------- ---------------
       Robert Crabb                             0                      0%               n/a             n/a
       ---------------------------- --------------------------- ----------------- ---------------- ---------------
       Stephen L. Sadle                         0                      0%               n/a             n/a
       ---------------------------- --------------------------- ----------------- ---------------- ---------------
       E. Barry Smith                           0                      0%               n/a             n/a
       ---------------------------- --------------------------- ----------------- ---------------- ---------------
</TABLE>

                                       18
<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, 2004 by those persons listed on the
Summary Compensation Table.

<TABLE>
                                                                                           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>
       Ronald W. Pickett                       -                   -                   -0-                -0-
                                                                                       -0-                -0-
       --------------------------------------- ------------------- ------------------- ------------------ -------------------
       Robert Crabb                            -                   -                   333,333/           1,520,000/
                                                                                       166,667            760,000
       --------------------------------------- ------------------- ------------------- ------------------ -------------------
       Stephen L. Sadle                        -                   -                   600,000/           2,736,000/
                                                                                       300,000            1,368,000
       --------------------------------------- ------------------- ------------------- ------------------ -------------------
       James Landry                            100,000             350,000             208,333/           950,000/
                                                                                       291,667            717,500
       --------------------------------------- ------------------- ------------------- ------------------ -------------------
       E. Barry Smith                          25,000              89,350              305,333/           1,392,320/
                                                                                       166,667            760,000
       --------------------------------------- ------------------- ------------------- ------------------ -------------------
</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 $48,000 annually and $1,000 for
each meeting of the Board of Directors. For the year ended December 31, 2004,
each non-management director received an aggregate of $3,000 for his attendance
at board of directors meetings. 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 $3.45 per share for options issued after
April 1, 2004 and $2.00 per share for options issued through March 31, 2004.

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

         Stephen L. Sadle, Senior Vice President, is employed pursuant to an
employment agreement for a three-year term that commenced January 18, 2003 and
provides for an annual salary of $130,000 and bonuses and benefits based upon
Telkonet's internal policies. Mr. Sadle's annual salary was increased to
$171,872 in 2004 and he received a bonus of $6,538.

         James Landry, Chief Technology Officer, has been employed since
September 24, 2001 with an annual salary of $160,000 with bonuses and benefits
based upon Telkonet's internal policies. Mr. Landry's annual salary was
increased to $176,508 in 2004 and he received a bonus of $15,000 for the year
ended December 31, 2004.

         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
$172,340 in 2004 and he received a bonus of $6,538.

         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. Mr. Pickett's annual salary was
increased to $102,340 on August 1, 2004.

                                       19
<PAGE>

         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
$171,872 in 2004 and he received a bonus of $15,000.

         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, in connection with Mr. Lubert's separation from the Company, Telkonet
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 AND
         RELATED STOCKHOLDER MATTERS.

         The following table provides information concerning securities
authorized for issuance pursuant to equity compensation plans approved by the
Company's stockholders and equity compensation plans not approved by the
Company's stockholders as of December 31, 2004.

<TABLE>
                                                                                                    NUMBER OF SECURITIES
                                                                                                   REMAINING AVAILABLE FOR
                                              NUMBER OF SECURITIES TO      WEIGHTED -AVERAGE        FUTURE ISSUANCE UNDER
                                              BE ISSUED UPON EXERCISE      EXERCISE PRICE OF      EQUITY COMPENSATION PLANS
                                              OF OUTSTANDING OPTIONS,    OUTSTANDING OPTIONS,       (EXCLUDING SECURITIES
                                                WARRANTS AND RIGHTS       WARRANTS AND RIGHTS     REFLECTED IN COLUMN (a))
       -------------------------------------- ------------------------- ------------------------ ----------------------------
                                                        (a)                       (b)                         (c)
       -------------------------------------- ------------------------- ------------------------ ----------------------------
        <S>                                          <C>                         <C>                       <C>
        EQUITY COMPENSATION PLANS APPROVED
                BY SECURITY HOLDERS                  15,000,000                  $1.52                     33,973
       -------------------------------------- ------------------------- ------------------------ ----------------------------
           EQUITY COMPENSATION PLANS NOT
           APPROVED BY SECURITY HOLDERS                 n/a                       n/a                        n/a
       -------------------------------------- ------------------------- ------------------------ ----------------------------
                       TOTAL                         15,000,000                  $1.52                     33,973
       -------------------------------------- ------------------------- ------------------------ ----------------------------
</TABLE>

         The following table sets forth, as of March 8, 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 Company's outstanding common stock. As of March 8, 2004, there were
no issued and outstanding shares of any other class of the Company's equity
securities.

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

OFFICERS AND DIRECTORS
----------------------------------------------------- ------------------------------------- --------------------------
<S>                                                                <C>                                <C>
Ronald W. Pickett, President and CEO
20374 Seneca Meadows Parkway
Germantown, MD  20876                                            2,109,205                            4.7%
----------------------------------------------------- ------------------------------------- --------------------------

E. Barry Smith, Chief Financial Officer
20374 Seneca Meadows Parkway
Germantown, MD  20876                                              408,579 (1)                        0.9%
----------------------------------------------------- ------------------------------------- --------------------------

Stephen L. Sadle, Senior Vice President
20374 Seneca Meadows Parkway
Germantown, MD  20876                                            3,900,514 (2)                        8.6%
----------------------------------------------------- ------------------------------------- --------------------------

                                       20
<PAGE>

----------------------------------------------------- ------------------------------------- --------------------------
NAME AND ADDRESS OF BENEFICIAL OWNER                       SHARES BENEFICIALLY OWNED           PERCENTAGE OF CLASS
----------------------------------------------------- ------------------------------------- --------------------------

OFFICERS AND DIRECTORS
----------------------------------------------------- ------------------------------------- --------------------------

James Landry, Chief Technology Officer
20374 Seneca Meadows Parkway
Germantown, MD  20876                                              352,950 (3)                        0.8%
----------------------------------------------------- ------------------------------------- --------------------------

Robert P. Crabb, Corporate Secretary
20374 Seneca Meadows Parkway
Germantown, MD  20876                                              375,000 (4)                        0.8%
----------------------------------------------------- ------------------------------------- --------------------------

Warren V. Musser, Chairman
20374 Seneca Meadows Parkway
Germantown, MD  20876                                            1,735,027 (5)                        3.8%
----------------------------------------------------- ------------------------------------- --------------------------

David Grimes, Director
20374 Seneca Meadows Parkway
Germantown, MD  20876                                            1,435,405 (6)                        3.2%
----------------------------------------------------- ------------------------------------- --------------------------

Thomas C. Lynch, Director
20374 Seneca Meadows Parkway
Germantown, MD  20876                                               60,000 (7)                        0.1%
----------------------------------------------------- ------------------------------------- --------------------------

