**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**


FORM
        10-K
 
 Annual
        Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
        1934
 
 Commission
        file number: 000-27305
 
 **TELKONET,
        INC.**
 (Exact
        name of registrant as specified in its charter)
 Utah
                
                87-0627421(State
                    or other jurisdiction of
                
                (IRS
                    Employee Identification No.)incorporation
                    or organization)
 
 20374
        Seneca Meadows Parkway
 Germantown,
        MD 20876
 (Address
        of principal executive offices)
 
 (240)
        912-1800
 (Issuer’s
        telephone number)
 Securities
          Registered pursuant to section 12(g) of the Act:  None
 
 Indicate
          by check mark if the registrant is a well-know seasoned issuer, as defined
          in
          Rule 405 of the Securities Act. __Yes X No
 
 Indicate
          by check mark if the registrant is not required to file reports pursuant
          to
          Section 13 or Section 15(b) of the Act. __
          Yes X No
 
 Indicate
          by check mark whether the registrant (1) has filed all reports required
          to be
          filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934
          during
          the preceding 12 months (or for such shorter period that the registrant
          was
          required to file such reports), and (2) has been subject to such filing
          requirements for the past 90 days. X Yes
          ___No
 
 Check
          if
          disclosure of delinquent filers pursuant to Item 405 of Regulation S-K
          is not
          contained in this form, and no disclosure will be contained, to the best
          of
          Registrant’s knowledge, in definitive proxy or information statements
          incorporated by reference in Part III of this Form 10-K or any amendment
          to this
          Form 10-K.
 
 Indicate
          by check mark whether the registrant is a large accelerated filer, an
          accelerated filer, or a non-accelerated filer. See the definition of
“accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange
          Act.
 ___
                      Large Accelerated Filer
                  XAccelerated
                      Filer
                  ___
                      Non-Accelerated Filer
 Indicate
          by check mark whether the registrant is a shell company (as defined in
          Rule
          12b-2 of the Exchange Act) __
          Yes X No
 
 Aggregate
          market value of the voting stock held by non-affiliates of the registrant
          as of
          March 1, 2007: $136,993,170.
 Number
          of
          outstanding shares of the registrant’s par value $0.001 common stock
          a s
          of March 1, 2007: 57,002,301.


**TELKONET,
      INC.**


**FORM
      10-K**


**INDEX**





PagePart
                IItem
                1.
            Description
                of Business
            1Item
                1A.
            Risk
                Factors
            10Item
                1B.
            Unresolved
                Staff Comments
            15Item
                2.
            Description
                of Property
            15Item
                3.
            Legal
                Proceedings
            16Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            16Part
                IIItem
                5.
            Market
                for Registrant’s Common Equity, Related Stockholder Matters and
                Registrant’s Purchases of Securities
            17Item
                6.
            Selected
                Financial Data
            19Item
                7.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            19Item
                7A.
            Quantitative
                and Qualitative Disclosures About Market Risk.
            32Item
                8.
            Financial
                Statements
            32Item
                9.
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            32Item
                9A.
            Controls
                and Procedures
            32Item
                9B.
            Other
                Information
            35Part
                IIIItem
                10.
            Directors
                and Executive Officers of the Registrant
            35Item
                11.
            Executive
                Compensation
            38Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            46Item
                13.
            Certain
                Relationships and Related Transactions
            48Item
                14.
            Principal
                Accounting Fees and Services
            49Part
                IVItem
                15.
            Exhibits
                and Financial Statement Schedules
            50








**PART
      I**





**ITEM
      1.** **DESCRIPTION
      OF BUSINESS.**





**GENERAL**





***Business***





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





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





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





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


The
        Company’s offices are located at 20374 Seneca Meadows Parkway, Germantown,
        Maryland 20876. The reports that the Company files pursuant to the Securities
        Exchange Act of 1934 can be found at the Company’s web site at
        www.telkonet.com.
 
 **Segment
        Reporting**
 
 We
        classify our operations in two reportable segments: the Telkonet Segment
        and the
        MST Segment
 
 ***Telkonet
        Segment (“Telkonet”)***
 
 Through
        the revolutionary Telkonet iWire SystemTM , Telkonet
        utilizes proven PLC technology to deliver commercial high-speed Broadband
        access
        from an IP “platform” that is easy to deploy, reliable and cost-effective by
        leveraging a building’s existing electrical infrastructure. The building’s
        existing electrical wiring becomes the backbone of the local area network,
        which
        converts virtually every electrical outlet into a high-speed data port without
        the costly installation of additional wiring or major disruption of business
        activity.
 
 The
        Telkonet iWire SystemTM offers
        a viable
        and cost-effective alternative to the challenges of hardwiring and wireless
        local area networks (LANs). Telkonet’s products are designed for use in
        commercial and residential applications, including multi-dwelling units and
        the
        hospitality and government markets. Applications supported by the Telkonet
        “platform” include, but are not limited to, VoIP telephones, internet
        connectivity, local area networking, video conferencing, closed circuit security
        surveillance and a host of other information services.
 
 Telkonet’s
        Product has been installed in all present target market segments. Government
        and
        regulatory certifications have been obtained to sell the product
        internationally. Telkonet has been shipping PLC products since 2003, initially
        targeting the multi-hospitality unit (MHU) market followed by the multi-dwelling
        unit (MDU) market as well as the Government and Public Sector markets. Telkonet
        employs both direct and indirect sales model to distribute and support product
        on a worldwide basis.
  1
  
 On
        March
        9, 2007, the Company acquired substantially all of the assets of Smart Systems
        International (SSI), a leading provider of energy management products and
        solutions to customers in the United States and Canada for cash and Company
        common stock having an aggregate value of $7,000,000. The purchase price
        was
        comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
        stock. The Company is obligated to register the stock portion of the purchase
        price on or before May 15, 2007 and 1,090,000 shares are being held in an
        escrow
        account for a period of one year following the closing from which certain
        potential indemnification obligations under the purchase agreement may be
        satisfied. The aggregate number of shares held in escrow is subject to
        adjustment upward or downward depending upon the trading price of the Company’s
        common stock during the one year period following the closing date.
 
 On
        March
        15, 2007, the Company acquired 100% of the outstanding membership units of
        Ethostream, LLC, a network solutions integration company that offers
        installation, sales and service to the hospitality industry. The Ethostream,
        LLC
        acquisition will enable Telkonet to provide installation and support for
        PLC
        products and third party applications to customers across North America.
        The
        purchase price of $11,756,097 was comprised of $2.0 million in cash and
        3,459,609 shares of the Company’s common stock. The entire stock portion of the
        purchase price is being held in escrow to satisfy certain potential
        indemnification obligations of the sellers under the purchase agreement.
        The
        shares held in escrow are distributable over the three years following the
        closing. The aggregate number of shares issuable to the sellers is subject
        to
        downward adjustment in the event the Company’s common stock trades at or above a
        price of $4.50 per share for twenty consecutive trading days during the one
        year
        period following the closing.
 
 **Competition**
 
 Telkonet
        is a member of the HomePlug(TM) Powerline Alliance, an industry trade group
        that
        engages in marketing and educational initiatives and sets standards and
        specifications for products in the powerline communications
        industry.
 
 The
        HomePlug (TM) Powerline Alliance has grown over the past year and now includes many well
        recognized brands in the networking and communications industries. These
        include
        Linksys (a Cisco company), Intel, GE, Motorola, Netgear, Sony and Samsung.
        With
        the exception of Motorola, who recently introduced a commercial product,
        these
        companies do not presently represent a direct competitive threat to Telkonet
        since they only market and sell their products in the residential
        sector.
 
 There
        can
        be no assurance that other companies will not develop PLC products that compete
        with Telkonet’s products in the future. They all have longer operating
        histories, greater name recognition and substantially greater financial,
        technical, sales, marketing and other resources than Telkonet. These potential
        competitors may, among other things, undertake more extensive marketing
        campaigns, adopt more aggressive pricing policies, obtain more favorable
        pricing
        from suppliers and manufacturers and exert more influence on the sales channel
        than Telkonet can. As a result, Telkonet may not be able to compete successfully
        with these potential competitors and these potential competitors may develop
        or
        market technologies and products that are more widely accepted than those
        being
        developed by Telkonet or that would render Telkonet’s products obsolete or
        noncompetitive.
 
 Management
        has focused its sales and marketing efforts primarily on the commercial sector,
        which includes office buildings, hotels, schools, shopping malls, commercial
        buildings, multi-dwelling units, government facilities, and any other commercial
        facilities that have a need for Internet access and network connectivity.
        Telkonet has also focused on establishing relationships with value added
        resellers. Telkonet continues to examine, select and approach entities with
        existing distribution channels that will be enhanced by Telkonet’s offerings.
        Telkonet also intends to focus future sales and marketing efforts in Europe,
        South America, Asia and the Pacific Rim.
 
 **Raw
        Materials**
 
 Telkonet
        has not experienced any significant or unusual problems in the purchase of
        raw
        materials or commodities. While Telkonet is dependent, in certain situations,
        on
        a limited number of vendors to provide certain raw materials and components,
        it
        has not experienced significant problems or issues purchasing any essential
        materials, parts or components. Telkonet obtains the majority of its raw
        materials from the following suppliers: Avnet Electronics Marketing, Digi-Key
        Corporation, Intellon Corporation, and Parkview Metal Products. In addition,
        Superior Manufacturing Services, a U.S. based company, provides substantially
        all the manufacturing and assembly requirements for Telkonet.
  2
 **Customers**
 
 Telkonet
          is neither limited to, nor reliant upon, a single or narrowly segmented
          consumer
          base from which it derives its revenues. Presently, Telkonet is not dependent
          on
          any particular customer under contract. However, Telkonet’s sale of certain
          rental contract agreements to Hospitality Leasing Corporation represented
          approximately 18.0% of total revenues in each of 2005 and 2006. Telkonet’s
          primary focus is in the commercial, government and international
          markets.
 
 **Intellectual
          Property**
 
 Telkonet
          has applied for patents that cover the unique technology integrated into
          the
          Telkonet iWire System TM product
          suite. Telkonet also continues to identify, design and develop enhancements
          to
          its core technologies that will provide additional functionality,
          diversification of application and desirability for current and future
          users of
          the Telkonet iWire System TM product
          suite.
 
 In
          January 2003, Telkonet received Federal Communications Commission
          (FCC) approval to market the Telkonet iWire SystemTM product suite. FCC
          rules permit the operation of unlicensed digital devices that radiate radio
          frequency emissions if the manufacturer complies with certain equipment
          authorization procedures, technical requirements, marketing restrictions
          and
          product labeling requirements. An independent, FCC-certified testing lab
          has
          verified the Company’s Gateway complies with the FCC technical requirements for
          Class A digital devices. No further testing of this device is required and
          the device may be manufactured and marketed for commercial use.
 
 In
          December 2003, Telkonet received approval from the U.S. Patent and Trademark
          Office for its “Method and Apparatus for Providing Telephonic Communication
          Services” Patent No.: 6,668,058. This invention covers the utilization of an
          electrical power grid, for a concentration of electrical power consumers,
          and
          use of existing consumer power lines to provide for a worldwide voice and
          data
          telephony exchange
 
 In
          March 2005, Telkonet received final certification of its Telkonet iWire
          System TM product
          suite from European Union (EU) authorities, which certification was
          required before Telkonet could sell and permanently install products in
          EU
          countries. As a result of the certification, Telkonet products that will
          be sold
          and installed in EU countries will bear the Conformite Europeene (CE) mark,
          a
          symbol that demonstrates that the product has met the EU’s regulatory standards
          and is approved for sale within the EU. Telkonet now has satisfied the
          governmental requirements for product safety and certification in the EU
          and is
          free to sell and install the Telkonet iWire System TM product
          suite in the EU.
 
 In
          June 2005, Telkonet received the National Institute of Standards and
          Technology (NIST) Federal Information Processing Standard (FIPS) 140-2
          validation for the Gateway. In July 2005, Telkonet received FIPS 140-2
          validation for the eXtender and iBridge. The U.S. federal government requires,
          as a condition to purchasing certain information processing applications,
          that
          such applications receive FIPS 140-2 validation. U.S. federal agencies
          use FIPS
          140-2 compliant products for the protection of sensitive information. As
          a
          result of the foregoing validations, as of July 2005, all of Telkonet’s
          powerline carrier products have satisfied all governmental requirements
          for
          security certification and are eligible for purchase by the U.S. federal
          government. In addition to the foregoing, Canadian provincial authorities
          use
          FIPS 140-2 compliant products for the protection of sensitive designate
          information. The Communications-Electronics Security Group (CESG) also has
          stated that FIPS 140-2 compliant products meet its security criteria for
          use in
          data traffic categorized as “Private.” CESG is part of the United Kingdom’s
          National Technical Authority for Information Assurance, which is a government
          agency responsible for validating the security of information processing
          applications for the government of the United Kingdom, financial institutions,
          healthcare organizations, and international governments, among others.
 
 In
          November 2005, Telkonet received the Norma Official Mexicana
          (NOM) certification, enabling Telkonet to sell the iWire System TM product
          suite in Mexico. NOM certification is required for Telkonet’s products to be
          sold in Mexico, and no further certifications are required to sell the
          Telkonet
          iWire System TM product
          suite in Mexico.
 
 In
          December 2005, the United States Patent and Trademark Office issued Patent
          No: 6,975,212 titled “Method and Apparatus for Attaching Power Line
          Communications to Customer Premises”. The patent covers the method and apparatus
          for modifying a three-phase power distribution network in a building in
          order to
          provide data communications by using a PLC signal to an electrical central
          location point of the power distribution system. Telkonet’s Coupler technology
          enables the conversion of electrical outlets into high-speed data ports
          without
          costly installation, additional wiring, or significant disruption of business
          activity. The Coupler is an integral component of the Telkonet iWire
          System TM product
          suite.
  3
 In
          August
          2006, the United States Patent and Trademark Office issued Patent No: 7,091,831,
          titled "Method and Apparatus for Attaching Power Line Communications to
          Customer
          Premises". The patented technology incorporates a safety disconnect circuit
          breaker into the Telkonet Coupler, creating a single streamlined unit.
          In doing
          so, installation of the Telkonet iWire System(TM) is faster, more efficient,
          and
          more economical than with separate disconnect switches, delivering optimal
          signal quality. The Telkonet Integrated Coupler Breaker patent covers the
          unique
          technique used for interfacing and coupling its communication devices onto
          the
          three-phase electrical systems that are predominant in commercial
          buildings.
 
 In
          January 2007, the United States Patent and Trademark Office issued Patent
          No:
          7,170,395 titled “Methods and Apparatus for Attaching Power Line Communications
          to Customer Premises” for Delta phase power distribution system applications,
          which are prevalent in the maritime industry, shipboard systems, along
          with that
          of heavy industrial plants and facilities.
 
 Assumed
          through the acquisition of SSI, the United States Patent and Trademark
          Office
          issued Patent No: 5,395,042 in March 1995 titled “Apparatus and Method for
          automatic climate control” calculates and records the amount of time needed for
          the thermostat to return the room temperature to the occupant’s set point once a
          person re-enters the room
 
 In
          addition Telkonet currently has multiple patent applications under examination,
          and intends to file additional patent applications covering a wide range
          of
          technologies including that of improved network topologies and techniques
          for
          imposing LANs over existing wired infrastructures.
 
 Telkonet
          has also filed multiple Patent Cooperation Treaty (PCT) patent applications,
          which have been used to file national patent applications in foreign countries
          including the European Union, Japan, China, Russia, India and
          others.
 
 Notwithstanding
          the issuance of these patents, there can be no assurance that any of Telkonet’s
          current or future patent applications will be granted, or, if granted,
          that such
          patents will provide necessary protection for the Company’s technology or its
          product offerings, or be of commercial benefit to the Company.
 
 **Government
          Regulation**
 
 We
          are
          subject to regulation in the United States by the FCC. FCC rules permit
          the
          operation of unlicensed digital devices that radiate radio frequency (RF)
          emissions if the manufacturer complies with certain equipment authorization
          procedures, technical requirements, marketing restrictions and product
          labeling
          requirements. An independent, FCC-certified testing lab has verified that
          the
          Company’s our PLC product line complies with the FCC technical requirements for
          Class B digital devices. No further testing of these devices is required
          and the
          devices may be manufactured and marketed for commercial and residential
          use.
 
 In
          Europe
          and other overseas markets, Telkonet’s products are subject to safety and RF
          emissions regulations adopted by the European Union (EU) for Information
          Technology Equipment. In March 2005, the Company received final Conformite
          Europeene (CE) certification, which is required for the Company to freely
          market
          and sell its products within the EU. As a result of the certification,
          Telkonet’s products sold and installed in EU countries will bear the CE marking,
          a symbol that demonstrates that the product has met the EU’s regulatory
          standards and is approved for sale in the EU. The Restriction of Hazardous
          Substances Directive (RoHS) directive took effect in the EU on July 1,
          2006.
          This directive restricts the use of six hazardous materials in the manufacture
          of various types of electronic and electrical equipment. It is closely
          linked
          with the Waste Electrical and Electronic Equipment Directive (WEEE) which
          sets collection, recycling and recovery targets for electrical goods and
          is part
          of a legislative initiative to solve the problem of huge amounts of toxic
          e-waste. Telkonet has taken the appropriate measures to be fully
          compliant with both of these directives.
 
 Future
          products designed by the Company will require testing for compliance with
          FCC
          and CE regulations. Moreover, if in the future, the FCC or EU changes its
          technical requirements, further testing and/or modifications may be
          necessary.
 
 **Research
          and Development**
 
 During
          the years ended December 31, 2006, 2005 and 2004, Telkonet spent $1,925,746,
          $2,096,104, and $1,852,309, respectively, on research and development
          activities. In 2006, research and development activities were focused on
          the
          development of Telkonet’s next generation product. In 2005, research and
          development activities included (a) QoS for VoIP service for both commercial
          and
          FIPS 140-2 product applications, (b) design of the next generation high-speed
          development platform, (c) design, prototype & release of the Integrated
          Coupler Breaker product line, (d) design & development of the second
          generation automated test equipment for manufacturing, (e) automated SQA
          regression testing. In 2004, research and development activities included
          (a)
          development of a further cost-reduced (“G3”) iBridge/eXtender, (b) router
          software development, and (c) advanced encryption support.
  4
 
 **Long
        Term Investments**
 
 Amperion,
        Inc.
  On
        November 30, 2004, Telkonet entered into a Stock Purchase Agreement
        (“Agreement”) with Amperion, Inc. ("Amperion"), a privately held company.
        Amperion is engaged in the business of developing networking hardware and
        software that enables the delivery of high-speed broadband data over
        medium-voltage power lines. Pursuant to the Agreement, the Company invested
        $500,000 in Amperion in exchange for 11,013,215 shares of Series A Preferred
        Stock for an equity interest of approximately 4.7%. Telkonet accounted for
        this
        investment under the cost method, as the Company does not have the ability
        to
        exercise significant influence over operating and financial policies of the
        investee.
  It
        is the
        policy of Telkonet to regularly review the assumptions underlying the operating
        performance and cash flow forecasts in assessing the carrying values of the
        investment. Telkonet identifies and records impairment losses on investments
        when events and circumstances indicate that such decline in fair value is
        other
        than temporary. Such indicators include, but are not limited to, limited
        capital
        resources, limited prospects of receiving additional financing, and limited
        prospects for liquidity of the related securities. Telkonet determined that
        its
        investment in Amperion was impaired based upon forecasted discounted cash
        flow.
        Accordingly, Telkonet wrote-off $92,000 and $400,000 of the carrying value
        of
        its investment through a charge to operations during the year-ended December
        31,
        2006 and 2005, respectively. The remaining value of Telkonet’s investment in
        Amperion is $8,000 and $100,000 at December 31, 2006 and 2005, respectively,
        and
        the amount at December 31, 2006, represents the current fair value.
 
 BPL
        Global, Ltd.
  On
        February 4, 2005, the Company’s Board of Directors approved an investment in BPL
        Global, Ltd. (“BPL Global”), a privately held company. Telkonet funded an
        aggregate of $131,000 as of December 31, 2005 and additional $44 during the
        year
        of 2006. This investment represents an equity interest of approximately 4.67% at
        December 31, 2006. BPL Global is engaged in the business of developing broadband
        services via power lines through joint ventures in the United States, Asia,
        Eastern Europe and the Middle East. Telkonet accounted for this investment
        under
        the cost method, as the Company does not have the ability to exercise
        significant influence over operating and financial policies of the investee.
        Telkonet reviewed the assumptions underlying the operating performance and
        cash
        flow forecasts in assessing the carrying values of the investment. The fair
        value of Telkonet's investment in BPL Global, Ltd. amounted $131,044 and
        $131,000 as of December 31, 2006 and 2005, respectively.
 
 **Backlog**
 
 As
        of
        March 1, 2007 and 2006, revenues to be recognized under non-cancelable leases
        and service contracts in the hospitality market of approximately $1,331,000
        and
        $2,411,000, respectively. Additionally, Telkonet has a commitment to deploy
        the
        Telkonet iWire System TM at 50
        properties for a major resort company which deployment represents revenue
        of
        approximately $1,100,000 over a 3 year term.
 
 In
        conjunction with the acquisition of Smart Systems International on March
        9,
        2007, Telkonet assumed certain purchase orders relating to a major utilities
        energy management initiative provided through the two selected providers.
        The
        current order backlog amounts to approximately $500,000 and the estimated
        remaining program value amounts to $3,000,000 for products and services to
        be
        provided through 2008.
 
 In
        conjunction with the acquisition of Ethostream, LLC on March 15, 2007, Telkonet
        acquired support contracts and monthly services for more than 1500 hotels
        which
        is expected to generate approximately $2,000,000 annual recurring support
        and
        internet advertising revenue.
 
 ***MST
        Segment (“MST”)***
 
 MST
        is a
        communications service provider offering quadruple play (“Quad-Play”) services
        to multi-tenant unit (“MTU”) and multi-dwelling unit (“MDU”) residential,
        hospitality and commercial properties. These Quad-Play services include video,
        voice, high-speed internet and wireless fidelity (“Wi-Fi”) access. In addition,
        MST currently offers or plans to offer a variety of next-generation
        telecommunications solutions and services including satellite installation,
        video conferencing, surveillance/security and energy management, and other
        complementary professional services.




5


*NuVisionsTM*
  MST
        currently offers digital television service through DISH Network, a national
        satellite television provider, under its private label NuVisionsTM brand of
        services. The NuVisions TV offering currently includes over 500 channels
        of
        video and audio programming, with a large high definition (more than 40
        channels) and ethnic offering (over 100 channels from 17 countries) available
        in
        the market today. MST also offers its NuVisions Broadband high speed internet
        service and NuVisions Digital Voice telephone service to multi-family residences
        and commercial properties. MST delivers its broadband based services using
        terrestrial fiber optic links and in February 2005, began deployment in New
        York
        City of a proprietary wireless gigabit network that connects properties served
        in a redundant gigabit ring - a virtual fiber optic network in the air.
 
 *Wi-Fi
        Network*
 
 MST
        has
        constructed a large NuVisions Wi-Fi footprint in New York City intended to
        create a ubiquitous citywide Wi-Fi network. NuVisions Wi-Fi offers Internet
        access in the southern-half of Central Park, Riverside Park from 60th to
        79th
        Streets, Dag Hammarskjold Plaza, and the United Nations Plaza. In addition,
        MST
        provides NuVisions Wi-Fi service in and around Trump Tower on Fifth Avenue,
        Trump World Tower on First Avenue, the Trump Place properties located on
        Riverside Boulevard, Trump Palace, Trump Parc, Trump Parc East as well as
        portions of Roosevelt Island surrounding the Octagon residential community.
        MST
        currently has plans to deploy additional Wi-Fi “Hot Zones” throughout New York
        City and continue to enlarge its Wi-Fi footprint as new properties are served.
 
 *Internet
        Protocol Television (“IPTV”)*
 
 In
        fourth
        quarter of 2006, MST invested in an IPTV platform to deploy in 2007. IPTV
        is a
        method of distributing television content over IP that enables a more
        user-defined, on-demand and interactive experience than traditional cable
        or
        satellite television. The IPTV service delivers traditional cable TV programming
        and enables subscribers to surf the Internet, receive on-demand content,
        and
        perform a host of Internet-based functions via their TV sets.
 
 **Competition**
  The
        home
        entertainment and video programming industry is competitive, and MST expects
        competition to intensify in the future. MST faces its most significant
        competition from the franchised cable operators. In addition, MST’s competition
        includes other satellite providers, telecom providers and off-air
        broadcasters.
 
 *Hardwired
        Franchised Cable System*
 
 Cable
        companies currently dominate the market in terms of subscriber penetration,
        the
        number of programming services available, audience ratings and expenditures
        on
        programming. However, satellite services are gaining market share which MST
        believes will provide it with the opportunity to acquire and consolidate
        a
        subscriber base by providing a high quality signal at a comparable or reduced
        price to many cable
        operators' current service.
 
 *Other
        Operators*
 
 MST’s
        next largest competitors are other operators who build and operate
        communications systems such as satellite master antenna television systems,
        commonly known as SMATV, or private cable headend systems, which generally
        serve
        condominiums, apartment and office complexes and residential developments.
        MST
        also competes with other national DBS operators such as EchoStar.
 
 *Off-Air
        Broadcasters*
 
 A
        majority of U.S. households that are not serviced by cable operators are
        serviced only by broadcast networks and local television stations (“off-air
        broadcasters”). Off-air broadcasters send signals through the air, which are
        received by traditional television antennas. Signals are accessible to anyone
        with an antenna and programming is funded by advertisers. Audio and video
        quality is limited and service can be adversely affected by weather or by
        buildings blocking a signal.
 
 *Traditional
        Telephone Companies*
  Traditional
        telephone companies such as Verizon and AT&T have recently diversified their
        service offerings to compete with traditional franchised cable companies
        in a
        triple-play market. Although their subscriber growth is currently smaller
        than
        franchise cable companies, these traditional phone companies are developing
        video offerings such as Verizon's FIOS product. These phone companies have
        in
        the past also been resellers of DIRECTV and EchoStar video programming, however,
        rarely in the multi-dwelling unit market. In the future, video offerings
        from
        traditional phone companies may become a significant competitor in the MDU
        market.




6


**Customers/Strategy**
 
 MST’s
        customer base and strategy is to target and cultivate a subscriber base that
        will demand high margin products including, video, IPTV, VoIP, high-speed
        Internet and Wi-Fi services.
  MST
        currently maintains service agreements with approximately 20 MDU and MTU
        properties. Generally, under the terms of a service agreement, MST provides
        either (i) “bulk services,” which may include one or all of a bundle of products
        and services, at a fixed price per month to the owner of the MDU or MTU
        property, and contract with individual residents for enhanced services, such
        as
        premium cable channels, for a monthly fee or (ii) contract with individual
        residents of the MDU property for one or more basic or enhanced services
        for a
        monthly fee. These agreements typically include a revenue sharing arrangement
        with property owners, whereby the property owner is entitled to a share of
        the
        revenues derived from subscribers who reside at the MDU/MTU property **.** These **** revenue
        sharing arrangements are either based upon a fix amount per subscriber or
        based
        on a percentage, typically between 7-10%, of the monthly fees MST charges
        residents for its services. MST believes that its complementary products
        and
        services allows for future growth and as such are designed and integrated
        with
        scalability in mind.
 
 **Governmental
        Regulation**
 
 *Federal
        Regulation*
  MST’s
        systems do not use  or
        traverse public rights-of-way and thus are exempt from the comprehensive
        regulation of cable systems under the Federal
        Communications Act of 1934, as amended (the “Communications Act”). Because its
        systems are subject to minimal federal regulation, MST has greater
        pricing freedom and is not required to serve any customer whom it does not
        choose to serve, and management believes that MST has significantly  more
        competitive flexibility than do the franchised cable systems. Management
        believes that these regulatory advantages help to make MSTs’ private
        systems competitive with larger franchised cable systems.
 
 On
        October 5, 1992, Congress enacted the Cable Consumer Protection and Competition
        Act of 1992 (the “1992 Cable Act”), which imposed additional regulation on
        traditional franchised cable operators and permits regulation of rates in
        markets in which there is no “effective competition”, as defined in the 1992
        Cable Act, and directed the FCC to adopt comprehensive new federal standards
        for
        local regulation of certain rates charged by traditional franchised cable
        operators. Conversely, the legislation also provides for deregulation of
        traditional hardwire cable in a given market where effective competition
        is
        shown to exist. Rates charged by private cable operators, typically already
        lower than traditional franchise cable rates, are not subject to regulation
        under the 1992 Cable Act.
 
 In
        February 1996, Congress passed the Telecommunications Act of 1996 (the “1996
        Act”), which substantially amended the Communications Act. The 1996 Act contains
        provisions intended to increase competition in the telephone, radio, broadcast
        television, and hardwire and wireless cable television businesses. This
        legislation has altered, and management believes will continue to alter,
        federal, state, and local laws and regulations affecting the communications
        industry, including certain of the services MST provides.
 
 Under
        the
        federal copyright laws, permission from the copyright holder generally must
        be
        secured before a video program may be retransmitted. Section 111 of the
        Copyright Act establishes the cable compulsory license pursuant to which
        certain
“cable systems” are entitled to engage in the secondary transmission of
        broadcast programming without the prior permission of the holders of copyrights
        in the programming. In order to do so, a cable system must secure a compulsory
        copyright license. Such a license may be obtained upon the filing of certain
        reports with and the payment of certain licensing fees to the U.S. Copyright
        Office. Private cable operators, such as MST, may rely on the cable compulsory
        license with respect to the secondary transmission of broadcast programming.
        Management does not expect the licensing fees to have a material adverse
        effect
        on MST’s business.
 
 Under
        the
        retransmission consent provisions of the 1992 Cable Act, multichannel video
        programming distributors, including, but not limited to, franchised and private
        cable operators, seeking to retransmit certain commercial television broadcast
        signals, notwithstanding the cable compulsory license, must first obtain
        the
        permission of the broadcast station in order to retransmit the station’s signal.
        However, private cable systems, unlike franchised cable systems, are not
        required under the FCC’s “must carry” rules to retransmit local television
        signals. Although there can be no assurances that MST will be able to obtain
        requisite broadcaster consents, management believes, in most cases, MST will
        be
        able to do so for little or no additional cost.




7


On
        November 29, 1999, Congress enacted the Satellite Home Viewer Improvement
        Act of
        1999 (“SHVIA”), which amended the Satellite Home Viewer Act. SHVIA permits DBS
        operators to transmit local television signals into local markets. SHVIA
        generally seeks to place satellite operators on an equal footing with cable
        television operators in regards to the availability of television broadcast
        programming. SHVIA amends the Copyright Act and other applicable laws and
        regulations in order to clarify the terms and conditions under which a DBS
        operator may retransmit local and distant broadcast television stations to
        subscribers. The law was intended to promote the ability of satellite services
        to compete with cable television systems and to resolve disputes that had
        arisen
        between broadcasters and satellite carriers regarding the delivery of broadcast
        television station programming to satellite service subscribers. As a result
        of
        SHVIA, television stations are generally entitled to seek carriage on any
        DBS
        operator's system providing local service in their respective markets. SHVIA
        creates a statutory copyright license applicable to the retransmission of
        broadcast television stations to DBS subscribers located in their markets.
        Although there is no royalty payment obligation associated with this license,
        eligibility for the license is conditioned on the satellite carrier's compliance
        with applicable laws, regulations and FCC rules governing the retransmission
        of
        such “local” broadcast television stations to satellite service subscribers.
        Noncompliance with such laws, regulations and/or FCC requirements could subject
        a satellite carrier to liability for copyright infringement. SHVIA was extended
        and re-enacted by the Satellite Home Viewer Extension and Reauthorization
        Act
        (“SHVERA”) in December of 2004.
 
