**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 incorporation or
                  organization)
              (IRS
                  Employee Identification
                  No.)
  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.   o Yes  xNo
  Indicate
        by check mark if the registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(b) of the Act.   o Yes  xNo
 
 Indicate
        by check mark whether the registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during
        the preceding 12 months (or for such shorter period that the registrant was
        required to file such reports), and (2) has been subject to such filing
        requirements for the past 90 days.   x Yes  oNo
 
 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. o
 
 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.
 
 o Large
        Accelerated
        Filer    x Accelerated Filer   o Non-Accelerated Filer
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act)  o Yes  xNo
 
 Aggregate
        market value of the voting stock held by non-affiliates of the registrant
        as of
        March 1 2006: $155,184,856
 Number
        of
        outstanding shares of the registrant’s par value $0.001 common stock
        a s
        of
        March 1, 2006: 46,316,539.
 
 
 **TELKONET,
        INC.**
 **FORM
        10-K**
 **INDEX**
 PagePart
                    IItem
                    1.
                Description
                    of Business
                3Item
                    1A.
                Risk
                    Factors
                7Item
                    1B.
                Unresolved
                    Staff Comments
                11Item
                    2.
                Description
                    of Property
                11Item
                    3.
                Legal
                    Proceedings
                11Item
                    4.
                Submission
                    of Matters to a Vote of Security
                    Holders
                11Part
                    IIItem
                    5.
                Market
                    for Registrant's Common Equity, Related Stockholder
                    Matters and Registrant's Purchases of Securities
                12Item
                    6.
                Selected
                    Financial Data
                13Item
                    7.
                Management's
                    Discussion and Analysis of Financial Condition
                    and Results of Operations
                13Item
                    7A.
                Quantitative
                    and Qualitative Disclosures About Market
                    Risk
                21Item
                    8.
                Financial
                    Statements
                21Item
                    9.
                Changes
                    in and Disagreements with Accountants on Accounting
                    and Financial Disclosure
                21Item
                    9A.
                Controls
                    and Procedures
                22Item
                    9B.
                Other
                    Information
                24Part
                    IIIItem
                    10.
                Directors
                    and Executive Officers of the
                    Registrant
                24Item
                    11.
                Executive
                    Compensation
                27Item
                    12.
                Security
                    Ownership of Certain Beneficial Owners and
                    Management and Related Stockholder Matters
                32Item
                    13.
                Certain
                    Relationships and Related
                    Transactions
                34Item
                    14.
                Principal
                    Accounting Fees and Services
                34Part
                    IVItem
                    15.
                Exhibits
                    and Financial Statement
                    Schedules
                35
 
 2
 Table
            of Contents
 **PART
        I**
 
 **ITEM
        1.** **DESCRIPTION
        OF BUSINESS.**
 
 **General**
 
 Telkonet,
        Inc. was formed in 1999 to develop products for use in the powerline
        communications (PLC) industry. PLC products use existing electrical wiring
        in
        commercial and residential buildings to carry high speed data communications
        signals, including the Internet. Since the Company’s formation, it has focused
        on development and marketing of its PLC technology.
 
 The
        Company’s PLC technology, the “Telkonet iWire System(TM)” product
        suite (formerly referred to as the PlugPlusTM product suite), consists of four
        primary components, the Gateway, the eXtender, the Coupler and the iBridge.
        The
        Gateway, the hub of the Telkonet iWire System TM product
        suite, is a modular, self-contained unit that accepts data from an existing
        network on one port and distributes it via a second port. The Gateway integrates
        a communications processor that runs a series of proprietary applications
        under
        Linux. The signal generated by the Gateway can be directly coupled into low
        voltage wiring via the Coupler, which interfaces directly between the Gateway
        and the building’s electrical panel. Multi-panel buildings typically require
        multiple Couplers, which are connected to the Gateway via inexpensive coaxial
        cable and concentrated using standard radio frequency splitters. A suite
        of
        software applications running on the Gateway can perform communications
        functions or system management functions. The iBridge serves as the user’s
        network access device and connects to a user’s personal computer through a
        standard Ethernet cable. The iBridge’s AC line cord serves as its power source
        as well as its network interface. The eXtender is used to extend the reach
        of
        the Gateway in larger buildings or campus environments.
 
 The
        Telkonet iWire SystemTM product suite delivers data to the user at speeds in
        excess of 7 Mega bits per second (Mbps), with burst speeds of 12.6 Mbps.
        The
        Telkonet iWire SystemTM product suite is installed by connecting an incoming
        broadband signal (DSL, T-1, satellite or cable modem) into the Gateway and
        connecting the Gateway to a building's electrical panel using one or more
        Couplers. Once installed, the Gateway distributes the high-speed Internet
        signal
        throughout the entire existing network of electrical wires within the building.
        The user may access a high-speed Internet signal by plugging the iBridge
        into
        any electrical outlet and connecting a personal computer to the iBridge using
        the computer's built-in Ethernet port. Multiple personal computers connected
        to
        the iBridge can communicate with one another and can share a single broadband
        resource via the Gateway.
 
 The
        Company is a member of the HomePlug (TM) Powerline Alliance, an industry trade group that engages in marketing and
        educational initiatives, and sets standards and specifications for products
        in
        the powerline communications industry.
 
 The
        Company’s principal executive offices are located at 20374 Seneca Meadows
        Parkway, Germantown, Maryland 20876.
 
 **Business
        History**
 
 In
        January 2002, the Company announced that it had shifted its management emphasis
        from research and development to product sales and marketing in order to
        move
        its initial proprietary products into the commercial market. In January 2002,
        the Board of Directors, Founders and executive management of the Company
        also
        reassessed the Company’s capital structure. In order to attract additional
        management and marketing expertise, and to raise the necessary capital for
        manufacturing, sales, and marketing, the Board of Directors approved a plan
        authorizing the repurchase of certain shares of, and options to purchase,
        Telkonet common stock held by each of David Grimes, L. Peter Larson and Stephen
        Sadle who, at the time of the stock repurchase, each owned in excess of five
        percent of the issued and outstanding capital stock and were directors and
        executive officers of Telkonet. The net effect of the recapitalization was
        to
        reduce the number of shares of issued and outstanding common stock from
        approximately 22,100,000 shares to 13,900,000 shares.
 
 In
        May
        2002, the Company concluded an offering of Series A convertible debentures
        pursuant to which the Company raised approximately $1.7 million dollars for
        working capital purposes. In the fourth quarter of 2002, the Company announced
        the successful installation of its PlugPlusTM product suite at a historic inn in
        Augusta, Georgia and installation of a product field trial in Wilmington,
        North
        Carolina.
 
 In
        the
        first quarter of 2003, the Company concluded an offering of Series B convertible
        debentures pursuant to which the Company raised approximately $2.5 million
        dollars for working capital purposes. The Company also executed a strategic
        alliance agreement with Choice Hotels International (NYSE: CHH), one of the
        largest hotel franchise companies in the world, pursuant to which Telkonet
        agreed to become a Choice Hotels-endorsed vendor.
 
 3
 Table
            of Contents
  In
        the
        second quarter of 2003, the Company concluded an offering of Senior Notes
        pursuant to which the Company raised approximately $5,000,000, exclusive
        of
        placement costs and fees. The proceeds of the Senior Note offering were
        designated for working capital purposes.
 
 In
        January 2004, the Board of Directors determined to permit the Senior
        Noteholders, for a limited period of time, to convert their Senior Notes
        into
        the Company's common stock at a conversion price of $2.10 per share. In
        connection with this transaction, Senior Noteholders converted Senior Notes
        having an aggregate principal value of $2,539,000. As of December 31, 2005,
        the
        aggregate outstanding balance on the Senior Notes, including principal and
        accrued but unpaid interest, was $102,000.
 
 In
        February 2004, the Company completed a private offering of its common stock
        resulting in net proceeds of $12.8 million. The Company sold 6,387,600 shares
        of
        its common stock in the private offering. The proceeds of the private placement
        were designated for working capital purposes.
 
 In
        October 2005, the Company announced that it completed a convertible senior
        debt financing of $20 million. The $20 million is for general working
        capital needs. The convertible notes bear interest at a fixed rate of 7.25%,
        payable in cash or, under certain
        conditions, Telkonet common stock, and call for monthly principal
        installments beginning March 1, 2006. The  convertible senior notes
        were purchased by two institutional investors in the face amount of
        $10 million each.
 
 In
        January 2006, the Company acquired, for $9 million, a 90% interest in Microwave
        Satellite Technologies (MST), 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). This acquisition will allow the
        Company to provide a “triple-play” solution to HDTV, VoIP telephony and
        Internet subscribers. The $9 million purchase price is payable $1.8 million
        in
        cash and 1.6 million unregistered shares of the Company’s common stock,
        the $900,000 of the cash portion of the purchase price was paid at the
        closing and the remaining $900,000 is payable in January 2007. With
        respect to the stock portion of the purchase price, 400,000 shares of Telkonet
        common stock were paid at the closing and the remaining 1,200,000 shares
        are
        currently held in escrow and shall be released upon the achievement of
        3,300 “triple play” subscribers over a three year period. The Company plans to
        expand MST's existing operations, which currently
        are concentrated in Manhattan, throughout New York and increase its
        presence in other major metropolitan cities using the New York system as
        a
        template.
 