Dr. Thomas M. Hall, Director
20374 Seneca Meadows Parkway
Germantown, MD  20876                                              546,640 (8)                        1.2%
----------------------------------------------------- ------------------------------------- --------------------------

James "Lou" L. Peeler, Director
20374 Seneca Meadows Parkway
Germantown, MD  20876                                               40,000 (9)                        0.1%
----------------------------------------------------- ------------------------------------- --------------------------


All Directors and Executive Officers as a Group                 10,963,320                           22.6%
----------------------------------------------------- ------------------------------------- --------------------------

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

Stephen L. Sadle
20374 Seneca Meadows Parkway
Germantown, MD  20876                                            3,900,514 (2)                        8.6%
----------------------------------------------------- ------------------------------------- --------------------------
</TABLE>

_____________________
(1)      Includes options exerciseable within 60 days to purchase 375,000 shares
         of the Company's common stock at $1.00 per share.
(2)      Includes options exerciseable within 60 days to purchase 675,000 shares
         of the Company's common stock at $1.00 per share.
(3)      Includes options exerciseable within 60 days to purchase 218,750 and
         50,000 shares of the Company's common stock at $1.00 and $3.45 per
         share, respectively.
(4)      Includes options exerciseable within 60 days to purchase 375,000 shares
         of the Company's common stock at $1.00 per share.
(5)      Includes options exerciseable within 60 days to purchase 1,500,000
         shares of the Company's common stock at $1.00 per share.
(6)      Includes options exerciseable within 60 days to purchase 675,000 shares
         of the Company's common stock at $1.00 per share.
(7)      Includes options exerciseable within 60 days to purchase 20,000 and
         40,000 shares of the Company's common stock at $2.00 and $3.45 per
         share, respectively.
(8)      Includes options exerciseable within 60 days to purchase 40,000 shares
         of the Company's common stock at $3.45 per share.
(9)      Includes options exerciseable within 60 days to purchase 40,000 shares
         of the Company's common stock at $3.45 per share.

                                       21
<PAGE>

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

         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. For the year ended December 31, 2004 and 2003,
the Company paid and expensed $100,000 and $33,333, respectively. Warren Musser,
Chairman of the Board of Directors, is a principal of the Musser Group.

                                     PART IV

ITEM 13. EXHIBITS.

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 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
10.3              Employment Agreement by and between Telkonet, Inc. and Robert
                  P. Crabb, dated as of January 18, 2003 (incorporated by
                  reference to our Registration Statement on Form S-1 (No.
                  333-108307), filed on August 28, 2003)
10.4              Employment Agreement by and between Telkonet, Inc. and Ronald
                  W. Pickett, dated as of January 30, 2003 (incorporated by
                  reference to our Registration Statement on Form S-1 (No.
                  333-108307), filed on August 28, 2003)
10.5              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 (incorporated by reference to our Form 10-KSB
                  (No. 001-31972), filed on March 30, 2004).
21                Telkonet, Inc. Subsidiaries (incorporated by reference to our
                  Registration Statement on Form S-1 (No. 333-108307), filed on
                  August 28, 2003)
23                Consent of Registered Independent Certified Public Accountants
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

                                       22
<PAGE>

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, 2004 and 2003

       -------------------------- ----------------- -----------------
                                  DECEMBER 31, 2004 DECEMBER 31, 2003
       -------------------------- ----------------- -----------------
       1.  Audit Fees               $    63,875        $    53,925
       -------------------------- ----------------- -----------------
       2.  Audit Related Fees            23,900                 --
       -------------------------- ----------------- -----------------
       3.  Tax Fees                       5,000              3,000
       -------------------------- ----------------- -----------------
       4.  All Other Fees                    --                 --
       -------------------------- ----------------- -----------------
            Total Fees              $    92,775        $    56,925
       -------------------------- ----------------- -----------------

         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."

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

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

         Prior to the Company's engagement of its independent auditor, such
engagement is approved by the Company's audit committee. The services provided
under this engagement may include audit services, audit-related services, tax
services and other services. Pre-approval is generally provided for up to one
year and any pre-approval is detailed as to the particular service or category
of services and is generally subject to a specific budget. Pursuant to the
Company's Audit Committee Charter, the independent auditors and management are
required to report to the Company's audit committee at least quarterly regarding
the extent of services provided by the independent auditors in accordance with
this pre-approval, and the fees for the services performed to date. The audit
committee may also pre-approve particular services on a case-by-case basis. All
audit fees, audit-related fees, tax fees and other fees incurred by the Company
for the year ended December 31, 2004, were approved by the Company's audit
committee.

                                       23
<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 30, 2005
------------------------
Warren V. Musser


/s/ Ronald W.  Pickett       Chief Executive Officer &
------------------------     Director                          March 30, 2005
Ronald W.  Pickett


/s/ E. Barry Smith           Chief Financial Officer           March 30, 2005
------------------------
E. Barry Smith


/s/ James Landry             Chief Technology Officer
------------------------
James Landry                                                   March 30, 2005


/s/ Stephen L. Sadle         Senior Vice President &
------------------------
Stephen L. Sadle             Director                          March 30, 2005


/s/ Dr. Thomas M. Hall
------------------------
Dr. Thomas M. Hall           Director                          March 30, 2005


/s/ James L. Peeler
------------------------
James L. Peeler              Director                          March 30, 2005


/s/ David Grimes             Director                          March 30, 2005
------------------------
David Grimes


/s/ Thomas C. Lynch          Director                          March 30, 2005
------------------------
Thomas C. Lynch


                                       24
<PAGE>


                       SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549



                       FINANCIAL STATEMENTS AND SCHEDULES

                           DECEMBER 31, 2004 AND 2003



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


                                 TELKONET, INC.


                                       F-1

<PAGE>


<TABLE>
                                                    TELKONET, INC.

                                            INDEX TO FINANCIAL STATEMENTS

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


<S>                                                                                                                 <C>
Report of Registered Independent Certified Public Accountants                                                     F-3

Consolidated Balance Sheets at December 31, 2004 and 2003                                                         F-4

Consolidated Statements of Losses for the Years ended December 31, 2004 and 2003                                  F-5

Consolidated Statements of  Stockholders' Equity for the Years ended December 31, 2004 and 2003             F-6 - F-7

Consolidated Statements of Cash Flows for the Years ended December 31, 2004 and 2003                        F-8 - F-9

Notes to Consolidated Financial Statements                                                                F-10 - F-26


                                                         F-2
</TABLE>
<PAGE>

                    RUSSELL BEDFORD STEFANOU MIRCHANDANI LLP
                          CERTIFIED PUBLIC ACCOUNTANTS

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


Board of Directors
Telkonet, Inc.
Germantown, MD


         We have audited the accompanying consolidated balance sheets of
Telkonet, Inc. and its wholly-owned subsidiary (the "Company") as of December
31, 2004 and 2003 and the related consolidated statements of losses,
stockholders' equity, and cash flows for the two years then ended. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based upon
our audit.