 MST
        is
        not directly subject to rate regulation or certification requirements by
        the FCC
        or state public utility commissions because its equipment installation and
        sales
        agent activities do not constitute the provision of common carrier or cable
        television services. As a private cable operator, MST is not subject to
        regulation as a DBS provider, but primarily relies upon its third-party
        programming aggregators to procure all necessary re-transmission consents
        and
        other programming rights under the Communications Act and the Copyright Act.
 
 *State
        and Local Cable System Regulation*
  MST
        does
        not anticipate that its deployment of video programming services will be
        subject
        to state or local franchise laws primarily due to the fact that its facilities
        do not use or traverse public rights-of-way. Although MST may be required
        to
        comply with state and local property tax, environmental laws and local zoning
        laws, management does not anticipate that compliance with these laws will
        have
        any material adverse impact on MST’s business.
 
 *Preferential
        Access Right*
  MST
        generally negotiates exclusive rights to provide satellite services singularly
        or in competition with competing cable providers, and also negotiates, where
        possible, “rights-of-first-refusal” to match price and terms of third-party
        offers to provide other communication services in buildings where it has
        negotiated broadcast access rights. Management believes that these preferential
        rights of entry are generally enforceable under applicable law. However,
        current
        trends at the state and federal level suggest that the future enforceability
        of
        these provisions may be uncertain. The FCC has recently issued an order
        prohibiting telecommunications service providers from negotiating exclusive
        contracts with owners of commercial MDU properties, although it deferred
        determination in a pending rulemaking whether to render existing exclusive
        access agreements unenforceable, or to extend this prohibition to residential
        MDUs due to an inadequate administrative record. Although it is open to question
        whether the FCC has statutory and constitutional authority to compel mandatory
        access, there can be no assurance that it will not attempt to do so. Any
        such
        action may undermine the exclusivity provisions of MST’s rights of entry on the
        one hand, but would also open up many other properties to which MST could
        provide a competing service. There can be no assurance that future state
        or
        federal laws or regulations will not restrict MST’s ability to offer access
        payments, limit MDU owners' ability to receive access payments or prohibit
        MDU
        owners from entering into exclusive agreements, any of which could have a
        material adverse effect on MST’s business.
 
 *Regulation
        of the High-Speed lnternet and Wi-Fi Business*
  ISPs,
        including Internet access providers, are largely unregulated by the FCC or
        state
        public utility commissions at this time (apart from federal, state and local
        laws and regulations applicable to business in general). However, there can
        be
        no assurance that this business will not become subject to regulatory
        restraints. Also, although the FCC has rejected proposals to impose additional
        costs and regulations on ISPs to the extent they use local exchange telephone
        network facilities, such change may affect demand for Internet related services.
        No assurance can be given that changes in current or future regulations adopted
        by the FCC or state regulators or other legislative or judicial initiatives
        relating to Internet services would not have a material adverse effect on
        MST’s
        business.




8


*Regulation
        of the VoIP Business*
  IP-based
        voice services are currently exempt from the reporting and pricing restrictions
        placed on common carriers by the FCC. However, there are several state and
        federal regulatory proceedings further defining what specific service offerings
        qualify for this exemption. Due to the growing acceptance and deployment
        of VoIP
        services, the FCC and a number of state public service commissions are
        conducting regulatory proceedings that could affect the regulatory duties
        and
        rights of entities that provide IP-based voice applications. There is regulatory
        uncertainty as to the imposition of traditional retail, common carrier
        regulation on VoIP products and services.
 
 **Long
        Term Investments**
 
 MST
        maintains an investment in Interactivewifi.com, LLC a privately held company.
        This investment represents an equity interest of approximately 50% at December
        31, 2006. Interactivewifi.com is engaged in providing internet and related
        services to customers throughout metropolitan New York, including the Nuvisions
        internet services. MST accounted for this investment under the cost method,
        as
        MST does not have the ability to exercise significant influence over operating
        and financial policies of the investee. Telkonet reviewed the assumptions
        underlying the operating performance and cash flow forecasts in assessing
        the
        carrying values of the investment. The fair value of MST’s investment in
        Interactivewifi.com amounted to approximately $55,000 as of December 31,
        2006.
 
 **Backlog**
 
 The
        MST
        subscriber portfolio includes approximately 20 MDU properties with bulk service
        agreements and/or access licenses to service the individual subscribers in
        metropolitan New York. The remaining terms of the access agreements provide
        MST
        access rights from 7 to 15 years with the final agreement expiring in 2016
        and
        the revenues to be recognized under non-cancelable bulk agreements provide
        a
        minimum of $1,800,000 in revenue through 2013.
 
 ***Other
        information***
 
 ***Employees***
 
 As
        of
        March 1, 2007, the Company had 104 full time employees comprised of 69 full
        time
        employees of Telkonet and 27 employees of MST. The Company anticipates that
        it
        will hire additional key staff throughout 2007 in the areas of business
        development, sales and marketing, and engineering.
 
 Following
        the acquisition of SSI and Ethostream, LLC on March 9, 2007 and March 15,
        2007,
        respectively, the Company had 177 full
        time
        employees.
 
 ***Environmental
        Matters***
 
 The
        Company does not anticipate any material effect on its capital expenditures,
        earnings or competitive position due to compliance with government regulations
        involving environmental matters.
 
 ***Financial
        Information About Geographic Areas***
 
 To
        date,
        the majority of the Company’s revenue has been derived in the United States,
        although the Company continues to expand a growing portion of our revenue
        from
        international sales. International sales as a percentage of total revenue
        represented 19% and 25% in 2006 and 2005, respectively. Our international
        sales
        are concentrated in Canada, Latin America and Western Europe and we continue
        to
        expand into other markets worldwide. The table below sets forth our net revenue
        by major geographic region.
 
 **Year
                  Ended December 31,****2006**
              
              **Percentage
                  Change**
              
              **2005**
              
              **Percentage
                  Change**
              
              **2004**United
                  States
              
              $
              4,508,478
              
              
              141%
              
              $
              1,871,241
              
              
              197%
              
              $
              630,957Worldwide
              
              
              672,850
              
              
              9%
              
              
              617,082
              
              
              812%
              
              
              67,695Total
              
              $
              5,181,328
              
              
              108%
              
              $
              2,488,323
              
              
              256%
              
              $
              698,652






9


**ITEM
            1A.** **RISK
            FACTORS.**
 
 The
        Company’s results of operations, financial condition and cash flows can be
        adversely affected by various risks. These risks include, but are not limited
        to, the principal factors listed below and the other matters set forth in
        this
        annual report on Form 10-K. You should carefully consider all of these
        risks.
 
 *The
        Company has a history of operating losses and an accumulated deficit and
        expects
        to continue to incur losses for the foreseeable future.*
  Since
        inception through December 31, 2006, the Company has incurred cumulative
        losses
        of $70,424,669 and has never generated enough funds through operations to
        support its business. Additional capital may be required in order to provide
        working capital requirements for the next twelve months. The Company’s losses to
        date have resulted principally from:
 
 ·
              research
                  and development costs relating to the development of the Telkonet
                  iWire
                  SystemTMproduct suite;
 
 ·
              costs
                  and expenses associated with manufacturing, distribution and marketing
                  of
                  the Company’s products;
 
 ·
              general
                  and administrative costs relating to the Company’s operations;
                  and
 
 ·
              interest
                  expense related to the Company’s
                  indebtedness.
  The
        Company is currently unprofitable and may never become profitable. Since
        inception, the Company has funded its research and development activities
        primarily from private placements of equity and debt securities, a bank loan
        and
        short term loans from certain of its executive officers. As a result of its
        substantial research and development expenditures and limited product revenues,
        the Company has incurred substantial net losses. The Company’s ability to
        achieve profitability will depend primarily on its ability to successfully
        commercialize the Telkonet iWire SystemTM product suite. If the Company is
        not
        successful in generating sufficient liquidity from operations or in raising
        sufficient capital resources on terms acceptable to the Company, this could
        have
        a material adverse effect on the Company’s business, results of operations,
        liquidity and financial condition.
 
 *Potential
        fluctuations in operating results could have a negative effect on the price
        of
        the Company’s common stock.*
  The
        Company’s operating results may fluctuate significantly in the future as a
        result of a variety of factors, most of which are outside the Company’s control,
        including:
 
 ·
              the
                  level of use of the Internet;
 
 ·
              the
                  demand for high-tech goods;
 
 ·
              the
                  amount and timing of capital expenditures and other costs relating
                  to the
                  expansion of the Company’s
                  operations;
 
 ·
              price
                  competition or pricing changes in the
                  industry;
 
 ·
              technical
                  difficulties or system downtime;
 
 ·
              economic
                  conditions specific to the internet and communications industry;
                  and
 
 ·
              general
                  economic conditions.
  The
        Company’s quarterly results may also be significantly impacted by certain
        accounting treatment of acquisitions, financing transactions or other matters.
        Such accounting treatment could have a material impact on the Company’s results
        of operations and have a negative impact on the price of the Company’s common
        stock.


10




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




As
      of
      March 1, 2007, the Company’s officers and directors owned 17.8% of the Company’s
      issued and outstanding common stock. This means that the Company’s officers and
      directors, as a group, exercise significant control over matters upon which
      the
      Company’s stockholders may vote, including the selection of the Board of
      Directors, mergers, acquisitions and other significant corporate
      transactions.




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




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





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





As
      of
      December 31, 2006, the Company had outstanding employee options to purchase
      a
      total of 8,520,929 shares of common stock at exercise prices ranging from $1.00
      to $5.97 per share, with a weighted average exercise price of $2.06. As of
      December 31, 2006, the Company had outstanding non-employee options to purchase
      a total of 1,815,937 shares of common stock at an exercise price of $1.00 per
      share. As of December 31, 2006, the Company had warrants outstanding to purchase
      a total of 4,557,850 shares of common stock at exercise prices ranging from
      $2.59 to $4.87 per share, with a weighted average exercise price of $4.20.
      The
      exercise of outstanding options and warrants and the sale in the public market
      of the shares purchased upon such exercise will be dilutive to existing
      stockholders and could adversely affect the market price of the Company’s common
      stock.





*The
      powerline communications industry is intensely competitive and rapidly
      evolving.*




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




Delays
      in
      product development and introduction could result in:





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





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





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




*The
      communication industry is intensely competitive and rapidly evolving.*





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






11


Delays
      in
      product development and introduction could result in:





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





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





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





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





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




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





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




FCC
      rules
      permit the operation of unlicensed digital devices that radiate radio frequency
      emissions if the manufacturer complies with certain equipment authorization
      procedures, technical requirements, marketing restrictions and product labeling
      requirements. Differing technical requirements apply to “Class A” devices
      intended for use in commercial settings, and “Class B” devices intended for
      residential use to which more stringent standards apply. An independent,
      FCC-certified testing lab has verified that the Company’s Telkonet’s iWire
      System 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.






12


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




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




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




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




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




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




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




The
      Company’s success depends partly on its ability to maintain patent and trade
      secret protection, to obtain future patents and licenses, and to operate without
      infringing on the proprietary rights of third parties. There can be no assurance
      that the measures the Company has taken to protect its intellectual property,
      including those integrated to its Telkonet iWire System TM product
      suite, will prevent misappropriation or circumvention. In addition, there can
      be
      no assurance that any patent application, when filed, will result in an issued
      patent, or that the Company’s existing patents, or any patents that may be
      issued in the future, will provide the Company with significant protection
      against competitors. Moreover, there can be no assurance that any patents issued
      to, or licensed by, the Company will not be infringed upon or circumvented
      by
      others. Infringement by third parties on the Company’s proprietary technology
      could negatively impact its business. Moreover, litigation to establish the
      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.






13


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




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





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




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




·
            failure
                of the acquired businesses to achieve expected
                results;





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





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





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





·
            risks
                associated with unanticipated events, liabilities or
                contingencies.





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




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




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






14


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





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





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





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





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




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





**ITEM
      1B.** **UNRESOLVED
      STAFF COMMENTS.**





None.





**ITEM
      2.** **PROPERTIES.**





The
      Company presently leases 11,600 square feet of commercial office space in
      Germantown, Maryland for its corporate headquarters. The Germantown lease
      expires in November 2010. The Company is currently planning to increase the
      office space of its Germantown headquarters by approximately 6,000 square feet
      in April 2007 in conjunction with a corporate initiative to consolidate office
      space.





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





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





In
      conjunction with the January 2006 acquisition of MST, the Company presently
      leases 12,600 square feet of commercial office space in Hawthorne, New Jersey
      for its office and warehouse spaces. This lease expires in April 2010 with
      an
      option to extend the lease an additional five years.





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






15


**ITEM
      3.** **LEGAL
      PROCEEDINGS.**





None.





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





On
      December 8, 2006, the Company held its annual meeting of stockholders at which
      the Company’s stockholders elected seven (7) directors to serve on the Company’s
      Board of Directors and ratified the appointment of the Company’s independent
      accountants for 2006. The following directors were elected at the annual meeting
      based on the number of votes indicated below. Each director was elected to
      serve
      until the next annual meeting of stockholders or until his successor is elected
      and qualified.








**Director
                Name**
            **For**
            **Against**
            **Abstain**
            **Broker
                Non-votes**Warren
                V. Musser
            45,352,150
            0
            1,520,291
            0Ronald
                W. Pickett
            45,343,879
            0
            1,526,562
            0Stephen
                L. Sadle
            45,399,903
            0
            1,472,538
            0Thomas
                C. Lynch
            46,385,473
            0
            486,968
            0James
                L. Peeler
            46,376,673
            0
            495,768
            0Thomas
                M. Hall
            46,423,873
            0
            448,568
            0Seth
                D. Blumenfeld
            45,392,739
            0
            1,479,702
            0





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





**Matter
                Voted Upon**
            **For**
            **Against**
            **Abstain**
            **Broker
                Non-votes**Ratification
                of Telkonet’s Amended and Restated Stock Incentive Plan
            12,119,456
            2,641,084
            222,197
            31,889,704Ratification
                of Independent Accountants
            46,555,175
            142,308
            174,958
            0







16


**PART
      II**





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





On
      January 24, 2004, the Company’s common stock was listed for trading on the
      American Stock Exchange (AMEX) under the ticker symbol “TKO.” Prior to January
      24, 2004, the Company’s common stock was quoted on the OTC Bulletin Board under
      the symbol “TLKO.OB.” As of March 1, 2007, the Company had 216 stockholders of
      record and 57,002,301 shares of its common stock issued and outstanding.




The
      following table documents the high and low sales prices for the Company’s common
      stock on the AMEX for the period beginning January 1, 2005 through December
      31,
      2006. The information provided for the periods listed below was obtained from
      the Yahoo! Finance web site.





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





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




17





**Performance
      Graph**





Set
      forth
      below is a line graph comparing the cumulative total return on Telkonet’s common
      stock against the cumulative total return of the Market Index for the American
      Stock Exchange (U.S.) (“AMEX”) and for the peer group “Communications Services,
      within the Standard Industrial Classification Code category, (SIC) Code 4899”,
      for the period beginning August 15, 2002 and each fiscal year ending December
      31
      thereafter through the fiscal year ended December 31, 2006. Because Telkonet’s
      common stock was not widely traded prior to August 15, 2002, the graph does
      not
      show the total return on Telkonet’s common stock prior to August 15, 2002. The
      total returns assume $100 invested on August 15, 2002 with reinvestment of
      dividends.













18


ITEM
        6.SELECTED
        FINANCIAL DATA
  The
        following table sets forth selected financial data for the last 5 years.
        This
        selected financial data should be read in conjunction with the consolidated
        financial statements and related notes included in Item 15 of this Form
        10-K.
 **Year
                    Ended December 31,****(in
                    thousands, except per share amounts)**
                
                **2006**
                
                2005
                
                **2004**
                
                **2003**
                
                **2002**Total
                    revenues
                
                $
                5,181
                
                $
                2,488
                
                $
                698
                
                $
                94
                
                $
                —Operating
                    loss
                
                
                (17,563
                )
                
                (15,307
                )
                
                (13,112
                )
                
                (6,564
                )
                
                (3,155
                )Net
                    loss
                
                
                (27,437
                )
                
                (15,778
                )
                
                (13,093
                )
                
                (7,657
                )
                
                (3,778
                )Loss
                    per share - basic
                
                
                (0.54
                )
                
                (0.35
                )
                
                (0.32
                )
                
                (0.37
                )
                
                (.22
                )Loss
                    per share - diluted
                
                
                (0.54
                )
                
                (0.35
                )
                
                (0.32
                )
                
                (0.37
                )
                
                (.22
                )Basic
                    weighted average common shares outstanding
                
                
                50,824
                
                
                44,743
                
                
                41,384
                
                
                20,702
                
                
                17,120Diluted
                    weighted average common shares outstanding
                
                
                50,824
                
                
                44,743
                
                
                41,384
                
                
                20,702
                
                
                17,120Working
                    capital
                
                
                (531
                )
                
                12,061
                
                
                12,672
                
                
                5,296
                
                
                (894
                )Total
                    assets
                
                
                12,517
                
                
                23,291
                
                
                15,493
                
                
                6,176
                
                
                295Short-term
                    borrowings and current portion of long-term debt
                
                
                —
                
                
                6,350
                
                
                —
                
                
                15
                
                
                310Long-term
                    debt, net of current portion
                
                
                —
                
                
                9,617
                
                
                588
                
                
                3,132
                
                
                863Stockholders’
                    equity (deficiency)
                
                
                8,135
                
                
                5,315
                
                
                13,646
                
                
                2,388
                
                
                (1,527
                )




**ITEM
        7.** **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
        OPERATIONS.**
 
 The
        following discussion and analysis of the Company’s financial condition and
        results of operations should be read in conjunction with the accompanying
        financial statements and related notes thereto.
 
 The
        Company reports financial results for the following operating business
        segments:
 
 **Telkonet**
 
 Through
        the revolutionary Telkonet iWire SystemTM , Telkonet utilizes proven PLC
        technology to deliver commercial high-speed Broadband access from an IP
“platform” that is easy to deploy, reliable and cost-effective by leveraging a
        building’s existing electrical infrastructure. The building’s existing
        electrical wiring becomes the backbone of the local area network, which converts
        virtually every electrical outlet into a high-speed data port, without the
        costly installation of additional wiring or major disruption of business
        activity. The segment’s net sales in 2006 were $3,425,525, representing 66% of
        the Company’s consolidated net sales.
  19


**MST**





MST
      is a
      communications service provider offering Quad-Play services to MTU and MDU
      residential, hospitality and commercial properties. These Quad-Play services
      include video, voice, high-speed internet and wireless fidelity (“Wi-Fi”)
      access. In addition, MST currently offers or plans to offer a variety of
      next-generation telecommunications solutions and services, including satellite
      installation, video conferencing, surveillance/security and energy management,
      and other complementary professional services. The segments’ net sales upon
      acquisition for the period February 1 through December 31, 2006 were $1,755,803,
      representing 34% of the Company’s consolidated net sales.


**Critical
        Accounting Policies and Estimates**
 
 The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States of America requires us to make estimates
        and assumptions that affect the amounts reported in the consolidated financial
        statements and accompanying notes. On an ongoing basis, we evaluate significant
        estimates used in preparing our financial statements, including those related
        to
        revenue recognition, guarantees and product warranties and stock based
        compensation. We base our estimates on historical experience, underlying
        run
        rates and various other assumptions that we believe to be reasonable, the
        results of which form the basis for making judgments about the carrying values
        of assets and liabilities. Actual results could differ from these estimates.
        The
        following are critical judgments, assumptions, and estimates used in the
        preparation of the consolidated financial statements.
 
 **Revenue
        Recognition**
 
 For
        revenue from product sales, the Company recognizes revenue in accordance
        with
        Staff Accounting Bulletin No. 104, *Revenue
        Recognition* (“SAB104”), which superceded Staff Accounting Bulletin No. 101, *Revenue
        Recognition in Financial Statements* (“SAB101”). SAB 101 requires that four basic criteria must be met before revenue
        can be recognized: (1) persuasive evidence of an arrangement exists; (2)
        delivery has occurred; (3) the selling price is fixed and determinable; and
        (4)
        collectibility is reasonably assured. Determination of criteria (3) and (4)
        are
        based on management’s judgments regarding the fixed nature of the selling prices
        of the products delivered and the collectibility of those amounts. Provisions
        for discounts and rebates to customers, estimated returns and allowances,
        and
        other adjustments are provided for in the same period the related sales are
        recorded. The Company defers any revenue for which the product has not been
        delivered or is subject to refund until such time that the Company and the
        customer jointly determine that the product has been delivered or no refund
        will
        be required. SAB 104 incorporates Emerging Issues Task Force 00-21 (“EITF
        00-21”), *Multiple-Deliverable
        Revenue Arrangements.* EITF
        00-21 addresses accounting for arrangements that may involve the delivery
        or
        performance of multiple products, services and/or rights to use assets.
 
 For
        equipment under lease, revenue is recognized over the lease term for operating
        lease and rental contracts. All of the Company’s leases are accounted for as
        operating leases. At the inception of the lease, no lease revenue is recognized
        and the leased equipment and installation costs are capitalized and appear
        on
        the balance sheet as “Equipment Under Operating Leases.” The capitalized cost of
        this equipment is depreciated from two to three years, on a straight-line
        basis
        down to the Company’s original estimate of the projected value of the equipment
        at the end of the scheduled lease term. Monthly lease payments are recognized
        as
        rental income.
 
 MST
        accounts for the revenue, costs and expense related to residential cable
        services as the related services are performed in accordance with SFAS
        No. 51, Financial Reporting by Cable Television Companies. Installation
        revenue for residential cable services is recognized to the extent of direct
        selling costs incurred. Direct selling costs have exceeded installation revenue
        in all reported periods. Generally, credit risk is managed by disconnecting
        services to customers who are delinquent.
 
 **Guarantees
        and Product Warranties**
 
 FASB
        Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
        Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”),
        requires that upon issuance of a guarantee, the guarantor must disclose and
        recognize a liability for the fair value of the obligation it assumes under
        that
        guarantee.




20


The
      Company’s guarantees issued subject to the recognition and disclosure
      requirements of FIN 45 as of December 31, 2006 and 2005 were not material.
      The
      Company records a liability for potential warranty claims. The amount of the
      liability is based on the trend in the historical ratio of claims to sales,
      the
      historical length of time between the sale and resulting warranty claim, new
      product introductions and other factors. The products sold are generally covered
      by a warranty for a period of one year. In the event the Company determines
      that
      its current or future product repair and replacement costs exceed its estimates,
      an adjustment to these reserves would be charged to earnings in the period
      such
      determination is made. During the year ended December 31, 2006, the Company
      experienced approximately 3% percent of units returned. Using this experience
      factor a reserve of $23,300 was accrued. Prior to the fiscal year of 2005,
      the
      Company had not established historical ratio of claims, and the cost of
      replacing defective products and product returns were immaterial and within
      management's expectations, accordingly there were no warranties provided with
      the purchase of the Company's products during the year ended December 31,
      2004.





**Stock
      Based Compensation**





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




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




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




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




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






21


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





**Revenues**





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





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





*Product
      Revenue*





Product
      revenue in the Telkonet Segment increased approximately $800,000, excluding
      the
      sale of certain rental contract agreements to HLC, for the year ended December
      31, 2006, and the MST Segment revenue amounted to approximately $280,000 in
      installation and ancillary services provided to customers for the eleven months
      ended December 31, 2006. The Telkonet Segment revenue principally arises from
      the sale of iBridges and other Telkonet iWire System TM components directly to customers. Revenues to date have been principally derived
      from the Commercial (Hospitality and Multi-Dwelling) and International business
      units. The Telkonet Segment anticipates continued growth in Commercial and
      International product revenue in the Value Added Reseller (VAR) purchase
      programs. The Telkonet Segment expanded its international sales and marketing
      efforts upon receiving its European certification (CE). The Company has received
      the FIPS 140-2 certification and continues to pursue opportunities within the
      government sector. The Company has extended its iWire System TM to
      included energy information, management and control solutions for residential
      and commercial buildings.





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





*Rental
      (lease)Revenue*





A
      significant increase in the overall recurring revenue was attributable to the
      addition of the MST segment subscriber base in February 2006 and amounted to
      approximately $1,476,000 for the eleven months ended December 31, 2006. The
      MST
      Segment subscriber portfolio in includes approximately 20 MDU properties with
      service bulk service agreements and/or access licenses to service the individual
      subscribers in metropolitan New York. The Telkonet Segment rental (lease)
      revenue decreased by $95,000 in the year ended December 31, 2006 compared to
      the
      prior year primarily due to the sale of rental contracts to Hospitality Leasing
      Corporation (HLC) and the VAR purchase program sales effort.





**Cost
      of Sales**





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




22


*Product
      Costs*




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





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




*Rental
      (lease) Costs*





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





**Gross
      Profit**





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




*Product
      Gross Profit*





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





*Rental
      (lease) Gross Profit*





Telkonet
      gross profit associated with recurring (lease) revenue decreased as a result
      of
      the sale of rental contracts to Hospitality Leasing Corporation (HLC) resulting
      in a decrease in recurring (lease) revenue which was more than offset by
      increased customer support services related to the increased number of iBridges
      supported. As MST develops the infrastructure and continues to build-out the
      subscriber base, the gross margins were $417,664 or -28% for the 11 months
      end
      December 31, 2006, primarily due to programming costs and the support
      infrastructure. MST anticipates increased margins in 2007 as the projected
      new
      subscriber base absorbs the current infrastructure.






23


**Operating
      Expenses**





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





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





**Product
      Research and Development**





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




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





**Selling,
      General and Administrative**





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





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





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





**Revenues**





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





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






24




*Product
        revenue*
 
 Product
        revenue principally arises from the sale of iBridges and other Telkonet iWire
        System TM components directly to customers. Revenues to date have been principally
        derived
        from the Commercial (Hospitality and Multi-Dwelling) and International business
        units. The Company anticipates continued growth in Commercial and International
        product revenue in the Value Added Reseller purchase programs. The Company
        expanded its international sales and marketing efforts upon receiving its
        European certification (CE) in March 2005. The Company expanded its sales
        and
        marketing efforts in the government sector in connection with the receipt
        of the
        FIPS 140-2 certification received in July 2005.
 
 In
        December 2005, the Company consummated a non-recourse sale of certain rental
        contract agreements and the related capitalized equipment which were accounted
        for as operating leases with Hospitality Leasing Corporation. The remaining
        rental income payments of the contracts were valued at approximately $732,000,
        including the customer support component of approximately $205,000 which
        the
        Company will retain and continue to receive monthly customer support payments
        over the remaining average unexpired lease term of 26 months. In December
        2005,
        the Company recognized revenue of approximately $439,000 for the sale,
        calculated based on the present value of total unpaid rental payments, and
        expensed the associated capitalized equipment cost, net of depreciation,
        of
        approximately $267,000 and expensed associated taxes of approximately $40,000.
 
 *Rental
        (lease) revenue*
 
 The
        increase in rental (lease) revenue was primarily due to the increase in
        non-cancelable leases. Accordingly, revenues associated with these leases
        are
        recognized ratably over a three to five year lease term. Revenues to be
        recognized under these non-cancelable leases (backlog) was approximately
        $2,411,000 including a non-recourse sale of $918,000 certain rental
        contract  agreements
        in January 2006. The weighted average remaining lease term was approximately
        31
        months as of December 31, 2005. The associated unamortized capitalized costs
        in
        connection with these leases was approximately $664,000 or 26% of revenue
        backlog.
 
 **Cost
        of Sales**
 
 Year
                  ended December 31,Cost
                  of Sales:
              
              2005
              
              2004
              
              VarianceProduct
              
              $
              1,183,574
              
              
              67%
              
              $
              459,225
              
              
              96%
              
              $
              724,349
              
              
              158%Rental
                  (lease)
              
              
              533,605
              
              
              74%
              
              
              83,634
              
              
              38%
              
              
              449,971
              
              
              538%Total
              
              $
              1,717,179
              
              
              695
              
              $
              542,859
              
              
              78%
              
              $
              1,174,320
              
              
              216%
 
 *Product
        Costs*
  Product
        cost primarily includes Telkonet iWire System TM product
        suite equipment cost and installation labor. The related product cost in
        connection with the non-recourse sale of approximately $766,000 of rental
        contract agreements amounted to approximately $267,000 of previously capitalized
        equipment cost and other related cost.
 
 *Rental
        (lease) Costs*
 
 Lease
        Cost primarily represents the amortization of the capitalized costs which
        are
        amortized over the lease term and include Telkonet equipment, installation
        labor
        and customer support. This increase compared to the prior year quarter is
        commensurate with the increase in leases.
 
 **Gross
        Profit**
  Year
                  ended December 31,Gross
                  Profit:
              
              2005
              
              2004
              
              VarianceProduct
              
              $
              586,153
              
              
              33%
              
              $
              18,330
              
              
              4%
              
              $
              567,823
              
              
              3,098%Rental
                  (lease)
              
              
              184,991
              
              
              26%
              
              
              137,463
              
              
              62%
              
              
              47,528
              
              
              -35%Total
              
              $
              771,144
              
              
              31%
              
              $
              155,793
              
              
              22%
              
              $
              615,351
              
              
              395%






25


*Product
      Costs*





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





*Rental
      (lease) Costs*





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





**Operating
      Expenses**





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




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





**Product
      Research and Development**





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




Research
      and development costs related to both present and future products are expensed
      in the period incurred. Total expenses for the year ended December 31, 2005
      increased over the comparable prior year by $243,795 or 13%. This increase
      was
      primarily related to an increase in salaries and related costs associated with
      the addition of employees and costs related to CE, FIPS 140-2 and other required
      certifications of the Company’s product.





**Selling,
      General and Administrative**





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




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






26


**Liquidity
      and Capital Resources**





*Working
      Capital*





Our
      working capital surplus decreased by $12,591,438 during the twelve months ended
      December 31, 2006 from a working capital surplus of $12,060,807 at December
      31, 2005 to a working capital deficit of $(530,631) at December 31, 2006.
      The decrease in working capital for the twelve months ended December 31, 2006,
      is due to a combination of factors, of which the significant factors are set
      out
      below:





·
            Cash
                had a net decrease from working capital by $6,778,042 for the period
                ended
                December 31, 2006. The most significant uses of cash are as
                follows:


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


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


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


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


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


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





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





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




*Senior
      Notes*





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





*Convertible
      Senior Notes*





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





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






27


*Principal
      Payments of Debt*





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





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





*Early
      Extinguishment of Debt*





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





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





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





The
      settlement agreements provide that the number of shares issued to the
      noteholders shall be adjusted based upon the arithmetic average of the weighted
      average price of the Company’s common stock on the American Stock Exchange for
      the twenty trading days immediately following the settlement date.  The
      Company has concluded that, based upon the weighted average of the Company's
      common stock between August 16, 2006 and September 13, 2006, the Company is
      entitled to a refund from the two noteholders.  One of the noteholders has
      informed the Company that it does not believe such a refund is required. 
As a result, the Company has declined to deliver to the noteholders certain
      stock purchase warrants issued to them pursuant to the settlement agreements
      pending resolution of this disagreement. One of the noteholders has alleged
      that
      the Company has failed to satisfy its obligations under the settlement agreement
      by failing to deliver the warrants. In addition, the noteholder maintains that
      the Company has breached certain provisions of the registration rights agreement
      and, as a result of such breach, such noteholder claims that it is entitled
      to
      receive liquidated damages from the Company. As of March 15, 2007, no legal
      claim has been filed by the noteholder.


28


*Acquisition
      of Microwave Satellite Technologies, Inc.*





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





*Acquisition
      of Smart Systems International (SSI)*





On
      March
      9, 2007, the Company acquired substantially all of the assets of Smart Systems
      International (SSI), a leading provider of energy management products and
      solutions to customers in the United States and Canada for cash and Company
      common stock having an aggregate value of $7,000,000. The purchase price was
      comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
      stock. The Company is obligated to register the stock portion of the purchase
      price on or before May 15, 2007 and 1,090,000 shares are being held in an escrow
      account for a period of one year following the closing from which certain
      potential indemnification obligations under the purchase agreement may be
      satisfied. The aggregate number of shares held in escrow is subject to
      adjustment upward or downward depending upon the trading price of the Company’s
      common stock during the one year period following the closing date.