 **Competition**
 
 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.
        While
        these companies may choose to move into the commercial market at a future
        date,
        they do not presently represent a direct competitive threat to Telkonet since
        they only market and sell their products in the residential sector.
 
 Notwithstanding
        the present absence of direct competitors, there can be no assurance that
        the
        HomePlug(TM) Powerline Alliance members, or any other company will
        not develop PLC products that compete with Telkonet’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 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.
        The
        Company 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 the Company’s offerings.
        The Company also intends to focus future sales and marketing efforts in Europe,
        South America, Asia and the Pacific Rim.
 
 4
 Table
            of Contents
 
 **Raw Materials**
 
 The
        Company has not experienced any significant or unusual problems in the purchase
        of raw materials or commodities. While the Company is dependent, in certain
        situations, on a limited number of vendors to provide certain raw materials
        and
        components, it has not experienced significant problems or issues purchasing
        any
        essential materials, parts or components. The Company obtains the majority
        of
        its raw materials from the following suppliers: 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 the
        Company.
 
 **Customers**
 
 The
        Company is neither limited to, nor reliant upon, a single or narrowly segmented
        consumer base from which it derives its revenues. Presently, the Company
        is not
        dependent on any particular customer under contract. However, in 2005, the
        Company sold certain rental contract agreements to Hospitality Leasing
        Corporation, which sale represented approximately 18% of total revenues. In
        2004, revenues from another customer represented approximately 19% of total
        revenues. The Company’s primary focus is in the hospitality, multi-dwelling
        units, government and international markets.
 
 **Intellectual
        Property**
 
 The
        Company has applied for patents that cover its unique technology, and has
        utilized the recently announced advancements in transmission speeds to build
        its
        next generation of products. The Company continues to identify, design and
        develop enhancements to its core technologies that will provide additional
        functionality, diversification of application and desirability for current
        and
        future users. It is the intent of the Company to protect this intellectual
        property by filing additional patent applications. The Company also has multiple
        registered and common law trademarks that it uses in the conduct of its
        business. The Company is presently not a party to any intellectual property
        licensing agreements.
 
 In
        September 2003, the Company received approval from the U.S. Patent and Trademark
        Office for its “Method and Apparatus for Providing Telephonic Communication
        Services” patent.
 
 In
        December 2005, Telkonet was granted United States Patent 6,975,212 by the
        U.S.
        Patent and Trademark Office. The patent is titled “Method and Apparatus for
        Attaching Power Line Communications to Customer Premises.” This patent covers
        the Telkonet Coupler, which is a unique technique used by the Company to
        interface and couple its communication devices onto the three-phase electrical
        systems that are predominate in commercial buildings and facilities
        worldwide. In addition to the foregoing, in 2005, Telkonet filed three new
        patent applications related to its PLC technology.
  Notwithstanding
        the issuance of this patent, there
        can be no assurance that any of the Company’s current or future patent
        applications will be granted, or, if granted, that such patents will provide
        necessary protection for the Company’s technology or its product offerings, or
        be of commercial benefit to the Company.
 
 **Government
        Regulation**
 
 We
        are
        subject to regulation in the United States by the FCC. FCC rules permit the
        operation of unlicensed digital devices that radiate radio frequency (RF)
        emissions if the manufacturer complies with certain equipment authorization
        procedures, technical requirements, marketing restrictions and product labeling
        requirements. An independent, FCC-certified testing lab has verified that
        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, the Company’s products are subject to safety and RF
        emissions regulations adopted by the European Union (EU) for Information
        Technology Equipment. In March 2005, the Company received final Conformite
        Europeene (CE) certification, which is required for the Company to freely
        market
        and sell its products within the EU. As a result of the certification, the
        Company’s products that will be sold and installed in EU countries will bear the
        CE marking, a symbol that demonstrates that the product has met the EU’s
        regulatory standards and is approved for sale in the EU.
 
 Future
        products designed by the Company will require testing for compliance with
        FCC
        and EU regulations. Moreover, if in the future, the FCC or EU change their
        respective regulatory requirements, further testing and/or modifications
        to the
        Company's products may be necessary to comply with such
        changes.
 
 5
 Table
            of Contents
 
 **Research and Development**
 
 During
        the years ended December 31, 2005, 2004 and 2003, the Company spent $2,096,104,
        $1,852,308 and $1,370,785, respectively, on research and development activities.
        In 2005, research and development activities included (a)
        Quality of Service (QoS) for VoIP service for both commercial and FIPS
        140-2 product applications, (b) design of next generation high-speed development
        platform, (c) design, prototype and release of a new Integrated
        Coupler Breaker product line, (d) design and development of second
        generation automated test equipment for manufacturing Telkonet's products,
        (e)
        automated Software Quality Assurance (SQA) regression testing. In
        2004,
        research and development activities included (a) development of a reduced
        cost (“G3”) iBridge/eXtender, (b) router software development, and (c) advanced
        encryption support. In 2003, research and development activities included
        (a)
        improved network capabilities with the introduction of the Company’s
        secondary gateway, (b) the introduction of an encrypted product feature
        to enhance security functions, (c) improved ability to remotely monitor
        network status, (d) the addition of a Virtual Local Area Network (VLAN) support
        function for enhanced integration of subscriber management and billing
        systems, and (e) development of the reduced cost iBridge/eXtender
        products.
 
 **Long
        Term Investments**
  Amperion,
        Inc.
  On
        November 30, 2004, the Company invested $500,000 in Amperion, Inc., a privately
        held company, in exchange for 11,013,215 shares of Series A Preferred Stock,
        which represents an equity interest in Amperion of approximately 4.7%.
        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. The Series A Preferred Stock has a preferential
        right to receive dividends and with respect to liquidation. The Series A
        Preferred Stock also votes as a single class with the shares of common stock
        and
        Class C common stock, except with respect to certain extraordinary matters,
        including an amendment to Amperion’s certificate of incorporation, an increase
        in the number of authorized shares of preferred stock, the issuance of any
        class
        of stock having parity with or rights superior to those of the Series A
        Preferred Stock and certain material transactions, in which case, the Series
        A
        Preferred Stock must approve such extraordinary action voting as a separate
        class. The Company has the right to designate one member of Amperion’s
        seven-person board of directors. The Board of Directors has designated Warren
        “Pete” Musser, the Chairman of the Board of Directors of Telkonet, to fill this
        position. Each share of Series A Preferred Stock is entitled to one vote
        per
        share. The Company accounted for this investment under the cost method, as
        the
        Company does not have the ability to exercise significant influence over
        Amperion’s operating or financial policies. The
        Company determined that its investment in Amperion was impaired based upon
        forecasted discounted cash flow and has written-off 80%, or $400,000, of
        its
        investment based on management assessment. The remaining value of the Company’s
        investment in Amperion is $100,000 at December 31, 2005.
 
 BPL
        Global, Ltd.
  On
        February 4, 2005, the board of directors approved an investment
        in BPL Global, Ltd. (“BPL Global”), a privately held company. During the
        year-end December 31, 2005, the Company funded, in the aggregate, $131,000
        of the approved committment. This investment represents an equity
        interest of approximately 6.21% at December 31, 2005. 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 BPL Global. 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 remained at $131,000 as of December 31, 2005.
  **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.
 
 **Employees**
 
 As
        of
        March 1, 2006, the Company had eighty-three (83) full time employees, which
        were comprised of sixty-six (66) full-time employees of Telkonet and
        seventeen (17) employees of MST. The Company anticipates that it will hire
        additional key staff throughout 2006 in the areas of business development,
        sales
        and marketing, and engineering.
 
 **Backlog**
 
 As
        of
        December 31, 2005 and 2004, revenues to be recognized under non-cancelable
        leases (backlog) was approximately $2,411,000 and $933,000, respectively.
        The
        associated remaining weighted average lease term was approximately 31 months
        for
        both years. In January 2006, the Company consummated a non-recourse sale
        of
        certain rental contract agreements (backlog) of approximately $918,000. Of
        the
        remaining $1,493,000 backlog, $498,000 will be recognized as revenue in 2006
        while the remaining $995,000 will be recognized in 2007 through
        2010.
 
 6
 Table
            of Contents
 **Financial
        Information About Geographic Areas**
 
 To
        date,
        the majority of the Company's revenue has been derived from United
        States sources although the Company does recognize revenue from
        international sales. International sales represented 25% and 10% of the
        Company's total revenue in 2005 and 2004, respectively. Telkonet's
        international sales presently are concentrated in Canada, Latin America and
        Western Europe, however, Telkonet continues to expand into other markets
        worldwide. The table below sets forth the Company's net
        revenue in the United States and Worldwide.
 
 **Year
                  Ended December 31,****2005**
              
              **Percentage
                  Change**
              
              **2004**
              
              **Percentage
                  Change**
              
              **2003**United
                  States
              
              $
              1,871,241
              
              
              197
              %
              $
              630,957
              
              
              574
              %
              $
              93,660Worldwide
              
              
              617,082
              
              
              812
              %
              
              67,695
              
              
              -
              
              
              -Total
              
              $
              2,488,323
              
              
              256
              %
              $
              698,652
              
              
              646
              %
              $
              93,660
  
 **ITEM
            1A.** **RISK
            FACTORS.**
 
 The
        risks
        and uncertainties described below are those that the Company currently deems
        to
        be material and that it believes are specific to the Company and the industry
        in
        which it competes. In addition to these risks, the Company’s business may be
        subject to risks currently unknown to the Company.
 