         We conducted our audits in accordance with standards of the Public
Company Accounting Oversight Board (United States of America). Those standards
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatements. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe our
audits provide a reasonable basis for our opinion.

         In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Telkonet,
Inc. and its wholly-owned subsidiary as of December 31, 2004 and 2003, and the
results of its operations and its cash flows for the two years then ended, 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
January 18, 2005


                                      F-3
<PAGE>

<TABLE>
                                             TELKONET, INC.
                                       CONSOLIDATED BALANCE SHEETS
                                       DECEMBER 31, 2004 AND 2003


ASSETS                                                                        2004              2003
                                                                         -------------     -------------
<S>                                                                      <C>               <C>
 CURRENT ASSETS:
 Cash and cash equivalents                                               $ 11,838,702      $  5,177,918
 Accounts receivable, net of allowance for doubtful accounts of
   $13,000 and $7,000 at December 31, 2004 and 2003, respectively              63,147            58,196
 Inventories (Note B)                                                       1,873,718           608,516
 Prepaid expenses and deposits                                                124,852           107,991
                                                                         -------------     -------------
 Total current assets                                                      13,900,419         5,952,621

 PROPERTY AND EQUIPMENT, AT COST (Note C):
 Furniture and equipment                                                      704,689           191,248
 Less:  accumulated depreciation                                              137,739            67,687
                                                                         -------------     -------------
Total property and equipment, net                                             566,950           123,561

EQUIPMENT UNDER OPERATING LEASES, AT COST (Note D):
Telecommunications and related equipment, at cost                             525,664            33,888
Less: accumulated depreciation                                                 75,329             3,485
                                                                         -------------     -------------
Total equipment under operating leases, net                                   450,335            30,403

OTHER ASSETS:
Long-term investments (Note E)                                                500,000                --
Deposits                                                                       76,288            70,000
                                                                         -------------     -------------
Total other assets                                                            576,288            70,000

 TOTAL ASSETS                                                            $ 15,493,992      $  6,176,585
                                                                         =============     =============

 LIABILITIES AND STOCKHOLDERS' EQUITY
 CURRENT LIABILITIES:
 Accounts payable and accrued liabilities (Note M)                       $  1,195,924      $    629,852
 Customer deposits held                                                        32,975            11,199
 Capital lease obligation- current (Note N)                                        --            15,000
                                                                         -------------     -------------
 Total current liabilities                                                  1,228,899           656,051

LONG-TERM LIABILITIES:
Convertible debentures, net of discounts - including related
  parties (Note F)                                                            137,910           143,205
 Senior notes payable (Note G)                                                450,000         2,989,000
 Deferred lease liability                                                      30,911                --
                                                                         -------------     -------------
Total long-term liabilities                                                   618,821         3,132,205

COMMITMENTS AND CONTINGENCIES (Note N)                                             --                --

STOCKHOLDERS' EQUITY (Note H)
Preferred stock, par value $.001 per share; 15,000,000 shares
  authorized; none issued and outstanding at December 31, 2004
  and 2003                                                                         --                --
Common stock, par value $.001 per share; 100,000,000 shares
  authorized; 44,335,989 and 30,689,522 shares issued and
  outstanding at December 31, 2004 and 2003, respectively                      44,336            30,690
Additional paid-in-capital                                                 40,811,208        16,474,251
Accumulated deficit                                                       (27,209,272)      (14,116,612)
                                                                         -------------     -------------
Stockholders' equity                                                       13,646,272         2,388,329
                                                                         -------------     -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                               $ 15,493,992      $  6,176,585
                                                                         =============     =============

                       See accompanying notes to consolidated financial statements


                                                  F-4
</TABLE>
<PAGE>

<TABLE>
                                             TELKONET, INC.
                                    CONSOLIDATED STATEMENTS OF LOSSES
                             FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003


                                                                           2004                2003
                                                                      -------------        -------------
<S>                                                                   <C>                  <C>
Product Revenues, net                                                 $    477,555         $     88,403
Rental Revenue, net                                                        221,097                5,257
                                                                      -------------        -------------
Total Revenue                                                              698,652               93,660

Cost of Sales                                                              542,859              104,656
                                                                      -------------        -------------
Gross Profit (Loss)                                                        155,793              (10,996)

Operating Expenses:
Research and Development (Note A)                                        1,852,308            1,370,785
Selling, General and Administrative                                      7,663,369            4,089,172
Consulting Fees (Note H)                                                 2,500,000                   --
Non-Employee Stock Options and Warrants (Note I)                         1,180,876              982,390
Depreciation and Amortization                                               71,514              110,988
                                                                      -------------        -------------
Total Operating Expense                                                 13,268,067            6,553,335

Loss from Operations                                                   (13,112,274)          (6,564,331)

Other Income (Expense):
Interest Income                                                            128,938               20,297
Interest (Expense)                                                        (109,324)          (1,113,902)
                                                                      -------------        -------------
Total Other Income (Expenses)                                               19,614           (1,093,605)

(Loss) Before Provision for Income Taxes                               (13,092,660)          (7,657,936)
Provision for Income Tax (Note K)                                               --                   --
                                                                      -------------        -------------

Net (Loss)                                                            $(13,092,660)        $ (7,657,936)
                                                                      =============        =============

Loss per common share (basic and assuming dilution)                   $      (0.32)        $      (0.37)
(Note L)                                                              =============        =============


Weighted average common shares outstanding                              41,384,074           20,702,482
                                                                      =============        =============

                       See accompanying notes to consolidated financial statements


                                                  F-5
</TABLE>
<PAGE>

<TABLE>
                                                           TELKONET, INC.
                                           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                           FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003


                                              Preferred                     Common        Additional
                                 Preferred      Stock         Common         Stock           Paid       Accumulated
                                   Shares       Amount        Shares         Amount       in Capital       Deficit         Total
                               ------------- ------------- -------------  -------------  -------------  -------------  -------------
<S>                            <C>          <C>             <C>          <C>            <C>            <C>            <C>
Balance at
  January 1, 2003                        --  $         --    15,721,131   $     15,721   $  4,916,433   $ (6,458,676)  $ (1,526,522)
Shares issued for cash at
  $2.00 per share, net of
  costs and fees                         --            --           333             --            666             --            666
Shares issued for employee
  stock options exercised
  at approximately
  $1.01 per share                        --            --       109,333            109        110,724             --        110,833
Shares issued to a director
  for employee stock options
  exercised at
  $.50 per share                         --            --       315,000            315        157,185             --        157,500
Shares issued in exchange
  for non-employee options
  exercised at $1.00
  per share                              --            --       187,499            189        187,311             --        187,500
Shares issued to consultants
  in exchange for services at
  approximately $2.13 per share          --            --       149,498            150        318,955             --        319,105
Shares issued to noteholders
  for warrants exercised at
  $1.00 per share                        --            --     3,599,250          3,599      3,595,651             --      3,599,250
Shares issued to noteholders
  for warrants exercised at
  $.50 per share                         --            --       500,000            500        249,500             --        250,000
Shares issued to noteholders
  for cashless warrants
  exercised                              --            --       317,239            317           (317)            --             --
Shares issued in exchange for
  convertible debentures
  (Note F)                               --            --     7,217,836          7,218      3,799,882             --      3,807,100
Shares issued in exchange for
  accrued interest on
  convertible
  debentures (Note F)                    --            --       525,403            525        280,209             --        280,734
Shares issued for warrants
  exercised at $1.00, in
  exchange for Senior
  Notes (Note G)                         --            --     2,011,000          2,011      2,008,989             --      2,011,000
Write-off of beneficial
  conversion features and
  warrants attached to
  convertible debentures in
  connection with conversion
  of Debenture-1
  and Series B debentures
  (Note F)                               --            --            --             --     (2,342,949)            --     (2,342,949)
Shares issued to an
  employee in exchange
  for services at
  approximately $1.79 per
  share                                  --            --        36,000             36         64,433             --         64,469
Stock options and warrants
  granted to consultants
  in exchange for
  services rendered
  (Note I)                               --            --            --             --      1,013,262             --      1,013,262
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
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 footnotes to consolidated financial statements