*Acquisition
      of Ethostream, LLC*





On
      March
      15, 2007, the Company acquired 100% of the outstanding membership units of
      Ethostream, LLC, a network solutions integration company that offers
      installation, sales and service to the hospitality industry. The Ethostream
      acquisition will enable Telkonet to provide installation and support for PLC
      products and third party applications to customers across North America. The
      purchase price of $11,756,097 was comprised of $2.0 million in cash and
      3,459,609 shares of the Company’s common stock. The entire stock portion of the
      purchase price is being held in escrow to satisfy certain potential
      indemnification obligations of the sellers under the purchase agreement. The
      shares held in escrow are distributable over the three years following the
      closing. The aggregate number of shares issuable to the sellers is subject
      to
      downward adjustment in the event the Company’s common stock trades at or above a
      price of $4.50 per share for twenty consecutive trading days during the one
      year
      period following the closing.





*Proceeds
      from the issuance of common stock*





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





During
      the twelve months ended December 31, 2006, the Company issued 2,400,000 shares
      of common stock valued at $2.50 per share for an aggregate purchase price of
      $6,000,000. The Company also issued to this investor warrants to purchase 1.56
      million shares of its common stock at an exercise price of $4.17 per share.




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





*Cash
      flow analysis*





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






29


The
      Company was provided and utilized cash for investing activities $6,717,442
      and
      $10,925,719 during the twelve months ended December 31, 2006 and 2005,
      respectively. During the period ended December 31, 2006, the proceeds from
      the
      release of funds from the Restricted Certificate of Deposit provided
      $10,000,000 in
      conjunction with the conversion and settlement agreement with the lenders under
      the Company’s Convertible Senior Notes .
      The expenditures were primarily the result of the acquisition of MST in January
      2006 of $958,438, net of acquired cash. Additionally, cost of equipment under
      operating leases amounted to $1,589,188, net of proceeds from sale of certain
      equipment under operating lease of $350,571, and $458,271 for the December
      31,
      2006 and 2005, respectively. Furthermore, purchases of property and equipment
      amounted to $734,888 and $336,448 for the year ended December 31, 2006 and
      2005,
      respectively.




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





The
      Company believes it has sufficient access to capital to meet its working capital
      requirements through the remainder of 2007 in available cash and in cash
      generated from operations. Additional financing may be required in order to
      meet
      growth opportunities in financing and/or investing activities. If additional
      capital is required and the Company is not successful in generating sufficient
      liquidity from operations or in raising sufficient capital resources on terms
      acceptable to the Company, this could have a material adverse effect on the
      Company’s business, results of operations, liquidity and financial
      condition.





**Inflation**





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





**Acquisition
      or Disposition of Plant and Equipment**





During
      the year ended December 31, 2006, fixed assets increased $1,169,899 or 112%
      primarily from the addition of the MST Segment assets acquired on January 31,
      2006 of approximately $435,000 and approximately $674,000 of equipment purchase
      for the MST build-out. The remainder related to computer equipment and
      peripherals used in day-to-day operations. The Company anticipates significant
      expenditures in the MST Segment to continue the build-out the head-end
      equipment, IPTV and other related projects. The Telkonet segment does not
      anticipate the sale or purchase of any significant property, plant or equipment
      during the next twelve months, other than computer equipment and peripherals
      to
      be used in the Company’s day-to-day operations.





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





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





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





**New
      Accounting Pronouncements**





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


30


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





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




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


In
        December 2006, the FASB issued FSP EITF 00-19-2, Accounting for Registration
        Payment Arrangements (" FSP
        00-19 -2")
        which addresses accounting for registration payment arrangements. FSP
        00-19 -2
        specifies that the contingent obligation to make future payments or otherwise
        transfer consideration under a registration payment arrangement, whether
        issued
        as a separate agreement or included as a provision of a financial instrument
        or
        other agreement, should be separately recognized and measured in accordance
        with
        FASB Statement No. 5, Accounting for Contingencies. FSP
        00-19 -2
        further clarifies that a financial instrument subject to a registration payment
        arrangement should be accounted for in accordance with other applicable
        generally accepted accounting principles without regard to the contingent
        obligation to transfer consideration pursuant to the registration payment
        arrangement. For registration payment arrangements and financial instruments
        subject to those arrangements that were entered into prior to the issuance
        of
        EITF 00-19-2, this guidance is effective for financial statements issued
        for
        fiscal years beginning after December 15, 2006 and interim periods within
        those
        fiscal years. The
        Company has not yet determined the impact that the adoption of FSP
        00-19 -2
        will have on its financial statements.
 
 In
        February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
        Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose
        to measure many financial instruments, and certain other items, at fair value.
        SFAS 159 applies to reporting periods beginning after November 15, 2007.
        The
        adoption of SFAS 159 is not expected to have a material impact on the Company’s
        financial condition or results of operations.




**Disclosure
      of Contractual Obligations**





Payment
                Due by PeriodContractual
                obligations
            
            
            Total
            
            
            Less
                than 1 year
            
            
            1-3
                years
            
            
            3-5
                years
            
            
            More
                than 5 yearsLong-Term
                Debt Obligations
            
            $
            900,000
            
            $
            900,000
            
            
            -
            
            
            -
            
            
            -Capital
                Lease Obligations
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Operating
                Lease Obligations
            
            $
            1,117,663
            
            $
            421,804
            
            $
            518,909
            
            $
            176,950
            
            
            -Purchase
                Obligations
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Other
                Long-Term Liabilities Reflected on the Registrant’s Balance Sheet Under
                GAAP
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Total
            
            $
            2,017,663
            
            $
            1,321,804
            
            $
            518,909
            
            $
            176,950
            
            
            -





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






31




**ITEM
        7A.** **QUANTITATIVE
        AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**
 
 **Short
        Term Investments**
 
 We
        held
        no marketable securities as of December 31, 2006. Our excess cash is held
        in
        money market accounts in a bank and brokerage firms both of which are nationally
        ranked top tier firms with an average return of approximately 400 basis points. Due
        to
        the conservative nature of our investment portfolio, an increase or decrease
        of
        100 basis points in interest rates would not have a material effect on our
        results of operations or the fair value of our portfolio.
 
 **Investments
        in Privately Held Companies**
 
 We
        have
        invested in privately held companies, which are in the startup or development
        stages. These investments are inherently risky because the markets for the
        technologies or products these companies are developing are typically in
        the
        early stages and may never materialize. As a result, we could lose our entire
        initial investment in these companies. In addition, we could also be required
        to
        hold our investment indefinitely, since there is presently no public market
        in
        the securities of these companies and none is expected to develop. These
        investments are carried at cost, which as of March 1, 2007 was $131,044 and
        $8,000 in BPL Global and Amperion, respectively, and at December 31, 2006,
        are
        recorded in other assets in the Consolidated Balance Sheets. The Company
        determined that its investment in Amperion was impaired based upon forecasted
        discounted cash flow. Accordingly, the Company wrote-off 80%, or $400,000
        and
        92%, or $92,000, of the carrying value of its investment through a charge
        to
        operations during the years ended December 31, 2005 and 2006, respectively.
        The
        fair value of the Company’s investment in BPL Global, remained at $131,044 as of
        December 31, 2006.
 
 **ITEM
        8.** **FINANCIAL
        STATEMENTS.**
 
 See
        the
        Financial Statements and Notes thereto commencing on Page F-1.
 
 **ITEM
        9.** **CHANGES
        IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
        DISCLOSURE.**
 
 None.
 
 **ITEM
        9A.** **CONTROLS
        AND PROCEDURES.**
  ***Evaluation
        of Disclosure Controls and Procedures*** **.** Under
        the supervision and with the participation of our management, including our
        Chief Executive Officer and Vice President of Finance (principal accounting
        officer), the Company evaluated the effectiveness of the design and operation
        of
        its disclosure controls and procedures (as such term is defined in Rule
        13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).
        Disclosure controls and procedures are the controls and other procedures
        that
        the Company designed to ensure that it records, processes, summarizes and
        reports in a timely manner the information it must disclose in reports that
        it
        files with or submits to the Securities and Exchange Commission under the
        Exchange Act. Based on this evaluation, the Chief Executive Officer and the
        Vice
        President of Finance concluded that the Company’s disclosure controls and
        procedures were effective as of the end of the period covered by this
        report.
 
 ***Changes
        in Internal Control over Financial Reporting*** **.** During
        the fourth quarter of 2006, there was no change in the Company’s internal
        control over financial reporting (as such term is defined in Rule 13a-15(f)
        under the Exchange Act) that has materially affected, or is reasonably likely
        to
        materially affect, the Company’s internal control over financial
        reporting.
  
 32
 ***Management
        Report On Internal Control over Financial Reporting.*** The
        Company’s management is responsible for establishing and maintaining adequate
        internal control over financial reporting. Internal control over financial
        reporting is defined in Rule 13a-15(f) under the Exchange Act as a process
        designed by, or under the supervision of, the Company’s principal executive and
        principal financial officers and effected by the Company’s board of directors,
        management and other personnel, to provide reasonable assurance regarding
        the
        reliability of financial reporting and the preparation of financial statements
        for external purposes in accordance with accounting principles generally
        accepted in the United States of America and includes those policies and
        procedures that:
  ·
                pertain
                    to the maintenance of records that, in reasonable detail, accurately
                    and
                    fairly reflect the transactions and dispositions of the Company’s
                    assets;
 
 ·
                provide
                    reasonable assurance that transactions are recorded as necessary
                    to permit
                    preparation of financial statements in accordance with accounting
                    principles generally accepted in the United States of America,
                    and that
                    the Company’s receipts and expenditures are being made only in accordance
                    with authorization of management and directors;
                    and
 
 ·
                provide
                    reasonable assurance regarding prevention or timely detection
                    of
                    unauthorized acquisition, use or disposition of the Company’s assets that
                    could have a material effect on the financial
                    statements.
  Because
        of its inherent limitations, internal control over financial reporting may
        not
        prevent or detect misstatements. Also, projections of any evaluation of
        effectiveness to future periods are subject to the risk that controls may
        become
        inadequate because of changes in conditions, or that the degree of compliance
        with the policies or procedures may deteriorate.





Under
      the
      supervision and with the participation of the Company’s management, including
      its principal executive and principal financial officers, the Company assessed,
      as of December 31, 2006, the effectiveness of its internal control over
      financial reporting. This assessment was based on criteria established in the
      framework in *Internal Control-Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission. Based
      on the Company’s assessment, management concluded that the Company’s internal
      control over financial reporting was effective as of December 31,
      2006.




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


33


RUSSELL
      BEDFORD STEFANOU MIRCHANDANI LLP


CERTIFIED
      PUBLIC ACCOUNTANTS





REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





Board
      of Directors


Telkonet,
      Inc.


Germantown,
      MD




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




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




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




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




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




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









/s/
      RUSSELL BEDFORD
      STEFANOU MIRCHANDANI LLP





Russell
      Bedford
      Stefanou Mirchandani LLP


Certified
      Public
      Accountants








McLean,
      Virginia


March
      15, 2007






34


**ITEM
      9B.** **OTHER
      INFORMATION.**





None.


**PART
      III**





**ITEM
      10.** **DIRECTORS
      AND EXECUTIVE OFFICERS OF THE REGISTRANT.**





The
      following table furnishes the information concerning the Company’s directors and
      officers during the fiscal year ended December 31, 2006. The directors of the
      Company are elected every year and serve until their successors are duly elected
      and qualified.





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


_________________________


(1)
            Member
                of the Audit Committee


(2)
            Member
                of the Compensation Committee








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





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





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





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






35


**Robert
      P. Crabb—Chief Marketing Officer**





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





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





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





**James
      F. Landry—Chief Technology Officer**





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





**Richard
      J. Leimbach—Vice President of Finance**




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





**Warren
      V. Musser—Chairman of the Board of Directors**





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





**Thomas
      C. Lynch—Director**





Mr.
      Lynch
      is Senior Vice President and Director of The Staubach Company’s Federal Sector
      (a real estate management and advisory services firm) in the Washington, D.C.
      area. Mr. Lynch joined The Staubach Company in November 2002 after 6 years
      as
      Senior Vice President at Safeguard Scientifics, Inc. (NYSE: SFE) (a high-tech
      venture capital company). While at Safeguard, he served nearly two years as
      President and Chief Operating Officer at CompuCom Systems, a Safeguard
      subsidiary. After a 31-year career of naval service, Mr. Lynch retired in the
      rank of Rear Admiral. Mr. Lynch’s Naval service included chief, Navy Legislative
      Affairs, command of the Eisenhower Battle Group during Operation Desert Shield,
      Superintendent of the United States Naval Academy from 1991 to 1994 and Director
      of the Navy Staff in the Pentagon from 1994 to 1995. Mr. Lynch presently serves
      as a Director of Pennsylvania Eastern Technology Council, Armed Forces Benefit
      Association, Catholic Leadership Institute, National Center for the American
      Revolution at Valley Forge and Mikros Systems. Mr. Lynch has been a director
      of
      the Company since October 2003.


36


**Dr.
      Thomas M. Hall—Director**





Dr.
      Hall
      is the Managing Member of Marrell Enterprises, LLC (a company that specializes
      in international business development).Dr. Hall also serves on the board of
      directors of Coris International SA (a Paris-based insurance services company
      with subsidiaries in 36 countries). For 12 years (until 2002), Dr. Hall was
      the
      chief executive officer of Medical Advisory Systems, Inc. (a company providing
      international medical services and pharmaceutical distribution). Dr. Hall holds
      a bachelor of science and a medical degree from the George Washington University
      and a master of international management degree from the University of Maryland.
      Dr. Hall has been a director of the Company since April 2004.





**James
      L. “Lou” Peeler—Director**





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





**Seth
      D. Blumenfeld—Director**





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





*Audit
      Committee*





The
      Company maintains an Audit Committee of the Board of Directors. For the year
      ended December 31, 2006, Messrs. Hall, Lynch and Peeler served on the Audit
      Committee. The Company’s Board of Directors has determined that each of Messrs.
      Hall, Lynch and Peeler is a “financial expert” as defined by Item 401 of
      Regulation S-K promulgated under the Securities Act of 1933 and the Securities
      Exchange Act of 1934. The Company’s Board of Directors also has determined that
      each of Messrs. Hall, Lynch and Peeler are “independent” as such term is defined
      in Section 121(A) of the AMEX Rules and Rule 10A-3 promulgated under the
      Securities Exchange Act of 1934. The Board of Directors has adopted an audit
      committee charter, which was ratified by the Company’s stockholders at the 2004
      Annual Meeting of Stockholders.





*Compensation
      Committee*





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




*Code
      of Ethics*





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






37


Beneficial
      OwnershipSECTION
      16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE





Section
      16(a) of the Securities Exchange Act of 1934 requires our directors and certain
      of our officers to file reports of holdings and transactions in shares of
      Telkonet common stock with the Securities and Exchange Commission. Based on
      our
      records and other information, we believe that in 2006 our directors and our
      officers who are subject to Section 16 met all applicable filing
      requirements.





**ITEM
      11.** **EXECUTIVE
      COMPENSATION.**


**COMPENSATION
      COMMITTEE REPORT**





The
      Compensation  Committee of the Board of Directors has reviewed and
      discussed the section of this Form 10-K entitled “Compensation Discussion and
      Analysis” with management. Based on this review and discussion, the Committee
      has recommended to the Board that the section entitled “Compensation Discussion
      and Analysis,” be included in this Form 10-K for the fiscal year ended
      December 31, 2006.





Thomas
      M. Hall


Thomas
      C. Lynch


James
      L. Peeler





**COMPENSATION
      DISCUSSION AND ANALYSIS**





**Oversight
      of Executive Compensation Program**





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





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





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


·
              annually
                  review and approve for the CEO and the executive officers of the
                  Company
                  the annual base salary, the annual incentive bonus, including the
                  specific
                  goals and amount, equity compensation, employment agreements, severance
                  arrangements, and change in control agreements/provisions, and
                  any other
                  benefits, compensation or
                  arrangements.
 
 ·
              make
                  recommendations to the Board with respect to incentive compensation
                  plans,
                  including reservation of shares for issuance under employee benefit
                  plans.
 
 ·
              annually
                  review and recommend to the Board of Directors for its approval
                  the
                  compensation, including cash, equity or other compensation, for
                  members of
                  the Board of Directors for their service as a member of the Board
                  of
                  Directors, a member of any committee of the Board of Directors,
                  a Chair of
                  any committee of the Board of Directors, and the Chairman of the
                  Board of
                  Directors.
  ·
              annually
                  review the performance of the Company’s Chief Executive
                  Officer.
 
 ·
              make
                  recommendations to the Board of Directors on the Company’s executive
                  compensation practices and policies, including the evaluation of
                  performance by the Company’s executive officers and issues of management
                  succession.
  38
 
 ·
              review
                  the Company’s compliance with employee benefit
                  plans.
 
 ·
              make
                  regular reports to the Board.
 
 ·
              annually
                  review and reassess the adequacy of the Compensation Committee
                  charter and
                  recommend any proposed changes to the Board for
                  approval.





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





**Overview
      of Compensation Program**





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





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


·
              drive
                  and reward performance which supports the Company’s core
                  values;
 
 ·
              provide
                  a percentage of total compensation that is “at-risk,” or variable, based
                  on predetermined performance
                  criteria;
 
 ·
              design
                  competitive total compensation and rewards programs to enhance
                  the
                  Company’s ability to attract and retain knowledgeable and experienced
                  senior executives; and
 
 ·
              set
                  compensation and incentive levels that reflect competitive market
                  practices.




**Compensation
      Elements and Rationale**





*Compensation
      for Named Executive Officers Other than the CEO*





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





*Compensation
      for the Company’s CEO*





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





(i)
            **Performance****Goals**





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





**(ii)**
            **Incentive
                Compensation**





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




39





**(iii)**
            **Competitive
                Compensation Program**





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





**Financial
      Metrics Used in Compensation Programs**





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





**Compensation
      Benchmarking Relative to Market**





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





**Review
      of Senior Executive Performance**





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





**Components
      of the Executive Compensation Program**





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


·
              base
                  salary;
 ·
              stock
                  incentive plan;
 ·
              retirement,
                  health and welfare benefits;
 ·
              perquisites
                  and perquisite allowance payments;
                  and
 ·
              termination
                  benefits.




**Base
      Salaries**





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




40


**Stock
      Incentive Plan**





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




The
        Company practice is that the exercise price for each stock option is equal
        to
        the fair market value on the date of grant. Under the terms of the Plan,
        the
        option price will not be less than the fair market value of the shares on
        the
        date of grant. Or in the case of a beneficial owner of more than 5.0% of
        the
        Company’s outstanding common stock on the date of grant, the option price will
        not be less than 110% of the fair market value of the shares on the date
        of
        grant.
 
 There
        is
        a limited term in which Plan participants can exercise stock options, known
        as
        the “option term.” The option term is generally ten years from the date of
        grant. At the end of the option term, the right to purchase any unexercised
        options expires. Option holders generally forfeit any unvested options if
        their
        employment with the Company terminates.
 
 Certain
        key executives may be a party to option agreements containing clauses that
        cause
        their options to become immediately and fully vested and exercisable upon
        a
        Change of Control, as defined in the Plan. Additionally, death or disability
        of
        the executive during his or her employment period may cause certain stock
        options to immediately vest and become exercisable per the terms outlined
        in the
        stock option award agreement.
 
 The
        Compensation Committee awards options to named executive officers upon
        commencement of their employment with the Company, and for successfully
        acheiving or exceeding predetermined individual and Company performance goals.
        In determining whether to award stock options and the number of stock options
        granted to a named executive officer, the Compensation Committee reviews
        the
        compensation of executives at peer group companies to ensure that the
        compensation program is competitive.
 
 **Retirement,
        Health and Welfare Benefits**
 
 The
        Company offers a variety of health and welfare and retirement programs to
        all
        eligible employees. The named executive officers generally are eligible for
        the
        same benefit programs on the same basis as the rest of the broad-based
        employees. The Company’s health and welfare programs include medical, dental,
        vision, life, accidental death and disability, and short and long-term
        disability insurance. In addition to the foregoing, the named executive officers
        are eligible to participate in the Company’s 401(k) Profit Sharing
        Plan.
 
 *401(k) Profit
        Sharing Plan*
 
 Telkonet
        maintains a defined contribution profit sharing plan for employees (the
“Telkonet 401(k)”) that is administered by a committee of trustees appointed by
        the Company. All Company employees are eligible to participate upon the
        completion of six months of employment, subject to minimum age
        requirements. Contributions by employees under the Telkonet 401(k) are
        immediately vested and each employee is eligible for distributions upon
        retirement, death or disability or termination of employment. Depending upon
        the
        circumstances, these payments may be made in installments or in a single
        lump
        sum.
 
 MST
        maintains a defined contribution profit sharing plan for employees (the “MST
        401(k)”) that is administered by a committee of trustees appointed by the
        Company. All Company employees are eligible to participate upon the completion
        of three months of employment, subject to minimum age requirements. Each
        year the Company makes a contribution to the MST 401(k) without regard to
        current or accumulated net profits of the Company. These contributions are
        allocated to participants in amounts of 100% of the participants’ contributions
        up to 1% of each participant’s gross pay, then 10% of the next 5% of each
        participant’s gross pay (a higher contribution percentage may be determined at
        the Company’s discretion). In addition, the Company makes a one-time, annual
        contribution of 3% of each participant’s gross pay to each participant’s
        contribution account in the MST 401(k) plan. Participants become vested in
        equal portions of their Company contribution account for each year of service
        until full vesting occurs upon the completion of six years of service.
        Distributions are made upon retirement, death or disability in a lump sum
        or in
        installments.




41


**Perquisites**
 
 The
        Company leases a vehicle for the use of Telkonet's CEO. The operating
        lease will expire in September 2008. Additionally, in the first quarter of
        2007
        the Company began providing monthly car allowance stipends to certain executives
        of MST and Ethostream.
 
 
 
 **EXECUTIVE
        COMPENSATION**
  The
        following table sets forth certain information with respect to compensation
        for
        services in all capacities for the years ended December 31, 2006, 2005 and
        2004 paid to our Chief Executive Officer, Vice President of Finance (principal
        financial officer) and the three other most highly compensated executive
        officers who were serving as such as of December 31, 2006.
 
 **Summary
        Compensation Table**
 **Name
                    and Principal Position**
                **Year**
                **Salary**
                  **($)**
                **Bonus**
                  **($)**
                **Stock
                    Awards**
                  **($)**
                **Option
                    Awards**
                  **($)**
                  **(3)(4)(5)**
                **Non-Equity
                    Incentive Plan Compensation ($)**
                **Change
                    in Pension Value and Nonqualified Deferred Compensation
                    Earnings**
                  **($)**
                **All
                    Other**
                  **Compen-sation**
                  **($)**
                **Total**
                  **($)**Ronald
                    W. Pickett
                2006
                $245,423
                $0
                $0
                $0
                $0
                $0
                $4,593
                    (3)
                $250,016President
                    and Chief
                2005
                $102,340
                $200,000
                $163,319
                    (1)
                $0
                $0
                $0
                $0
                $465,659Executive
                    Officer
                2004
                $100,089
                $0
                $107,779
                    (1)
                $0
                $0
                $0
                $0
                $207,868Frank
                    T. Matarazzo
                2006
                $244,539
                $9,615
                $0
                $0
                $0
                $0
                $0
                $254,154President
                    and Chief
                2005
                $0
                    (2)
                $0
                $0
                $0
                $0
                $0
                $0
                $0
                    (2)Executive
                    Officer, MST
                2004
                $0
                    (2)
                $0
                $0
                $0
                $0
                $0
                $0
                $0
                    (2)Stephen
                    L. Sadle
                2006
                $168,154
                $6,610
                $0
                $0
                $0
                $0
                $0
                $174,764Senior
                    Vice President
                2005
                $171,872
                $10,000
                $0
                $124,770
                $0
                $0
                $0
                $306,6422004
                $171,983
                $6,538
                $0
                $124,770
                $0
                $0
                $0
                $303,291Richard
                    J. Leimbach
                2006
                $111,231
                $5,000
                $0
                $36,312
                $0
                $0
                $0
                $152,543Vice
                    President, Finance
                2005
                $102,340
                $3,936
                $0
                $36,312
                $0
                $0
                $0
                $142,5882004
                $76,147
                $3,269
                $0
                $5,825
                $0
                $0
                $0
                $85,241James
                    F. Landry
                2006
                $174,886
                $6,789
                $0
                $104,500
                $0
                $0
                $0
                $286,176Chief
                    Technology
                2005
                $176,508
                $15,000
                $0
                $38,124
                $0
                $0
                $0
                $229,632Officer
                2004
                $172,514
                $15,000
                $0
                $44,958
                $0
                $0
                $0
                $232,499





(1)
      In
      each year ending December 31, 2005 and 2004, Mr. Pickett earned 36,000 shares
      issued under the Company’s Employee Stock Incentive Plan as additional
      compensation pursuant to his employment agreement. The fair market value of
      these shares upon issuance was $163,319, and $107,779,
      respectively.


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


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


(4)
        In 2005 the following assumptions were used to
        determine the fair value of stock option awards granted: historical volatility
        of 71% expected option life of 5.0 years and a risk-free interest rate of
        4.50%.
 (5)
          In 2006 the following assumptions were used to
          determine the fair value of stock option awards granted: historical volatility
          of 65% expected option life of 5.0 years and a risk-free interest rate
          of
          5.0%.




42


**Employment
      Agreements**





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





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





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





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





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




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





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





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





Jason
      Tienor, Chief Executive Officer of Ethostream, LLC, is employed pursuant to
      an
      employment agreement, dated March 15, 2007. Mr. Tienor’s employment agreement
      has a term of three years, which may be extended by mutual agreement of the
      parties thereto, and provides for a base salary of $148,000.00 per year and
      bonuses and benefits based upon Telkonet’s internal policies.





Jeff
      Sobieski, Chief Financial Officer of Ethostream, LLC, is employed pursuant
      to an
      employment agreement, dated March 15, 2007. Mr. Sobieski’s employment agreement
      has a term of three years, which may be extended by mutual agreement of the
      parties thereto, and provides for a base salary of $148,000.00 per year and
      bonuses and benefits based upon Telkonet’s internal policies.





**GRANT
      OF PLAN BASED AWARDS**


****


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





**OUTSTANDING
      EQUITY AWARDS AT FISCAL YEAR-END TABLE**





The
      following table shows outstanding stock option awards classified as exercisable
      and unexercisable as of December 29, 2006 for the named executive officers.
      The table also shows unvested and unearned stock awards (both time-based awards
      and performance-contingent) assuming a market value of $2.67 a share (the
      closing market price of the Company’s stock on December 29,
      2006).


43


**OUTSTANDING
      EQUITY AWARDS AT FISCAL YEAR-END**




**Option
                  Awards**
              **Stock
                  Awards****Name**
              **Number
                  of Securities Underlying Unexercised Options**
                **(#)**
                **Exerciseable**
              **Number
                  of Securities Underlying Unexercised Options**
                **(#)**
                **Unexerciseable**
              **Equity
                  Incentive Plan Awards: Number of Securities Underlying Unexercised
                  Unearned Options**
                **(#)**
              **Option
                  Exercise Price**
                **($)**
              **Option
                  Expiration Date**
              **Number
                  of Shares or Units of Stock That Have Not Vested**
                **(#)**
              **Market
                  Value of Shares or Units of Stock That Have Not
                  Vested**
                **($)**
              **Equity
                  Incentive Plan Awards: Number of Unearned Shares, Units or Other
                  Rights
                  That Have Not Vested**
                **(#)**
              **Equity
                  Incentive Plan Awards: Market or Payout Value of Unearned Shares,
                  Units or
                  Other Rights That Have Not Vested**
                **($)**Ronald
                  W. Pickett
              -
              -
              -
              N/A
              N/A
              -
              -
              -
              -Frank
                  T. Matarazzo
              -
              -
              -
              N/A
              N/A
              -
              -
              -
              -Stephen
                  L.
                Sadle
              900,000
              -
              -
              $1.00
              1/1/2003
              -
              -
              -
              -Richard
                  J. Leimbach
              32,500
              55,000
              -
              (1)
              (1)
              -
              -
              -
              -James
                  F.
                Landry
              350,000
              150,000
              -
              (2)
              (2)
              -
              -
              -
              -


_________________





(1)
            Includes
                12,500 and 25,000 vested and unvested options, respectively, exerciseable
                at $2.59 per share with an expiration of 1/26/2014 and 20,000 and
                30,000
                vested and unvested options, respectively, exerciseable at $5.08
                per share
                with an expiration of 1/1/2015.





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





**OPTION
      EXERCISES AND STOCK VESTED**





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






44


**POTENTIAL
      PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL**




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





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





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





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




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





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





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


Each
        of
        Mr. Dukes’ and Mr. Zirpoli’s employment agreements obligate the Company to
        continue to pay the executive’s base salary and provide continued participation
        in each Company benefit plan for a period of three months following the
        termination of the executive’s employment without cause. In the event the
        executive is terminated “for cause,” or for engaging in any unethical, immoral
        or unprofessional conduct or violation of a Company policy, he shall not
        be
        entitled to any payment beyond such termination date, except for accrued
        leave
        and vacation and except as may be required by applicable law. For purposes
        of
        the employment agreements, “cause” includes, but is not be limited to, the
        following: (i) theft, fraud, embezzlement, dishonesty or other similar behavior
        by the executive; (ii) any material breach by the executive of any provision
        of
        the employment agreement; (iii) any habitual neglect of duty or misconduct
        of
        the executive in discharging any of his duties and responsibilities under
        the
        employment agreement; (iv) any conduct of the executive which is detrimental
        to
        or embarrassing to the Company, including, but not limited to, the executive
        being indicated or convicted of a felony or any offense involving moral
        turpitude; or (v) any default of the executive’s obligations under the
        employment agreement, which default, failure or refusal is not cured within
        a
        reasonable time (but not to exceed thirty (30) days) after written notification
        thereof to the executive by the Company.




45


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


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





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





**Name**
            **Fees
                Earned or Paid in Cash**
              **($)**
            **Stock
                Awards**
              **($)**
            **Option
                Awards**
              **($)**
            **Non-Equity
                Incentive Plan Compensation**
              **($)**
            **Change
                in Pension Value and Nonqualified Deferred Compensation
                Earnings**
            **All
                Other Compensation**
              **($)**
            **Total**
              **($)**Warren
                V. Musser
            $       
                48,000
            $                   
                 -
            $                     
                 -
            $                               
                 -
            $                           
                 -
            $                  
                52,000 (1)
            $         
                 100,000Thomas
                M. Hall
            52,000
            -
            34,500
                (2)
            -
            -
            -
            86,500Thomas
                C. Lynch
            52,000
            -
            34,500
                (2)
            -
            -
            -
            86,500James
                L. Peeler
            52,000
            -
            34,500
                (2)
            -
            -
            -
            86,500Seth
                D. Blumenfeld
            -
            77,595(3)
            -
            -
            -
            -
            77,595Ronald
                W. Pickett
            -
            -
            -
            -
            -
            -
            -Stephen
                L. Sadle
            -
            -
            -
            -
            -
            -
            -





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


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


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





**COMPENSATION
      COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION**





During
      the year ended December 31, 2006, Messrs, Hall, Lynch and Peeler served as
      members of the Company’s Compensation Committee. None of the members of the
      Compensation Committee was an employee of the Company during the year ended
      December 31, 2006 nor has any of them been an officer of the Company. No
      executive officer of the Company served during the year ended December 31,
      2006
      as a member of a compensation committee or as a director of any entity of which
      any of the Company’s directors served as an executive officer.