 *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, 2005, the Company has incurred cumulative
        losses
        of $42,987,553 and has never generated enough funds through operations to
        support its business. The Company expects to continue to incur operating
        losses
        through 2006. 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 System TM product
        suite.
 
 *Potential
        fluctuations in operating results could have a negative effect on the price
        of
        the Company’s common stock.*
 
 The
        Company’s operating results may fluctuate significantly in the future as a
        result of a variety of factors, most of which are outside the Company’s control,
        including:
 
 ·
              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;
 
 7
 Table
            of Contents
 ·
              price
                  competition or pricing changes in the
                  industry;
 
 ·
              technical
                  difficulties or system downtime;
 
 ·
              economic
                  conditions specific to the internet and communications industry;
                  and
 
 ·
              general
                  economic conditions.
 
 The
        Company’s quarterly results may also be significantly impacted by certain
        accounting treatment of acquisitions, financing transactions or other matters.
        Such accounting treatment could have a material impact on the Company’s results
        of operations and have a negative impact on the price of the Company’s common
        stock.
 
 *The
        Company’s directors and executive officers own a substantial percentage of the
        Company’s issued and outstanding common stock. Their ownership could allow them
        to exercise significant control over corporate decisions.*
 
 As
        of
        March 1, 2006, the Company’s officers and directors owned 26.4% of the Company’s
        issued and outstanding common stock. This means that the Company’s officers and
        directors, as a group, exercise significant control over matters upon which
        the
        Company’s stockholders may vote, including the selection of the Board of
        Directors, mergers, acquisitions and other significant corporate
        transactions.
 
 *Further
        issuances of equity securities may be dilutive to current
        stockholders.*
 
 Although
        the funds raised in the Company’s debenture offerings, the note 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.
 
 *Our
        significant indebtedness and interest payment obligations may adversely affect
        our ability to obtain additional financings, service other existing debt,
        use
        our operating cash flow in other areas of our business, or otherwise adversely
        affect our operations.*
 
 In
        October 2005, the Company completed a $20 million convertible senior debt
        financing to two institutional investors in exchange for $20
        million, in the aggregate pursuant to which the Company issued senior
        convertible notes. The convertible senior notes accrue interest at 7.25%
        per
        annum and call for monthly principal installments beginning March 1, 2006.
        The
        convertible senior notes, coupled with our other outstanding indebtedness,
        could
        make it difficult for us to obtain additional financing when, and if, needed.
        In
        addition, the significant interest payment obligations on the convertible
        senior
        notes could make it difficult to service our other outstanding indebtedness.
        Both the failure to obtain additional financing and the default on existing
        indebtedness could have a negative impact on the Company's business and results
        of operations.
  *Our
        convertible senior debt financing contains loan covenants relating to revenue
        targets and other restrictions which may reduce our operating
        cash.*
 
 The
        documents executed in connection with the $20 million convertible senior
        debt
        financing, contain certain covenants that require the Company to achieve
        minimum
        revenue of $3 million for the period October 1, 2005 through March 31, 2006
        and $2 million for each fiscal quarter thereafter in 2006. The covenant
        requires that the Company pay an accelerated principal payment of up to
        $1 million on a pro rata basis calculated based upon the
        percentage shortfall between actual revenues and the quarterly
        targeted revenues. Failure to meet these revenue targets could reduce our
        operating cash and have a negative impact on the Company's business and results
        of operations.
 
 *If
        we
        acquire any companies or technologies in the future, they could provide
        difficult to integrate, disrupt our business, dilute stockholder value and
        adversely affect our operating results.*
 
 In
        January 2006, the Company acquired a 90% interest in Microwave Satellite
        Technologies (MST), a communications technology company that offers complete
        sales, installation, and service of VSAT and business television networks,
        and
        is a full-service national Internet Service Provider (ISP). The failure of
        the
        Company to successfully integrate MST, or any Company acquired by Telkonet
        in
        the future, to Telkonet's business, could have a negative impact on the
        Company's results of operations.
 
 8
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            of Contents
  *Recent
        accounting pronouncements may impact our future financial position and results
        of operations.*
 
 There
        have been new accounting pronouncements or regulatory rulings that will have
        an
        impact on our future financial position and results of operations. For instance,
        on December 16, 2004, the Financial Accounting Standards Board (FASB) issued
        FASB Statement No. 123 (revised 2004), "Share-Based Payment", which is a
        revision of FASB Statement No. 123, "Accounting for Stock-Based Compensation".
        SFAS 123(R) supersedes APB Opinion No. 25, "Accounting for Stock Issued to
        Employees", and amends FASB Statement No. 95, "Statement of Cash Flows".
        Generally, the approach in SFAS 123(R) is similar to the approach described
        in
        Statement 123. However, SFAS 123(R) requires all share-based payments to
        employees, including grants of employee stock options, to be recognized in
        the
        income statement based on their fair values. Pro forma disclosure is no longer
        an alternative. We expect to adopt SFAS 123(R) effective January 1, 2006
        under
        the modified-prospective method. The adoption of SFAS 123(R)'s fair value
        method
        will have a significant impact on our results of operations, although it
        will
        have no impact on our overall financial position. With the adoption of SFAS
        123(R), we expect to record stock-based compensation of approximately $2
        million
        in 2006. Our estimate of stock-based compensation expense is affected by
        our
        stock price, the number of stock-based awards we may grant in 2006, as well
        as a
        number of complex and subjective valuation assumptions including, but not
        limited to, the volatility of our stock price, interest rates and employee
        stock
        option exercise behaviors.
 
 *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, 2005, the Company had outstanding employee options to purchase
        a
        total of 10,151,078 shares of common stock at exercise prices ranging from
        $1.00
        to $5.97 per share, with a weighted average exercise price of $1.85. As of
        December 31, 2005, the Company had outstanding non-employee options to purchase
        a total of 1,841,774 shares of common stock at an exercise price of $1.00
        per
        share. As of December 31, 2005, the Company had warrants outstanding to purchase
        a total of 1,230,000 shares of common stock at exercise prices ranging from
        $1.00 to $5.00 per share, with a weighted average exercise price of $4.31.
        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.
 
 *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 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. In
        addition, the Company's products are subject to safety and RF emissions
        regulations adopted by the European Union (EU) for Information Technology
        Equipment. In March 2005, the Company received final Conformite Europeane
        (CE)
        certification, which is required for the Company to freely market and sell
        its
        products in the EU. Additional devices designed by the Company for commercial
        and residential use may be subject to FCC and EU rules. Moreover, if
        in the future, the FCC, EU or any other regulatory body changes its
        technical requirements for our products, further testing and/or
        modifications of the Company's products may be necessary to comply
        with such changes. Failure to comply with any existing or future
        applicable 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.
 
 9
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            of Contents
 
 *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 Company
        believes it has the only commercial integrated three phase solution for
“in-building” distribution of broadband utilizing the electrical wiring
        infrastructure. Certain HomePlug (TM) Powerline Alliance members offer similar PLC solutions for the residential
        market. Although the HomePlug (TM) Powerline Alliance members do not presently compete with the Company in the
        commercial market, there can be no assurance that the HomePlug (TM) Powerline Alliance members or any other company 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, may
        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.
 
 10
 Table
            of Contents
 *The
        Company depends on a small team of senior management, and it may have difficulty
        attracting and retaining additional personnel.*
 
 The
        Company’s future success will depend in large part upon the continued services
        and performance of senior management and other key personnel. If the Company
        loses the services of any member of its senior management team, its overall
        operations could be materially and adversely affected. In addition, the
        Company’s future success will depend on its ability to identify, attract, hire,
        train, retain and motivate other highly skilled technical, managerial,
        marketing, purchasing and customer service personnel when they are needed.
        Competition for these individuals is intense. The Company cannot ensure that
        it
        will be able to successfully attract, integrate or retain sufficiently qualified
        personnel when the need arises. Any failure to attract and retain the necessary
        technical, managerial, marketing, purchasing and customer service personnel
        could have a negative effect on the Company’s financial condition and results of
        operations.
 
 **ITEM
        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 also leases 1,800 square feet of office
        space in White Marsh, Maryland, where it operates a portion of its sales
        and
        marketing activities. The White Marsh lease expires in May 2007. The Company
        also leases a corporate apartment in Germantown, Maryland on a month-to-month
        basis for an executive officer.
 
 In
        March
        2005, the Company entered into a lease agreement for 6,742 square feet of
        commercial office space in Crystal City, Virginia. The majority of the Company’s
        sales organization is located at the Crystal City facility. The Crystal City
        lease expires in March 2008.
 
 MST,
        an
        entity controlled by the Company as a result of a January 2006 stock
        purchase, 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.
 
 **ITEM
        3.**  **LEGAL
        PROCEEDINGS.**
 
 None.
 