                                                                F-6
</TABLE>
<PAGE>

<TABLE>
                                                           TELKONET, INC.
                                     CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED)
                                           FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003


                                              Preferred                     Common        Additional
                                 Preferred      Stock         Common         Stock           Paid       Accumulated
                                   Shares       Amount        Shares         Amount       in Capital       Deficit         Total
                               ------------- ------------- -------------  -------------  -------------  -------------  -------------
<S>                            <C>          <C>             <C>          <C>            <C>            <C>            <C>

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

                                   See accompanying footnotes to consolidated financial statements


                                                                F-7
</TABLE>
<PAGE>

<TABLE>
                                           TELKONET, INC.
                                CONSOLIDATED STATEMENTS OF CASH FLOWS
                           FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003


                                                                             2004           2003
                                                                        -------------  -------------
<S>                                                                     <C>            <C>
INCREASE (DECREASE) IN CASH AND EQUIVALENTS
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss from development stage operations                              $(13,092,660)  $ (7,657,936)
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)                                           21,888        655,261
Amortization of debt discount - value of warrants attached to
    convertible debentures (Note F)                                           10,152         89,434
Stock options and warrants issued in exchange for services (Note I)        1,180,875      1,013,262
Common stock issued in exchange for services rendered (Note H)               304,094        383,574
Common stock issued in exchange for debenture interest (Note F)               23,276        280,735
Common stock issued in exchange for consulting fees (Note H)               2,500,000             --
Write-off of financing costs in connection with conversion of
    convertible debentures (Note F)                                               --        204,749
Depreciation and amortization, including equipment under operating
    leases                                                                   143,358        110,988
Increase / decrease in:
    Accounts receivable, trade and other                                      (4,950)       (56,646)
    Inventory                                                             (1,265,202)      (568,726)
    Prepaid expenses and deposits                                            (23,150)      (173,366)
     Deferred lease liability                                                 30,911             --
    Accounts payable, accrued liabilities and customer deposits, net         587,848        122,186
                                                                        -------------  -------------
NET CASH (USED IN) OPERATING ACTIVITIES                                   (9,583,560)    (5,596,485)

CASH FLOWS FROM INVESTING ACTIVITIES:
Costs of equipment under operating leases                                   (491,776)       (33,888)
Purchase of property and equipment, net                                     (514,903)      (103,033)
Investment in Amperion (Note E)                                             (500,000)            --
                                                                        -------------  -------------
NET CASH (USED IN) INVESTING ACTIVITIES                                   (1,506,679)      (136,921)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sale of common stock, net of costs and fees                 12,726,843            666
Repayments of stockholder advances                                                --       (122,830)
Proceeds from issuance of convertible debentures, net of costs and
    fees (Note F)                                                                 --      2,027,100
Proceeds from issuance of senior notes, net of costs and fees (Note G)            --      5,000,000
Proceeds from exercise of warrants (Note H)                                4,127,950      3,999,250
Proceeds from exercise of employee and non-employee stock options and
    warrants (Note H)                                                        911,230        298,311
Repayments of loans                                                               --       (310,000)
Repayments of capital leases                                                 (15,000)            --
                                                                        -------------  -------------
NET CASH PROVIDED BY FINANCING ACTIVITIES                                 17,751,023     10,892,497
NET INCREASE IN CASH AND EQUIVALENTS                                       6,660,784      5,159,091
Cash and cash equivalents at the beginning of the year                     5,177,918         18,827
                                                                        -------------  -------------
Cash and cash equivalents at the end of the year                        $ 11,838,702   $  5,177,918
                                                                        =============  =============
                     See accompanying notes to consolidated financial statements


                                                F-8
</TABLE>
<PAGE>

<TABLE>
                                           TELKONET, INC.
                          CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
                           FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003

                                                                                2004         2003
                                                                                ----         ----
<S>                                                                          <C>          <C>
Supplemental Disclosures of Cash Flow Information:
Cash transactions:
Cash paid during the period for interest                                     $  100,608   $  135,879
Income taxes paid                                                                    --           --
Non-cash transactions:
Issuance of stock options and warrants in exchange for services
     rendered (Note H)                                                        1,180,875    1,013,262
Issuance of stock warrants in exchange for financing costs (Note I)                  --       87,217
Common stock issued for services rendered (Note H)                              304,094      383,574
Common stock issued in exchange for interest (Note F and H)                      23,276      280,735
Common stock issued in exchange for consulting services (Note H)              2,500,000           --
Common stock issued in exchange for Senior Note (Note G and H)                2,539,000    2,011,000
Common stock issued in exchange for conversion of convertible
     debenture (Note F and H)                                                   172,000    3,807,100
Common stock issued in exchange for notes payable (Note H)                           --        7,500
Write-off of beneficial conversion feature for conversion of debenture
     (Note F)                                                                   134,135    2,046,479
Write-off of value of warrants attached to debenture in connection
     with conversion (Note F)                                                       531      296,470
Notes payable issued in connection with capital lease, net of
     repayments (Note N)                                                             --       15,000
Beneficial conversion feature on convertible debentures (Note F)                     --    1,761,675
Value of warrants attached to convertible debentures (Note F)                        --      265,425

                     See accompanying notes to consolidated financial statements


                                                F-9
</TABLE>
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE A-SUMMARY OF ACCOUNTING POLICIES

A summary of the significant accounting policies applied in the preparation of
the accompanying consolidated financial statements follows.

Business and Basis of Presentation
----------------------------------

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

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.

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

Financial instruments and related items, which potentially subject the Company
to concentrations of credit risk, consist primarily of cash and cash
equivalents. The Company places its cash and temporary cash investments with
credit quality institutions. At times, such investments may be in excess of the
FDIC insurance limit. The allowance for doubtful accounts was $13,000 and $7,000
at December 31, 2004 and December 31, 2003, respectively.