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





The
      following table provides information concerning securities authorized for
      issuance pursuant to equity compensation plans approved by the Company’s
      stockholders and equity compensation plans not approved by the Company’s
      stockholders as of December 31, 2006.





**Number
                of securities to be issued upon exercise of outstanding options,
                warrants
                and rights**
            **Weighted
                -average exercise price of outstanding options, warrants and
                rights**
            **Number
                of securities remaining available for future issuance under equity
                compensation plans (excluding securities reflected in column
                (a))****(a)**
            **(b)**
            **(c)****Equity
                compensation plans approved by security holders**
            10,336,866
            $1.87
            1,645,423**Equity
                compensation plans not approved by security
                holders**
            -
            -
            -**Total**
            10,336,866
            $1.87
            1,645,423




46




The
        following table sets forth, as of March 1, 2007, the number of shares of
        the
        Company’s common stock beneficially owned by each director and executive officer
        of the Company, by all directors and executive officers as a group, and by
        each
        person known by the Company to own beneficially more than 5.0% of the Company’s
        outstanding common stock. As of March 1, 2007, there were no issued and
        outstanding shares of any other class of the Company’s equity securities.
 
 **Name
                  and Address of Beneficial Owner**
              **Amount
                  and Nature of Beneficial Ownership**
              **Percentage
                  of Class****Officers
                  and Directors**Ronald
                  W. Pickett, President and CEO
                20374
                  Seneca Meadows Parkway
                Germantown,
                  MD 20876
              2,574,699
              4.5%Frank
                  T. Matarazzo, President and CEO, MST
                259-263
                  Goffle Road
                Hawthorne,
                  NJ 07506
              520,000(1)
              0.9%Stephen
                  L. Sadle, Senior Vice President
                20374
                  Seneca Meadows Parkway
                Germantown,
                  MD 20876
              4,284,514(2)
              7.4%James
                  Landry, Chief Technology Officer
                20374
                  Seneca Meadows Parkway
                Germantown,
                  MD 20876
              484,200(3)
              0.8%Richard
                  Leimbach, Vice President of Finance
                20374
                  Seneca Meadows Parkway
                Germantown,
                  MD 20876
              41,000(4)
              0.1%Warren
                  V. Musser, Chairman
                20374
                  Seneca Meadows Parkway
                Germantown,
                  MD 20876
              2,000,000(5)
              3.4%Thomas
                  C. Lynch, Director
                20374
                  Seneca Meadows Parkway
                Germantown,
                  MD 20876
              100,000(6)
              0.2%Dr.
                  Thomas M. Hall, Director
                20374
                  Seneca Meadows Parkway
                Germantown,
                  MD 20876
              647,790(7)
              1.1%James
                  “Lou” L. Peeler, Director
                20374
                  Seneca Meadows Parkway
                Germantown,
                  MD 20876
              84,400(8)
              0.1%Seth
                  D. Blumenfeld, Director
                20374
                  Seneca Meadows Parkway
                Germantown,
                  MD 20876
              65,000(9)
              0.1%All
                  Directors and Executive Officers as a Group
              10,801,603
              17.8%
 _____________________
 
 (1)
              Includes
                  600,000 shares of the Company’s common stock issued to Mr. Matarazzo in
                  conjunction with the Company’s January 2006 acquisition of a 90% interest
                  in Microwave Satellite Technologies, Inc. As part of the purchase
                  price,
                  an additional 1,000,000 shares of the Company’s common stock are held in
                  escrow, issuable upon the achievement of certain performance targets
                  and
                  excluded from this table.






47




(2)
              Includes
                  options exercisable within 60 days to purchase 900,000 shares of
                  the
                  Company’s common stock at $1.00 per share.(3)
              Includes
                  options exercisable within 60 days to purchase 250,000 and 150,000
                  shares
                  of the Company’s common stock at $1.00 and $3.45 per share,
                  respectively.(4)
              Includes
                  options exercisable within 60 days to purchase 17,500 and 22,500
                  shares of
                  the Company’s common stock at $2.59 and $5.08 per share,
                  respectively.(5)
              Includes
                  options exercisable within 60 days to purchase 2,000,000 shares
                  of the
                  Company’s common stock at $1.00 per share.(6)
              Includes
                  options exercisable within 60 days to purchase 20,000 and 80,000
                  shares of
                  the Company’s common stock at $2.00 and $3.45 per share,
                  respectively.(7)
              Includes
                  options exercisable within 60 days to purchase 80,000 shares of
                  the
                  Company’s common stock at $3.45 per share.(8)
              Includes
                  options exercisable within 60 days to purchase 80,000 shares of
                  the
                  Company’s common stock at $3.45 per share.(9)
              Includes
                  15,000 shares of the Company’s common stock to be issued within 60 days
                  pursuant to a Professional Services
                  Agreement.
 
 **ITEM
        13.** **CERTAIN
        RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
        INDEPENDENCE**
 
 ***Description
        of Related Party Transactions***
 
 In
        September 2003, the Company entered into a consulting agreement (renewable
        annually) with The Musser Group to compensate Mr. Musser in the amount of
        $100,000 per year for his services to the Company as a director. Mr. Musser,
        Chairman of the Board of Directors, is the sole principal and owner of The
        Musser Group.  For the years ended December 31, 2006, 2005 and 2004, the
        Company paid and expensed $100,000, $100,000 and $100,000, respectively.
 
 On
        July
        1, 2005, Mr. Blumenfeld was retained as a consultant to Telkonet pursuant
        to a
        Professional Services Agreement between the Company and Mr. Blumenfeld. Pursuant
        to the terms of the agreement, Mr. Blumenfeld received 10,000 shares of Company
        stock upon execution of the agreement, 10,000 shares of Company stock per
        quarter for the first year (for a total 50,000 shares in the first year)
        and
        5,000 shares of Company stock per quarter thereafter plus a five percent
        (5%)
        commission (payable in cash or Company stock) on international sales generated
        by him with gross margins of 50% or greater. The stock awarded to Mr. Blumenfeld
        pursuant to the agreement is restricted stock. The agreement has a one year
        term, which is renewable annually upon both parties' agreement. This agreement
        expired in June 2006.
 
 In
        December 2005, the Company issued an aggregate of 363,636 shares of common
        stock
        to Ronald W. Pickett, President and Chief Executive Officer of the Company,
        in
        exchange for $200,000 of Series B Debentures held by him. The Company also
        issued an aggregate of 48,858 shares of common stock in exchange for accrued
        interest of $26,872 for Series B Debentures held by Mr. Pickett. In addition,
        the Company issued an aggregate of 200,000 shares of common stock upon the
        exercise by Mr. Pickett of warrants to purchase shares of the Company’s common
        stock at $1.00 per share.
 
 In
        February 2007, the Company entered into a one-year professional services
        agreement with Global Transport Logistics, Inc. (“GTI”), for the provision of
        consulting services for which GTI is paid a fee of $10,000 per month. GTI
        is 50%
        owned by Anthony Matarazzo, the brother of MST’s Chief Executive
        Officer.
 
 The
        Chief
        Administrative Officer at MST, Laura Matarazzo, is the sister of the President
        of MST and receives an annual base salary of approximately $134,000 with
        bonuses
        and benefits based upon the Company’s internal policies.
 
 The
        Company’s Vice President of Government Sales, John Vasilj, is the son-in-law of
        the President and CEO of the Company and receives an annual base salary of
        approximately $150,000 with bonuses and benefits based upon the Company’s
        internal policies.
  48
  ***Company’s
        Policies on Related Party Transactions***
 
 Under
        the
        Company’s policies and procedures, related-party transactions that must be
        publicly disclosed under the federal securities laws require prior approval
        of the Company’s independent directors without the participation of
        any director who may have a direct or indirect interest in the transaction
        in
        question. Related parties include directors, nominees for director, principal
        shareholders, executive officers and members of their immediate families.
        For
        these purposes, a “transaction” includes all financial transactions,
        arrangements or relationships, ranging from extending credit to the provision
        of
        goods and services for value and includes any transaction with a company
        in
        which a director, executive officer immediate family member of a director
        or
        executive officer, or principal shareholder (that is, any person who
        beneficially owns five percent or more of any class of the Company’s voting
        securities) has an interest by virtue of a 10-percent-or-greater equity
        interest. The Company’s policies and procedures regarding related-party
        transactions are not a part of a formal written policy, but rather, represent
        the Company’s historical course of practice with respect to approval of
        related-party transactions.
 
 ***Director
        Independence***
 
  The
        Board
        of Directors has determined that the following Directors are “independent” under
        the listing standards of the American Stock Exchange (AMEX): Dr. Hall,
        Mr. Lynch and Mr. Peeler. Each of Dr. Hall, Mr. Peeler and Mr. Lynch serve
        on, and are the only members of, the Company’s Audit and Compensation
        Committees. Although Telkonet does not maintain a standing Nominating Committee,
        nominees for election as directors are considered and nominated by a majority
        of
        Telkonet’s independent directors in accordance with the AMEX listing standards.
“Independence” for these purposes is determined in accordance with
        Section 121(A) of the AMEX Rules and Rule 10A-3 under the Securities
        Exchange Act of 1934.
 
 **ITEM
        14.** **PRINCIPAL
        ACCOUNTANT FEES AND SERVICES.**
 
 The
        following table sets forth fees billed to the Company by our auditors during
        the
        fiscal years ended December 31, 2006 and 2005. Additionally, the Company
        incurred approximately $320,289, of consulting and internal
        resources associated with its Sarbanes-Oxley compliance review.
 
 **December
                  31, 2006**
              
              **December
                  31, 2005**1.
                  Audit Fees
              
              $
              229,552
              
              $
              119,0902.
                  Audit Related Fees
              
              
              52,600
              
              
              62,8253.
                  Tax Fees
              
              
              --
              
              
              1,1754.
                  All Other Fees
              
              
              --
              
              
              --Total
                  Fees
              
              $
              282,152
              
              $
              183,090
 
 Audit
        fees consist of fees billed for professional services rendered for the audit
        of
        the Company’s consolidated financial statements and review of the interim
        consolidated financial statements included in quarterly reports and services
        that are normally provided by Russell Bedford Stefanou Mirchandani LLP in
        connection with statutory and regulatory filings or engagements.
 
 Audit-related
        fees consists of fees billed for assurance and related services that are
        reasonably related to the performance of the audit or review of the Company’s
        consolidated financial statements, which are not reported under “Audit Fees.”
 
 Tax
        fees
        consists of fees billed for professional services for tax compliance, tax
        advice
        and tax planning. The tax fees relate to federal and state income tax reporting
        requirements.
 
 All
        other
        fees consist of fees for products and services other than the services reported
        above.
 
 Prior
        to
        the Company’s engagement of its independent auditor, such engagement is approved
        by the Company’s audit committee. The services provided under this engagement
        may include audit services, audit-related services, tax services and other
        services. Pre-approval is generally provided for up to one year and any
        pre-approval is detailed as to the particular service or category of services
        and is generally subject to a specific budget. Pursuant to the Company’s Audit
        Committee Charter, the independent auditors and management are required to
        report to the Company’s audit committee at least quarterly regarding the extent
        of services provided by the independent auditors in accordance with this
        pre-approval, and the fees for the services performed to date. The audit
        committee may also pre-approve particular services on a case-by-case basis.
        All
        audit fees, audit-related fees, tax fees and other fees incurred by the Company
        for the year ended December 31, 2006, were approved by the Company’s audit
        committee.
  49
  **PART
          IV**
 
 **ITEM
          15.** **EXHIBITS
          AND FINANCIAL STATEMENT SCHEDULES.**
  The
            following table sets forth selected unaudited quarterly information for
            the
            Company’s year-ended December 31, 2006 and 2005.
 **QUARTERLY
              FINANCIAL DATA**
 **(unaudited)**
 **March
                        31,**
                      **2006**
                    
                    **June
                        30,**
                      **2006**
                    
                    **September
                        30,**
                      **2006**
                    
                    **December
                        31,**
                      **2006**Net
                        Revenue
                    
                    $
                    1,943,912
                    
                    $
                    1,152,470
                    
                    $
                    1,143,097
                    
                    $
                    941,848Gross
                        Profit
                    
                    $
                    648,342
                    
                    $
                    139,628
                    
                    $
                    83,049
                    
                    $
                    (170,433
                    )Provision
                        for income taxes
                    
                    $
                    -
                    
                    $
                    -
                    
                    $
                    -
                    
                    $
                    -Net
                        loss per share -- basic
                    
                    $
                    (0.09
                    )
                    $
                    (0.16
                    )
                    $
                    (0.20
                    )
                    $
                    (0.08
                    )Net
                        loss per share -- diluted
                    
                    $
                    (0.09
                    )
                    $
                    (0.16
                    )
                    $
                    (0.20
                    )
                    $
                    (0.08
                    )**March
                        31,**
                      **2005**
                    
                    
                    **June
                        30,**
                      **2005**
                    
                    
                    **September
                        30, 2005**
                    
                    
                    **December
                        31,**
                      **2005**Net
                        Revenue
                    
                    $
                    246,188
                    
                    $
                    472,947
                    
                    $
                    621,923
                    
                    $
                    1,147,265Gross
                        Profit
                    
                    $
                    88,798
                    
                    $
                    120,791
                    
                    $
                    212,749
                    
                    $
                    348,806Provision
                        for income taxes
                    
                    $
                    -
                    
                    $
                    -
                    
                    $
                    -
                    
                    $
                    -Net
                        loss per share -- basic
                    
                    $
                    (0.07
                    )
                    $
                    (0.08
                    )
                    $
                    (0.08
                    )
                    $
                    (0.12
                    )Net
                        loss per share -- diluted
                    
                    $
                    (0.07
                    )
                    $
                    (0.08
                    )
                    $
                    (0.08
                    )
                    $
                    (0.12
                    )
  The
            following table sets forth selected unaudited valuation and qualifying
            account
            information for the Company’s year-ended December 31, 2006, 2005 and
            2004.
  **SCHEDULE
              II- VALUATION AND QUALIFYING ACCOUNTS**
 **(unaudited)**
 **DESCRIPTION**
                    
                    **BALANCE**
                      **BEGINNING
                        OF YEAR**
                    
                    **CHARGED
                        TO COSTS AND EXPENSES**
                    
                    **DEDUCTIONS**
                    
                    **BALANCE,
                        END OF YEAR****Allowance
                        for doubtful accounts:**Year
                        ended December 31,2006
                    
                    $
                    30,000
                    
                    $
                    36,659
                    
                    $
                    6,659
                    
                    $
                    60,0002005
                    
                    
                    13,000
                    
                    
                    39,710
                    
                    
                    (22,710
                    )
                    
                    30,0002004
                    
                    
                    7,000
                    
                    
                    30,637
                    
                    
                    (24,637
                    )
                    
                    13,000**Reserve
                        for product returns:**Year
                        ended December 31,2006
                    
                    $
                    24,000
                    
                    $
                    23,300
                    
                    $
                    —
                    
                    $
                    47,3002005
                    
                    
                    —
                    
                    
                    24,000
                    
                    
                    —
                    
                    
                    24,0002004
                    
                    
                    —
                    
                    
                    —
                    
                    
                    —
                    
                    
                    —
  50
  The
            following exhibits are included herein or incorporated by
            reference:
 **Exhibit
                        Number**
                    
                    **Description
                        Of Document**2.1
                    
                    MST
                        Stock Purchase Agreement and Amendment (incorporated by reference
                        to our
                        8-K filed on February 2, 2006)2.2
                    
                    Asset
                        Purchase Agreement by and between Telkonet, Inc. and Smart
                        Systems
                        International, dated as of February 23, 2007 (incorporated
                        by reference to
                        our Form 8-K filed on March 2, 2007)2.3
                    
                    Unit
                        Purchase Agreement by and among Telkonet, Inc., Ethostream,
                        LLC and the
                        members of Ethostream, LLC dated as of March 15, 2007 (incorporated
                        by
                        reference to our Form 8-K filed on March 16, 2007)3.1
                    
                    Articles
                        of Incorporation of the Registrant (incorporated by reference
                        to our Form
                        8-K (No. 000-27305), filed on August 30, 2000 and our Form
                        S-8 (No.
                        333-47986), filed on October 16, 2000)3.2
                    
                    Bylaws
                        of the Registrant (incorporated by reference to our Registration
                        Statement
                        on Form S-1 (No. 333-108307), filed on August 28, 2003)4.1
                    
                    Form
                        of Series A Convertible Debenture (incorporated by reference
                        to our Form
                        10-KSB (No. 000-27305), filed on March 31, 2003)4.2
                    
                    Form
                        of Series A Non-Detachable Warrant (incorporated by reference
                        to our Form
                        10- KSB (No. 000-27305), filed on March 31, 2003)4.3
                    
                    Form
                        of Series B Convertible Debenture (incorporated by reference
                        to our Form
                        10-KSB (No. 000-27305), filed on March 31, 2003)4.4
                    
                    Form
                        of Series B Non-Detachable Warrant (incorporated by reference
                        to our Form
                        10-KSB (No. 000-27305), filed on March 31, 2003)4.5
                    
                    Form
                        of Senior Note (incorporated by reference to our Registration
                        Statement on
                        Form S-1 (No. 333-108307), filed on August 28, 2003)4.6
                    
                    Form
                        of Non-Detachable Senior Note Warrant (incorporated by reference
                        to our
                        Registration Statement on Form S-1 (No. 333-108307), filed
                        on August 28,
                        2003)4.7
                    
                    Senior
                        Convertible Note by Telkonet, Inc. in favor of Portside Growth
&
                        Opportunity Fund (incorporated by reference to our Form 8-K
                        (No.
                        001-31972), filed on October 31, 2005)4.8
                    
                    Senior
                        Convertible Note by Telkonet, Inc. in favor of Kings Road
                        Investments Ltd.
                        (incorporated by reference to our Form 8-K (No. 001-31972),
                        filed on
                        October 31, 2005)4.11
                    
                    Warrant
                        to Purchase Common Stock by Telkonet, Inc. in favor of Portside
                        Growth
                        & Opportunity Fund (incorporated by reference to our Form 8-K
                        (No.
                        001-31972), filed on October 31, 2005)4.12
                    
                    Warrant
                        to Purchase Common Stock by Telkonet, Inc. in favor of Kings
                        Road
                        Investments Ltd. (incorporated by reference to our Form 8-K
                        (No.
                        001-31972), filed on October 31, 2005)4.13
                    
                    Form
                        of Warrant to Purchase Common Stock (incorporated by reference
                        to our
                        Current Report on Form 8-K (No. 001-31972), filed on September 6,
                        2006)4.14
                    
                    Form
                        of Accelerated Payment Option Warrant to Purchase Common
                        Stock
                        (incorporated by reference to our Registration Statement
                        on Form S-3 (No.
                        333-137703), filed on September 29, 2006.4.15
                    
                    Form
                        of Warrant to Purchase Common Stock (incorporated by reference
                        to our
                        Current Report on Form 8-K filed on February 5,
                        2007)10.1
                    
                    Amended
                        and Restated Telkonet, Inc. Incentive Stock Option Plan (incorporated
                        by
                        reference to our Registration Statement on Form S-8 (No.
                        333-412), filed
                        on April 17, 2002)10.2
                    
                    Employment
                        Agreement by and between Telkonet, Inc. and Stephen L. Sadle,
                        dated as of
                        January 18, 2003 (incorporated by reference to our Registration
                        Statement
                        on Form S-1 (No. 333-108307), filed on August 28,
                        2003
   51
  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
                    
                    Registration
                        Rights Agreement by and among Telkonet, Inc., Kings Road
                        Investments Ltd.
                        and Portside Growth & Opportunity Fund, dated October 27, 2005
                        (incorporated by reference to our Form 8-K (No. 001-31972),
                        filed on
                        October 31, 2005)10.6
                    
                    Professional
                        Services Agreement by and between Telkonet, Inc. and Seth
                        D. Blumenfeld,
                        dated July 1, 2005 (incorporated by reference to our Form
                        10-Q (No.
                        000-27305), filed on November 9, 2005.10.7
                    
                    Employment
                        Agreement by and between Telkonet, Inc. and Frank T. Matarazzo,
                        dated as
                        of February 1, 2006 (incorporated by reference to our Form
                        10-K (No.
                        001-31972), filed March 16, 2006)10.9
                    
                    Settlement
                        Agreement by and among Telkonet, Inc. and Kings Road Investments
                        Ltd.,
                        dated as of August 14, 2006 (incorporated by reference to
                        our Form 8-K
                        (No. 001-31972), filed on August 16, 2006)10.10
                    
                    Settlement
                        Agreement by and among Telkonet, Inc. and Portside Growth
&
                        Opportunity Fund, dated as of August 14, 2006 (incorporated
                        by reference
                        to our Form 8-K (No. 001-31972), filed on August 16,
                        2006)10.11
                    
                    Securities
                        Purchase Agreement, dated August 31, 2006, by and among Telkonet,
                        Inc.,
                        Enable Growth Partners LP, Enable Opportunity Partners LP
                        and Pierce
                        Diversified Strategy Master Fund LLC, Ena (incorporated by
                        reference to
                        our Form 8-K (No. 001-31972), filed on September 6,
                        2006)10.12
                    
                    Registration
                        Rights Agreement, dated August 31, 2006, by and among Telkonet,
                        Inc.,
                        Enable Growth Partners LP, Enable Opportunity Partners LP
                        and Pierce
                        Diversified Strategy Master Fund LLC, Ena (incorporated by
                        reference to
                        our Form 8-K (No. 001-31972), filed on September 6,
                        2006)10.13
                    
                    Securities
                        Purchase Agreement, dated February 1, 2007, by and among
                        Telkonet, Inc.,
                        Enable Growth Partners LP, Enable Opportunity Partners LP,
                        Pierce
                        Diversified Strategy Master Fund LLC, Ena, Hudson Bay Fund
                        LP and Hudson
                        Bay Overseas Fund, Ltd. (incorporated by reference to our
                        Current Report
                        on Form 8-K filed on February 5, 2007)10.14
                    
                    Registration
                        Rights Agreement, dated February 1, 2007, by and among Telkonet,
                        Inc.,
                        Enable Growth Partners LP, Enable Opportunity Partners LP
                        and Pierce
                        Diversified Strategy Master Fund LLC, Ena, Hudson Bay Fund
                        LP and Hudson
                        Bay Overseas Fund, Ltd. (incorporated by reference to our
                        Current Report
                        on Form 8-K filed on February 5, 2007)10.15
                    
                    Employment
                        Agreement by and between Telkonet, Inc. and William Dukes,
                        dated as of
                        March 9, 200710.16
                    
                    Employment
                        Agreement by and between Telkonet, Inc. and Robert Zirpoli,
                        dated as of
                        March 9, 200710.17
                    
                    Employment
                        Agreement by and between Telkonet, Inc. and Jason Tienor,
                        dated as of
                        March 15, 200710.18
                    
                    Employment
                        Agreement by and between Telkonet, Inc. and Jeff Sobieski,
                        dated as of
                        March 15, 200714
                    
                    Code
                        of Ethics (incorporated by reference to our Form 10-KSB (No.
                        001-31972),
                        filed on March 30, 2004).
  52
   21
                    
                    Telkonet,
                        Inc. Subsidiaries23
                    
                    Consent
                        of Russell Bedford Stefanou Mirchandani LLP , Independent
                        Registered
                        Certified Public Accounting Firm, filed herewith24
                    
                    Power
                        of Attorney (incorporated by reference to our Registration
                        Statement on
                        Form S-1 (No. 333-108307), filed on August 28, 2003)31.1
                    
                    Certification
                        Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
                        of Ronald W.
                        Pickett31.2
                    
                    Certification
                        Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
                        of Richard J.
                        Leimbach32.1
                    
                    Certification
                        of Ronald W. Pickett pursuant to 18 U.S.C. Section 1350,
                        as adopted
                        pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2
                    
                    Certification
                        of Richard J. Leimbach pursuant to 18 U.S.C. Section 1350,
                        as adopted
                        pursuant to Section 906 of the Sarbanes-Oxley Act of
                        2002
    53


**SIGNATURES**
 
 Pursuant
        to he requirements of Section 13 or 15(d) of the Exchange Act, the registrant
        has duly caused this report to be signed on its behalf by the undersigned,
        thereunto duly authorized.
  TELKONET,
                    INC./s/
                    Ronald W. PickettRonald
                    W. PickettChief
                    Executive Officer
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, this report has
        been
        signed below by the following persons on behalf of the registrant and in
        the
        capacities and on the dates indicated.
 
 Name
              Position
              Date/s/
                  Warren V. Musser
                Warren
                  V. Musser
              Chairman
                  of the Board
              March
                  16, 2007/s/
                  Ronald W. Pickett
                Ronald
                  W. Pickett
              Chief
                  Executive Officer &
                Director
              March
                  16, 2007/s/
                  Richard J. Leimbach
                Richard
                  J. Leimbach
              Vice
                  President of Finance
                (principal
                  financial officer)
                (principal
                  accounting officer)
              March
                  16, 2007/s/
                  Stephen L. Sadle
                Stephen
                  L. Sadle
              Senior
                  Vice President &
                Director
              March
                  16, 2007/s/
                  Dr. Thomas M. Hall
                  Dr.
                  Thomas M. Hall
              Director
              March
                  16, 2007/s/
                  James L. Peeler
                James
                  L. Peeler
              Director
              March
                  16, 2007/s/
                  Seth D. Blumenfeld
                Seth
                  D. Blumenfeld
              Director
              March
                  16, 2007/s/
                  Thomas C. Lynch
                Thomas
                  C. Lynch
              Director
              March
                  16, 2007
 
  54




**SECURITIES
          AND EXCHANGE COMMISSION**
 
 **WASHINGTON,
          D.C. 20549**
 
 
 
 **FINANCIAL
          STATEMENTS AND SCHEDULES**
 
 **DECEMBER
          31, 2006 AND 2005**
 
 
 
 **FORMING
          A PART OF ANNUAL REPORT**
 **PURSUANT
          TO THE SECURITIES EXCHANGE ACT OF 1934**
 
 
 **TELKONET,
          INC.**
   
  **TELKONET,
        INC.**
 
 **Index
        to Financial Statements**
 
 
  Report
                  of Independent Registered Certified Public Accounting Firm
              F-3Consolidated
                  Balance Sheets at December 31, 2006 and 2005
              F-4Consolidated
                  Statements of Losses for the Years ended December 31, 2006, 2005
                  and
                  2004
              F-5Consolidated
                  Statements of Stockholders’ Equity for the Years ended December 31, 2006,
                  2005 and 2004
              F-6
                  ~ F-8Consolidated
                  Statements of Cash Flows for the Years ended December 31, 2006,
                  2005 and
                  2004
              F-9
                  ~ F-10Notes
                  to Consolidated Financial Statements
              F-11
                  ~ F-37
  F-2
 
  **RUSSELL
            BEDFORD** **STEFANOU
            MIRCHANDANI LLP**
 **CERTIFIED
            PUBLIC ACCOUNTANTS**
 
 **REPORT
            OF INDEPENDENT REGISTERED CERTIFIED PUBLIC ACCOUNTING
            FIRM**
 
 Board
            of
            Directors
 Telkonet,
            Inc.
 Germantown,
            MD
 
 
 We
            have
            audited the accompanying consolidated balance sheets of Telkonet, Inc.
            and its
            subsidiaries (the "Company") as of December 31, 2006 and 2005 and the
            related
            consolidated statements of losses, stockholders' equity, and cash flows
            for each
            of the three years in the period ended December 31, 2006. These financial
            statements are the responsibility of the Company's management. Our
            responsibility is to express an opinion on these financial statements
            based upon
            our audit.
 
 We
            conducted our audits in accordance with standards of the Public Company
            Accounting Oversight Board (United States of America). Those standards
            require
            that we plan and perform the audit to obtain reasonable assurance about
            whether
            the financial statements are free of material misstatements. An audit
            includes
            examining, on a test basis, evidence supporting the amounts and disclosures
            in
            the financial statements. An audit also includes assessing the accounting
            principles used and significant estimates made by management, as well
            as
            evaluating the overall financial statement presentation. We believe our
            audits
            provide a reasonable basis for our opinion.
 
 In
            our
            opinion, the consolidated financial statements referred to above present
            fairly,
            in all material respects, the financial position of Telkonet, Inc. and
            its
            subsidiaries as of December 31, 2006 and 2005, and the results of its
            operations
            and its cash flows for each of the three years in the period ended
            December 31, 2006, in conformity with accounting principles generally
            accepted in the United States of America.
  As
            discussed in Note 1 to the consolidated financial
            statements, the Company adopted the provisions of Statement of Financial
            Accounting Standards No. 123(R), "Share-Based Payment", effective January
            1,
            2006.
 
 We
            have
            also audited, in accordance with the standards of the Public Company
            Accounting
            Oversight Board (United States), the effectiveness of the Company’s internal
            control over financial reporting as of December 31, 2006, based on the
            criteria established in ***Internal Control—Integrated Framework*** issued
            by the Committee of Sponsoring Organizations of the Treadway Commission
            and our
            report dated March 15, 2007 expressed an unqualified opinion on management’s
            assessment of the effectiveness of the Company’s internal control over financial
            reporting and an unqualified opinion on the effectiveness of the Company’s
            internal control over financial reporting.
 