 **ITEM
        4.**  **SUBMISSION
        OF MATTERS TO A VOTE OF SECURITY HOLDERS.**
 
 On
        December 9, 2005, the Company held its annual meeting of stockholders at
        which
        the Company’s stockholders were asked to elect seven (7) directors to serve on
        the Company’s Board of Directors and ratify the appointment of the Company’s
        independent accountants for 2005. 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
                33,192,391
                0
                518,356
                0Ronald
                    W. Pickett
                33,264,857
                0
                445,890
                0Stephen
                    L. Sadle
                33,257,667
                0
                453,080
                0Thomas
                    C. Lynch
                33,523,803
                0
                186,944
                0James
                    L. Peeler
                33,534,573
                0
                176,174
                0Thomas
                    M. Hall
                33,536,073
                0
                174,674
                0Seth
                    D. Blumenfeld
                33,262,997
                0
                447,750
                0
 
 11
 Table
              of Contents
 
 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 Independent Accountants
                33,604,555
                78,030
                28,162
                0
 
 
 **PART
          II**
 
 **ITEM
          5.**  **MARKET
          FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
          OF EQUITY SECURITIES.**
 
 On
          January 24, 2004, the Company’s common stock was listed for trading on the
          American Stock Exchange (AMEX) under the ticker symbol “TKO.” Prior to January
          24, 2004, the Company’s common stock was quoted on the OTC Bulletin Board under
          the symbol “TLKO.OB.” As of March 1, 2006, the Company had 253 stockholders of
          record and 46,316,539 shares of its common stock issued and outstanding.
 
 The
          following table documents the high and low sales prices for the Company’s common
          stock on the AMEX for the period beginning January 24, 2004 through December
          31,
          2005. The information provided for the period prior to January 24, 2004
          was
          obtained from the Yahoo! Finance web site.
 
 **High**
                **Low****Year
                    Ended December 31, 2005**First
                    Quarter
                $6.85
                $3.66Second
                    Quarter
                $5.34
                $2.61Third
                    Quarter
                $5.60
                $3.11Fourth
                    Quarter
                $5.23
                $3.51**Year
                    Ended December 31, 2004**First
                    Quarter
                $5.48
                $2.54Second
                    Quarter
                $5.32
                $3.00Third
                    Quarter
                $3.50
                $2.20Fourth
                    Quarter
                $5.98
                $2.61
  The
          Company has never paid dividends on its common stock and does not anticipate
          paying dividends in the foreseeable future.
 
 During
          the three months ended December 31, 2005, the Company agreed to issue 9,000
          shares of common stock to Ronald W. Pickett, the Company’s President and Chief
          Executive Officer, pursuant to his employment agreement dated January 20,
          2004.
 
 During
          the three months ended December 2005, the Company also issued an aggregate
          of
          363,636 shares of common stock to Ronald W. Pickett, the Company's President
          and
          Chief Executive Officer, in connection with Mr. Pickett's conversion of
          Series B
          Debentures. The Company also issued an aggregate of 48,858 shares of common
          stock in payment of accrued interest on the 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.
 
 During
          the three months ended December 31, 2005, the Company issued 30,000 shares
          of
          common stock to Seth Blumenfeld, a member of the board of directors, pursuant
          to
          the terms of the Professional Services Agreement dated July 1, 2005.
 
 This
          issuance of foregoing shares was made in reliance on the exemption from
          registration provided by Section 4(2) of the Securities Act of 1933 and/or
          Rule
          506 of Regulation D promulgated thereunder.
 
 12
 Table
              of Contents
  **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)**
                
                
                **2005**
                
                
                **2004**
                
                
                **2003**
                
                
                **2002**
                
                
                **2001**
                  **(Restated)**Total
                    revenues
                
                $
                2,488
                
                $
                698
                
                $
                94
                
                $
                —
                
                $
                —Operating
                    loss
                
                
                (15,307
                )
                
                (13,112
                )
                
                (6,564
                )
                
                (3,155
                )
                
                (1,577
                )Net
                    loss
                
                
                (15,778
                )
                
                (13,093
                )
                
                (7,657
                )
                
                (3,778
                )
                
                (,1,716
                )Loss
                    per share - basic
                
                
                (0.35
                )
                
                (0.32
                )
                
                (0.37
                )
                
                (.22
                )
                
                (0.08
                )Loss
                    per share - diluted
                
                
                (0.35
                )
                
                (0.32
                )
                
                (0.37
                )
                
                (.22
                )
                
                (0.08
                )Basic
                    weighted average common shares outstanding
                
                
                44,743
                
                
                41,384
                
                
                20,702
                
                
                17,120
                
                
                21,974Diluted
                    weighted average common shares outstanding
                
                
                44,743
                
                
                41,384
                
                
                20,702
                
                
                17,120
                
                
                21,974Working
                    capital
                
                
                12,061
                
                
                12,672
                
                
                5,296
                
                
                (894
                )
                
                (502
                )Total
                    assets
                
                
                23,291
                
                
                15,493
                
                
                6,176
                
                
                295
                
                
                236Short-term
                    borrowings and current portion of long-term debt
                
                
                6,350
                
                
                —
                
                
                15
                
                
                310
                
                
                400Long-term
                    debt, net of current portion
                
                
                9,617
                
                
                588
                
                
                3,132
                
                
                863
                
                
                126Stockholders’
                    equity (deficiency)
                
                
                5,315
                
                
                13,646
                
                
                2,388
                
                
                (1,527
                )
                
                (414
                )
  
 
 **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.
 
 **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.
 
 13
 Table
              of Contents
 **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.
 
 **Guarantees
          and Product Warranties**
 
 FASB
          Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
          Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”),
          requires that upon issuance of a guarantee, the guarantor must disclose
          and
          recognize a liability for the fair value of the obligation it assumes under
          that
          guarantee.
 
 The
          Company’s guarantees issued subject to the recognition and disclosure
          requirements of FIN 45 as of December 31, 2005 and 2004 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, 2005, the Company
          experienced approximately three percent of units returned. Using this experience
          factor a reserve of $24,000 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**
 
 In
          December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
          Compensation-Transition and Disclosure-an amendment of SFAS 123." This
          statement
          amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide
          alternative methods of transition for a voluntary change to the fair value
          based
          method of accounting for stock-based employee compensation. In addition,
          this
          statement amends the disclosure requirements of SFAS No. 123 to require
          prominent disclosures in both annual and interim financial statements about
          the
          method of accounting for stock-based employee compensation and the effect
          of the
          method used on reported results. The Company has chosen to continue to
          account
          for stock-based compensation using the intrinsic value method prescribed
          in APB
          Opinion No. 25 and related interpretations. Accordingly, compensation expense
          for stock options is measured as the excess, if any, of the fair market
          value of
          the Company's stock at the date of the grant over the exercise price of
          the
          related option. The Company has adopted the annual disclosure provisions
          of SFAS
          No. 148 in its financial reports for the years ended December 31, 2005,
          2004 and
          2003 and will adopt the interim disclosure provisions for its financial
          reports
          for the subsequent periods.
 
 On
          December 16, 2004, the Financial Accounting Standards Board (FASB) issued
          FASB
          Statement No. 123R (revised 2004), "Share-Based Payment" which is a revision
          of
          FASB Statement No. 123, "Accounting for Stock-Based Compensation". Statement
          123R supersedes APB opinion No. 25, "Accounting for Stock Issued to Employees",
          and amends FASB Statement No. 95, "Statement of Cash Flows". Generally,
          the
          approach in Statement 123R is similar to the approach described in Statement
          123. However, Statement 123R requires all share-based payments to employees,
          including grants of employee stock options, to be recognized in the income
          statement based on their fair values. Pro-forma disclosure is no longer
          an
          alternative. On April 14, 2005, the SEC amended the effective date of the
          provisions of this statement. The effect of this amendment by the SEC is
          that
          the Company will have to comply with Statement 123R and use the Fair Value
          based
          method of accounting no later than the first quarter of 2006. The Company
          has
          previously issued employee stock options for which no expense has been
          recognized, and which will not be fully vested as of the effective date
          of SFAS
          No. 123R. The Company has assessed the impact SFAS 123R and believes the
          impact of adopting SFAS No. 123R, based on our unvested options outstanding
          at December 31, 2005, will be to increase our pre-tax stock-based compensation
          expense in 2006 by approximately $2 million.
 
 14
 Table
              of Contents
 ***Year
          Ended December 31, 2005 Compared to Year Ended December 31,
          2004***
 
 **Revenues**
 
 The
          Company’s revenue consists of direct product sales and a rental (lease) model in
          the commercial, government and international markets. The table below outlines
          product versus rental (lease) revenues for comparable periods:
 
 Year
                    ended December 31,Revenue:
                
                2005
                
                2004
                
                VarianceProduct
                
                $
                1,769,727
                
                
                71
                %
                $
                477,555
                
                
                68
                %
                $
                1,292,172
                
                
                271
                %Rental
                    (lease)
                
                
                718,596
                
                
                29
                %
                
                221,097
                
                
                32
                %
                
                497,499
                
                
                225
                %Total
                
                $
                2,488,323
                
                
                100
                %
                $
                698,652
                
                
                100
                %
                $
                1,789,671
                
                
                256
                %
  *Product
          revenue*
  Product
          revenue principally arises from the sale of iBridges and other Telkonet
          iWire
          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
                
                
                69
                %
                $
                542,859
                
                
                78
                %
                $
                1,174,320
                
                
                216
                %
 
 15
 Table
              of Contents
 *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
                  %
  *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
                  %
  16
 Table
                of Contents
  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.
 