Cash and Cash Equivalents
-------------------------

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

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 undiscounted 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, Extenders, iBridges and Couplers
which are the significant components of the Telkonet solution. Cost is
determined by the first-in, first-out method. (Note B).


                                      F-10
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

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 2004 and 2003, common stock equivalents
are not considered in the calculation of the weighted average number of common
shares outstanding because they would be anti-dilutive, thereby decreasing the
net loss per common share.

Use of Estimates
----------------

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect certain reported amounts and disclosures. Accordingly, actual results
could differ from those estimates.

Revenue Recognition
-------------------

For revenue from product sales, the Company recognizes revenue in accordance
with Staff Accounting Bulletin No. 104, REVENUE RECOGNITION ("SAB104"), which
superceded Staff Accounting Bulletin No. 101, REVENUE RECOGNITION IN FINANCIAL
STATEMENTS ("SAB101").

SAB 101 requires that four basic criteria must be met before revenue can be
recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has
occurred; (3) the selling price is fixed and determinable; and (4)
collectibility is reasonably assured. Determination of criteria (3) and (4) are
based on management's judgments regarding the fixed nature of the selling prices
of the products delivered and the collectibility of those amounts. Provisions
for discounts and rebates to customers, estimated returns and allowances, and
other adjustments are provided for in the same period the related sales are
recorded. The Company defers any revenue for which the product has not been
delivered or is subject to refund until such time that the Company and the
customer jointly determine that the product has been delivered or no refund will
be required.

SAB 104 incorporates Emerging Issues Task Force 00-21 ("EITF 00-21"),
MULTIPLE-DELIVERABLE REVENUE ARRANGEMENTS. EITF 00-21 addresses accounting for
arrangements that may involve the delivery or performance of multiple products,
services and/or rights to use assets. The effect of implementing EITF 00-21 on
the Company's consolidated financial position and results of operations was not
significant.

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, and appear on the balance sheet as
"Equipment Under Operating Leases". The capitalized cost of this equipment is
depreciated from two to five years, on a straight-line basis down to the
Company's original estimate of the projected value of the equipment at the end
of the scheduled lease term. Monthly lease payments are recognized as rental
income.


                                      F-11
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE A-SUMMARY OF ACCOUNTING POLICIES (CONTINUED)

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

The Company follows the policy of charging the costs of advertising to expenses
incurred. The Company incurred $499,874 and $136,758 in advertising costs during
the years ended December 31, 2004 and 2003, respectively.

Liquidity
---------

As shown in the accompanying consolidated financial statements, the Company has
incurred a net loss of $13,092,660 and $7,657,936 for the year ended December
31, 2004 and 2003, respectively. The Company's current assets exceeded its
current liabilities by $12,671,520, with cash and cash equivalents representing
$11,838,702 of this amount as of December 31, 2004.

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 2004 and 2003 were $1,852,308 and
$1,370,785, respectively.

Comprehensive Income
--------------------

Statement of Financial Accounting Standards No. 130 ("SFAS 130"), "Reporting
Comprehensive Income," establishes standards for reporting and displaying of
comprehensive income, its components and accumulated balances. Comprehensive
income is defined to include all changes in equity except those resulting from
investments by owners and distributions to owners. Among other disclosures, SFAS
130 requires that all items that are required to be recognized under current
accounting standards as components of comprehensive income be reported in a
financial statement that is displayed with the same prominence as other
financial statements. The Company does not have any items of comprehensive
income in any of the periods presented.

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 change 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 years ended December 31, 2004 and 2003
and will adopt the interim disclosure provisions for its financial reports for
the subsequent periods.

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):


                                      F-12
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE A-SUMMARY OF ACCOUNTING POLICIES (CONTINUED)

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

<TABLE>
                                                                                    2004                 2003
                                                                                -------------     -------------
<S>                                                                             <C>               <C>
Net loss - as reported                                                          $(13,092,660)     $ (7,657,936)
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)                                         (7,830,385)       (5,211,112)
                                                                                -------------     -------------
Net loss - Pro Forma                                                            $(20,923,045)     $(12,869,048)
                                                                                =============     =============
Net loss attributable to common stockholders - Pro forma                        $(20,923,045)     $(12,869,048)
                                                                                =============     =============
Basic (and assuming dilution) loss per share - as reported                      $      (0.32)     $      (0.37)
                                                                                =============     =============
Basic (and assuming dilution) loss per share - Pro forma                        $      (0.51)     $      (0.62)
                                                                                =============     =============
</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.

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

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

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

In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS
151, Inventory Costs-- an amendment of ARB No. 43, Chapter 4. This Statement
amends the guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to clarify
the accounting for abnormal amounts of idle facility expense, freight, handling
costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4,
previously stated that ". . . under some circumstances, items such as idle
facility expense, excessive spoilage, double freight, and rehandling costs may
be so abnormal as to require treatment as current period charges. . . ." This
Statement requires that those items be recognized as current-period charges
regardless of whether they meet the criterion of "so abnormal." In addition,
this Statement requires that allocation of fixed production overheads to the
costs of conversion be based on the normal capacity of the production
facilities. This Statement is effective for inventory costs incurred during
fiscal years beginning after June 15, 2005. Management does not believe the
adoption of this Statement will have any immediate material impact on the
Company.

In December 2004, the FASB issued SFAS No.152, "Accounting for Real Estate
Time-Sharing Transactions--an amendment of FASB Statements No. 66 and 67" ("SFAS
152"). This Statement amends FASB Statement No. 66, Accounting for Sales of Real
Estate, to reference the financial accounting and reporting guidance for real
estate time-sharing transactions that is provided in AICPA Statement of Position
(SOP) 04-2, Accounting for Real Estate Time-Sharing Transactions. This Statement
also amends FASB Statement No. 67, Accounting for Costs and Initial Rental
Operations of Real Estate Projects, to state that the guidance for (a)
incidental operations and (b) costs incurred to sell real estate projects does
not apply to real estate time-sharing transactions. The accounting for those
operations and costs is subject to the guidance in SOP 04-2. This Statement is
effective for financial statements for fiscal years beginning after June 15,
2005, with earlier application encouraged. The Company does not anticipate that
the implementation of this standard will have a material impact on its financial
position, results of operations or cash flows.


                                      F-13
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE A-SUMMARY OF ACCOUNTING POLICIES (CONTINUED)

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

On December 16, 2004, FASB published Statement of Financial Accounting Standards
No. 123 (Revised 2004), Share-Based Payment ("SFAS 123R"). SFAS 123R requires
that compensation cost related to share-based payment transactions be recognized
in the financial statements. Share-based payment transactions within the scope
of SFAS 123R include stock options, restricted stock plans, performance-based
awards, stock appreciation rights, and employee share purchase plans. The
provisions of SFAS 123R are effective as of the first interim period that begins
after June 15, 2005. Accordingly, the Company will implement the revised
standard in the third quarter of fiscal year 2005. Currently, the Company
accounts for its share-based payment transactions under the provisions of APB
25, which does not necessarily require the recognition of compensation cost in
the financial statements. Management is assessing the implications of this
revised standard, which may materially impact the Company's results of
operations in the third quarter of fiscal year 2005 and thereafter.