 
 /s/RUSSELL
                      BEDFORD STEFANOU MIRCHANDANI LLP
                    Russell
                      Bedford Stefanou Mirchandani LLP
 
 McLean,
              Virginia
 March
            15,
            2007
 F-3
  **TELKONET,
            INC.**
 **CONSOLIDATED
            BALANCE SHEETS**
 **DECEMBER
            31, 2006 AND 2005**
  **ASSETS**
                  
                  2006
                  
                  2005**Current Assets:**Cash and cash equivalents
                  
                  $
                  1,644,037
                  
                  $
                  8,422,079Restricted Certificate of Deposit
                  
                  
                  -
                  
                  
                  10,000,000Accounts receivable, net of allowance for doubtful accounts
                      of
                      $60,000
                    and $30,000 atDecember
                      31, 2006 and 2005, respectively
                  
                  
                  295,116
                  
                  
                  119,191Income tax receivable (Note L)
                  
                  
                  291,000
                  
                  
                  -Inventories (Note D)
                  
                  
                  1,306,593
                  
                  
                  1,475,806Prepaid expenses and deposits
                  
                  
                  229,333
                  
                  
                  360,880Total current assets
                  
                  
                  3,766,079
                  
                  
                  20,377,956**Property and equipment, at cost**(Note E):Furniture and equipment
                  
                  
                  2,211,036
                  
                  
                  1,041,137Less: accumulated depreciation
                  
                  
                  582,248
                  
                  
                  323,667Total property and equipment, net
                  
                  
                  1,628,788
                  
                  
                  717,470**Equipment under operating leases, at cost**(Note F):Telecommunications and related equipment, at cost
                  
                  
                  3,186,000
                  
                  
                  789,099Less: accumulated depreciation
                  
                  
                  564,233
                  
                  
                  124,669Total equipment under operating leases, net
                  
                  
                  2,621,767
                  
                  
                  664,430**Other assets:**Long-term investments (Note G)
                  
                  
                  193,847
                  
                  
                  231,000Intangible assets, net of accumulated amortization of $282,325
                      and $0
                      at
                    December
                      31, 2006and
                      December 31, 2005, respectively (Note B and C)
                  
                  
                  2,181,602
                  
                  
                  -Financing Costs, net of accumulated amortization and write-off
                      of
                      $1,219,410
                    and $73,499 atDecember
                      31, 2006 and 2005, respectively (Note H)
                  
                  
                  -
                  
                  
                  1,145,911Goodwill (Note B and C)
                  
                  
                  1,977,768
                  
                  
                  -Deposits
                  
                  
                  146,665
                  
                  
                  154,216Total other assets
                  
                  
                  4,499,882
                  
                  
                  1,531,127**Total Assets**
                  
                  $
                  12,516,516
                  
                  $
                  23,290,983**LIABILITIES
                      AND STOCKHOLDERS' EQUITY****Current liabilities:**Accounts payable and accrued liabilities (Note P)
                  
                  $
                  2,865,144
                  
                  $
                  1,821,872Customer deposits held
                  
                  
                  -
                  
                  
                  86,257Senior notes payable, current portion (Note I)
                  
                  
                  -
                  
                  
                  100,000Note Payable - officer (Note L)
                  
                  
                  80,444
                  
                  
                  -Income tax refund due to officer (Note L)
                  
                  
                  291,000
                  
                  
                  -Convertible debentures, current portion (Note H)
                  
                  
                  -
                  
                  
                  6,250,000Note payable in connection with subsidiary acquisition (Note
                      B)
                  
                  
                  900,000
                  
                  
                  -Deferred revenue
                  
                  
                  160,125
                  
                  
                  59,020Total current liabilities
                  
                  
                  4,296,713
                  
                  
                  8,317,149**Long-term liabilities:**Convertible debentures, net of debt discounts (Note H)
                  
                  
                  -
                  
                  
                  9,616,521Deferred revenue
                  
                  
                  42,019
                  
                  
                  -Deferred lease liability
                  
                  
                  42,561
                  
                  
                  42,317Total long-term liabilities
                  
                  
                  84,580
                  
                  
                  9,658,838**Commitments and contingencies**(Note Q)
                  
                  
                  -
                  
                  
                  -**Minority interest**
                  
                  
                  **-**
                  
                  
                  **-****Stockholders’ equity**(Note J)Preferred stock, par value $.001 per share; 15,000,000 shares
                      authorized;
                    none issued and outstanding at December 31, 2006 and 2005
                  
                  
                  -
                  
                  
                  -Common stock, par value $.001 per share; 100,000,000 shares
                      authorized;56,992,301and
                    45,765,171 shares issued and outstanding at December 31, 2006
                      and 2005,
                      respectively
                  
                  
                  56,992
                  
                  
                  45,765Additional paid-in-capital
                  
                  
                  78,502,900
                  
                  
                  48,256,784Accumulated deficit
                  
                  
                  (70,424,669
                  )
                  
                  (42,987,553
                  )Stockholders’ equity
                  
                  
                  8,135,223
                  
                  
                  5,314,996**Total Liabilities and Stockholders’ Equity**
                  
                  $
                  12,516,516
                  
                  $
                  23,290,983
  See
          accompanying notes to consolidated financial statements
 F-4
  **TELKONET,
          INC.**
 **CONSOLIDATED
          STATEMENTS OF LOSSES**
 **FOR
          THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**
 
 2006
                
                2005
                
                2004Product
                    Revenues, net
                
                $
                3,092,967
                
                $
                1,769,727
                
                $
                477,555Rental
                    Revenue, net
                
                
                2,088,361
                
                
                718,596
                
                
                221,097Total
                    Revenue
                
                
                5,181,328
                
                
                2,488,323
                
                
                698,652Product
                
                
                2,062,399
                
                
                1,183,574
                
                
                459,225Rental
                
                
                2,418,260
                
                
                533,605
                
                
                83,634Total
                    Cost of Sales
                
                
                4,480,659
                
                
                1,717,179
                
                
                542,859Gross
                    Profit
                
                
                700,669
                
                
                771,144
                
                
                155,793Operating
                    Expenses:Research
                    and Development (Note A)
                
                
                1,925,746
                
                
                2,096,104
                
                
                1,852,309Selling,
                    General and Administrative
                
                
                14,346,364
                
                
                12,041,661
                
                
                7,663,369Consulting
                    Fees (Note J)
                
                
                -
                
                
                -
                
                
                2,500,000Impairment
                    write-down in investment in affiliate (Note G)
                
                
                92,000
                
                
                400,000
                
                
                -Non-Employee
                    Stock Options and Warrants (Note K)
                
                
                277,344
                
                
                1,354,219
                
                
                1,180,875Employee
                    Stock based compensation (Note K)
                
                
                1,080,895
                
                
                -
                
                
                -Depreciation
                    and Amortization
                
                
                540,906
                
                
                185,928
                
                
                71,514Total
                    Operating Expense
                
                
                18,263,255
                
                
                16,077,912
                
                
                13,268,067Loss
                    from Operations
                
                
                (17,562,586
                )
                
                (15,306,768
                )
                
                (13,112,274
                )Other
                    Income (Expense):Other
                    Income (Note H)
                
                
                -
                
                
                8,600
                
                
                -Loss
                    on early extinguishment of debt (Note H)
                
                
                (4,626,679
                )Interest
                    Income
                
                
                327,184
                
                
                166,070
                
                
                128,938Interest
                    Expense
                
                
                (5,594,604
                )
                
                (
                    646,183
                )
                
                (109,324
                )Total
                    Other Income (Expenses)
                
                
                (9,894,099
                )
                
                (471,513
                )
                
                19,614Loss
                    Before Provision for Income Taxes
                
                
                (27,456,685
                )
                
                (15,778,281
                )
                
                (13,092,660
                )Minority
                    interest (Note B)
                
                
                19,569Provision
                    for Income Tax (Note N)
                
                
                -
                
                
                -
                
                
                -Net
                    (Loss)
                
                $
                (27,437,116
                )
                $
                (15,778,281
                )
                $
                (13,092,660
                )Loss
                    per common share (basic and assuming dilution) (Note O)
                
                $
                (0.54
                )
                $
                (0.35
                )
                $
                (0.32
                )Weighted
                    average common shares outstanding
                
                
                50,823,652
                
                
                44,743,223
                
                
                41,384,074
 
  See
          accompanying notes to consolidated financial statements
 F-5
  **TELKONET,
            INC.**
 **CONSOLIDATED
            STATEMENTS OF STOCKHOLDERS’ EQUITY**
 **FOR
            THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**
  Preferred
                      Shares
                  
                  Preferred
                      Stock
                    Amount
                  
                  Common
                    Shares
                  
                  Common
                      Stock Amount
                  
                  Additional
                      Paid in Capital
                  
                  Accumulated
                      Deficit
                  
                  TotalBalance
                      at January 1, 2004
                  
                  
                  **-**
                  
                  $
                  -
                  
                  
                  30,689,522
                  
                  $
                  30,690
                  
                  $
                  16,474,251
                  
                  $
                  (14,116,612
                  )
                  $
                  2,388,329Shares
                      issued for employee stock options exercised at approximately
                      $1.08 per
                      share
                  
                  
                  -
                  
                  
                  -
                  
                  
                  540,399
                  
                  
                  540
                  
                  
                  582,358
                  
                  
                  -
                  
                  
                  582,898Shares
                      issued in exchange for non-employee options exercised at $1.00
                      per
                      share
                  
                  
                  -
                  
                  
                  -
                  
                  
                  328,333
                  
                  
                  328
                  
                  
                  328,005
                  
                  
                  -
                  
                  
                  328,333Shares
                      issued to consultants in exchange for services rendered at
                      approximately
                      $3.07 per share
                  
                  
                  -
                  
                  
                  -
                  
                  
                  63,566
                  
                  
                  63
                  
                  
                  196,252
                  
                  
                  -
                  
                  
                  196,315Shares
                      issued for senior note conversion at $2.10 per share (Note
                      I)
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,209,038
                  
                  
                  1,209
                  
                  
                  2,537,791
                  
                  
                  -
                  
                  
                  2,539,000Shares
                      issued in connection with private placement at $2.00 per share,
                      net of
                      costs
                  
                  
                  -
                  
                  
                  -
                  
                  
                  6,387,600
                  
                  
                  6,388
                  
                  
                  12,720,455
                  
                  
                  -
                  
                  
                  12,726,843Shares
                      issued to consultants for warrants exercised at $2.54 per
                      share
                  
                  
                  -
                  
                  
                  -
                  
                  
                  50,000
                  
                  
                  50
                  
                  
                  126,950
                  
                  
                  -
                  
                  
                  127,000Shares
                      issued to noteholders for warrants exercised at $1.00 per share
                  
                  
                  -
                  
                  
                  -
                  
                  
                  4,000,950
                  
                  
                  4,001
                  
                  
                  3,996,949
                  
                  
                  -
                  
                  
                  4,000,950Shares
                      issued to noteholders for cashless warrants exercised
                  
                  
                  -
                  
                  
                  -
                  
                  
                  203,751
                  
                  
                  204
                  
                  
                  (204
                  )
                  
                  -
                  
                  
                  -Shares
                      issued for cashless exercise of underwriter warrants
                  
                  
                  -
                  
                  
                  -
                  
                  
                  165,116
                  
                  
                  165
                  
                  
                  (165
                  )
                  
                  -
                  
                  
                  -Shares
                      issued in exchange for convertible debentures at $0.50 per
                      share
                  
                  
                  **-**
                  
                  
                  -
                  
                  
                  124,000
                  
                  
                  124
                  
                  
                  61,876
                  
                  
                  -
                  
                  
                  62,000Shares
                      issued in exchange for convertible debentures at $0.55 per
                      share
                  
                  
                  **-**
                  
                  
                  -
                  
                  
                  200,000
                  
                  
                  200
                  
                  
                  109,800
                  
                  
                  -
                  
                  
                  110,000Shares
                      issued in exchange for accrued interest on convertible debentures
                  
                  
                  -
                  
                  
                  -
                  
                  
                  42,999
                  
                  
                  43
                  
                  
                  23,233
                  
                  
                  -
                  
                  
                  23,276Shares
                      issued to an employee in exchange for services at approximately
                      $2.99 per
                      share
                  
                  
                  -
                  
                  
                  -
                  
                  
                  36,000
                  
                  
                  36
                  
                  
                  107,743
                  
                  
                  -
                  
                  
                  107,779Shares
                      issued to consultants in exchange for consulting fees at $2.50
                      per
                      share
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,000,000
                  
                  
                  1,000
                  
                  
                  2,499,000
                  
                  
                  -
                  
                  
                  2,500,000Founders
                      shares returned and canceled in connection with January 2002
                      capital
                      restructure
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (705,285
                  )
                  
                  (705
                  )
                  
                  705
                  
                  
                  -
                  
                  
                  -Write-off
                      of beneficial conversion features and warrants attached to
                      convertible
                      debentures in connection with conversion of Debenture-1 and
                      Series B
                      debentures
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (134,666
                  )
                  
                  -
                  
                  
                  (134,666
                  )Stock
                      options and warrants granted to consultants in exchange for
                      services
                      rendered
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,180,875
                  
                  
                  -
                  
                  
                  1,180,875Net
                      loss
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (13,092,660
                  )
                  
                  (13,092,660
                  )Balance
                      at December 31, 2004
                  
                  
                  -
                  
                  $
                  -
                  
                  
                  44,335,989
                  
                  $
                  44,336
                  
                  $
                  40,811,208
                  
                  $
                  (27,209,272
                  )
                  $
                  13,646,272
   See
            accompanying footnotes to consolidated financial statements
 F-6
  **TELKONET,
          INC.**
 **CONSOLIDATED
          STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)**
 **FOR
          THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**
 
 Preferred
                    Shares
                
                Preferred
                    Stock
                  Amount
                
                Common
                    Shares
                
                Common
                    Stock Amount
                
                Additional
                    Paid in Capital
                
                Accumulated
                    Deficit
                
                TotalBalance
                    at January 1, 2005
                
                
                **-**
                
                $
                -
                
                
                44,335,989
                
                $
                44,336
                
                $
                40,811,208
                
                $
                (27,209,272
                )
                $
                13,646,272Shares
                    issued for employee stock options exercised at approximately
                    $1.19 per
                    share
                
                
                -
                
                
                -
                
                
                415,989
                
                
                416
                
                
                496,077
                
                
                -
                
                
                496,493Shares
                    issued in exchange for non-employee options exercised at approximately
                    $2.07 per share
                
                
                -
                
                
                -
                
                
                172,395
                
                
                172
                
                
                355,973
                
                
                -
                
                
                356,145Shares
                    issued to noteholders for warrants exercised at $1.00 per share
                
                
                -
                
                
                -
                
                
                321,900
                
                
                322
                
                
                321,578
                
                
                -
                
                
                321,900Shares
                    issued to noteholders for cashless warrants exercised
                
                
                -
                
                
                -
                
                
                36,150
                
                
                36
                
                
                (36
                )
                
                -
                
                
                -Shares
                    issued to an employee in exchange for services at approximately
                    $4.65 per
                    share
                
                
                -
                
                
                -
                
                
                36,000
                
                
                36
                
                
                163,283
                
                
                -
                
                
                163,319Shares
                    issued to director in exchange for services rendered at approximately
                    $4.26 per share
                
                
                -
                
                
                -
                
                
                30,000
                
                
                30
                
                
                127,766
                
                
                -
                
                
                127,796Shares
                    issued to consultants in exchange for services rendered at approximately
                    $4.28 per share
                
                
                -
                
                
                -
                
                
                1,968
                
                
                2
                
                
                9,000
                
                
                -
                
                
                9,002Shares
                    issued in exchange for convertible debentures at $0.55 per share
                
                
                **-**
                
                
                -
                
                
                363,636
                
                
                364
                
                
                199,636
                
                
                -
                
                
                200,000Shares
                    issued in exchange for interest expense on convertible debentures
                
                
                -
                
                
                -
                
                
                51,144
                
                
                51
                
                
                28,080
                
                
                -
                
                
                28,131Beneficial
                    conversion feature of convertible debentures (Note H)
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                1,479,300
                
                
                -
                
                
                1,479,300Value
                    of warrants attached to convertible debentures (Note H)
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                2,910,700
                
                
                -
                
                
                2,910,700Stock
                    options and warrants granted to consultants in exchange for services
                    rendered
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                1,354,219
                
                
                -
                
                
                1,354,219Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (15,778,281
                )
                
                (15,778,281
                )Balance
                    at December 31, 2005
                
                
                -
                
                $
                -
                
                
                45,765,171
                
                $
                45,765
                
                $
                48,256,784
                
                $
                (42,987,553
                )
                $
                5,314,996
   See
          accompanying footnotes to consolidated financial statements
 F-7
  **TELKONET,
          INC.**
 **CONSOLIDATED
          STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)**
 **FOR
          THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**
 
 Preferred
                    Shares
                
                Preferred
                    Stock
                  Amount
                
                Common
                    Shares
                
                Common
                    Stock Amount
                
                Additional
                  Paid
                    in Capital
                
                Accumulated
                    Deficit
                
                Total**Balance
                    at January 1, 2006**
                
                
                **-**
                
                
                -
                
                
                45,765,171
                
                
                45,765
                
                
                48,256,784
                
                
                (42,987,553
                )
                
                5,314,996Shares
                    issued for employee stock options exercised at approximately
                    $1.36 per
                    share
                
                
                -
                
                
                -
                
                
                2,051,399
                
                
                2,051
                
                
                2,656,774
                
                
                -
                
                
                2,658,826Shares
                    issued in exchange for non-employee options exercised at $1.00
                    per
                    share
                
                
                -
                
                
                -
                
                
                25,837
                
                
                26
                
                
                25,811
                
                
                -
                
                
                25,837Shares
                    issued in exchange for warrants exercised at $1.15 per
                    share
                
                
                -
                
                
                -
                
                
                47,750
                
                
                48
                
                
                55,090
                
                
                -
                
                
                55,138Issuance
                    of shares for purchase of subsidiary (Note B)
                
                
                -
                
                
                -
                
                
                600,000
                
                
                600
                
                
                2,699,400
                
                
                -
                
                
                2,700,000Shares
                    issued in exchange for services rendered at approximately $3.87
                    per
                    share
                
                
                -
                
                
                -
                
                
                52,420
                
                
                52
                
                
                202,974
                
                
                -
                
                
                203,026Shares
                    issued in exchange for convertible debentures, interest expense
                    and
                    penalty at approximately $2.36 per share (Note H)
                
                
                -
                
                
                -
                
                
                6,049,724
                
                
                6,050
                
                
                14,249,979
                
                
                -
                
                
                14,256,029Shares
                    issued for cash in connection with a private placement, shares
                    issued at
                    $2.50 per share
                
                
                -
                
                
                -
                
                
                2,400,000
                
                
                2,400
                
                
                5,997,600
                
                
                -
                
                
                6,000,000Value
                    of additional warrants issued in conjunction with exchange of
                    convertible
                    debentures (Note H)
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                3,000,249
                
                
                -
                
                
                3,000,249Stock-based
                    compensation expense related to employee stock options (Note
                    K)
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                1,080,895
                
                
                -
                
                
                1,080,895Stock
                    options and warrants granted to consultants in exchange for services
                    rendered (Note K)
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                277,344
                
                
                -
                
                
                277,344Net
                    Loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (27,437,116
                )
                
                (27,437,116
                )**Balance
                    at December 31, 2006**
                
                
                **-**
                
                
                **-**
                
                
                56,992,301
                
                $
                56,992
                
                $
                78,502,900
                
                $
                (70,424,669
                )
                $
                8,135,223
   See
        accompanying footnotes to consolidated financial
        statements
 F-8
  **TELKONET,
          INC.**
 **CONSOLIDATED
          STATEMENTS OF CASH FLOWS**
 **FOR
          THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**
   2006
                
                2005
                
                2004**Increase
                    (Decrease) In Cash and Equivalents****Cash
                    Flows from Operating Activities:**Net
                    loss from operating activities
                
                $
                (27,437,116
                )
                $
                (15,778,281
                )
                $
                (13,092,660
                )Adjustments
                    to reconcile net loss from operations to cash used in operating
                    activities:Minority
                    interest
                
                
                (19,569
                )
                
                -
                
                
                -Amortization
                    and write-off of debt discount - beneficial conversion feature
                    ofconvertible
                    debentures (Note H)
                
                
                1,390,137
                
                
                138,406
                
                
                21,888Amortization
                    and write-off of debt discount - value of warrants attached to
                    convertibledebentures
                    (Note H)
                
                
                2,743,342
                
                
                198,805
                
                
                10,152Amortization
                    and write-off of financing costs
                
                
                1,145,911
                
                
                73,499
                
                
                -Other
                    income in connection with derivative warrant liabilities (Note
                    H)
                
                
                -
                
                
                (8,600
                )
                
                -Warrants
                    issued prepayment of debt
                
                
                3,000,249
                
                
                -
                
                
                -Common
                    stock issued in exchange for and penalty in connection with earlyextinguishment
                    of debt (Note H)
                
                
                2,006,029
                
                
                -
                
                
                -Stock
                    options and warrants issued in exchange for services (Note
                    K)
                
                
                1,358,239
                
                
                1,354,219
                
                
                1,180,875Common
                    stock issued in exchange for services rendered (Note J)
                
                
                203,026
                
                
                300,117
                
                
                304,094Common
                    stock issued in exchange for conversion of interest
                
                
                -
                
                
                28,131
                
                
                23,276Common
                    stock issued in exchange for consulting fees (Note J)
                
                
                -
                
                
                -
                
                
                2,500,000Depreciation,
                    including equipment under operating leases
                
                
                980,470
                
                
                430,104
                
                
                143,358Impairment
                    write-down in investment in Amperion (Note G)
                
                
                92,000
                
                
                400,000
                
                
                -Increase
                    / decrease in:Accounts
                    receivable, trade and other
                
                
                (143,013
                )
                
                (56,044
                )
                
                (4,950
                )Inventory
                
                
                169,213
                
                
                397,912
                
                
                (1,265,202
                )Prepaid
                    expenses and deposits
                
                
                405,952
                
                
                (313,956
                )
                
                (23,150
                )Deferred
                    lease liability
                
                
                245
                
                
                11,406
                
                
                30,911Deferred
                    revenue
                
                
                68,801
                
                
                59,020
                
                
                -Accounts
                    payable, accrued expenses, net
                
                
                64,555
                
                
                679,230
                
                
                587,848**Net
                    Cash Used In Operating Activities**
                
                
                (13,971,529
                )
                
                (12,086,032
                )
                
                (9,583,560
                )**Cash
                    Flows From Investing Activities:**Costs
                    of equipment under operating leases
                
                
                (1,939,759
                )
                
                (458,271
                )
                
                (491,776
                )Sale
                    of equipment under operating lease, net
                
                
                350,571
                
                
                -
                
                
                -Purchase
                    of property and equipment, net
                
                
                (734,888
                )
                
                (336,448
                )
                
                (514,903
                )Proceeds
                    (Investment) in Restricted Certificate of Deposit (Note A)
                
                
                10,000,000
                
                
                (10,000,000
                )
                
                -Investment
                    in MST (Note B)
                
                
                (900,000
                )Net
                    cash acquired from MST (Note B)
                
                
                59,384Acquisition
                    costs (Note B)
                
                
                (117,822
                )Investment
                    in Amperion and BPL Global (Note G)
                
                
                (44
                )
                
                (131,000
                )
                
                (500,000
                )**Net
                    Cash Used In Investing Activities**
                
                
                6,717,442
                
                
                (10,925,719
                )
                
                (1,506,679
                )**Cash
                    Flows From Financing Activities:**Proceeds
                    from sale of common stock, net of costs and fees (Note J)
                
                
                6,000,000
                
                
                -
                
                
                12,726,843Proceeds
                    from issuance of convertible debentures, net of costs and fees
                    (Note
                    H)
                
                
                -
                
                
                18,780,590
                
                
                -Repayment
                    of convertible debenture (Note H)
                
                
                (7,750,000
                )
                
                (10,000
                )
                
                -Repayment
                    of senior notes (Note I)
                
                
                (100,000
                )
                
                (350,000
                )
                
                -Proceeds
                    from exercise of warrants (Note K)
                
                
                55,138
                
                
                321,900
                
                
                4,127,950Proceeds
                    from exercise of employee and non-employee stock options and
                    warrants
                    (Note K)
                
                
                2,684,663
                
                
                852,638
                
                
                911,230Repayments
                    of loans
                
                
                (413,756
                )
                
                -
                
                
                -Repayments
                    of capital leases
                
                
                -
                
                
                -
                
                
                (15,000
                )**Net
                    Cash Provided By Financing Activities**
                
                
                476,045
                
                
                19,595,128
                
                
                17,751,023**Net
                    Increase (Decrease) In Cash and Equivalents**
                
                
                (6,778,042
                )
                
                (3,416,623
                )
                
                6,660,784Cash
                    and cash equivalents at the beginning of the year
                
                
                8,422,079
                
                
                11,838,702
                
                
                5,177,918Cash
                    and cash equivalents at the end of the year
                
                $
                1,644,037
                
                $
                8,422,079
                
                $
                11,838,702
   See
          accompanying notes to consolidated financial statements
 F-9
  **TELKONET,
          INC.**
 **CONSOLIDATED
          STATEMENTS OF CASH FLOWS (Continued)**
 **FOR
          THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**
 
 2006
                
                2005
                
                2004Supplemental
                    Disclosures of Cash Flow Information:Cash
                    transactions:Cash
                    paid during the period for interest
                
                $
                990,846
                
                $
                40,645
                
                $
                100,608Income
                    taxes paid
                
                
                -
                
                
                -
                
                
                -Non-cash
                    transactions:Issuance
                    of stock options and warrants in exchange for services rendered
                    (Note
                    K)
                
                
                1,358,239
                
                
                1,354,219
                
                
                1,180,875Common
                    stock issued for services rendered (Note J)
                
                
                203,026
                
                
                300,117
                
                
                304,094Common
                    stock issued in exchange for interest (Note J)
                
                
                -
                
                
                28,131
                
                
                23,276Common
                    stock issued in exchange for consulting services (Note J)
                
                
                -
                
                
                -
                
                
                2,500,000Note
                    payable under subsidiary acquisition (Note B)
                
                
                900,000
                
                
                -
                
                
                -Common
                    stock issued in exchange for interest expense and penalty in
                    connectionwith
                    early extinguishment of debt (Note H)
                
                
                2,006,030
                
                
                -
                
                
                -Issuance
                    of shares for purchase of subsidiary
                
                
                2,700,000
                
                
                -
                
                
                -Common
                    stock issued in exchange for Senior Note (Note I and K)
                
                
                -
                
                
                -
                
                
                2,539,000Common
                    stock issued in exchange for conversion of convertible debenture
                    (Note H
                    and K)
                
                
                12,250,000
                
                
                200,000
                
                
                172,000Write-off
                    of beneficial conversion feature for conversion of debenture
                
                
                -
                
                
                -
                
                
                134,135Write-off
                    of value of warrants attached to debenture in connection with
                    conversion
                
                
                -
                
                
                -
                
                
                531Impairment
                    write-down in investment in affiliate (Note G)
                
                
                92,000
                
                
                400,000
                
                
                -Beneficial
                    conversion feature on convertible debentures (Note H)
                
                
                -
                
                
                1,479,300
                
                
                -Value
                    of warrants attached to convertible debentures (Note H)
                
                
                -
                
                
                2,910,700
                
                
                -Acquisition
                    of MST (Note B):Assets
                    acquired
                
                
                4,120,600
                
                
                -
                
                
                -Goodwill
                    (including purchase price contingency)
                
                
                6,477,767
                
                
                -
                
                
                -Minority
                    Interest
                
                
                (19,569
                )
                
                -
                
                
                -Liabilities
                    assumed
                
                
                (1,460,976
                )
                
                -
                
                
                -Common
                    stock issued
                
                
                (2,700,000
                )
                
                -
                
                
                -Notes
                    payable issued
                
                
                (900,000
                )
                
                -
                
                
                -Purchase
                    price contingency
                
                
                (4,500,000
                )
                
                -
                
                
                -Direct
                    acquisition costs
                
                
                (117,822
                )
                
                -
                
                
                -Cash
                    paid for acquisition
                
                
                900,000
                
                
                -
                
                
                -
 
  See
          accompanying notes to consolidated financial statements
 F-10
 **TELKONET,
        INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**
   **NOTE
          A-SUMMARY OF ACCOUNTING POLICIES**
 
 A
          summary
          of the significant accounting policies applied in the preparation of the
          accompanying consolidated financial statements follows.
 
 Business
          and Basis of Presentation
 
 Telkonet,
          Inc. (the "Company"), formerly Comstock Coal Company, Inc., was formed
          on
          November 3, 1999 under the laws of the state of Utah. The Company was a
          “development stage enterprise” (as defined by Statement of Financial Accounting
          Standards No. 7) until December 31, 2003. The Company is engaged in the
          business
          of developing, producing and marketing proprietary equipment enabling the
          transmission of voice and data over electric utility lines.
 
 In
          January 2006, following the acquisition of Microwave Satellite Technologies
          (MST) (Note B), the Company began offering complete sales, installation,
          and service of VSAT and business television networks, and became a
          full-service national Internet Service Provider (ISP). The MST solution
          offers a
          complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
          Broadband  Internet
          access and wireless fidelity (“Wi-Fi”) access, to commercial multi-dwelling
          units and hotels.
 
 The
          consolidated financial statements include the accounts of the Company and
          its
          wholly-owned subsidiary, Telkonet Communications, Inc. and 90% owned subsidiary
          Microwave Satellite Technologies (MST). Significant intercompany transactions
          have been eliminated in consolidation.
 
 Investments
          in entities over which the Company has significant influence, typically
          those
          entities that are 20 to 50 percent owned by the Company, are accounted for
          using the equity method of
          accounting, whereby the investment is carried at cost of acquisition, plus
          the
          Company’s equity in undistributed earnings or losses since acquisition.
 
 Concentrations
          of Credit Risk
 
 Financial
          instruments and related items, which potentially subject the Company to
          concentrations of credit risk, consist primarily of cash and cash equivalents.
          The Company places its cash and temporary cash investments with credit
          quality
          institutions. At times, such investments may be in excess of the FDIC insurance
          limit. The allowance for doubtful accounts was $60,000 and $30,000 at December
          31, 2006 and December 31, 2005, respectively.
 
 Cash
          and Cash Equivalents
 
 For
          purposes of the Statements of Cash Flows, the Company considers all highly
          liquid debt instruments purchased with a maturity date of three months
          or less
          to be cash equivalents.
 
 Restricted
          Certificate of Deposit
 
 In
          the
          year ended December 31, 2006, restricted cash was drawn down to zero upon
          in
          conjunction with the settlement agreements with the lenders of its Convertible
          Senior Notes (Note H ). The restricted cash at December 31, 2005 consisted
          of a
          $10,000,000 certificate of deposit pledged as collateral for an irrevocable
          letter of credit agreement.  The letter of credit agreement automatically
          renewed annually as required in the Convertible Senior Notes loan
          covenant.  The certificate of deposit provided for approximately 4%
          interest payable at maturity.
 
 Liquidity
  As
          shown
          in the accompanying consolidated financial statements, the Company incurred
          net
          loss of $27,437,116, $15,778,281 and $13,092,660 for the years ended December
          31, 2006, 2005 and 2004, respectively. Net loss included $5,658,986, $338,620
          and $0 of non-cash interest and financing expense in connection with the
          convertible debentures, $4,626,769, $0 and $0 of non-cash expense in connection
          with the early extinguishment of debt, and $1,358,239, $1,354,219 and $1,180,875
          of non-cash compensation to employees and non-employees in connection with
          stock
          options granted and vested and $0, $0 and $2,500,000 of common stock issued
          in
          exchange for consulting services for the years ended December 31, 2006,
          2005 and
          2004, respectively. The Company's current liabilities, on a consolidated
          basis,
          exceeded its current assets by $530,634 as of December 31, 2006.
 
 F-11
 
 **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 
 **NOTE
          A-SUMMARY OF ACCOUNTING POLICIES (Continued)**
 
 Property
          and Equipment
 
 Property
          and equipment is stated at cost. Depreciation is calculated using the
          straight-line method over the estimated useful lives of the assets. The
          estimated useful life ranges from 3 to 10 years.
 
 Long-Lived
          Assets
 
 The
          Company has adopted Statement of Financial Accounting Standards No. 144
          (SFAS
          144). The Statement requires that long-lived assets and certain identifiable
          intangibles held and used by the Company be reviewed for impairment whenever
          events or changes in circumstances indicate that the carrying amount of
          an asset
          may not be recoverable. Events relating to recoverability may include
          significant unfavorable changes in business conditions, recurring losses,
          or a
          forecasted inability to achieve break-even operating results over an extended
          period. The Company evaluates the recoverability of long-lived assets based
          upon
          forecasted discounted cash flows. Should an impairment in value be indicated,
          the carrying value of intangible assets will be adjusted, based on estimates
          of
          future discounted cash flows resulting from the use and ultimate disposition
          of
          the asset. SFAS No. 144 also requires assets to be disposed of be reported
          at
          the lower of the carrying amount or the fair value less costs to sell.
          The
          company has determined that its investment in Amperion Inc. has been impaired
          based upon forecasted discounted cash flow and has written off $92,000
          and
          $400,000, of its investment based on management assessment during the year
          ended
          December 31, 2006 and 2005, respectively. (Note G).
 
 Inventories
 
 Inventories
          consist primarily of Gateways, Extenders, iBridges and Couplers which are
          the
          significant components of the Telkonet solution. Cost is determined by
          the
          first-in, first-out method. (Note D).
 
 Income
          Taxes
 
 The
          Company has implemented the provisions on Statement of Financial Accounting
          Standards No. 109, "Accounting for Income Taxes" (SFAS 109). SFAS 109 requires
          that income tax accounts be computed using the liability method. Deferred
          taxes
          are determined based upon the estimated future tax effects of differences
          between the financial reporting and tax reporting bases of assets and
          liabilities given the provisions of currently enacted tax laws.
 
 Net
          Loss Per Common Share
 
 The
          Company computes earnings per share under Financial Accounting Standard
          No. 128,
          "Earnings Per Share" (SFAS 128). Net loss per common share is computed
          by
          dividing net loss by the weighted average number of shares of common stock
          and
          dilutive common stock equivalents outstanding during the year. Dilutive
          common
          stock equivalents consist of shares issuable upon conversion of convertible
          notes and the exercise of the Company's stock options and warrants (calculated
          using the treasury stock method). During 2006, 2005 and 2004, common stock
          equivalents are not considered in the calculation of the weighted average
          number
          of common shares outstanding because they would be anti-dilutive, thereby
          decreasing the net loss per common share.
 