 ***Year
            Ended December 31, 2004 Compared to Year Ended December 31,
            2003***
 
 **Revenues**
 
 Year
                      ended December 31,Revenue:
                  
                  2004
                  
                  2003
                  
                  VarianceProduct
                  
                  $
                  477,555
                  
                  
                  68
                  %
                  $
                  88,403
                  
                  
                  94
                  %
                  $
                  389,152
                  
                  
                  440
                  %Rental
                      (lease)
                  
                  
                  221,097
                  
                  
                  32
                  %
                  
                  5,257
                  
                  
                  6
                  %
                  
                  215,840
                  
                  
                  4,106
                  %Total
                  
                  $
                  698,652
                  
                  
                  100
                  %
                  $
                  93,660
                  
                  
                  100
                  %
                  $
                  604,992
                  
                  
                  646
                  %
  *Product
            revenue*
 
 Product
            revenue principally arises from the sale of iBridges and other Telkonet
            iWire
            SystemTM components directly to customers. Revenues have primarily been
            derived
            from the Hospitality and Multi-Dwelling business units. The Company has
            expanded
            its marketing efforts in the International and Government markets and
            anticipates full deployment of its product upon successful product certification
            in each of these respective markets.
  *Rental
            (lease) revenue*
 
 As
            of
            December 31, 2004, revenues to be recognized under non-cancelable contracts
            (backlog) was approximately $933,000 with a weighted average remaining
            term of
            approximately 31 months. The remaining costs to be amortized in connection
            with
            these contracts is approximately $451,000.
 **Cost
            of Sales**
 
 Year
                      ended December 31,Cost
                      of Sales:
                  
                  2004
                  
                  2003
                  
                  VarianceProduct
                  
                  $
                  459,225
                  
                  
                  96
                  %
                  $
                  101,171
                  
                  
                  114
                  %
                  $
                  358,054
                  
                  
                  354
                  %Rental
                      (lease)
                  
                  
                  83,634
                  
                  
                  38
                  %
                  
                  3,485
                  
                  
                  66
                  %
                  
                  80,149
                  
                  
                  2,300
                  %Total
                  
                  $
                  542,859
                  
                  
                  78
                  %
                  $
                  104,656
                  
                  
                  112
                  %
                  $
                  438,203
                  
                  
                  419
                  %
  *Product
            Costs*
 
 The
            Company emerged from its development stage as of December 31, 2003. Therefore,
            there were no comparable costs of sales in the prior year. Product cost
            primarily includes Telkonet iWire SystemTM product suite equipment cost
            and
            installation labor.
 
 17
 Table
                of Contents
  *Rental
            (lease) Costs*
 
 During
            the year, revenue from the Company’s rental (lease) sales model was derived
            principally in the Hospitality and Multi-Dwelling markets.
 
 **Gross
            Profit**
 
 Year
                      ended December 31Gross
                      Profit:
                  
                  2004
                  
                  2003
                  
                  VarianceProduct
                  
                  $
                  18,330
                  
                  
                  4
                  %
                  $
                  (12,768
                  )
                  
                  (14
                  %)
                  $
                  31,098
                  
                  
                  244
                  %Rental
                      (lease)
                  
                  
                  137,463
                  
                  
                  62
                  %
                  
                  1,772
                  
                  
                  34
                  %
                  
                  135,691
                  
                  
                  7,658
                  %Total
                  
                  $
                  155,793
                  
                  
                  22
                  %
                  $
                  (10,996
                  )
                  
                  (12
                  %)
                  $
                  166,789
                  
                  
                  1,517
                  %
  The
            Company improved installation processes and began operational improvements
            which
            resulted in increased gross margins.
 
 **Operating
            Expenses**
 
 Year
                      ended December 312004
                  
                  2003
                  
                  VarianceTotal
                  
                  $
                  13,268,067
                  
                  $
                  6,553,335
                  
                  $
                  6,714,732
                  
                  
                  102
                  %
  Overall
            expenses increased for the year ended December 31, 2004 over the prior
            year by
            $6,714,732 or 102%. Excluding the fee paid pursuant to certain agreements
            with
            consultants of $2,500,000 which was expensed during the second quarter,
            the
            increase for the year was $4,214,732 or 64%. This increase is principally
            due to
            payroll and related costs for administrative sales and marketing, non-employee
            compensation for services, advertising and trade show attendance, and
            rent and
            related relocation costs for our corporate and sales offices.
 
 **Product
            Research and Development**
 
 Year
                      ended December 312004
                  
                  2003
                  
                  VarianceTotal
                  
                  $
                  1,852,309
                  
                  $
                  1,370,785
                  
                  $
                  481,524
                  
                  
                  35
                  %
 
 Company-sponsored
            research and development costs related to both present and future products
            are
            expended in the period incurred. Total expenses for the year ended December
            31,
            2004 increased over the comparable prior year by $481,524, or 35%. This
            increase
            was primarily related to an increase in salaries and related costs associated
            with the addition of two full-time employees and costs related to independent
            lab testing and certification of the Company's product.
 
 **Selling,
            General and Administrative**
 
 Year
                      ended December 312004
                  
                  2003
                  
                  VarianceTotal
                  
                  $
                  7,663,369
                  
                  $
                  4,089,172
                  
                  $
                  3,574,197
                  
                  
                  87
                  %
  Selling,
            general and administrative expenses increased for the year ended December
            31,
            2004 over the comparable prior year by $3,574,197 or 87%. The increase
            is
            related to an increase in payroll and associated costs for management,
            sales and
            marketing resources, advertising and trade show attendance and related
            relocation costs for corporate and new sales offices.
 
 18
 Table
                of Contents
 
 **Liquidity
            and Capital
            Resources**
 
 As
            of
            December 31, 2005, the Company's current assets exceeded its current
            liabilities
            by $12,060,807, with cash and cash equivalents representing $8,422,079
            and
            Restricted Certificate of Deposit representing $10,000,000 of the current
            assets
            as of December 31, 2005.
 
 While
            the
            Company believes it has sufficient capital to meet its working capital
            requirements for the next twelve months, additional financing may be
            required in
            order to meet growth opportunities in financing and/or investing activities.
            If
            additional capital is required and the Company is not successful in generating
            sufficient liquidity from operations or in raising sufficient capital
            resources
            on terms acceptable to the Company, this could have a material adverse
            effect on
            the Company’s business, results of operations, liquidity and financial
            condition.
 
 The
            recent acquisition of Microwave Technologies, Inc. (MST) and its related
            planned
            roll-out requires capital equipment, which if financing is not available
            may
            limit the rate upon which roll-out occurs. The Company is exploring several
            of
            its options such as lease financing or strategic partnerships to provide
            the
            necessary funding which may or may not occur.
 
 In
            January 2004, the Board of Directors determined to permit the Senior
            Noteholders, for a limited period of time, to convert their Senior Notes
            into
            the Company's common stock at a conversion price of $2.10 per share.
            In
            connection with this transaction, Senior Noteholders converted Senior
            Notes
            having an aggregate principal value of $2,539,000.
 
 In
            February 2004, Telkonet completed a private placement of its common stock
            resulting in net proceeds to the Company of approximately $12.8 million.
            The
            Company sold 6,387,600 shares of its common stock at a discount of 18%
            to the
            average market price of the Company’s common stock for the preceding 30 days.
 
 In
            March
            2004, the Company received $3.9 million upon the exercise of 4,235,007
            warrants
            to purchase the Company’s common stock. Additionally, $200,000 of debentures
            were converted into 324,000 shares of the Company’s common stock.
 
 In
            October 2005, the Company completed a convertible senior debt financing of
            $20 million, exclusive of placement cost and fees. The Company intends to
            use the $20 million for general working capital needs. The convertible
            notes bear interest at a fixed rate of 7.25%, payable in cash, plus equal
            monthly principal installments beginning March 1, 2006. The maturity date
            is 3 years from the issuance of the notes. At any time or times, the
            noteholders
            are entitled to convert any portion of the outstanding and unpaid note
            amount
            into fully paid and nonassessable common shares at a conversion price
            of $5 per
            share. At any time at the option of the Company, the principal payments
            due
            under the notes may be paid either in cash or in common stock at the lower
            of $5 or 92.5% of the average recent market price of the Company's common
            stock. 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, warrant coverage to the noteholders increases
            from
            25% to 65% for 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 which
            is
            renewed annually. Once each of the notes decline below $15 million, the
            balance on the letter of credit is reduced by $.50 for every $1 amortized.
            Also,
            the Company is required to achieve minimum revenue of $3 million for
            the period
            October 1, 2005 through March 31, 2006 and $2 million for each fiscal
            quarter
            thereafter in 2006. The covenant requires that the Company pay an
            accelerated principal payment up to $1 million on a pro rata basis
            calculated based upon the percentage shortfall between actual
            revenues and the quarterly targeted revenues. The Company may, at its
            option, repay all or any part of the outstanding debt represented by
            the Senior
            Convertible Notes in Company common stock. Once the Senior Convertible
            Notes are
            repaid, the funds underlying a Certificate of Deposit in the amount of
            $10
            million, which has been posted as collateral for the Letter of Credit,
            will be
            available for operating purposes.
 
 The
            Company filed a registration statement to cover the future issuance of
            shares
            which may be issued upon conversion of the notes and/or warrants. The
            registration statement was declared effective by the Securities and Exchange
            Commission on December 13, 2005.
 