On December 16, 2004, FASB issued Statement of Financial Accounting Standards
No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29,
Accounting for Nonmonetary Transactions (" SFAS 153"). This statement amends APB
Opinion 29 to eliminate the exception for nonmonetary exchanges of similar
productive assets and replaces it with a general exception for exchanges of
nonmonetary assets that do not have commercial substance. Under SFAS 153, if a
nonmonetary exchange of similar productive assets meets a commercial-substance
criterion and fair value is determinable, the transaction must be accounted for
at fair value resulting in recognition of any gain or loss. SFAS 153 is
effective for nonmonetary transactions in fiscal periods that begin after June
15, 2005. The Company does not anticipate that the implementation of this
standard will have a material impact on its financial position, results of
operations or cash flows.

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,
Extenders, iBridges and Couplers which are the significant components of the
Telkonet solution. Components of inventories as of December 31, 2004 and 2003
are as follows:

                                             2004                2003
                                          -----------        -----------
         Raw Materials                    $  748,110         $  374,794
         Finished Goods                    1,125,608            233,722
                                          -----------        -----------
                                          $1,873,718         $  608,516
                                          ===========        ===========

NOTE C - PROPERTY, PLANT AND EQUIPMENT

The Company's property and equipment at December 31, 2004 and 2003 consists of
the following:

                                                 2004           2003
                                              ----------     ----------
         Development Test Equipment           $  74,920      $  72,774
         Computer Software                       62,919             --
         Leasehold Improvements                 203,948             --
         Office Equipment                       235,114        103,773
         Office Fixtures and Furniture          127,788         14,701
                                              ----------     ----------
            Total                               704,689        191,248
         Accumulated Depreciation              (137,739)       (67,687)
                                              ----------     ----------
                                              $ 566,950      $ 123,561
                                              ==========     ==========

Depreciation expense included as a charge to income was $71,514 and $35,920 for
the years ended December 31, 2004 and 2003, respectively.


                                      F-14
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

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, 2004 and 2003 consist of the following:

<TABLE>
                                                                       2004           2003
                                                                    ----------     ----------
<S>                                                                 <C>            <C>
         Telecommunications and related equipment                   $ 525,664      $  33,888

         Less: accumulated depreciation                               (75,329)        (3,485)
                                                                    ----------     ----------
         Capitalized equipment, net of accumulated depreciation       450,335         30,403
         Less: estimated reserve for residual values                       --             --
                                                                    ----------     ----------
         Capitalized equipment under operating leases, net            450,335      $  30,403
                                                                    ==========     ==========
</TABLE>


The following is a schedule by years of minimum future rentals on
non-cancellable operating leases as of December 31, 2004:

         2005                                                     $ 366,000
         2006                                                       337,000
         2007                                                       187,000
         2008                                                        29,000
         2009                                                        14,000
                                                                  ----------
                                                                  $ 933,000

NOTE E - LONG-TERM INVESTMENTS

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

It is the policy of the Company to regularly review the assumptions underlying
the operating performance and cash flow forecasts in assessing the carrying
values of the investment. The Company identifies and records impairment losses
on investments when events and circumstances indicate that such decline in fair
value is other than temporary. Such indicators include, but are not limited to,
limited capital resources, limited prospects of receiving additional financing,
and limited prospects for liquidity of the related securities. The fair value of
the Company's investment in Amperion remained at $500,000 as of December 31,
2004.


                                      F-15
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE F - CONVERTIBLE PROMISSORY NOTES PAYABLE

A summary of convertible promissory notes payable at December 31, 2004 and 2003
is as follows:

<TABLE>
                                                                                             2004              2003
                                                                                          -----------       -----------
<S>                                                                                       <C>               <C>
  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. The remaining
    $62,000 of Debenture-1 was converted to common stock of the Company during
    the year ended December 31, 2004. As of December 31, 2004, all Debenture-1
    has been converted into the Company's common stock (Note H).                          $        -        $   62,000
  Debt Discount - beneficial conversion feature, net of accumulated amortization of
    $0 and $41,411 at December 31, 2004 and 2003, respectively.                                    -           (24,718)
  Debt Discount - value attributable to warrants attached to notes, net of
    accumulated amortization of $0 and $3,605 at December 31, 2004 and 2003,
    respectively.                                                                                  -            (2,116)
                                                                                          -----------       -----------
                                                                                                   -            35,166
  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. During the year ended December 31, 2004, additional $110,000 of
    Series B Debenture was converted to common stock of the Company (Note H).                210,000           320,000
  Debt Discount - beneficial conversion feature, net of accumulated amortization of
    $49,249 and $75,426 at December 31, 2004 and 2003, respectively.                         (49,243)         (180,546)
  Debt Discount - value attributable to warrants attached to notes, net of
    accumulated amortization of $22,841 and $13,194 at December 31, 2004 and 2003,
    respectively.                                                                            (22,847)          (31,415)
                                                                                          -----------       -----------
                                                                                             137,910           108,039
                                                                                          -----------       -----------

  Total                                                                                   $  137,910        $  143,205
                                                                                          -----------       -----------
  Less: current portion
                                                                                                   -                 -
                                                                                          $  137,910        $  143,205
                                                                                          ==========        ==========
</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-16
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

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 issued during the year ended December 31,
2001. 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 in 2001, 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 issued during the year ended
December 31, 2001. 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 additional
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 issued during the year ended December 31, 2002.
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 issued during the year ended
December 31, 2002. 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-17
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

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 issued during the year ended December
31, 2002. 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 issued during the year
ended December 31, 2002. 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 issued during the year ended December
31, 2003. 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 issued
during the year ended December 31, 2003. 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.


                                      F-18
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

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. (Note H).

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

In connection with the conversion of Debenture-1 and Series B Debentures, the
Company wrote off the unamortized 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, as of December 31, 2003, and an
additional $134,135 and $531, respectively, during the year ended December 31,
2004.

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 in the amount of $32,040 and
$744,695 for the years ended December 31, 2004 and 2003, respectively.

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. Total outstanding balance of senior notes as of
December 31, 2003 was $2,989,000. In January 2004, certain senior note holders
elected to convert $2,539,000 of their senior notes into 1,209,038 shares of
common stock of the Company, at a conversion price of $2.10 per share (Note H).
The remaining outstanding balance of senior notes as of December 31, 2004 was
$450,000.

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, 2004 and 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,
2004 and 2003, the Company has 44,335,989 and 30,689,522 shares, respectively,
of common stock issued and outstanding.