 Use
          of
          Estimates
 
 The
          preparation of financial statements in conformity with generally accepted
          accounting principles requires management to make estimates and assumptions
          that
          affect certain reported amounts and disclosures. Accordingly, actual results
          could differ from those estimates.
 
 F-12
  **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 **NOTE
          A-SUMMARY OF ACCOUNTING POLICIES (Continued)**
  Revenue
          Recognition
 
 For
          revenue from product sales, the Company recognizes revenue in accordance
          with
          Staff Accounting Bulletin No. 104, *Revenue
          Recognition* (“SAB104”), which superceded Staff Accounting Bulletin No. 101, *Revenue
          Recognition in Financial Statements* (“SAB101”). SAB 101 requires that four basic criteria must be met before revenue
          can be recognized: (1) persuasive evidence of an arrangement exists; (2)
          delivery has occurred; (3) the selling price is fixed and determinable;
          and (4)
          collectibility is reasonably assured. Determination of criteria (3) and
          (4) are
          based on management’s judgments regarding the fixed nature of the selling prices
          of the products delivered and the collectibility of those amounts.
          Provisions for discounts and rebates to customers, estimated returns and
          allowances, and other adjustments are provided for in the same period the
          related sales are recorded. The Company defers any revenue for which the
          product
          has not been delivered or is subject to refund until such time that the
          Company
          and the customer jointly determine that the product has been delivered
          or no
          refund will be required. SAB 104 incorporates Emerging Issues Task Force
          00-21
          (“EITF 00-21”), *Multiple-Deliverable
          Revenue Arrangements.* EITF
          00-21 addresses accounting for arrangements that may involve the delivery
          or
          performance of multiple products, services and/or rights to use assets.
 
 For
          equipment under lease, revenue is recognized over the lease term for operating
          lease and rental contracts. All of the Company’s leases are accounted for as
          operating leases. At the inception of the lease, no lease revenue is recognized
          and the leased equipment and installation costs are capitalized and appear
          on
          the balance sheet as “Equipment Under Operating Leases.” The capitalized cost of
          this equipment is depreciated from two to three years, on a straight-line
          basis
          down to the Company’s original estimate of the projected value of the equipment
          at the end of the scheduled lease term. Monthly lease payments are recognized
          as
          rental income. The Company has sold a portion of its lease portfolio in
          December
          2005 and substantially all the remaining portfolio during 2006. The related
          equipment was charged to cost of sales commensurate with the associated
          revenue
          recognition (Note F ).
 
 MST
          accounts for the revenue, costs and expense related to residential cable
          services as the related services are performed in accordance with SFAS
          No. 51, *Financial
          Reporting by Cable Television Companies* .
          Installation revenue for residential cable services is recognized to the
          extent
          of direct selling costs incurred. Direct selling costs have exceeded
          installation revenue in all reported periods. Generally, credit risk is
          managed
          by disconnecting services to customers who are delinquent.
 
 Guarantees
          and Product Warranties
 
 FASB
          Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
          Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”),
          requires that upon issuance of a guarantee, the guarantor must disclose
          and
          recognize a liability for the fair value of the obligation it assumes under
          that
          guarantee.
 
 The
          Company’s guarantees were issued subject to the recognition and disclosure
          requirements of FIN 45 as of December 31, 2006 and 2005. The Company records
          a
          liability for potential warranty claims. The amount of the liability is
          based on
          the trend in the historical ratio of claims to sales, the historical length
          of
          time between the sale and resulting warranty claim, new product introductions
          and other factors. The products sold are generally covered by a warranty
          for a
          period of one year. In the event the Company determines that its current
          or
          future product repair and replacement costs exceed its estimates, an adjustment
          to these reserves would be charged to earnings in the period such determination
          is made. During the year ended December 31, 2006 and 2005, the Company
          experienced approximately three percent of units returned. As of December
          31,
          2006 and 2005, the Company recorded warranty liabilities in the amount
          of
          $47,300 and $24,000, respectively, using this experience factor.  Prior to
          the fiscal year of 2005, the Company had not established historical ratio
          of
          claims, and the cost of replacing defective products and product returns
          were
          immaterial and within management's expectations, accordingly there were
          no
          warranties provided with the purchase of the Company's products during
          the year
          ended December 31, 2004.
 
 Advertising
 
 The
          Company follows the policy of charging the costs of advertising to expenses
          incurred. The Company incurred $663,323, $657,794, and $499,874 in advertising
          costs during the years ended December 31, 2006, 2005 and 2004,
          respectively.
 
 Research
          and Development
 
 The
          Company accounts for research and development costs in accordance with
          the
          Financial Accounting Standards Board's Statement of Financial Accounting
          Standards No. 2 ("SFAS 2"), "Accounting for Research and Development Costs.”
Under SFAS 2, all research and development costs must be charged to expense
          as
          incurred. Accordingly, internal research and development costs are expensed
          as
          incurred. Third-party research and developments costs are expensed when
          the
          contracted work has been performed or as milestone results have been achieved.
          Company-sponsored research and development costs related to both present
          and
          future products are expensed in the period incurred. Total expenditures
          on
          research and product development for 2006, 2005 and 2004 were $1,925,746,
          $2,096,104, and $1,852,309, respectively.
 
 F-13
  **TELKONET,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005 AND 2004**
  **NOTE
          A-SUMMARY OF ACCOUNTING POLICIES (Continued)**
  Comprehensive
          Income
 
 Statement
          of Financial Accounting Standards No. 130 ("SFAS 130"), "Reporting Comprehensive
          Income," establishes standards for reporting and displaying of comprehensive
          income, its components and accumulated balances. Comprehensive income is
          defined
          to include all changes in equity except those resulting from investments
          by
          owners and distributions to owners. Among other disclosures, SFAS 130 requires
          that all items that are required to be recognized under current accounting
          standards as components of comprehensive income
          be
          reported in a financial statement that is displayed with the same prominence
          as
          other financial statements. The Company does not have any items of comprehensive
          income in any of the periods presented.
 
 Reclassifications
 
 Certain
          reclassifications have been made in prior year's financial statements to
          conform
          to classifications used in the current year.
 
 Stock
          Based Compensation
 
 On
          January 1, 2006, the Company adopted Statement of Financial Accounting
          Standards
          No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which
          requires the measurement and recognition of compensation expense for all
          share-based payment awards made to employees and directors including employee
          stock options based on estimated fair values. SFAS 123(R) supersedes the
          Company’s previous accounting under Accounting Principles Board Opinion
          No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods
          beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission
          issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS
          123(R). The Company has applied the provisions of SAB 107 in its adoption
          of
          SFAS 123(R).
  The
          Company adopted SFAS 123(R) using the modified prospective transition method,
          which requires the application of the accounting standard as of January
          1, 2006,
          the first day of the Company’s fiscal year 2006. The Company’s Consolidated
          Financial Statements as of and for the year ended December 31, 2006 reflect
          the
          impact of SFAS 123(R). In accordance with the modified prospective transition
          method, the Company’s Consolidated Financial Statements for prior periods have
          not been restated to reflect, and do not include, the impact of SFAS 123(R).
          Stock-based compensation expense recognized under SFAS 123(R) for the year
          ended
          December 31, 2006 was $1,080,895, net of tax effect.
  SFAS
          123(R) requires companies to estimate the fair value of share-based payment
          awards on the date of grant using an option-pricing model. The value of
          the
          portion of the award that is ultimately expected to vest is recognized
          as
          expense over the requisite service periods in the Company’s Consolidated
          Statement of Operations. Prior to the adoption of SFAS 123(R), the Company
          accounted for stock-based awards to employees and directors using the intrinsic
          value method in accordance with APB 25 as allowed under Statement of Financial
          Accounting Standards No. 123, “Accounting for Stock-Based Compensation”
(“SFAS 123”). Under the intrinsic value method, no stock-based compensation
          expense had been recognized in the Company’s Consolidated Statement of
          Operations because the exercise price of the Company’s stock options granted to
          employees and directors approximated or exceeded the fair market value
          of the
          underlying stock at the date of grant.
  Stock-based
          compensation expense recognized during the period is based on the value
          of the
          portion of share-based payment awards that is ultimately expected to vest
          during
          the period. Stock-based compensation expense recognized in the Company’s
          Consolidated Statement of Operations for the year ended December 31, 2006
          included compensation expense for share-based payment awards granted prior
          to,
          but not yet vested as of December 31, 2005 based on the grant date fair
          value
          estimated in accordance with the pro forma provisions of SFAS 123 and
          compensation expense for the share-based payment awards granted subsequent
          to
          December 31, 2005 based on the grant date fair value estimated in accordance
          with the provisions of SFAS 123(R). SFAS 123(R) requires forfeitures to
          be
          estimated at the time of grant and revised, if necessary, in subsequent
          periods
          if actual forfeitures differ from those estimates. In the Company’s pro forma
          information required under SFAS 123 for the periods prior to fiscal 2006,
          the
          Company accounted for forfeitures as they occurred.
  Upon
          adoption of SFAS 123(R), the Company is using the Black-Scholes option-pricing
          model as its method of valuation for share-based awards granted beginning
          in
          fiscal 2006, which was also previously used for the Company’s pro forma
          information required under SFAS 123. The Company’s determination of fair value
          of share-based payment awards on the date of grant using an option-pricing
          model
          is affected by the Company’s stock price as well as assumptions regarding a
          number of highly complex and subjective variables. These variables include,
          but
          are not limited to the Company’s expected stock price volatility over the term
          of the awards, and certain other market variables such as the risk free
          interest
          rate.
  F-14
 **TELKONET,
              INC.**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
              31, 2006, 2005 AND 2004**
  **NOTE
            A-SUMMARY OF ACCOUNTING POLICIES (Continued)**
 
 The
            following table shows the effect on net earnings and earnings per share
            had
            compensation cost been recognized based upon the estimated fair value
            on the
            grant date of stock options for the years ended December 31, 2005 and
            2004, in
            accordance with SFAS 123, as amended by SFAS No. 148 “Accounting for Stock-Based
            Compensation - Transition and Disclosure."
  2005
                  
                  2004Net
                      loss - as reported
                  
                  $
                  (15,778,281
                  )
                  $
                  (13,092,660
                  )Deduct:
                      stock-based compensation expense, net of tax
                  
                  
                  (2,440,097
                  )
                  
                  (7,830,385
                  )Net
                      loss - pro forma
                  
                  $
                  (18,218,378
                  )
                  $
                  (20,923,045
                  )Net
                      loss per common share — basic (and assuming dilution):As
                      reported
                  
                  $
                  (0.35
                  )
                  $
                  (0.32
                  )Deduct:
                      stock-based compensation expense, net of tax
                  
                  
                  (0.06
                  )
                  
                  (0.19
                  )Pro
                      forma
                  
                  $
                  (0.41
                  )
                  $
                  (0.51
                  )
  Disclosure
            for the year ended December 31, 2006 is not presented because the amounts
            are
            recognized in the consolidated financial statements. The fair value for
            stock
            awards was estimated at the date of grant using the Black-Scholes option
            valuation model with the following weighted average assumptions for the
            year
            ended December 31, 2005 and 2004:
 
 2005
                  
                  2004Significant
                      assumptions (weighted-average):Risk-free
                      interest rate at grant date
                  
                  
                  4.5%
                  
                  
                  1.35%Expected
                      stock price volatility
                  
                  
                  71%
                  
                  
                  76%Expected
                      dividend payout
                  
                  
                  -
                  
                  
                  -Expected
                      option life (in years)
                  
                  
                  5.0
                  
                  
                  5.0
 
 The
            expected term of the options represents the estimated period of time
            until
            exercise and is based on historical experience of similar awards, giving
            consideration to the contractual terms, vesting schedules and expectations
            of
            future employee behavior. For 2006 and prior years, expected stock price
            volatility is based on the historical volatility of the Company’s stock for the
            related vesting periods. Prior to the adoption of SFAS 123R, expected
            stock
            price volatility was estimated using only historical volatility. The
            risk-free
            interest rate is based on the implied yield available on U.S. Treasury
            constant
            maturity securities with an equivalent remaining term. The Company has
            not paid
            dividends in the past and does not plan to pay any dividends in the near
            future.
 
 The
            Black-Scholes option valuation model was developed for use in estimating
            the
            fair value of traded options, which have no vesting restrictions and
            are fully
            transferable. In addition, option valuation models require the input
            of highly
            subjective assumptions, particularly for the expected term and expected
            stock
            price volatility. The Company’s employee stock options have characteristics
            significantly different from those of traded options, and changes in
            the
            subjective input assumptions can materially affect the fair value estimate.
            Because Company stock options do not trade on a secondary exchange, employees
            do
            not derive a benefit from holding stock options unless there is an increase,
            above the grant price, in the market price of the Company’s stock. Such an
            increase in stock price would benefit all shareholders commensurately.
 
 F-15
 **TELKONET,
                INC.**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                31, 2006, 2005 AND 2004**
  **NOTE
              A-SUMMARY OF ACCOUNTING POLICIES (Continued)**
 Segment
            Information
 
 Statement
            of Financial Accounting Standards No. 131, "Disclosures about Segments
            of an
            Enterprise and Related Information" ("SFAS 131") establishes standards
            for
            reporting information regarding operating segments in annual financial
            statements and requires selected information for those segments to be
            presented
            in interim financial reports issued to stockholders. SFAS 131 also establishes
            standards for related disclosures about products and services and geographic
            areas. Operating segments are identified as components of an enterprise
            about
            which separate discrete financial information is available for evaluation
            by the
            chief operating decision maker, or decision-making group, in making decisions
            how to allocate resources and assess performance. The information disclosed
            herein materially represents all of the financial information related
            to the
            Company's principal operating segment.
 New
            Accounting Pronouncements
 
 On
            February 16, 2006 the FASB issued SFAS 155, “Accounting for Certain Hybrid
            Instruments,” which amends SFAS 133, “Accounting for Derivative Instruments and
            Hedging Activities,” and SFAS 140, “Accounting for Transfers and Servicing of
            Financial Assets and Extinguishments of Liabilities.” SFAS 155 allows financial
            instruments that have embedded derivatives to be accounted for as a whole
            (eliminating the need to bifurcate the derivative from its host) if the
            holder
            elects to account for the whole instrument on a fair value basis. SFAS
            155 also
            clarifies and amends certain other provisions of SFAS 133 and SFAS 140.
            This
            statement is effective for all financial instruments acquired or issued
            in
            fiscal years beginning after September 15, 2006. The Company does not
            expect its adoption of this new standard to have a material impact on
            its
            financial position, results of operations or cash flows.
 
 The
            FASB
            issued SFAS No. 156, “Accounting for Servicing of Financial Assets an
            amendment of FASB Statement No. 140” (“SFAS No. 156”) in March
            2006. SFAS No. 156 requires a company to recognize a servicing asset
            or servicing liability each time it undertakes an obligation to service
            a
            financial asset. A company would recognize a servicing asset or servicing
            liability initially at fair value. A company will then be permitted to
            choose to
            subsequently recognize servicing assets and liabilities using the amortization
            method or fair value measurement method. SFAS No. 156 is effective for
            fiscal years beginning after September 15, 2006. The
            Company does not expect its adoption of this new standard to have a material
            impact on its financial position, results of operations or cash
            flows.
  On
            July 13, 2006, the FASB issued FASB Interpretation No. 48, “Accounting
            for Uncertainty in Income Taxes-an Interpretation of FASB Statement
            No. 109” (“FIN No. 48”). FIN No. 48 clarifies what
            criteria must be met prior to recognition of the financial statement
            benefit of
            a position taken in a tax return. FIN No. 48 will require companies to
            include additional qualitative and quantitative disclosures within their
            financial statements. The disclosures will include potential tax benefits
            from
            positions taken for tax return purposes that have not been recognized
            for
            financial reporting purposes and a tabular presentation of significant
            changes
            during each period. The disclosures will also include a discussion of
            the nature
            of uncertainties, factors which could cause a change, and an estimated
            range of
            reasonably possible changes in tax uncertainties. FIN No. 48 will also
            require a company to recognize a financial statement benefit for a position
            taken for tax return purposes when it will be more-likely-than-not that
            the
            position will be sustained. FIN No. 48 will be effective for fiscal
            years beginning after December 15, 2006 **.**
  On
            September 15, 2006, the FASB issued SFAS No. 157, “Fair Value
            Measurements” (“SFAS No. 157”). SFAS No. 157 addresses how
            companies should measure fair value when they are required to use a fair
            value
            measure for recognition and disclosure purposes under generally accepted
            accounting principles. SFAS No. 157 will require the fair value of an
            asset or liability to be based on a market based measure which will reflect
            the
            credit risk of the company. SFAS No. 157 will also require expanded
            disclosure requirements which will include the methods and assumptions
            used to
            measure fair value and the effect of fair value measures on earnings.
            SFAS No. 157 will be applied prospectively and will be effective for
            fiscal years beginning after November 15, 2007 and to interim periods
            within those fiscal years.
  In
            September 2006, the Financial Accounting Standards Board issued FASB
            Statement
            No. 158, “Employers’ Accounting for Defined Benefit Pension and Other
            Postretirement Plans” (“SFAS 158”). SFAS 158 requires the Company to
            record the funded status of its defined benefit pension and other postretirement
            plans in its financial statements. The Company is required to record
            an asset in
            its financial statements if a plan is overfunded or record a liability
            in its
            financial statements if a plan is underfunded with a corresponding offset
            to
            shareholders’ equity. Previously unrecognized assets and liabilities are
            recorded as a component of shareholders’ equity in accumulated other
            comprehensive income, net of applicable income taxes. SFAS 158 also
            requires the Company to measure the value of its assets and liabilities
            as of
            the end of its fiscal year ending after December 15, 2008. The Company has
            implemented SFAS 158 using the required prospective method. The recognition
            provisions of SFAS 158 are effective for the fiscal year ending after
            December 15, 2006. The
            Company does not expect its adoption of this new standard to have a material
            impact on its financial position, results of operations or cash
            flows.
  In
              December 2006, the FASB issued FSP EITF 00-19-2, Accounting for Registration
              Payment Arrangements (" FSP
              00-19 -2")
              which addresses accounting for registration payment arrangements. FSP
              00-19 -2
              specifies that the contingent obligation to make future payments or
              otherwise
              transfer consideration under a registration payment arrangement, whether
              issued
              as a separate agreement or included as a provision of a financial instrument
              or
              other agreement, should be separately recognized and measured in accordance
              with
              FASB Statement No. 5, Accounting for Contingencies. FSP
              00-19 -2
              further clarifies that a financial instrument subject to a registration
              payment
              arrangement should be accounted for in accordance with other applicable
              generally accepted accounting principles without regard to the contingent
              obligation to transfer consideration pursuant to the registration payment
              arrangement. For registration payment arrangements and financial instruments
              subject to those arrangements that were entered into prior to the issuance
              of
              EITF 00-19-2, this guidance is effective for financial statements issued
              for
              fiscal years beginning after December 15, 2006 and interim periods
              within those
              fiscal years. The
              Company has not yet determined the impact that the adoption of FSP
              00-19 -2
              will have on its financial statements.
  In
            February 2007, the FASB issued SFAS No. 159, “The
            Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159
            permits entities to choose to measure many financial instruments, and
            certain
            other items, at fair value. SFAS 159 applies to reporting periods beginning
            after November 15, 2007. The adoption of SFAS 159 is not expected to
            have a
            material impact on the Company’s financial condition or results of
            operations.
  F-16
 **TELKONET,
                INC.**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                31, 2006, 2005 AND 2004**
  **NOTE
              B - ACQUISITION OF SUBSIDIARY**
 Acquisition
            of Microwave Satellite Technologies, Inc.
 
 On
            January 31, 2006, the Company acquired a 90% interest in Microwave Satellite
            Technologies, Inc. (“MST”) from Frank Matarazzo, the sole stockholder of MST, in
            exchange for $1.8 million in cash and 1.6 million unregistered shares
            of the
            Company’s common stock for an aggregate purchase price of $9,000,000. The
            purchase price of $9,000,000 was increased by $117,822 for direct costs
            related
            to the acquisition. These direct costs included legal, accounting and other
            professional fees. The cash portion of the purchase price was paid in
            two
            installments, $900,000 at closing and $900,000 in February 2007. The
            stock
            portion is payable from shares held in escrow, 400,000 shares at closing
            and the
            remaining 1,200,000 “purchase price contingency” shares issued based on the
            achievement of 3,300 “Triple Play” subscribers over a three year period. In the
            year ended December 31, 2006, the Company issued 200,000 shares of the
            purchase
            price contingency valued at $900,000 as an adjustment to Goodwill.
 
 The
            purchase price contingency shares are price protected for the benefit
            of the
            former owner of MST. In the event the Company’s common stock price is below
            $4.50 per share upon issuance of the shares from escrow, a pro rata adjustment
            in the number of shares will be required to support the aggregate consideration
            of $5.4 million. The price protection provision provides a cash benefit
            to the
            former owner of MST if the as-defined market price of the Company’s common stock
            is less than $4.50 per share at the time of issuance from the escrow.
            The
            issuance of additional shares or distribution of other consideration
            upon
            resolution of the contingency based on the Company’s common stock prices will
            not affect the cost of the acquisition. When the contingency is resolved
            or
            settled, and additional consideration is distributable, the Company will
            record
            the current fair value of the additional consideration and the amount
            previously
            recorded for the common stock issued will be simultaneously reduced to
            the lower
            current value of the Company’s common stock.
 
 MST
            is a
            communications technology company that offers complete sales, installation,
            and
            service of Very Small Aperture Terminal (VSAT) and business television
            networks,
            and is a full-service national Internet Service Provider (ISP).  Management
            believes that the MST acquisition will enable Telkonet to provide a complete
            “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
            Broadband  Internet
            access and wireless fidelity (“Wi-Fi”) access, to commercial multi-dwelling
            units and hotels.
 
 The
            acquisition of MST was accounted for using the purchase method in accordance
            with SFAS 141, “Business Combinations.” The value of the Company’s common stock
            issued as a part of the acquisition was determined based on the average
            price of
            the Company's common stock for several days before and after the acquisition
            of
            MST. The results of operations for MST have been included in the Consolidated
            Statements of Operations since the date of acquisition. The components of
            the purchase price were as follows:
  As
                      Reported
                  
                  Including
                    Purchase
                      Price Contingency (*)Common
                      stock
                  
                  $
                  2,700,000
                  
                  $
                  7,200,000Cash
                      (including note payable)
                  
                  
                  1,800,000
                  
                  
                  1,800,000Direct
                      acquisition costs
                  
                  
                  117,822
                  
                  
                  117,822Purchase
                      price
                  
                  
                  4,617,822
                  
                  
                  9,117,822Minority
                      interest
                  
                  
                  19,569
                  
                  
                  19,569Total
                  
                  $
                  4,637,391
                  
                  $
                  9,137,391
  In
            accordance with Financial Accounting Standard
            (SFAS) No. 141, Business Combinations, the total purchase price was allocated
            to
            the estimated fair value of assets acquired and liabilities assumed.
            The fair
            value of the assets acquired was based on management’s best estimates. The
            purchase price was allocated to the fair value of assets acquired and
            liabilities assumed as follows:
  F-17
  **TELKONET,
              INC.**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
              31, 2006, 2005 AND 2004**
 **NOTE
            B - ACQUISITION OF SUBSIDIARY (continued)**
 
 As
                      Reported
                  
                  Including
                    Purchase
                      Price Contingency (*)Cash
                      and other current assets
                  
                  $
                  346,548
                  
                  $
                  346,548Equipment
                      and other assets
                  
                  
                  1,310,125
                  
                  
                  1,310,125Subscriber
                      lists
                  
                  
                  2,463,927
                  
                  
                  2,463,927Goodwill
                      and other intangible assets
                  
                  
                  1,977,767
                  
                  
                  6,477,767Subtotal
                  
                  
                  6,098,367
                  
                  
                  10,598,367Current
                      liabilities
                  
                  
                  1,460,976
                  
                  
                  1,460,976Total
                  
                  $
                  4,637,391
                  
                  $
                  9,137,391
 
 (*)
            At
            the date of the acquisition, the effect of the “purchase price contingency”
shares valued at approximately $5.4 million had not been recorded in
            accordance
            with FAS 141. In the second quarter of 2006, the Company issued 200,000
            shares
            of the purchase price contingency valued at $900,000 as an adjustment
            to
            Goodwill. The remaining shares, when issued, will reflect an adjustment
            to
            Goodwill and Other Intangibles.
 
 Goodwill
            and other intangible assets represent the excess of the purchase price
            over the
            fair value of the net tangible assets acquired. The Company engaged an
            independent firm to assist in allocating the excess purchase price to
            the
            intangible assets and goodwill as appropriate. In accordance with SFAS
            142,
            goodwill is not amortized and will be tested for impairment at least
            annually.
            The subscriber list was independently valued at $2,463,927 with an estimated
            useful life of eight years.
 
 The
            following unaudited condensed combined pro forma results of operations
            reflect
            the pro forma combination of the Telkonet and MST businesses as if the
            combination had occurred at the beginning of the periods presented compared
            with
            the actual results of operations of Telkonet for the same period. The
            unaudited
            pro forma condensed combined results of operations do not purport to
            represent
            what the companies’ combined results of operations would have been if such
            transaction had occurred at the beginning of the periods presented, and
            are not
            necessarily indicative of Telkonet’s future results.
  **Year
                      Ended**
                    **December
                      31,****Proforma**
                    **2006**
                  
                  **Proforma**
                    **2005**Product
                      revenue
                  
                  $
                  3,128,120
                  
                  $
                  2,393,010Recurring
                      revenue
                  
                  
                  2,188,329
                  
                  
                  1,918,2005,316,449
                  
                  
                  4,311,210Net
                      (loss)
                  
                  $
                  (27,578,779
                  )
                  $
                  (11,685,089
                  )Basic
                      (loss) per share
                  
                  $
                  (0.54
                  )
                  $
                  (0.26
                  )Diluted
                      (loss) per share
                  
                  $
                  (0.54
                  )
                  $
                  (0.26
                  )
  The
            acquisition of MST resulted in the valuation by an independent appraiser
            of
            MST’s subscriber lists as intangible assets. The MST subscriber list was
            determined to have an eight-year life. This intangible was amortized
            using that
            life, and amortization from the date of the acquisition through December
            31,
            2006, was taken as a charge against income in the consolidated statement
            of
            operations. In accordance with SFAS 144, Accounting
            for the Impairment or Disposal of Long-Lived Assets ,
            the intangible asset subject to amortization was reviewed for impairment
            at December
            31, 2006 .
            Goodwill of $1,977,768, excluding the remaining purchase price contingency,
            represented the excess of the purchase price over the fair value of the
            net
            tangible and intangible assets acquired.
  At
            December 31, 2006, the Company performed an impairment test on the goodwill
            and
            intangibles acquired, it was determined that there were no changes in
            the
            carrying value of goodwill and intangibles acquired.
 
 F-18
  **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 
 **NOTE
            C - INTANGIBLE ASSETS ACQUIRED**
 
 Total
            identifiable intangible assets acquired and their carrying value at December
            31,
            2006 are:
 
 Gross
                    Carrying
                      Amount
                  
                  Accumulated
                      Amortization
                  
                  Net
                  
                  Residual
                    Value
                  
                  Weighted
                    Average
                    Amortization
                    Period
                    (Years)Amortized
                      Identifiable tangible Assets:Subscriber
                      lists
                  
                  $
                  2,463,927
                  
                  
                  (282,325)
                  
                  
                  2,181,602
                  
                  $
                  -
                  
                  
                  8.0Total
                      Amortized Identifiable Intangible Assets
                  
                  $
                  2,463,927
                  
                  
                  (282,325)
                  
                  
                  2,181,602
                  
                  $
                  -Unamortized
                      Identifiable Intangible Assets:
                  
                  
                  NoneTotal
                  
                  $
                  2,463,927
                  
                  
                  (282,325)
                  
                  
                  2,181,602
                  
                  $
                  -
 
 Total
            amortization expense charged to operations for the year ended December 31,
            2006 was $282,325. Estimated amortization expense as of December 31,
            2006 is as
            follows:
 
 Fiscal2007
                  307,9912008
                  307,9912009
                  307,9912010
                  307,9912011
                  307,9912012
                      and after
                  641,647Total
                  2,181,602
 
 **NOTE
            D - INVENTORIES**
 
 Inventories
            are stated at the lower of cost or market determined by the first-in,
            first-out
            (FIFO) method. Inventories primarily consist of Gateways, Extenders,
            iBridges
            and Couplers which are the significant components of the Telkonet solution.
            Components of inventories as of December 31, 2006 and 2005 are as follows:
 
 2006
                  
                  2005Raw
                      Materials
                  
                  $
                  516,604
                  
                  $
                  598,335Finished
                      Goods
                  
                  
                  789,989
                  
                  
                  877,471$
                  1,306,593
                  
                  $
                  1,475,806
 
 F-19
 **TELKONET,
              INC.**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
              31, 2006, 2005 AND 2004**
 
 **NOTE
            E - PROPERTY, PLANT AND EQUIPMENT**
 
 The
            Company’s property and equipment at December 31, 2006 and 2005 consists of the
            following:
 
 2006
                  
                  2005Development
                      Test Equipment
                  
                  $
                  184,575
                  
                  $
                  96,967Computer
                      Software
                  
                  
                  151,986
                  
                  
                  142,894Leasehold
                      Improvements
                  
                  
                  394,871
                  
                  
                  209,911Office
                      Equipment
                  
                  
                  1,137,942
                  
                  
                  360,527Office
                      Fixtures and Furniture
                  
                  
                  341,662
                  
                  
                  230,838Total
                  
                  
                  2,211,036
                  
                  
                  1,041,137Accumulated
                      Depreciation
                  
                  
                  (582,248
                  )
                  
                  (323,667
                  )$
                  1,628,788
                  
                  $
                  717,470
 
 Depreciation
            expense included as a charge to income was $258,581, $185,928, and $71,514
            for
            the years ended December 31, 2006, 2005 and 2004, respectively.
 