 During
            the year the Company received $852,638 proceeds from the exercise of
            employee
            and non-employee stock options and $321,900 from exercise of warrants.
 
 19
 Table
                of Contents
 **Inflation**
 
 We
            do not
            believe that inflation has had a material effect on our business, financial
            condition or results of operations. If our costs were to become subject
            to
            significant inflationary pressures, we may not be able to fully offset
            such
            higher costs through price increases. Our inability or failure to do
            so could
            adversely affect our business, financial condition and results of
            operations.
 
 **Off
            Balance Sheet Arrangements**
 
 In
            October 2005, the Company entered into an irrevocable letter of credit
            with a
            bank for $10 million as collateral for the $20 million Senior Convertible
            Notes.
            A $10 million Certificate of Deposit is pledged as collateral for the
            irrevocable letter of credit agreement. The letter of credit is automatically
            renewable annually as required in the loan covenant. As of December 31,
            2005,
            the $10 million Restricted Certificate of Deposit is recorded in the
            accompanying consolidated balance sheet as a current asset.
 
 **Acquisition
            or Disposition of Plant and Equipment**
 
 During
            the year ended December 31, 2005, fixed assets increased $336,448 or
            48% which
            is primarily related to furniture and fixtures in the Crystal City, Virginia
            office, sales support software and computer equipment related to new
            employees.
            The Company 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.
 
 **New
            Accounting Pronouncements**
  In
            March
            2005, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
            (FIN) No. 47, “Accounting for Conditional Asset Retirement Obligations, an
            interpretation of FASB Statement No. 143,” which requires an entity to recognize
            a liability for the fair value of a conditional asset retirement obligation
            when
            incurred if the liability’s fair value can be reasonably estimated. The Company
            is required to adopt the provisions of FIN 47 no later than the first
            quarter of
            fiscal 2006. The Company does not expect the adoption of this Interpretation
            to
            have a material impact on its consolidated financial position, results
            of
            operations or cash flows.
 
 In
            May
            2005 the FASB issued Statement of Financial Accounting Standards (SFAS)
            No. 154,
“Accounting Changes and Error Corrections, a replacement of APB Opinion
            No. 20
            and FASB Statement No. 3.” SFAS 154 requires retrospective application to prior
            periods’ financial statements for changes in accounting principle, unless it is
            impracticable to determine either the period-specific effects or the
            cumulative
            effect of the change. SFAS 154 also requires that retrospective application
            of a
            change in accounting principle be limited to the direct effects of the
            change.
            Indirect effects of a change in accounting principle, such as a change
            in
            non-discretionary profit-sharing payments resulting from an accounting
            change,
            should be recognized in the period of the accounting change. SFAS 154
            also
            requires that a change in depreciation, amortization, or depletion method
            for
            long-lived, non-financial assets be accounted for as a change in accounting
            estimate effected by a change in accounting principle. SFAS 154 is effective
            for
            accounting changes and corrections of errors made in fiscal years beginning
            after December 15, 2005. Early adoption is permitted for accounting changes
            and
            corrections of errors made in fiscal years beginning after the date this
            Statement is issued. The Company does not expect the adoption of this
            SFAS to
            have a material impact on its consolidated financial position, results
            of
            operations or cash flows.
 
 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.
  20
 Table
            of Contents
 **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
                $20,100,000
                $6,350,000
                $13,750,000
                -
                -Capital
                    Lease Obligations
                -
                -
                -
                -
                -Operating
                    Lease Obligations
                $1,715,000
                    (1)
                $514,000
                $785,000
                $416,000
                -Purchase
                    Obligations
                -
                -
                -
                -
                -Other
                    Long-Term Liabilities Reflected on the Registrant’s Balance Sheet Under
                    GAAP
                -
                -
                -
                -
                -Total
                $21,815,000
                $6,864,000
                $14,535,000
                $416,000
                -
 
 (1)
          Operating lease obligations includes approximately $352,000 of future lease
          obligations, primarily related to office and warehouse space, in conjunction
          with the January 2006 acquisition of Microwave Satellite Technologies,
          Inc.
 
 **ITEM
          7A.**  **QUANTITATIVE
          AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**
 
 **Short
          Term Investments**
 
 We
          held
          no marketable securities as of December 31, 2005. 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 300 basis
          points.
          The certificate of deposit, which is restricted and currently held as collateral
          for the Letter of Credit in connection with the $20 million senior convertible
          notes, accrues interest 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, 2006 was $131,000
          and
          $100,000 in BPL Global and Amperion, respectively, and at December 31,
          2005, 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, of the carrying value of its investment through a charge to operations
          during the year ended December 31, 2005. The fair
          value of the Company’s investment in BPL Global, remained at $131,000 as of
          December 31, 2005.
 
 **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.
 
 21
 Table
              of Contents
 **ITEM
          9A.**  **CONTROLS
          AND PROCEDURES.**
  As
          of
          December 31, 2005, the Company performed an evaluation, under the supervision
          and with the participation of management, including its Chief Executive
          Officer
          and Chief Financial Officer, of the effectiveness of the design and operation
          of
          its disclosure controls and procedures as defined in Rules 13a-15(e) and
          15d-15(e) under the Securities Exchange Act of 1934, as amended. Based
          upon that
          evaluation, the Chief Executive Officer and Chief Financial Officer concluded
          that the Company’s disclosure controls and procedures are effective in timely
          alerting them to material information required to be included in the Company’s
          periodic filings with the U.S. Securities and Exchange Commission. There
          were no
          significant changes in the Company’s internal controls or in other factors that
          could materially affected or are reasonable likely to materially affect,
          the
          Company’s internal controls subsequent to the date of the most recent
          evaluation.
   22
 Table
              of Contents
 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
          wholly-owned subsidiary (the Company) maintained effective internal control
          over
          financial reporting as of December 31, 2005, 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
          subsidiary maintained effective internal control over financial reporting
          as of
          December 31, 2005, 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 wholly-owned subsidiary,
          maintained, in all material respects, effective internal control over financial
          reporting as of December 31, 20005, 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 balance sheets of Telkonet,
          Inc. and its wholly-owned subsidiary as of December 31, 2005 and 2004,
          and the
          related consolidated statements of losses, stockholders' equity, and cash
          flows
          for the three-years ended December 31, 2005, and our report dated February
          2,
          2006 expressed an unqualified opinion on those consolidated financial
          statements,
  
 /s/RUSSELL
          BEDFORD STEFANOU MIRCHANDANI LLP
 
 Russell
          Bedford Stefanou Mirchandani LLP
 Certified
          Public Accountants
 
 
 McLean,
          Virginia
 February
          2, 2006
 
 23
 Table
              of Contents
 **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, 2005. The directors
            of the
            Company are elected every year and serve until their successors are duly
            elected
            and qualified.
 
 Name
                  Age
                  TitleRonald
                      W. Pickett
                  58
                  President,
                      Director & Chief Executive OfficerFrank
                      T. Matarazzo
                  44
                  President
                      & Chief Executive Officer, Microwave Satellite Technologies,
                      Inc.John
                      Cramp
                  50
                  Chief
                      Operating OfficerE.
                      Barry Smith
                  55
                  Chief
                      Financial OfficerStephen
                      Sadle
                  60
                  Senior
                      Vice President & DirectorJames
                      Landry
                  50
                  Chief
                      Technology OfficerWarren
                      V. Musser
                  79
                  Chairman
                      of the Board (3)David
                      Grimes
                  67
                  Director
                      (1)Thomas
                      C. Lynch
                  63
                  Director
                      (2), (3)Dr.
                      Thomas M. Hall
                  54
                  Director
                      (2), (3)James
                      L. “Lou” Peeler
                  72
                  Director
                      (2)Seth
                      Blumenfeld
                  65
                  Director
                      (1)
 
 (1)
                Mr.
                    Grimes died on September 27, 2005. Mr. Blumenfeld was elected
                    to Mr.
                    Grimes’ vacant board seat on December 9, 2005. (2)
                Member
                    of the Audit Committee (3)
                Member
                    of the Compensation Committee 
 
 24
 Table
                of Contents
 **Ronald
            W. Pickett—President, Chief Executive Officer &
Director**
 
 Mr.
            Pickett has served as the Company’s Chief Executive Officer since January 2003.
            In addition, he has fostered the development of Telkonet since 1999 as
            the
            Company’s principle investor and co-Founder. He was the Founder, and for twenty
            years served as the Chairman of the Board and President of Medical Advisory
            Systems, Inc. (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.
 
 **John
            Cramp—Chief Operating Officer**
 
 Mr.
            Cramp
            has served as the Company’s Chief Operating Officer since December 2005.
            Prior to this appointment, Mr. Cramp served as the Company’s Executive Vice
            President of Government Sales. Before joining Telkonet in May, 2005,
            Mr. Cramp
            served as President and CEO and Director of Seneca Corporation, a
            privately-held information technology company, from October 2004 to April
            2005.
            Mr. Cramp served as Chief Executive Officer and Director of CardSystems
            Solutions, Inc., an Electronic Payment Company, from 1998 to 2004 and
            was
            Executive Vice President and COO from 1997 to 1998. Prior to joining
            CardSystems, Mr. Cramp was Vice President of Information Management Consultants
            Inc., a systems integration and software development company. From 1990
            to 1995,
            Mr. Cramp was President and CEO (in 1995) of Simpact Inc., a privately
            held data
            communication products and services company. Prior to 1990, Mr. Cramp
            spent over 10 years in the computer industry in management roles with
            Encore Computer, Wang Laboratories and Data General. Mr. Cramp earned
            a BA from
            Franklin and Marshall College in 1977.
 