                                      F-19
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE H - CAPITAL STOCK (CONTINUED)

During the year ended December 31, 2003, the Company issued 109,333 shares of
common stock for an aggregate purchase price of $110,833 to certain employees
upon exercise of employee stock options at approximately $1.01 per share.
Additionally, the Company issued 187,499 shares of common stock for an aggregate
purchase price of $187,500 to consultants upon exercise of non-employee stock
options at approximately $1.00 per share. The Company also issued 333 shares of
common stock for $666 of cash, net of costs and fees.

During the year ended December 31, 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

During the year ended December 31, 2003, the Company issued an aggregate of
149,498 shares of common stock, having an aggregate fair market value of
$319,105, to consultants in exchange for services rendered, which approximated
the fair value of the shares issued during the period services were completed
and rendered.

During the year ended December 31, 2003, the Company issued an aggregate of
7,217,836 shares of common stock to its convertible debenture holders in
exchange for $3,807,100 of debt (Note F) . The Company also issued an aggregate
of 525,403 shares of common stock in exchange for accrued interest of $280,734
for Debenture 1 and Series B Debentures (Note F).

During the year ended December 31, 2003, the Company issued an aggregate of
3,599,250 and 500,000 shares of common stock for warrants exercised at $1.00 and
$0.50 per share, respectively.

During the year ended December 31, 2003, 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 G).

During the year ended December 31, 2003, the Company issued an aggregate of
36,000 shares of common stock to an employee in exchange for $64,469 of services
rendered, which approximated the fair value of the shares issued during the
period services were completed and rendered. Compensation costs of $64,469 were
charged to operations.

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

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

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

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

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

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


                                      F-20
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE H - CAPITAL STOCK (CONTINUED)

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

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

In March 2004, the Company entered into consulting agreements (the "Agreements")
with Aware Capital Consultants, Inc. and Scarborough, Ltd. ("Consultants").
Pursuant to the Agreements, the Company issued an aggregate of 1,000,000 shares
of its restricted common stock to Consultants in exchange for professional
services rendered and to be rendered. In accordance with EMERGING ISSUES TASK
FORCE ISSUE 96-18, ACCOUNTING FOR EQUITY INSTRUMENTS THAT ARE ISSUED TO OTHER
THAN EMPLOYEES FOR ACQUIRING, OR IN CONJUNCTION WITH SELLING, GOODS OR SERVICES
("EITF 96-18"), the measurement date to determine fair value was the date at
which a commitment for performance by the counter party to earn the equity
instrument was reached. The Company valued the shares issued for consulting
services at the rate which represents the fair value of the services received
which did not differ materially from the value of the stock issued. Compensation
cost of $2,500,000 was charged to operations during the year ended December 31,
2004.

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

Share amounts presented in the consolidated balance sheets and consolidated
statements of stockholders' equity reflect the actual share amounts outstanding
for each period presented.

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.


<TABLE>
                                Options Outstanding                                     Options Exercisable
                                -------------------                                     -------------------
                                            Weighted Average         Weighted                        Weighted
                          Number         Remaining Contractual       Average          Number         Average
    Exercise Prices     Outstanding          Life (Years)         Exercise Price    Exercisable   Exercise Price
    ---------------     -----------          ------------         --------------    -----------   --------------
<S> <C>     <C>          <C>                    <C>                   <C>            <C>              <C>
    $1.00 - $1.99        6,183,600              7.93                  $ 1.00         4,158,878        $1.00
    $2.00 - $2.99        2,211,167              8.77                  $ 2.29           517,350        $2.23
    $3.00 - $3.99        1,200,000              9.38                  $ 3.44           142,250        $3.47
    $4.00 - $4.99           20,000              9.99                  $ 4.42                --        $0.00
                        -----------          ------------         --------------    -----------   --------------
                         9,614,767              8.31                  $ 1.61         4,818,478        $1.21
                        ===========          ============         ==============    ===========   ==============

</TABLE>

                                                      F-21
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE I - STOCK OPTIONS AND WARRANTS (CONTINUED)

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

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

                                                                Weighted Average
                                             Number of Shares   Price Per Share
                                             ----------------   ---------------
         Outstanding at January 1, 2003           1,950,000      $        1.00
            Granted                               7,202,333               1.22
            Exercised                              (109,333)              1.01
            Cancelled or expired                   (750,000)              1.00
                                             ----------------   ---------------
         Outstanding at December 31, 2003         8,293,000      $        1.19
                                             ================    ==============
            Granted                               2,108,000               3.06
            Exercised                              (540,399)              1.08
            Cancelled or expired                   (245,834)              1.74
                                             ----------------   ---------------
         Outstanding at December 31, 2004         9,614,767      $        1.61
                                             ================   ===============


The weighted-average fair value of stock options granted to employees during the
years ended December 31, 2004 and 2003 and the weighted-average significant
assumptions used to determine those fair values, using a Black-Scholes option
pricing model are as follows:

                                                              2004       2003
                                                              ----       ----
         Significant assumptions (weighted-average):
             Risk-free interest rate at  grant date          1.35%       1.13%

             Expected stock price volatility                   76%        118%
             Expected dividend payout                          --          --
             Expected option life (in years)                  5.0        10.0

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 $(20,923,045) and $(0.51), respectively,
for the year ended December 31, 2004; and $(12,869,048) and $(0.62),
respectively, for the year ended December 31, 2003.

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.

<TABLE>
                                Options Outstanding                                     Options Exercisable
                                -------------------                                     -------------------
                                            Weighted Average         Weighted                        Weighted
                          Number         Remaining Contractual       Average          Number         Average
    Exercise Prices     Outstanding          Life (Years)         Exercise Price    Exercisable   Exercise Price
    ---------------     -----------          ------------         --------------    -----------   --------------
<S> <C>                <C>                    <C>                   <C>             <C>              <C>
    $        1.00       1,999,169              7.14                  $    1.07       1,570,002    $       1.09
    ==============      ===========          ============         ==============    ===========   ==============
</TABLE>


                                      F-22
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE I - STOCK OPTIONS AND WARRANTS (CONTINUED)

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

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

                                               Number of      Weighted Average
                                                Shares        Price Per Share
                                              -----------     ---------------
         Outstanding at January 1, 2003        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
                                              ===========     ===============
            Granted                               60,000                3.45
            Exercised                           (328,331)               1.00
            Canceled or expired               (1,000,000)               1.00
                                              -----------     ---------------
         Outstanding at December 31, 2004      1,999,169      $         1.07
                                              ===========     ===============


The estimated value of the non-employee stock options vested during the year
ended December 31, 2004 was determined using the Black-Scholes option pricing
model and the following assumptions: expected option life of 5 years, a risk
free interest rate of 1.35%, a dividend yield of 0% and volatility of 76%. The
amount of the expense charged to operations in connection with granting the
options was $1,130,780 and $982,390 during the year ended December 31, 2004 and
2003, 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.