 **NOTE
            F - EQUIPMENT UNDER OPERATING LEASES**
 
 Equipment
            leased to customers under operating leases is recorded at cost and is
            depreciated on the straight line basis to its estimated residual value.
            Estimated useful lives are two to ten years. Equipment under operating
            leases at
            December 31, 2006 and 2005 consist of the following:
 
 2006
                  
                  2005Telecommunications
                      and related equipment
                  
                  $
                  3,186,000
                  
                  $
                  789,099Less:
                      accumulated depreciation
                  
                  
                  (564,233
                  )
                  
                  (124,669
                  )Capitalized
                      equipment, net of accumulated depreciation
                  
                  
                  2,697,517
                  
                  
                  664,430Less:
                      estimated reserve for residual values
                  
                  
                  -
                  
                  
                  --Capitalized
                      equipment under operating leases, net
                  
                  
                  2,621,767
                  
                  
                  664,430
 
 In
            the
            year end December 31, 2006 and 2005, the Company consummated a non-recourse
            sale
            of certain rental contract agreements and the related capitalized equipment
            which were accounted for as operating leases with Hospitality Leasing
            Corporation. The remaining rental income payments of the contracts were
            valued
            at approximately $1,209,000 and $732,000 including the customer support
            component of approximately $370,000 and $205,000 which the Company will
            retain
            and continue to receive monthly customer support payments over the remaining
            average unexpired lease term of 36 and 26 months, respectively. In the
            year
            ending December 31, 2006 and 2005, the Company recognized revenue of
            approximately $683,000 and $439,000 for the sale, calculated based on
            the
            present value of total unpaid rental payments, and expensed the associated
            capitalized equipment cost, net of depreciation, of approximately $340,000
            and
            $267,000, and expensed associated taxes of approximately $64,000 and
            $40,000,
            respectively.
  The
            following is a schedule by years of minimum future rentals on non-cancellable
            operating leases as of December 31, 2006:
 
 2007
                  
                  
                  615,3952008
                  
                  
                  488,4002009
                  
                  
                  402,2912010
                  
                  
                  328,9752011
                  
                  
                  289,224$
                  2,124,285
 
 F-20
 **TELKONET,
              INC.**
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
              31, 2006, 2005 AND 2004**
 
 **NOTE
            G - LONG-TERM INVESTMENTS**
  Amperion,
            Inc.
  On
            November 30, 2004, the Company entered into a Stock Purchase Agreement
            (“Agreement”) with Amperion, Inc. ("Amperion"), a privately held company.
            Amperion is engaged in the business of developing networking hardware
            and
            software that enables the delivery of high-speed broadband data over
            medium-voltage power lines. Pursuant to the Agreement, the Company invested
            $500,000 in Amperion in exchange for 11,013,215 shares of Series A Preferred
            Stock for an equity interest of approximately 0.8%. The Company has the
            right to
            appoint one person to Amperion’s seven-person board of directors. The Company
            accounted for this investment under the cost method, as the Company does
            not
            have the ability to exercise significant influence over operating and
            financial
            policies of the investee.
  It
            is the
            policy of the Company to regularly review the assumptions underlying
            the
            operating performance and cash flow forecasts in assessing the carrying
            values
            of the investment. The Company identifies and records impairment losses
            on
            investments when events and circumstances indicate that such decline
            in fair
            value is other than temporary. Such indicators include, but are not limited
            to,
            limited capital resources, limited prospects of receiving additional
            financing,
            and limited prospects for liquidity of the related securities. The Company
            determined that its investment in Amperion was impaired based upon forecasted
            discounted cash flow. Accordingly,
            the Company wrote-off $92,000 and $400,000 of the carrying value of its
            investment through a charge to operations during the year ended December
            31,
            2006 and 2005, respectively.  The
            remaining value of the Company’s investment in Amperion is $8,000 and $100,000
            at December 31, 2006 and 2005, respectively, and this amount represents
            the
            current fair value.
 
 BPL
            Global, Ltd.
  On
            February 4, 2005, the Company’s Board of Directors approved an investment in BPL
            Global, Ltd. (“BPL Global”), a privately held company. The Company funded an
            aggregate of $131,000 as of December 31, 2005 and additional $44 during
            the year
            of 2006. This investment represents an equity interest of approximately
            4.67% at
            December 31, 2006. BPL Global is engaged in the business of developing
            broadband
            services via power lines through joint ventures in the United States,
            Asia,
            Eastern Europe and the Middle East. The Company accounted for this investment
            under the cost method, as the Company does not have the ability to exercise
            significant influence over operating and financial policies of the investee.
            The
            Company reviewed the assumptions underlying the operating performance
            and cash
            flow forecasts in assessing the carrying values of the investment. The
            fair
            value of the Company's investment in BPL Global, Ltd. amounted $131,044
            and
            $131,000 as of December 31, 2006 and 2005, respectively.
 
 Interactivewifi.com,
            LLC
  MST
            maintains an investment in Interactivewifi.com, LLC a privately held
            company.
            This investment represents an equity interest of approximately 50% at
            December
            31, 2006. Interactivewifi.com is engaged in providing internet and related
            services to customers throughout metropolitan New York, including the
            Nuvisions
            internet services. MST accounted for this investment under the cost method,
            as
            MST does not have the ability to exercise significant influence over
            operating
            and financial policies of the investee. Telkonet reviewed the assumptions
            underlying the operating performance and cash flow forecasts in assessing
            the
            carrying values of the investment. The fair value of MST’s investment in
            Interactivewifi.com amounted to approximately $53,000 as of December
            31,
            2006.
 
 **NOTE
            H - CONVERTIBLE PROMISSORY NOTES PAYABLE**
 
 A
            summary
            of convertible promissory notes payable at December 31, 2006 and 2005
            is as
            follows:
 
 2006
                  
                  2005Convertible
                      Senior Notes payable (“Convertible Senior Notes”), accrue interest at
                      7.25% per annum and provide for equal monthly principal installments
                      beginning March 1, 2006. Maturity date is in October 2008.
                      Noteholder has
                      the option to convert unpaid note principal together with accrued
                      and
                      unpaid interest to the Company’s common stock at a rate of $5.00 per share
                      at any time. During the year ended December 31, 2006, the Company
                      paid
                      down $7,750,000 of principal in cash and a total of $12,250,000
                      of
                      principal was converted to common stock of the Company.
                  
                  
                  -
                  
                  $
                  20,000,000Debt
                      Discount - beneficial conversion feature, net of accumulated
                      amortization
                      and write-off of $1,479,300 and $89,163 at December 31, 2006
                      and 2005,
                      respectively.
                  
                  
                  -
                  
                  
                  (1,390,137
                  )Debt
                      Discount - value attributable to warrants attached to notes,
                      net of
                      accumulated amortization and write-off of $ 2,919,300 and $175,958
                      at
                      December 31, 2006 and 2005, respectively.
                  
                  
                  -
                  
                  
                  (2,743,342
                  )Total
                  
                  
                  -
                  
                  $
                  15,866,521Less:
                      current portion
                  
                  
                  -
                  
                  
                  (6,250,000
                  )-
                  
                  $
                  9,616,521
 
 F-21
  **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
  **NOTE
            H - CONVERTIBLE PROMISSORY NOTES PAYABLE (Continued)**
 
 During
            the year ended December 31, 2005, the Company issued convertible
            senior notes (the "Convertible Senior Notes") having an aggregate principal
            value of $20 million to sophisticated investors in exchange for
            $20,000,000, exclusive of $1,219,410 in placement costs and fees. The
            Convertible Senior Notes accrue interest at 7.25% per annum and call
            for monthly
            principal installments beginning March 1, 2006. The maturity date is
            3 years
            from the date of issuance of the notes. At any time or times, the Noteholders
            shall be entitled to convert any portion of the outstanding and unpaid
            note
            amount into fully paid and nonassessable shares of the Company’s common Shares
            at $5 per share. At any time at the option of the Company, the principal
            payments may be paid either in cash or in common stock at the lower of
            $5 or
            92.5% of the average recent market price. At any time after six months
            should
            the stock trade at or above $8.75 for 20 of 30 consecutive trading days,
            the
            Company can cause a mandatory redemption and conversion to shares at
            $5 per
            share. At any time, the Company can pre-pay the notes with cash or common
            stock.
            Should the Company pre-pay the Notes other than by mandatory conversion,
            the
            Company must issue additional warrants to the Noteholders covering 65%
            of the
            amount pre-paid at a strike price of $5 per share. In addition to standard
            financial covenants, the Company has agreed to maintain a letter of credit
            in
            favor of the Noteholders equal to $10 million (Note A). Once the principal
            amount of the note declines below $15 million, the balance is reduced
            by $.50
            for every $1 amortized. In accordance with Emerging Issues Task Force
            Issue
            98-5, Accounting for Convertible Securities with a Beneficial Conversion
            Features or Contingently Adjustable Conversion Ratios ("EITF 98-5"),
            the Company
            recognized an imbedded beneficial conversion feature present in the notes.
            The
            Company allocated a portion of the proceeds equal to the intrinsic value
            of that
            feature to additional paid in capital. The Company recognized and measured
            an
            aggregate of $1,479,300 of the proceeds, which is equal to the intrinsic
            value
            of the imbedded beneficial conversion feature, to additional paid in
            capital and
            a discount against the Notes issued during the year ended December 31,
            2005. The
            debt discount attributed to the beneficial conversion feature is amortized
            over
            the Notes maturity period (three years) as interest expense.
 
 In
            connection with the placement of the Notes in October 2005, the Company
            has also
            agreed to issue to the Noteholders one million warrants to purchase company
            common stock exercisable for five years at $5 per share. The Company
            recognized
            the value attributable to the warrants in the amount of $2,919,300 to
            a
            derivative liability due to the possibility of the Company having to
            make a cash
            settlement, including penalties, in the event the Company failed to register
            the
            shares underlying the warrants under the Securities Act of 1933, as amended,
            within 90 days after the closing of the transaction. The Company accounted
            for this warrant derivative in accordance with EITF 00-19 Accounting
            for
            Derivative Financial Instruments Indexed to, and Potentially Settled
            in, a
            Company's Own Stock. The warrants were included as a liability and valued
            at
            fair market value until the Company met the criteria under EITF 00-19
            for
            permanent equity. A registration statement covering shares issuable to
            the
            Noteholders upon conversion, amortization and/or redemption of the Convertible
            Senior Notes and upon exercise of the warrants was filed with the Securities
            and
            Exchange Commission on Form S-3 on November 23, 2005 and was declared
            effective on December 13, 2005. The warrant derivative liability was
            valued at
            the issuance date of the Notes in the amount of $2,919,300 and then revalued
            at
            $2,910,700 on December 13, 2005 upon effectiveness of the Form S-3.
            The Company charged $8,600 to Other Income and the derivative warrant
            liability
            was reclassified to additional paid in capital at December 13, 2005.
            The Company
            valued the warrants in accordance with EITF 00-27 using the Black-Scholes
            pricing model and the following assumptions: contractual terms of 5 years,
            an
            average risk free interest rate of 4.00%, a dividend yield of 0%, and
            volatility
            of 76%. The $2,919,300 of debt discount attributed to the value of the
            warrants
            issued is amortized over the Notes maturity period (three years) as interest
            expense.
  ***Principal
            Payments of Debt***
  For
          the
          period of January 1, 2006 through August 14, 2006, the Company paid down
          principal of $1,250,000 in cash and issued an aggregate of 4,226,246 shares
          of
          common stock in connection with the conversion of $10,821,686 aggregate
          principal amount of the Senior Convertible Notes. Pursuant to the note
          agreement, the Company issued warrants to purchase 1,081,820 shares of
          common
          stock to the Noteholders, at a strike price of $5.00 per share, which
          represented 65% of the $8,321,686 accelerated principal at a strike price
          of $5
          per share. The Company valued the warrants at $1,906,089 using the Black-Scholes
          pricing model and the following assumptions: contractual terms of 5 years,
          an
          average risk free interest rate of 5.00%, a dividend yield of 0%, and volatility
          of 65%. The warrants issues are subject to an anti-dilution protection
          in
          conjunction with the issuance of certain equity securities. The Company
          has
          warrants due the Noteholders as a result of the anti-dilution impact from
          a
          $6,000,000 private placement in September 2006 (Note J). The Company has
          accounted for the additional 53,578 warrants issued, valued at $79,226,
          as
          interest expense during the year ended December 31, 2006.
 For
              the
              period of January 1, 2006 through August 14, 2006, the Company amortized
              the
              debt discount to the beneficial conversion feature and value of the
              attached
              warrants, and recorded non-cash interest expense in the amount of $251,759
              and
              $500,353, respectively. The Company also wrote-off the unamortized
              debt discount
              attributed to the beneficial conversion feature and the value of the
              attached
              warrants in the amount of $708,338 and $1,397,857, respectively, in
              connection
              with paydown and conversion of the note.
 
 F-22
 
 **TELKONET,
                INC.**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                31, 2006, 2005 AND 2004**
 **NOTE
              H - CONVERTIBLE PROMISSORY NOTES PAYABLE (Comtinued)**
 
 ***Early
              Extinguishment of Debt***
 
 On
              August
              14, 2006, the Company executed separate settlement agreements with
              the lenders
              of its Convertible Senior Notes. Pursuant to the settlement agreements
              the
              Company paid to the lenders on August 15, 2006 in the aggregate $9,910,392
              plus
              accrued but unpaid interest of $23,951 and certain premiums specified
              in the
              Notes in satisfaction of the amounts then outstanding under the Notes.
              Of the
              amount to be paid to the lenders under the Notes, $6,500,000 was paid
              in cash
              through a drawdown on a letter of credit previously pledged as collateral
              for
              the Company’s obligations under the Notes. The remaining note balance of
              $1,428,314 and a Redemption Premium of $1,982,078, calculated as 25%
              of
              remaining principal, was paid to the lenders in shares of Company’s common stock
              valued at the lower of $5.00 per share and 92.5% of the arithmetic
              average of
              the weighted average price of the Company’s common stock on the American stock
              exchange for the twenty trading days beginning on August 16, 2006.
              The Company
              also issued 862,452 warrants to purchase shares of the Company’s common stock at
              the exercise price of $2.58 per share (92.5% of the average trading
              price as
              described above). The Company valued the warrants at $1,014,934 using
              the
              Black-Scholes pricing model and the following assumptions: contractual
              terms of
              5 years, an average risk free interest rate of 5.00%, a dividend yield
              of 0%,
              and volatility of 65%. The Company has accounted for the Redemption
              Premium and
              the additional warrants issued as non-cash early extinguishment of
              debt expense
              during the year ended December 31, 2006. Registration statements covering
              the
              shares underlying the warrants, were filed with the Securities and
              Exchange
              Commission on Form S-3 on September 29, 2006 and October 13, 2006 and were
              declared effective on October 16, 2006 and October 24, 2006, respectively.
              As of
              December 31, 2006, the Company included the warrant derivatives as
              equity since
              the criteria under EITF 00-19 for permanent equity was achieved in
              a nominal
              period of time subsequent to year end.
  As
              a
              result of the execution of the settlement agreements and the payments
              required
              thereby, the Company fully believes it repaid and satisfied all of
              its
              obligations under the Notes. The Company also agreed to pay the expenses
              of the
              lenders incurred in connection with the negotiation and execution of
              the
              settlement agreements. The settlement agreements were negotiated following
              the
              allegation by one of the lenders that the Company’s failure to meet the minimum
              revenue test for the period ending June 30, 2006 as specified on the
              Notes
              constituted an event of default under the Notes, which allegation the
              Company
              disputed.
 
 The
              Settlement Agreement provides that the number of shares issued to the
              Noteholders shall be adjusted based upon the arithmetic average of
              the weighted
              average price of the Company’s common stock on the American Stock Exchange for
              the twenty trading days immediately following the settlement date.  The
              Company has concluded that, based upon the weighted average of the
              Company's
              common stock between August 16, 2006 and September 13, 2006, the Company
              is
              entitled to a refund from the two Noteholders.  One of the Noteholders has
              informed the Company that it does not believe such a refund is required. 
As a result, the Company has declined to deliver to the Noteholders
              certain
              stock purchase warrants issued to them pursuant to the Settlement Agreement
              pending resolution of this disagreement. The Noteholder has alleged
              that the
              Company has failed to satisfy its obligations under the Settlement
              Agreement by
              failing to deliver the warrants. In addition, the Noteholder maintains
              that the
              Company has breached certain provisions of the Registration Rights
              Agreement
              and, as a result of such breach, such Noteholder claims that it is
              entitled to
              receive liquidated damages from the Company.
 
 In
              conjunction with the settlement agreement, the Company recorded $4,626,679
              of
              loss from early extinguishment of debt, which consists of $1,982,078
              redemption
              premium paid with the Company’s common stock, $1,014,934 of additional warrants
              issued to the lenders, write-off of the remaining unamortized debt
              discount
              attributed to the beneficial conversion feature and the value of the
              attached
              warrants in the amount of $430,040 and $845,143, respectively, and
              write-off the
              remaining unamortized financing costs of $354,484.
  F-23
 **TELKONET,
                INC.**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                31, 2006, 2005 AND 2004**
 **NOTE
              I - SENIOR NOTES PAYABLE**
 
 In
              the
              second quarter of 2003, the Company issued Senior Notes to Company
              officers,
              shareholders, and sophisticated investors in exchange for $5,000,000,
              exclusive
              of placement costs and fees. The Senior Notes are denominated in units
              of
              $100,000, accrue interest at 8% per annum and are due three years from
              the date
              of issuance with the latest maturity date of June 2006. Attached to
              each Senior
              Note are warrants to purchase 125,000 shares of common stock. The warrants
              have
              a three-year contractual life and are exercisable immediately after
              the issuance
              of the Senior Note at exercise price of $1.00 per share. The Senior
              Notes are
              secured by a first priority security interest in all intellectual property
              assets of the Company. The Company plans to use the Senior Note proceeds
              for
              expansion of sales, marketing and strategic partnership programs, building
              required infrastructure and for working capital.
 
 In
              September 2003, certain Senior noteholders elected to surrender their
              Senior
              Notes as consideration for the exercise of warrants to purchase shares
              of common
              stock of the Company. The Company issued an aggregate of 2,011,000
              restricted
              shares of common stock for warrants exercised at $1.00 per share, in
              exchange
              for $2,011,000 of Senior Notes.
  In
              January 2004, certain noteholders requested conversion of their senior
              notes into Company restricted shares of common stock. The Company’s Board of
              Directors approved this request by amending the terms of the Senior
              Note for a
              limited time. The Company immediately notified all of the outstanding
              Senior
              Noteholders of this temporary conversion option, and indicated that
              it would
              accept the surrender of the Senior Notes as consideration for the purchase
              of
              the Company’s common shares at a price of $2.10 per share. The conversion price
              represented the current market price of the Company’s common stock. An aggregate
              of $2,539,000 of senior notes were converted into 1,209,038 shares
              of common
              stock of the Company in January 2004. On November 3, 2005, the Company
              paid
              $350,000 of these senior notes and obtained a subordination agreement
              from the
              remaining $100,000 noteholder. The remaining outstanding senior note
              matured and
              was repaid in June 2006. The Company issued 20,000 warrants to purchase
              common
              stock of the Company at $5.00 in consideration for the subordination
              agreement.
              These warrants expired on June 15, 2006.
 
 **NOTE
              J - CAPITAL STOCK**
 
 The
              Company has authorized 15,000,000 shares of preferred stock, with a
              par value of
              $.001 per share. As of December 31, 2006, 2005 and 2004, the Company
              has no
              preferred stock issued and outstanding. The company has authorized
              100,000,000
              shares of common stock, with a par value of $.001 per share. As of
              December 31,
              2006, 2005 and 2004, the Company has 56,992,301, 45,765,171 and 44,335,989
              shares, respectively, of common stock issued and outstanding.
 
 During
              the year ended December 31, 2004, the Company issued 540,399 shares
              of common
              stock for an aggregate purchase price of $582,898 to certain employees
              upon
              exercise of employee stock options at approximately $1.08 per share.
              Additionally, the Company issued 328,333 shares of common stock for
              an aggregate
              purchase price of $328,333 to consultants upon exercise of non-employee
              stock
              options at approximately $1.00 per share.
 
 During
              the year ended December 31, 2004, the Company issued an aggregate of
              63,566
              shares of common stock, having an aggregate fair market value of $196,315,
              to
              consultants in exchange for services rendered, which approximated the
              fair value
              of the shares issued during the period services were completed and
              rendered.
 
 During
              the year ended December 31, 2004, the Company issued an aggregate of
              1,209,038
              of restricted shares of common stock upon the election of certain senior
              note
              holders to convert their senior notes into equity at a conversion price
              of $2.10
              per share.
 
 During
              the year ended December 31, 2004, the Company issued 6,387,600 shares
              of its
              common stock for an aggregate purchase price of $12,726,843, net of
              costs and
              fees.
 
 During
              the year ended December 31, 2004, the Company issued an aggregate of
              4,000,950
              shares of common stock upon the exercise of warrants at approximately
              $1.00 per
              share and an aggregate of 368,867 shares of common stock in exchange
              for 448,407
              outstanding warrants.
 
 During
              the year ended December 31, 2004, the Company issued an aggregate of
              50,000
              shares of common stock to consultants pursuant to warrants exercised
              at $2.54
              per share.
 
 During
              the year ended December 31, 2004, the Company issued an aggregate of
              324,000
              shares of common stock in connection with the conversion of $62,000
              aggregate
              principal amount of the Debenture-1 and $110,000 aggregate principal
              amount of
              the Series B Debentures. The Company also issued an aggregate of 42,999
              shares
              of common stock in exchange for accrued interest of $23,276 for Debenture
              1 and
              Series B Debentures.
 
 During
              the year ended December 31, 2004, the Company issued an aggregate of
              36,000
              shares of common stock to an employee in exchange for $107,779 of services
              rendered, which approximated the fair value of the shares issued during
              the
              period services were completed and rendered. Compensation costs of
              $107,779 were
              charged to operations.
  F-24
  **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 **NOTE
              J - CAPITAL STOCK (Continued)**
 
 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.
 
 During
              the year ended December 31, 2005, the Company issued an aggregate of
              415,989
              shares of common stock for an aggregate purchase price of $496,493
              to certain
              employees upon exercise of employee stock options at approximately
              $1.19 per
              share. Additionally, the Company issued an aggregate of 172,395 shares
              of common
              stock for an aggregate purchase price of $356,145 to consultants upon
              exercise
              of non-employee stock options at $2.07 per share (Note I).
 
 During
              the year ended December 31, 2005, the Company issued an aggregate of
              1,968
              shares of common stock, having an aggregate fair market value of $9,002,
              to
              consultants in exchange for services rendered, which approximated the
              fair value
              of the shares issued during the period services were completed and
              rendered.
              Compensation costs of $9,002 were charged to operations during the
              year ended
              December 31, 2005.
 
 The
              Company issued an aggregate of 321,900 shares of common stock to its
              convertible
              noteholders upon the exercise of warrants at $1.00 per share. The Company
              also
              issued 36,150 shares of common stock in exchange for 50,000 cashless
              warrants
              exercised .
  The
              Company issued an aggregate of 36,000 shares of common stock to an
              employee in
              exchange for $163,319 of services rendered, which approximated the
              fair value of
              the shares issued during the period services were completed and rendered.
              Compensation costs of $163,319 were charged to operations during the
              year ended
              December 31, 2005.
 
 The
              Company issued an aggregate of 30,000 shares of common stock to a member
              of the
              board of directors in exchange for $127,796 of consulting services
              rendered,
              which approximated the fair value of shares issued during the period
              services
              were completed and rendered. Compensation costs of $127,796 were charged
              to
              operations during the year ended December 31, 2005.
 
 During
              the year ended December 31, 2005, the Company issued an aggregate of
              363,636
              shares of common stock to its convertible debenture holders in exchange
              for
              $200,000 of Series B Debentures. The Company also issued an aggregate
              of 51,114
              shares of common stock in exchange for accrued interest of $28,131
              for Series B
              Debentures.
 
 During
              the year ended December 31, 2006, the Company issued an aggregate of
              2,051,399
              shares of common stock for an aggregate purchase price of $2,658,826
              to certain
              employees upon exercise of employee stock options at approximately
              $1.36 per
              share. Additionally, the Company issued an aggregate of 25,837 shares
              of common
              stock for an aggregate purchase price of $25,837 to consultants upon
              exercise of
              non-employee stock options at $1.00 per share (Note K).
  During
              the year ended December 31, 2006, the Company issued an aggregate of
              52,420
              shares of common stock, valued at $203,026, to consultants in exchange
              for
              services rendered, which approximated the fair value of the shares
              issued during
              the year services were completed and rendered (Note K).
  During
              the year ended December 31, 2006, the Company issued an aggregate of
              6,049,724
              shares of common stock at approximately $2.36 per share to its senior
              convertible debenture holders in exchange for $12,250,000 of debt,
              $23,951 of
              interest expenses, and $1,982,078 of redemption premium (Note H).
 
 F-25
 
 **TELKONET,
                INC.**
 **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                31, 2006, 2005 AND 2004**
 **NOTE
              J - CAPITAL STOCK (Continued)**
 
 The
              Company issued an aggregate of 47,750 shares of common stock to debenture
              holders upon the exercise of warrants at approximately $55,138 per
              share (Note
              K).
  On
              January 31, 2006, the Company entered into a Stock Purchase Agreement
              (“Agreement”) with MST, a privately held company. Pursuant to the Agreement, the
              Company issued 600,000 shares of Common Stock valued at $4.50 per share
              (Note
              B).
 
 During
              the year ended December 31, 2006, the Company issued 2,400,000 shares
              of Common
              Stock valued at $2.50 per share for an aggregate purchase price of
              $6,000,000.
              The Company also has issued to this investor warrants to purchase 1.56
              million
              shares of its common stock at an exercise price of $4.17 per share.
              A
              registration statement covering the shares underlying the warrants
              was filed
              with the Securities and Exchange Commission on Form S-3 on September 29,
              2006 and was declared effective on October 16, 2006. As of December
              31, 2006,
              the Company included the warrant derivatives as equity since the criteria
              under
              EITF 00-19 for permanent equity was achieved (Note K).
 
 **NOTE
              K - STOCK OPTIONS AND WARRANTS**
 
 Employee
              Stock Options
 
 The
              following table summarizes the changes in options outstanding and the
              related
              prices for the shares of the Company’s common stock issued to employees of the
              Company under a non-qualified employee stock option plan.
  Options
                        Outstanding
                    
                    Options
                        ExercisableExercise
                        Prices
                    
                    NumberOutstanding
                    
                    Weighted
                        Average Remaining ContractualLife
                        (Years)
                    
                    Weighted
                        Average
                      Exercise
                        Price
                    
                    Number
                      Exercisable
                    
                    Weighted
                        Average
                      Exercise
                        Price$1.00
                        - $1.99
                    
                    
                    4,197,929
                    
                    
                    5.87
                    
                    
                    $1.00
                    
                    
                    4,196,262
                    
                    
                    $1.00$2.00
                        - $2.99
                    
                    
                    1,446,000
                    
                    
                    7.18
                    
                    
                    $2.49
                    
                    
                    905,800
                    
                    
                    $2.43$3.00
                        - $3.99
                    
                    
                    2,554,000
                    
                    
                    8.37
                    
                    
                    $3.21
                    
                    
                    889,167
                    
                    
                    $3.34$4.00
                        - $4.99
                    
                    
                    161,000
                    
                    
                    8.14
                    
                    
                    $4.44
                    
                    
                    49,000
                    
                    
                    $4.44$5.00
                        - $5.99
                    
                    
                    162,000
                    
                    
                    8.02
                    
                    
                    $5.28
                    
                    
                    62,250
                    
                    
                    $5.258,520,929
                    
                    
                    6.92
                    
                    
                    $2.06
                    
                    
                    6,102,479
                    
                    
                    $1.62
 
 Transactions
              involving stock options issued to employees are summarized as
              follows:
 
 Number
                        of Shares
                    
                    Weighted
                      AveragePrice
                      Per
                        ShareOutstanding
                        at January 1, 2004
                    
                    
                    8,293,000
                    
                    $
                    1.19Granted
                    
                    
                    2,108,000
                    
                    
                    3.06Exercised
                        (Note J)
                    
                    
                    (540,399
                    )
                    
                    1.08Cancelled
                        or expired
                    
                    
                    (245,834
                    )
                    
                    1.74Outstanding
                        at December 31, 2004
                    
                    
                    9,614,767
                    
                    $
                    1.61Granted
                    
                    
                    1,325,000
                    
                    
                    3.97Exercised
                        (Note J)
                    
                    
                    (415,989
                    )
                    
                    1.18Cancelled
                        or expired
                    
                    
                    (372,200
                    )
                    
                    3.74Outstanding
                        at December 31, 2005
                    
                    
                    10,151,078
                    
                    $
                    1.85Granted
                    
                    
                    1,125,000
                    
                    
                    3.01Exercised
                        (Note J)
                    
                    
                    (2,051,399
                    )
                    
                    1.30Cancelled
                        or expired
                    
                    
                    (703,750
                    )
                    
                    2.67Outstanding
                        at December 31, 2006
                    
                    
                    8,520,929
                    
                    $
                    2.06
  The
          weighted-average fair value of stock options granted to employees during
          the
          years ended December 31, 2006, 2005 and 2004 and the weighted-average
          significant assumptions used to determine those fair values, using a
          Black-Scholes option pricing model are as follows:
  F-26
 **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 **NOTE
          K - STOCK OPTIONS AND WARRANTS (Continued)**
 
 Employee
          Stock Options (Continued)
 
 2006
                
                2005
                
                2004Significant
                    assumptions (weighted-average):Risk-free
                    interest rate at grant date
                
                
                5.0%
                
                
                4.5%
                
                
                1.35%Expected
                    stock price volatility
                
                
                65%
                
                
                71%
                
                
                76%Expected
                    dividend payout
                
                
                -
                
                
                -
                
                
                -Expected
                    option life (in years)
                
                
                5.0
                
                
                5.0
                
                
                5.0
 
 Total
          stock-based compensation expense recognized in the consolidated statement
          of
          earnings for the year ended December 31, 2006 was $1,080,895, net of tax
          effect.
 
 The
          financial statements for the year ended December 31, 2005 and 2004 have
          not been
          restated. Had compensation expense for employee stock options granted under
          the
          plan been determined based on the fair value at the grant date consistent
          with
          SFAS 123R, the Company’s pro forma net loss and net loss per share would have
          been $(18,218,378) and $(0.41), respectively, for the year ended December
          31,
          2005; and $(20,923,045) and $(0.51), respectively, for the year ended December
          31, 2004.
 
 Non-Employee
          Stock Options
 
 The
          following table summarizes the changes in options outstanding and the related
          prices for the shares of the Company’s common stock issued to the Company
          consultants. These options were granted in lieu of cash compensation for
          services performed.
 Options
                      Outstanding
                  
                  Options
                      ExercisableExercise
                      Prices
                  
                  NumberOutstanding
                  
                  Weighted
                      Average Remaining ContractualLife
                      (Years)
                  
                  Weighted
                      Average
                    Exercise
                      Price
                  
                  Number
                    Exercisable
                  
                  Weighted
                      Average
                    Exercise
                      Price$1.00
                  
                  
                  1,815,937
                  
                  
                  5.34
                  
                  
                  $1.00
                  
                  
                  1,815,937
                  
                  
                  $1.00
 Transactions
            involving options issued to non-employees are summarized as
            follows:
 
 Number
                    of Shares
                
                Weighted
                  AveragePrice
                  Per
                    ShareOutstanding
                    at January 1, 2004
                
                
                3,267,500
                
                $
                1.00Granted
                
                
                60,000
                
                
                3.45Exercised
                    (Note J)
                
                
                (328,331
                )
                
                1.00Canceled
                    or expired
                
                
                (1,000,000
                )
                
                1.00Outstanding
                    at December 31, 2004
                
                
                1,999,169
                
                $
                1.07Granted
                
                
                15,000
                
                
                3.45Exercised
                    (Note J)
                
                
                (172,395
                )
                
                2.07Canceled
                    or expired
                
                
                -
                
                
                -Outstanding
                    at December 31, 2005
                
                
                1,841,774
                
                $
                1.00Granted
                
                
                -
                
                
                -Exercised
                    (Note J)
                
                
                (25,837
                )
                
                1.00Canceled
                    or expired
                
                
                -
                
                
                -Outstanding
                    at December 31, 2006
                
                
                1,815,937
                
                $
                1.00
 
 The
          estimated value of the non-employee stock options vested during the year
          ended
          December 31, 2006 was determined using the Black-Scholes option pricing
          model
          and the amount of the expense charged to operations in connection with
          granting
          the options was $273,499, $1,191,767 and $1,130,780 during the year ended
          December 31, 2006, 2005 and 2004, respectively.
 