 **E.
            Barry Smith—Chief Financial Officer**
 
 Mr.
            Smith
            has served as the Company’s Chief Financial Officer since February 2003. Mr.
            Smith is a CPA and senior financial executive with diverse experience
            in both
            public and private companies. From September 1987 to February 2003, Mr.
            Smith
            was employed as a financial partner to, or retained as a consultant with,
            Safeguard Scientifics or its subsidiary companies. Mr Smith’s background also
            includes big-four public accounting experience with the accounting firm
            of
            Deloitte & Touche. Mr. Smith’s experience also includes serving as Vice
            President of Finance & Administration for US Golf Management (a
            public/private golf course and restaurant management company), Vice President
            of
            Finance for International Communications Research (a market research
            and
            database services company), and Treasurer for The Chilton Company (a
            publishing
            company).
 
 **Stephen
            L. Sadle—Senior Vice President, Co-Founder & Director**
 
 From
            1999
            until he joined Telkonet in 2000, Mr. Sadle served as Senior Vice President
            and
            General Sales Manager of Internos (a provider of web-based vertical extranet
            applications). From 1986 until 1999, Mr. Sadle was Vice President of
            Business
            Development and Sales for the Driggs Corporation, a major heavy and
            infrastructure contracting firm interfacing with government and the private
            sectors. From 1970 until 1986, Mr. Sadle was President of a successful
            infrastructure construction and development company in the Washington,
            D.C.
            metropolitan area. Mr. Sadle has been a director of the Company since
            November
            1999.
 
 25
 Table
                of Contents
 **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.
 
 **David
            W. Grimes—Co-Founder & Former Director**
 
 From
            1992
            until he joined Telkonet in 1999, Mr. Grimes served as Chief Engineer
            for Final
            Analysis, Inc. and led the design and development of the Low Earth Orbit
            constellation of 38 satellites for use in global store and forward
            communications. From 1989 to 1992 he was the Engineering Division Director
            at
            EER Inc. and supervised over 100 engineers and technicians on electrical
            mechanical and thermal tasks for Goddard Space Flight Center. From 1982
            to 1989
            Mr. Grimes served as Chief Executive Officer of Transpace Carriers Inc.,
            a
            venture to commercialize the Delta launch vehicle. From 1963 to 1982,
            Mr. Grimes
            was a Senior Executive with NASA, heading the $200 million per year Delta
            Program. Mr. Grimes is a recognized expert in space and ground communications
            systems and brings this expertise to bear on the implementation of the
            hybrid
            telephony and high speed Internet technology. Mr. Grimes has been a director
            of
            the Company since November 1999. Mr. Grimes died September 27,
            2005.
 
 **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 Mr. Musser 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.
 
 **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 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.
 
 26
 Table
                of Contents
  **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, 2005, Messrs. Hall, Lynch and Peeler served on the
            Audit
            Committee. The Company’s Board of Directors has determined that each of Messrs.
            Hall and Lynch is a “financial expert” as defined by Item 401 of Regulation S-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 Item
            7(d)(3)(iv) of Schedule 14A promulgated under the Securities Exchange
            Act of
            1934. The Board of Directors has adopted an audit committee charter,
            which was
            ratified by the Company’s stockholders.
 
 *Compensation
            Committee*
 
 The
            Company maintains a Compensation Committee of the Board of Directors.
            For the
            year ended December 31, 2005, Messrs. Hall, Lynch and Musser served on
            the
            Compensation Committee. The committee held two meetings during
            2005.
  *Section
            16(a) Beneficial Ownership Reporting Compliance*
 
 David
            Grimes, a former director of the Company, failed to file on a timely
            basis
            certain reports required by Section 16(a) of the Exchange Act. Mr. Grimes
            failed
            to file 43 reports resulting in 43 transactions not being reported on
            a timely
            basis. Mr. Grimes’ estate filed a Form 5 on February 10, 2006 to make corrective
            disclosure with respect to these transactions.
 
 *Code
            of Ethics*
 
 The
            Company has also adopted a Code of Ethics that applies to the Company’s
            principal executive officer, principal financial officer and those persons
            performing similar functions, including those employees of the Company
            with
            senior financial roles. A copy of the Company’s Code of Ethics was filed as
            Exhibit 14 to the Company’s Annual Report on Form 10-KSB for the year ended
            December 31, 2003 (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.
 
 **ITEM
            11.**   **EXECUTIVE
            COMPENSATION.**
 
 The
            following table sets forth all compensation actually paid or accrued
            by the
            Company for services rendered to the Company for the years ended December
            31,
            2005, 2004 and 2003 to the Company’s Chief Executive Officer, the Company’s four
            most highly compensated executive officers other than the Chief Executive
            Officer who were serving as executive officers of the Company as of December
            31,
            2005, and those persons for whom disclosure would have been required
            but for the
            fact that they were not serving as an executive officer of the Company
            as of
            December 31, 2005.
  27
 Table
                of Contents
 **Summary
            Compensation Table**
 **Annual
                        Compensation**
                    **Long
                        Term Compensation****Awards**
                    **Payouts****(a)**
                    **(b)**
                    **(c)**
                    **(d)**
                    **(e)**
                    **(f)**
                    **(g)**
                    **(h)**
                    **(i)****Name
                        and Principal Position**
                    **Year**
                    **Salary
                        ($)**
                    **Bonus
                        ($)**
                    **Other
                        Annual Compensation**
                    **Restricted**
                      **Stock**
                      **($)**
                    **Securities**
                      **Underlying/**
                      **Options
                        SARs**
                      **(#)**
                    **LTIP
                        Payouts**
                    **All
                        Other Compensation**Ronald
                        W. Pickett
                      President
                        & Chief
                      Executive
                        Officer
                    2003
                    91,538
                    -
                    -
                    64,460
                        (1)
                    -
                    -
                    -2004
                    100,089
                    -
                    -
                    107,779
                        (1)
                    -
                    -
                    -2005
                    102,340
                    200,000
                    -
                    163,319(1)
                    -
                    -
                    -Frank
                        T. Matarazzo
                      President
                        & Chief Executive
                      Officer,
                        MST (2)
                    2003
                    -
                    -
                    -
                    -
                    -
                    -
                    -2004
                    -
                    -
                    -
                    -
                    -
                    -
                    -2005
                    -
                    -
                    -
                    -
                    -
                    -
                    -John
                        S. Cramp
                      Chief
                        Operating Officer
                    2003
                    -
                    -
                    -
                    -
                    -
                    -
                    -2004
                    -
                    -
                    -
                    -
                    -
                    -
                    -2005
                    135,288
                    6,731Howard
                        Lubert
                      Former
                        Chief Executive
                      Officer
                    2003
                    162,083(3)
                    -
                    -
                    -
                    -
                    -
                    -2004
                    130,000(3)Stephen
                        L. Sadle
                      Sr.
                        Vice President
                    2003
                    130,000
                    -
                    -
                    -
                    900,000
                    -
                    -2004
                    171,983
                    6,538
                    -
                    
                    -
                    -
                    -2005
                    171,872
                    10,000
                    -
                    -
                    -
                    -
                    -Jim
                        Landry
                      Chief
                        Technology Officer
                    2003
                    160,000
                    10,000
                    -
                    
                    100,000
                    -
                    -2004
                    172,514
                    15,000
                    -
                    
                    250,000
                    -
                    -2005
                    176,508
                    15,000
                    -
                    -
                    -
                    -
                    -E.
                        Barry Smith
                      Chief
                        Financial Officer
                    2003
                    115,539
                    -
                    -
                    
                    500,000
                    -
                    -2004
                    171,983
                    15,000
                    -
                    
                    -
                    -
                    -2005
                    171,872
                    15,000
                    -
                    -
                    -
                    -
                    -
  28
 Table
                  of Contents
 (1)
              In
              each year ending December 31, 2005, 2004 and 2003, Mr. Pickett earned
              36,000
              shares issued under the Company’s Employee Stock Incentive Plan as additional
              compensation pursuant to his employment agreement. The fair market
              value of
              these shares upon issuance was $163,319, $107,779 and $64,460, respectively.
              Mr.
              Pickett has deferred the receipt of his 2004 and 2005 shares although
              the value
              of such shares is reflected in this table. The number of restricted
              shares held
              by Mr. Pickett at December 31, 2005, was 108,000, and the aggregate
              value of
              these restricted shares of common stock as of December 31, 2005, was
              $448,200.
 (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,
                2004 and
                2003.
 
 (3)
                Mr.
                Lubert’s compensation includes $177,083 of the Company’s common stock acquired
                by Mr. Lubert upon the exercise of options exercised in conjunction
                his
                resignation in June 2003. The Company paid Mr. Lubert’s salary through December
                14, 2004 which was accrued in 2003 at an annual rate of $130,000.
 