<TABLE>
                                Options Outstanding                                     Options Exercisable
                                -------------------                                     -------------------
                                            Weighted Average         Weighted                        Weighted
                          Number         Remaining Contractual       Average          Number         Average
    Exercise Prices     Outstanding          Life (Years)         Exercise Price    Exercisable   Exercise Price
    ---------------     -----------          ------------         --------------    -----------   --------------
<S> <C>                <C>                     <C>                  <C>              <C>           <C>
     $     1.00           540,900               1.15                 $    1.00        540,900       $    1.00
     $     2.97            35,000               1.38                 $    2.97         35,000       $    2.97
                        -----------          ------------         --------------    -----------   --------------
                          575,900               1.17                 $    1.12        575,900       $    1.12
                        ===========          ============         ==============    ===========   ==============
</TABLE>

Transactions involving warrants are summarized as follows:

                                               Number of      Weighted Average
                                                Shares        Price Per Share
                                              -----------     ---------------
         Outstanding at January 1, 2003        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
                                              ===========     ===============
            Granted                                   --                  --
            Exercised                         (4,468,590)               0.99
            Canceled or expired                 (115,000)               1.00
                                              -----------     ---------------

         Outstanding at December 31, 2004        575,900      $         1.12
                                              ===========     ===============



                                      F-23
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE I - STOCK OPTIONS AND WARRANTS (CONTINUED)

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

The Company did not grant any compensatory warrants to non-employees during the
year ended December 31, 2004. The estimated value of previously granted warrants
vested during the period ended December 31, 2004 was determined using the
Black-Scholes option pricing model and the following assumptions: contractual
term of 3 years, a risk free interest rate of 1.35%, a dividend yield of 0% and
volatility of 76%. Compensation expense of $50,096 was charged to operations for
the year ended December 31, 2004. The Company capitalized financing costs of
$87,217 for compensatory warrants granted in connection with placement of
convertible debentures during the year ended December 31, 2003. The financing
cost was amortized over the life of the convertible debentures and all
unamortized financing cost was expensed upon the conversion of the convertible
debentures during the year ended December 31, 2003.

NOTE J - RELATED PARTY TRANSACTIONS

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 during 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 the Company
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 during the year
ended December 31, 2003.

In January 2003, the Company entered into an employment agreement with Ronald W.
Pickett, President and Chief Executive Officer of the Company, to provide for an
annual compensation of $100,000 and 3,000 shares of restricted stock from the
Employee Stock Option Plan for each month that he serves as President. As of
December 31, 2004 and 2003, the Company has provided for the issuance of 36,000
shares of its common stock to Mr. Pickett each year.

In September 2003, the Company entered into a consulting agreement that provides
for annual compensation of $100,000, payable monthly, with The Musser Group, an
entity controlled by the Company's Chairman of the Board of Directors, for
certain services. As of December 31, 2004 and 2003, an aggregate of $100,000 and
$33,333 of consulting fees was charged to income pursuant to the agreement,
respectively.

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 $27,200,000 which expire through 2024, subject to limitations
of Section 382 of the Internal Revenue Code, as amended. The deferred tax asset
related to the carryforward is approximately $9,520,000. 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.


                                      F-24
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE K - INCOME TAXES (CONTINUED)

Components of deferred tax assets as of December 31, 2004 are as follows:

          Non Current:
                 Net operating loss carryforward               $   9,520,000
                 Valuation allowance                              (9,520,000)
                                                               --------------
                 Net deferred tax asset                        $          --
                                                               ==============

NOTE L - LOSSES PER COMMON SHARE

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

                                                      2004           2003
                                                 --------------   -------------
Net loss available to common shareholders        $ (13,092,660)   $ (7,657,936)
                                                 ==============   =============
Basic and fully diluted loss per share           $       (0.32)   $      (0.37)
                                                 ==============   =============
Weighted average common shares outstanding          41,384,074      20,702,482
                                                 ==============   =============

NOTE M - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

Accounts payable and accrued liabilities at December 31, 2004 and 2003 are as
follows:

                                                  2004             2003
                                              --------------     --------------
        Accounts payable                      $     812,602      $     275,987
        Accrued interest                             21,611             67,350
        Accrued payroll and payroll taxes           348,471            283,699
        Other                                        13,240              2,816
                                              --------------     --------------
        Total                                 $   1,195,924      $     629,852
                                              =============      =============

NOTE N - COMMITMENTS AND CONTINGENCIES

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

The Company leases office space under a sub-lease agreement through November
2010 for office space which occupies approximately 11,600 square feet in
Germantown, MD. The Company also leases office space through May 2007 for office
space which occupies approximately 1,800 square feet in White Marsh, MD.
Additionally, the Company leases a corporate apartment through May 2005 in
Germantown, MD. Commitments for minimum rentals under non cancelable leases at
December 31, 2004 are as follows:


                          2005                                 $ 177,412
                          2006                                   183,252
                          2007                                   170,203
                          2008                                   157,271
                          2009 and thereafter                    312,113
                                                              -----------
                                                              $1,000,251
                                                              ===========

Rental expenses charged to operations for the year ended December 31, 2004 and
2003 are $165,249 and $74,777, respectively.


                                      F-25
<PAGE>

                                 TELKONET, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

NOTE N - COMMITMENTS AND CONTINGENCIES (CONTINUED)

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

Computer equipment and software includes the following amounts for capitalized
leases at December 31, 2004 and 2003:

                                                             2004         2003
                                                         ---------     ---------
Computer equipment and software                          $ 52,000      $ 52,000

Less: accumulated depreciation and amortization           (15,600)       (5,200)
                                                         ---------     ---------
                                                         $ 36,400      $ 46,800
                                                         =========     =========

The Company has computer equipment and software purchased under non-cancelable
leases with an original cost of $52,000. As of December 31, 2004, the Company
has paid in full the lease obligation. Depreciation expense of $10,400 and
$5,200 in connection with the capital leased equipment was charged to operations
during the year ended December 31, 2004 and 2003, respectively.

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

The Company has employment agreements with certain of its key employees which
include non-disclosure and confidentiality provisions for protection of the
Company's proprietary information.

The Company has consulting agreements with outside contractors to provide
marketing and financial advisory services. The Agreements are generally for a
term of 12 months from inception and renewable automatically from year to year
unless either the Company or Consultant terminates such engagement by written
notice.

Litigation
----------

The Company is subject to legal proceedings and claims which arise in the
ordinary course of its business. Although occasional adverse decisions or
settlements may occur, the Company believes that the final disposition of such
matters should not have a material adverse effect on its financial position,
results of operations or liquidity.

NOTE O - BUSINESS CONCENTRATION

Revenue from three (3) major customers approximated $219,963 or 31% of sales and
$41,262 or 44% of sales for the years ended December 31, 2004 and 2003,
respectively.


                                      F-26