 F-27
 **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 **NOTE
          K - STOCK OPTIONS AND WARRANTS (Continued)**
 
 Warrants
 
 The
          following table summarizes the changes in warrants outstanding and the
          related
          prices for the shares of the Company’s common stock issued to non-employees of
          the Company. These warrants were granted in lieu of cash compensation for
          services performed or financing expenses and in connection with placement
          of
          convertible debentures.
  Warrants
                    Outstanding
                
                
                
                Warrants
                    ExercisableExercise
                    Prices
                
                Number
                  Outstanding
                
                Weighted
                    Average
                  Remaining
                    Contractual
                  Life
                    (Years)
                
                Weighed
                  Average
                  Exercise
                    Price
                
                Number
                  Exercisable
                
                Weighted
                  Average
                  Exercise
                    Price$2.59
                
                862,452
                
                4.62
                
                $2.59
                
                862,452
                
                $2.59$4.17
                
                1,560,000
                
                4.67
                
                $4.17
                
                1,560,000
                
                $4.17$4.87
                
                2,135,398
                
                4.17
                
                $4.87
                
                2,135,398
                
                $4.874,557,850
                
                4.19
                
                $4.20
                
                4,557,850
                
                $4.20
 
 Transactions
          involving warrants are summarized as follows:
 
 Number
                    of Shares
                
                Weighted
                  Average
                    Price
                  Per
                    ShareOutstanding
                    at January 1, 2004
                
                
                5,159,490
                
                $
                1.01Granted
                
                
                -
                
                
                -Exercised
                    (Note J)
                
                
                (4,468,590
                )
                
                0.99Canceled
                    or expired
                
                
                (115,000
                )
                
                1.00Outstanding
                    at December 31, 2004
                
                
                575,900
                
                $
                1.12Granted
                
                
                1,040,000
                
                
                4.85Exercised
                    (Note J)
                
                
                (371,900
                )
                
                1.00Canceled
                    or expired
                
                
                (14,000
                )
                
                1.00Outstanding
                    at December 31, 2005
                
                
                1,230,000
                
                $
                4.31Granted
                
                
                3,657,850
                
                
                4.03Exercised
                    (Note J)
                
                
                (47,750
                )
                
                1.15Canceled
                      or expired
                
                
                (282,250
                )
                
                2.64Outstanding
                      at December 31, 2006
                
                
                4,557,850
                
                $
                4.20
 
 The
          Company granted 2,097,850 and 1,000,000 warrants to Convertible Senior
          Notes
          holders (Note H), 1,560,000 and 0 warrants to private placement investors
          (Note
          J), and 0 and 40,000 compensatory warrants to non-employees during the
          year
          ended December 31, 2006 and 2005, respectively. The Company did not granted
          any
          warrants during the year ended December 31, 2004. The estimated value of
          compensatory warrants granted during the period ended December 31, 2006
          was
          determined using the Black-Scholes option pricing model and the following
          assumptions: contractual term of 3 years, a risk free interest rate of
          approximately 4.50%, a dividend yield of 0% and volatility of 71%. Compensation
          expense of $3,845, $162,453, and $50,096 was charged to operations for
          the year
          ended December 31, 2006, 2005 and 2004, respectively. The purchase price
          of the
          warrants issued to Convertible Senior Notes holders was adjusted from $5.00
          to
          $4.87 per share and approximately 54,000 additional warrants were issued
          during
          the year ended December 31, 2006 in accordance with the anti-dilution protection
          provision of the Convertible Senior Notes Payable Agreement dated October
          27,
          2005 (Note H), upon the issuance of the 2,400,000 shares of common stock
          and
          1,560,000 warrants to private placement investors (Note J) for a price
          per share
          lower than $5.00.
  **NOTE
          L - RELATED PARTY TRANSACTIONS**
 
 In
          January 2003, the Company entered into an employment agreement with Ronald
          W.
          Pickett, President and Chief Executive Officer of the Company, to provide
          for an
          annual compensation of $100,000 and 3,000 shares of restricted stock from
          the
          Employee Stock Option Plan for each month that he serves as President.
          As of
          December 31, 2006, 2005 and 2004, the Company has provided for the issuance
          of
          36,000 shares of its common stock to Mr. Pickett each year.
  F-28
 **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 **NOTE
          L - RELATED PARTY TRANSACTIONS (Continued)**
 
 In
          September 2003, the Company entered into a consulting agreement that provides
          for annual compensation of $100,000, payable monthly, with The Musser Group,
          an
          entity controlled by the Company's Chairman of the Board of Directors,
          for
          certain services. As of December 31, 2006, 2005 and 2004, an aggregate
          of
          $100,000 of consulting fees was charged to income each year pursuant to
          the
          agreement.
 
 In
          July
          2005, the Company entered into a Professional Services Agreement for
          international consulting with Seth Blumenfeld, a member of the board of
          directors. Pursuant to the terms of the agreement, Mr. Blumenfeld received
          10,000 shares of Company stock upon execution of the agreement, 10,000
          shares of
          Company stock per quarter for the first year and 5,000 shares of Company
          stock
          per quarter thereafter plus a five percent (5%) commission. The stock awarded
          to
          Mr. Blumenfeld pursuant to the agreement is restricted stock. The agreement
          has
          a one year term, which is renewable annually upon both parties' agreement.
          During the year ended December 31, 2006 and 2005, the Company charged to
          operations stock-based compensation in aggregate amount of $105,195 and
          $127,766, respectively, in connection with this agreement.
 
 In
          December 2005, the Company issued an aggregate of 363,636 shares of common
          stock
          to Ronald W. Pickett, President and Chief Executive Officer of the Company,
          a
          convertible debenture holder in exchange for $200,000 of Series B Debentures.
          The Company also issued an aggregate of 48,858 shares of common stock in
          exchange for accrued interest of $26,872 for Series B Debentures. In addition,
          the Company issued an aggregate of 200,000 shares of common stock upon
          the
          exercise of warrants at $1.00 per share upon conversion of the notes.
 
 In
          conjunction with the acquisition of MST (Note B) on January 31, 2006, the
          Company assumed a non-interest bearing demand promissory note in the amount
          of
          $80,444 due to Frank Matarazzo, MST President. Additionally, an estimated
          $291,000 income tax receivable due to the Company for certain carryback
          tax
          losses of MST for the period prior to the Company’s acquisition is payable to
          Frank Matarazzo.
 
 In
          February 2006, the Company entered into a one-year professional services
          agreement with Global Transport Logistics, Inc. (“GTI”), for consulting services
          for which GTI is paid a fee of $10,000 per month. GTI is 50% owned by Anthony
          Matarazzo, the President of MST’s brother.
 
 F-29
  **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 **NOTE
          M - BUSINESS SEGMENTS AND GEOGRAPHIC INFORMATION**
  The
          Company's reportable operating segments are strategic businesses differentiated
          by the nature of their products, activities and customers and are described
          as
          follows:
  Telkonet
          (TKO) is engaged in the business of developing products for use in the
          powerline
          communications (PLC) industry. PLC products use existing electrical wiring
          in
          commercial buildings and residences to carry high speed data communications
          signals, including the internet.
 
 Microwave
          Satellite Technologies (MST) (Note B), offers complete sales, installation,
          and service of VSAT and business television networks, and became a
          full-service national Internet Service Provider (ISP). The MST solution
          offers a
          complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
          Broadband  Internet access and wireless fidelity (“Wi-Fi”) access, to
          commercial multi-dwelling units and hotels.
 
 The
          measurement of losses and assets of the reportable segments is based on
          the same
          accounting principles applied in the consolidated financial statements.
  Financial
          data relating to reportable operating segments is as follows:
  Year
                    ended December 31,2006
                
                2005
                
                2004(In
                    thousands of U.S. $)**Revenues:**Telkonet
                
                
                3,426
                
                
                2,488
                
                
                699MST
                
                
                1,756
                
                
                -
                
                
                -Total
                    revenue
                
                $
                5,182
                
                $
                2,488
                
                $
                699Year
                    ended December 31,2006
                
                
                2005
                
                
                2004(In
                    thousands of U.S. $)**Gross
                    Profit**Telkonet
                
                
                1,155
                
                
                771
                
                
                156MST
                
                
                (455
                )
                
                -
                
                
                -Total
                    revenue
                
                $
                700
                
                $
                771
                
                $
                156**Operating (loss):**Telkonet
                
                
                (14,477
                )
                
                (15,307
                )
                
                (13,112
                )MST
                
                
                (3,087
                )
                
                -
                
                
                -Total
                    operatiing (loss)
                
                $
                (17,564
                )
                $
                (15,307
                )
                $
                (13,112
                )**Interest
                    Income**Telkoent
                
                
                327
                
                
                166
                
                
                129MST
                
                
                -
                
                
                -
                
                
                -Total
                    interest income
                
                $
                327
                
                $
                166
                
                $
                129**Interest
                    Expenses**Telkonet
                
                
                5,594
                
                
                646
                
                
                109MST
                
                
                1
                
                
                -
                
                
                -Total
                    interest expense
                
                $
                5,595
                
                $
                646
                
                $
                109
  F-30
 
 **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 Year
                    ended December 31,2006
                
                2005
                
                2004(In
                    thousands of U.S. $)**Assets**Telkonet
                
                
                4,137
                
                
                23,291
                
                
                15,494MST
                
                
                8,379
                
                
                -
                
                
                -Total
                    asset
                
                $
                12,516
                
                $
                23,291
                
                $
                15,494**Capital
                    Expenditures**Telkonet
                
                
                94
                
                
                794
                
                
                1,007MST
                
                
                2,581
                
                
                -
                
                
                -Total
                    capital expenditures
                
                $
                2,675
                
                $
                794
                
                $
                1,007**Operating
                    Expenses**Telkonet
                
                
                15,632
                
                
                16,078
                
                
                13,268MST
                
                
                2,633
                
                
                -
                
                
                -Total
                    operating expenses
                
                $
                18,265
                
                $
                16,078
                
                $
                13,268**Depreciation
                    and Amortization**Telkonet
                
                
                221
                
                
                186
                
                
                72MST
                
                
                320
                
                
                -
                
                
                -Total
                    depreciation and amortization
                
                $
                541
                
                $
                186
                
                $
                72
 
 All
          of
          the Company’s assets as of December 31, 2006, 2005, and 2004 were attributable
          to U.S. operations.
  F-31
  **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
  The
          following is a summary of operations within geographic areas, classified
          by the
          Company's country of domicile and by foreign countries:
  Year
                    ended December 31,2006
                
                2005
                
                2004(In
                    thousands of U.S. $)Revenues
                    from sales to unaffiliatedcustomers
                    from continuing operationsin
                    Telkonet and MST segments:United
                    States
                
                
                4,509
                
                
                1,871
                
                
                631Worldwide
                
                
                673
                
                
                617
                
                
                68$
                5,182
                
                $
                2,488
                
                $
                699
  Sales
          to
          major customers in the Telkonet and MST segments out of total revenues
          are as
          follows:
  Year
                    ended December 31,2006
                
                2005
                
                2004Hospitality
                    Leasing Corporation
                
                
                18%
                
                
                18%
                
                
                19%
 
 **NOTE
          N - INCOME TAXES**
  The
          Company has adopted Financial Accounting Standard No. 109 which requires
          the
          recognition of deferred tax liabilities and assets for the expected future
          tax
          consequences of events that have been included in the financial statement
          or tax
          returns. Under this method, deferred tax liabilities and assets are determined
          based on the difference between financial statements and tax bases of assets
          and
          liabilities using enacted tax rates in effect for the year in which the
          differences are expected to reverse.
 
 A
          reconciliation of tax expense computed at the statutory federal tax rate
          on loss
          from operations before income taxes to the actual income tax expense is
          as
          follows:
  2006
                
                2005
                
                2004Tax
                    provision computed at the statutory rate
                
                $
                (9,564,000
                )
                $
                (5,522,000
                )
                $
                (4,583,000
                )Deferred
                    state income taxes, net of federal income tax benefit
                
                
                -
                
                
                (525,000
                )
                
                -Book
                    expenses not deductible for tax purposes
                
                
                526,000
                
                
                19,000
                
                
                15,000U.S.
                    NOL created from stock option exercise
                
                
                -
                
                
                (463,000
                )
                
                (404,000
                )U.S.
                    deferred tax liability for beneficial conversion feature
                
                
                -
                
                
                518,000
                
                
                -Change
                    in valuation allowance for deferred tax assets
                
                
                9,038,000
                
                
                5,973,000
                
                
                4,972,000Income
                    tax expense
                
                $
                --
                
                $
                --
                
                $
                --
 
 Deferred
          income taxes include the net tax effects of net operating loss (NOL)
          carryforwards and the temporary differences between the carrying amounts
          of
          assets and liabilities for financial reporting purposes and the amounts
          used for
          income tax purposes. Significant components of the Company's deferred tax
          assets
          are as follows:
 
 2006
                
                2005**Deferred
                    Tax Assets:**Net
                    operating loss carryforwards
                
                $
                24,273,000
                
                $
                15,015,000Warrants
                    and non-employee stock options
                
                
                774,000
                
                
                684,000Investment
                    in Amperion
                
                
                189,000
                
                
                152,000Other
                
                
                403,000
                
                
                487,000Total
                    deferred tax assets
                
                
                25,639,000
                
                
                16,338,000**Deferred
                    Tax Liabilities:**Beneficial
                    Conversion Feature of Convertible Debentures
                
                
                -
                
                
                (527,000
                )Property
                    and equipment, principally due to differences in
                    depreciation
                
                
                (13,000
                )
                
                (66,000
                )Acquired
                    Intangibles
                
                
                (1,050,000
                )
                
                -Other
                
                
                (19,000
                )
                
                -Total
                    deferred tax liabilities
                
                
                (1,082,000
                )
                
                (593,000
                )Valuation
                    allowance
                
                
                (24,557,000
                )
                
                (15,745,000
                )Net
                    deferred tax assets
                
                $
                --
                
                $
                --
 
 F-32
 **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 The
          Company has provided a valuation reserve against the full amount of the
          net
          deferred tax assets, because in the opinion of management, it is more likely
          than not that these tax assets will not be realized.
 
 At
          December 31, 2006, the Company has net operating loss carryforwards of
          approximately $66 million for federal income tax purposes which will expire
          at
          various dates from 2020 through 2026.
 
 With
          the
          implementation of FAS123R, the amount of the NOL carryforward related to
          stock
          based compensation expense is not recognized until the stock-based compensation
          tax deductions reduce taxes payable. Accordingly, the NOL's reported in
          the
          deferred tax asset that were generated in the current year do not include
          the
          component of the NOL related to excess tax deductions over book compensation
          cost related to stock based compensation.. The NOL deferred tax asset does
          include pre-implementation excess tax deductions over book compensation
          cost
          related to stock based compensation. The NOL related to excess tax deductions
          will be recorded directly into Additional Paid-in-Capital at the time they
          produce a future current tax benefit. Approximately, $2.5 million and $5.5
          million of the NOLs at December 31, 2005 and December 31, 2006, respectively,
          relate to stock option expense for which subsequently recognized tax benefits
          will be allocated to capital in excess of par value. No tax deduction benefit
          from the exercise of stock options was recorded to capital in excess of
          par
          value for the years ended December 31, 2006, 2005 and 2004,
          respectively.
 
 The
          Company’s NOL and tax credit carryovers may be significantly limited under
          Section 382 of the Internal Revenue Code (IRC). NOL and tax credit carryovers
          are limited under Section 382 when there is a significant “ownership change” as
          defined in the IRC. During 2005 and in prior years, the Company may have
          experienced such ownership changes.
  The
          limitation imposed by Section 382 would place an annual limitation on the
          amount
          of NOL and tax credit carryovers that can be utilized. When the Company
          completes the necessary studies, the amount of NOL carryovers available
          may be
          reduced significantly. However, since the valuation allowance fully reserves
          for
          all available carryovers, the effect of the reduction would be offset by
          a
          reduction in the valuation allowance.
 
 **NOTE
          O - LOSSES PER COMMON SHARE**
 
 The
          following table presents the computations of basic and dilutive loss per
          share:
 
 2006
                
                2005
                
                2004Net
                    loss available to common shareholders
                
                $
                (27,437,116
                )
                $
                (15,778,281
                )
                $
                (13,092,660
                )Basic
                    and fully diluted loss per share
                
                $
                (0.54
                )
                $
                (0.35
                )
                $
                (0.32
                )Weighted
                    average common shares outstanding
                
                
                50,823,652
                
                
                44,743,223
                
                
                41,384,074
 
 For
          the
          years ended December 31, 2006, 2005 and 2004, 4,604,414, 7,577,208, and
          9,198,646 potential shares, respectively were excluded from shares used
          to
          calculate diluted losses per share as their inclusion would reduce net
          losses
          per share.
 
 **NOTE
          P - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES**
 
 Accounts
          payable and accrued liabilities at December 31, 2006 and 2005 are as
          follows **:**
 
 2006
                
                2005Accounts
                    payable
                
                $
                1,625,357
                
                $
                880,802Accrued
                    interest
                
                
                -
                
                
                263,806Accrued
                    payroll and payroll taxes
                
                
                559,411
                
                
                594,401Accrued
                    purchase price contingency
                
                
                400,000
                
                
                -Warranty
                
                
                47,300
                
                
                24,000Other
                
                
                233,076
                
                
                58,863Total
                
                $
                2,865,144
                
                $
                1,821,872
 
 F-33
  **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 **NOTE
          Q - COMMITMENTS AND CONTINGENCIES**
 
 Office
          Leases Obligations
 
 The
          Company leases office space under a sub-lease agreement through November
          2010
          for office space which occupies approximately 11,600 square feet in Germantown,
          MD. In April 2005, the Company entered into a three-year lease agreement
          for
          6,742 square feet of commercial office space in Crystal City, Virginia.
          Pursuant
          to this lease, the Company agreed to assume a portion of the build-out
          cost for
          this facility. The Company also leases office space of approximately 1,800
          square feet in White Marsh, MD. Additionally, the Company leases two corporate
          apartments through May 2006 in Germantown, MD and Crystal City, VA.
 
 MST,
          which was acquired by the Company in January 2006, presently leases 12,600
          square feet of commercial office space in Hawthorne, New Jersey for its
          office
          and warehouse spaces. This lease will expire in April 2010.
 
 In
          the
          year ended September 2006, the Company leased a vehicle for the chief executive
          officer. The operating lease will expire in September 2008.
 
 Commitments
          for minimum rentals under non cancelable leases at December 31, 2006 are
          as
          follows:
 
 2007
                
                $
                421,8042008
                
                
                279,6182009
                
                
                239,2912010
                
                
                176,9502011
                    and thereafter
                
                
                -Total
                
                $
                1,117,663
 
 Rental
          expenses charged to operations for the year ended December 31, 2006, 2005
          and
          2004 are $578,022, $389,935, and $165,249, respectively.
  **NOTE
          R - COMMITMENTS AND CONTINGENCIES**
 
 Capital
          Lease Obligations
 
 Development
          test equipment (Note E) includes the following amounts for capitalized
          leases at
          December 31, 2006 and 2005:
 
 2006
                
                2005Computer
                    equipment and software
                
                $
                52,000
                
                $
                52,000Less:
                    accumulated depreciation and amortization
                
                
                (36,400
                )
                
                (26,000
                )$
                15,600
                
                $
                26,000
 
 The
          Company has computer equipment and software purchased under non-cancelable
          leases with an original cost of $52,000. As of December 31, 2006, the Company
          has paid in full the lease obligation. Depreciation expense of $10,400,
          $10,400,
          and $10,400 in connection with the capital leased equipment was charged
          to
          operations during the year ended December 31, 2006, 2005 and 2004,
          respectively.
 
 Employment
          and Consulting Agreements
 
 The
          Company has employment agreements with certain of its key employees which
          include non-disclosure and confidentiality provisions for protection of
          the
          Company’s proprietary information.
 
 The
          Company has consulting agreements with outside contractors to provide marketing
          and financial advisory services. The Agreements are generally for a term
          of 12
          months from inception and renewable automatically from year to year unless
          either the Company or Consultant terminates such engagement by written
          notice.
  The
          Company entered into an exclusive financial
          advisor and consulting agreement in January 2007. The agreement provides
          a
          minimum consideration fee, not less than $250,000, in the event of an equity
          or
          financing transaction where the advisor is engaged. The agreement may be
          terminated with sixty days notification by either party.
  Litigation
 
 The
          Company is subject to legal proceedings and claims which arise in the ordinary
          course of its business. Although occasional adverse decisions or settlements
          may
          occur, the Company believes that the final disposition of such matters
          should
          not have a material adverse effect on its financial position, results of
          operations or liquidity.
 
 Senior
          Convertible Noteholder Claim
 
 The
          August 14, 2006 Settlement Agreement with the Senior Convertible Debenture
          Noteholders provided that the number of shares issued to the Noteholders
          shall
          be adjusted based upon the arithmetic average of the weighted average price
          of
          the Company’s common stock on the American Stock Exchange for the twenty trading
          days immediately following the settlement date (Note H).  The Company has
          concluded that, based upon the weighted average of the Company's common
          stock
          between August 16, 2006 and September 13, 2006, the Company is entitled
          to a
          refund from the two Noteholders.  One of the Noteholders has informed the
          Company that it does not believe such a refund is required.  As a result,
          the Company has declined to deliver to the Noteholders certain stock purchase
          warrants issued to them pursuant to the Settlement Agreement pending resolution
          of this disagreement. The Noteholder has alleged that the Company has failed
          to
          satisfy its obligations under the Settlement Agreement by failing to deliver
          the
          warrants. In addition, the Noteholder maintains that the Company has breached
          certain provisions of the Registration Rights Agreement and, as a result
          of such
          breach, such Noteholder claims that it is entitled to receive liquidated
          damages
          from the Company.
 
 However,
          in the Company’s opinion, the ultimate disposition of these matters will not
          have a material adverse effect on the Company’s results of operations or
          financial position.
 
 F-34
 **** **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
  **NOTE
          R - COMMITMENTS AND CONTINGENCIES (continued)**
  Microwave
          Satellite Technology, Inc. Purchase Price Contingency
 
 In
          conjunction with the acquisition of MST on January 31, 2006, the purchase
          price
          contingency shares are price protected for the benefit of the former owner
          of
          MST (Note B). In the event the Company’s common stock price is below $4.50 per
          share upon issuance of the shares from escrow, a pro rata adjustment in
          the
          number of shares will be required to support the aggregate consideration
          of $5.4
          million. The price protection provision provides a cash benefit to the
          former
          owner of MST if the as-defined market price of the Company’s common stock is
          less than $4.50 per share at the time of issuance from the escrow. The
          issuance
          of additional shares or distribution of other consideration upon resolution
          of
          the contingency based on the Company’s common stock prices will not affect the
          cost of the acquisition. When the contingency is resolved or settled, and
          additional consideration is distributable, the Company will record the
          current
          fair value of the additional consideration and the amount previously recorded
          for the common stock issued will be simultaneously reduced to the lower
          current
          value of the Company’s common stock.
  **NOTE
          S - BUSINESS CONCENTRATION**
 
 Total
          sale of rental contract agreements (Note F) and the related capitalized
          equipment to Hospitality Leasing Corporation approximated $705,000 and
          $252,000
          in the year ending December 31, 2006, and $439,000 and $0 in the year ending
          2005, which constituted approximately 18% and approximately 18% of total
          revenue, respectively, and represented the only major customer for years
          then
          ended. Revenue from one major customer represented $136,166 or approximately
          19%
          of 2004 revenues. Total accounts receivable of $8,774, or 2% of total accounts
          receivable, was due from Hospitality Leasing Corporation as of December
          31,
          2006. There were no outstanding accounts receivable from these major customers
          as of December 31, 2005 and 2004.
 
 Purchases
          from three (3) major suppliers approximated $446,038or 61% of purchase,
          $598,000
          or 48% of purchases, and $885,568 or 40% of purchases for the years ended
          December 31, 2006, 2005 and 2004, respectively. Total accounts payable
          of
          approximately $1,871 or 0.3% of total accounts payable was due to these
          three
          suppliers as of December 31, 2006 and approximately $3,000 or .04% of total
          accounts payable was due to these three suppliers as of December 31,
          2005.
 
 **NOTE
          T - SUBSEQUENT EVENTS**
 
 $10
          million Private Placement
 
 On
          February 2, 2007, we completed a private placement of 4.0 million shares
          of our
          common stock to certain accredited investors for gross proceeds of $10
          million.
          The Company incurred $390,000 in private placement fees in connection with
          this transaction. The proceeds of this offering will be used for general
          working
          capital needs and to assist in funding the Company's strategic initiatives.
          Telkonet also has issued to the purchasers in the private
          placement warrants to purchase 2.6 million shares of common stock at an
          exercise price of $4.17 per share. Additionally, the Company agreed to
          issue to
          the placement agent warrants to purchase 79,000 shares of its common stock
          at an
          exercise price of $4.17 per share. These warrants expire five years from
          the date of issuance.
 
 Acquisition
          of Smart Systems International, Inc.
 
 On
          March
          9, 2007, the Company acquired substantially all of the assets of Smart
          Systems
          International (SSI), a leading provider of energy management products and
          solutions to customers in the United States and Canada for cash and Company
          common stock having an aggregate value of $7,000,000. The purchase price
          was
          comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
          stock. The Company is obligated to register the stock portion of the purchase
          price on or before May 15, 2007 and 1,090,000 shares are being held in
          an escrow
          account for a period of one year following the closing from which certain
          potential indemnification obligations under the purchase agreement may
          be
          satisfied. The aggregate number of shares held in escrow is subject to
          adjustment upward or downward depending upon the trading price of the Company’s
          common stock during the one year period following the closing date.
 
 The
          acquisition was accounted for using the purchase method of accounting under
          SFAS
          No. 141.
 
 The
          following table presents the purchase price allocation, including estimated
          professional fees and other related acquisition costs, to the assets acquired
          and liabilities assumed, based on their fair values as of December 31,
          2006
          which is the most recent unaudited financial statements:
 
 Current
                    assets
                
                $
                1,477,355Property,
                    plant and equipment
                
                
                32,052Other
                    assets
                
                
                378,170Goodwill and
                    Intangibles
                
                
                5,593,557Total
                    assets acquired
                
                
                7,481,134Accounts
                    payable and accrued liabilities
                
                
                (231,134
                )Total
                    liabilities assumed
                
                
                (231,134
                )Net
                    assets acquired
                
                $
                7,250,000
 
 F-35
  **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 Due
          to
          its recent date of acquisition, the purchase price allocation to Intangibles
          and
          Goodwill is based upon preliminary data that is subject to adjustment and
          could
          change significantly pending the completion of an independent appraisal
          to
          accurately evaluate this allocation. The Company recognizes goodwill in
          connection with this acquisition as a result of SSI’s historical development of
          its subscriber base, high profile customer acquisition, its proprietary
          suite of
          energy management products and strategic industry position. The results
          of the
          acquisition will be included within the consolidated financial statements
          from
          its date of acquisition in 2007.
 
 The
          following data presents unaudited pro forma revenues, net loss and basic
          and
          diluted net loss per share of common stock for the Company as if the acquisition
          discussed above, had occurred on January 1, 2005. The Company has prepared
          these
          pro forma financial results for comparative purposes only. These pro forma
          financial results may not be indicative of the results that would have
          occurred
          if the Company had completed the acquisition at the beginning of the periods
          shown below or the results that will be attained in the future:
 
 **Year
                    Ended December 31, 2006****As
                    Reported**
                
                **Pro
                    Forma Adjustments**
                
                **Pro
                    Forma**Revenues
                
                $
                5,181,328
                
                $
                1,599,935
                
                $
                6,781,263Net
                    loss
                
                $
                (27,437,116)
                
                $
                (1,187,836)
                
                $
                (28,624,952)Net
                    loss per common share outstanding - basic
                
                $
                (0.54)
                
                $
                -
                
                $
                (0.54)Weighted
                    average common shares outstanding - basic
                
                
                50,823,652
                
                
                -
                
                
                53,050,925
 
 **Year
                    Ended December 31, 2005****As
                    Reported**
                
                **Pro
                    Forma Adjustments**
                
                **Pro
                    Forma**Revenues
                
                $
                2,488,323
                
                $
                661,604
                
                $
                3,149,927Net
                    loss
                
                $
                (15,778,281)
                
                $
                (1,576,771)
                
                $
                (17,355,052)Net
                    loss per common share outstanding - basic
                
                $
                (0.35)
                
                $
                (0.02)
                
                $
                (0.37)Weighted
                    average common shares outstanding - basic
                
                
                44,743,223
                
                
                
                
                
                46,970,496
 
 Acquisition
          of Ethostream LLC
 
 On
          March
          15, 2007, the Company acquired 100% of the outstanding membership units
          of
          Ethostream, LLC, a network solutions integration company that offers
          installation, sales and service to the hospitality industry. The Ethostream
          acquisition will enable Telkonet to provide installation and support for
          PLC
          products and third party applications to customers across North America.
          The
          purchase price of $11,756,097 was comprised of $2.0 million in cash and
          3,459,609 shares of the Company’s common stock. The entire stock portion of the
          purchase price is being held in escrow to satisfy certain potential
          indemnification obligations of the sellers under the purchase agreement.
          The
          shares held in escrow are distributable over the three years following
          the
          closing. The aggregate number of shares issuable to the sellers is subject
          to
          downward adjustment in the event the Company’s common stock trades at or above a
          price of $4.50 per share for twenty consecutive trading days during the
          one year
          period following the closing.
 
 The
          acquisition was accounted for using the purchase method of accounting under
          SFAS
          No. 141.
 
 The
          following table presents the purchase price allocation, including estimated
          professional fees and other related acquisition costs, to the assets acquired
          and liabilities assumed, based on their fair values as of December 31,
          2006
          which is the most recent unaudited financial statements:
 
 Current
                    assets
                
                $
                877,389Property,
                    plant and equipment
                
                
                55,793Other
                    assets
                
                
                303,828Goodwill &
                    Intangibles
                
                
                11,285,895Total
                    assets acquired
                
                
                12,522,905Accounts
                    payable and accrued liabilities
                
                
                (466,808
                )Total
                    liabilities assumed
                
                
                (466,808
                )Net
                    assets acquired
                
                $
                12,056,097
 
 F-36
  **TELKONET,
            INC.**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2006, 2005 AND 2004**
 Due
          to
          its recent date of acquisition, the purchase price allocation to Intangibles
          and
          Goodwill is based upon preliminary data that is subject to adjustment and
          could
          change significantly pending the completion of an independent appraisal
          to
          accurately evaluate this allocation. The Company recognizes goodwill in
          connection with this acquisition as a result of Ethostrean’s historical
          development of its subscriber base, high profile customer acquisition,
          and
          strategic industry position. The results of the acquisition will be included
          within the consolidated financial statements from its date of acquisition
          in
          2007.
 
 The
          following data presents unaudited pro forma revenues, net loss and basic
          and
          diluted net loss per share of common stock for the Company as if the acquisition
          discussed above, had occurred on January 1, 2005. The Company has prepared
          these
          pro forma financial results for comparative purposes only. These pro forma
          financial results may not be indicative of the results that would have
          occurred
          if the Company had completed the acquisition at the beginning of the periods
          shown below or the results that will be attained in the future:
 
 **Year
                    Ended December 31, 2006****As
                    Reported**
                
                **Pro
                    Forma Adjustments**
                
                **Pro
                    Forma**Revenues
                
                $
                5,181,328
                
                $
                3,511,538
                
                $
                8,692,866Net
                    loss
                
                $
                (27,437,116)
                
                $
                (156,623)
                
                $
                (27,593,739)Net
                    loss per common share outstanding - basic
                
                $
                (.54)
                
                $
                (0.01)
                
                $
                (0.51)Weighted
                    average common shares outstanding - basic
                
                
                50,823,652
                
                
                
                
                
                54,283,261
  **Year
                    Ended December 31, 2005****As
                    Reported**
                
                **Pro
                    Forma Adjustments**
                
                **Pro
                    Forma**Revenues
                
                $
                2,488,323
                
                $
                2,752,355
                
                $
                5,240,678Net
                    loss
                
                $
                (15,778,281)
                
                $
                (113,996)
                
                $
                (15,892,277)Net
                    loss per common share outstanding - basic
                
                $
                (.35)
                
                $
                0.02
                
                $
                (0.33)Weighted
                    average common shares outstanding - basic
                
                
                44,743,223
                
                
                
                
                
                48,202,832
 
  F-37