 **Option/SAR
                Grants In Last Fiscal Year**
 
 The
                following table sets forth information concerning stock options granted
                in the
                fiscal year ended December 31, 2005, to the persons listed on the
                Summary
                Compensation Table.
 
 **Name**
                        **(a)**
                      **Number
                          of Securities**
                        **Underlying
                          Options/SARs**
                        **Granted**
                        **(#)**
                        **(b)**
                      **Percent
                          of Total Options/SARs**
                        **Granted
                          to**
                        **Employees
                          In**
                        **Fiscal
                          Year**
                        **(c)**
                      **Exercise
                          Or**
                        **Base
                          Price**
                        **($/sh)**
                        **(d)**
                      **Expiration
                          Date**
                        **(e)**Ronald
                          W. Pickett
                      0
                      0%
                      n/a
                      n/aFrank
                          T. Matarazzo
                      0
                      0%
                      n/a
                      n/aJohn
                          S. Cramp
                      500,000
                      37%
                      $3.04
                      5/1/2015Stephen
                          L. Sadle
                      0
                      0%
                      n/a
                      n/aJames
                          Landry
                      0
                      0%
                      n/a
                      n/aE.
                          Barry Smith
                      0
                      0%
                      n/a
                      n/a
  
 29
 Table
                    of Contents
 **Aggregated
                Option/SAR Exercises In Last Fiscal Year And Fiscal Year End Option/SAR
                Values**
 
 The
                following table summarizes information relating to stock option exercises
                during
                the year ended December 31, 2005 by those persons listed on the Summary
                Compensation Table.
 
 **Name**
                        **(a)**
                      **Shares
                          Acquired**
                        **on
                          Exercise**
                        **(#)**
                        **(b)**
                      **Value
                          Realized**
                        **($)**
                        **(c)**
                      **Number
                          of Unexercised Securities Underlying Options/SARs at**
                        **FY-End
                          (#)**
                        **Exerciseable/**
                        **Unexerciseable**
                        **(d)**
                      **Value
                          of Unexercised**
                        **In-The-Money**
                        **Options/SARs**
                        **at
                          FY-End ($)**
                        **Exerciseable/**
                        **Unexerciseable**
                        **(e)**Ronald
                          W. Pickett
                      -0-
                      -0-
                      -0-
                        -0-
                      -0-
                        -0-Frank
                          T. Matarazzo (1)
                      -0-
                      -0-
                      -0-
                        -0-
                      -0-
                        -0-John
                          S. Cramp
                      -0-
                      -0-
                      50,000/
                        450,000
                      55,500/
                        499,500Stephen
                          L. Sadle
                      -0-
                      -0-
                      900,000/
                        -0-
                      2,835,000/
                        -0-James
                          Landry
                      -0-
                      -0-
                      350,000/
                        150,000
                      857,500/
                        105,000E.
                          Barry Smith
                      31,000
                      110,050
                      441,000/
                        -0-
                      1,389,150/
                        -0-
  **Director
                Compensation**
 
 Telkonet
                reimburses non-management directors for costs and expenses in connection
                with
                their attendance and participation at Board of Directors meetings
                and for other
                travel expenses incurred on Telkonet’s behalf. Telkonet compensates each
                non-management director (excluding Mr. Musser): $4,000 per month,
                10,000 vested
                stock options per quarter and $1,000 for each committee meeting of
                the Board of
                Directors such director attends, except that Mr. Musser, as Chairman
                of the
                Board of Directors, is compensated $8,333 per month (consisting of
                monthly
                payments in the amount of $4,000, which payments are consistent with
                the monthly
                payments made to the other non-management directors, and $4,333.33
                per month,
                which payments are in lieu of the 10,000 vested stock options per
                quarter and
                $1,000 for each committee meeting that the other non-management directors
                receive). Payments to Mr. Musser for Board services were made to
                The Musser
                Group pursuant to a consulting agreement described below under the
                heading
“Certain Relationships and Related Transactions.”
 
 **Employment
                Agreements**
 
 Stephen
                L. Sadle, Senior Vice President, is employed pursuant to an employment
                agreement
                for a three-year term that commenced January 18, 2003 and 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.
 
 James
                Landry, Chief Technology Officer, has been employed since September
                24, 2001
                with an annual salary of $160,000 with bonuses and benefits based
                upon
                Telkonet’s internal policies. Mr. Landry’s annual salary was increased to
                $176,508 in 2004.
  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 will be awarded based on the successful achievement of $15
                million in
                revenues in 2006 and a cash flow break even run rate by the fourth
                quarter,
                2006.
  30
 Table
                    of Contents
 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.
 
 E.
                Barry
                Smith, Chief Financial Officer, is employed pursuant to an employment
                agreement
                for a one-year term that commenced February 17, 2003 and renewed
                for a one-year
                term through February 16, 2007 and provides for an annual salary
                of $130,000 and
                bonuses and benefits based upon Telkonet’s internal policies. Mr. Smith’s annual
                salary was increased to $171,872 in 2004.
 
 Howard
                Lubert, former Chief Executive Officer, was employed pursuant to
                an employment
                agreement for a two-year term that commenced January 1, 2003 and
                provided for an
                annual salary of $130,000 and bonuses and benefits based upon Telkonet’s
                internal policies. Mr. Lubert resigned effective June 16, 2003, however,
                in
                connection with Mr. Lubert’s separation from the Company, Telkonet agreed to pay
                Mr. Lubert’s salary through December 14, 2004.
 
 In
                addition, under the Stock Incentive Plan, stock options are periodically
                granted
                to employees at the discretion of the Compensation Committee of the
                Board of
                Directors. Executives of Telkonet are eligible to receive stock option
                grants,
                based upon individual performance and the performance of Telkonet
                as a
                whole.
 
 **Compensation
                Committee Interlocks and Insider Participation**
 
 In
                September 2005, the Board of Directors nominated and approved a Compensation
                Committee which consisted of Messrs. Musser and Lynch and Dr. Hall.
                Prior to
                September 2005, Telkonet did not have a Compensation Committee.  However,
                Messrs. Lynch and Peeler and Dr. Hall, all of the independent members
                of the
                Company's Board of Directors, fulfilled the functions of a Compensation
                Committee. None of these individuals was, or has been, an officer
                or employee of
                Telkonet or any of its subsidiaries, nor does any of these individuals
                have a
                relationship that would constitute an interlocking relationship with
                executive
                officers or directors of Telkonet or another entity.
  **Board
                Compensation Committee Report on Executive
                Compensation**
 
 **Report
                  of the Compensation Committee**
  *Notwithstanding anything to the contrary set forth in any of Telkonet's
                  previous
                  filings under the Securities Act of 1933 or the Exchange Act that
                  might
                  incorporate future filings or this proxy statement, the following
                  report shall
                  not be deemed to be incorporated by reference into any such filings.
                  In
                  addition, the following report shall not be deemed to be "soliciting
                  material"
                  or "filed" with the SEC.*
  The base salary, bonus, benefits and other compensation payable
                  to Telkonet's
                  executive officers for the year ended December 31, 2004 were fixed
                  under written
                  employment agreements (except for Mr. Landry, who does not have
                  an employment
                  agreement) described above under the heading Employment Contracts
                  and
                  Termination of Employment Arrangements.
 
 Prior to establishing Mr. Pickett's compensation pursuant to his
                  employment
                  agreement (as well as the compensation of the other executive officers),
                  the
                  Board of Directors reviewed compensation recommendations prepared
                  by Telkonet's
                  human resources director, which recommendations provide information
                  regarding
                  compensation at the tenth to fiftieth percentiles in peer companies.
                  The Board
                  of Directors believes that Mr. Pickett's executive compensation
                  is commensurate
                  with his peers in comparable companies. In 2004, the Telkonet Board
                  of Directors
                  determined to increase Mr. Pickett's compensation from approximately
                  $92,000 to
                  $101,000 to give effect to a one-time adjustment for company-paid
                  medical
                  benefits in accordance with Mr. Pickett's employment agreement.
                  Thereafter, all
                  employees, including Mr. Pickett, are required to pay 25% of their
                  respective
                  medical premiums as part of a cost containment initiative.
 
 Messrs. Lynch and Peeler and Dr. Hall have the power to administer
                  the Amended
                  and Restated Stock Incentive Plan, which stock options may be granted
                  to
                  officers, directors, employees, advisors and consultants who render
                  services to
                  Telkonet. For the fiscal year ended December 31, 2004, no awards
                  were made to
                  the executive officers pursuant to the Amended and Restated Stock
                  Incentive
                  Plan, except that Mr. Pickett, pursuant to the terms of his employment
                  agreement, was awarded 3,000 restricted shares of Telkonet's common
                  stock per
                  month which vest immediately, and Mr. Landry received an stock
                  option award to
                  purchase 250,000 shares of Telkonet's common stock, based on his
                  years of
                  contribution to the development of Telkonet's technology and his
                  promotion to
                  the position of Telkonet's Chief Technology Officer.
 
 By,
 
 Thomas
                  M.
                  Hall
 Thomas
                  C.
                  Lynch
 James
                  L.
                  Peeler
 31
 Table
                        of Contents
 
 **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, 2005. 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.
 **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, 2005.
  **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**
                        15,000,000
                        $1.56
                        -**Equity
                            compensation plans not approved**
                          **by
                            security holders**
                        933,327
                        $3.64
                        -**Total**
                        15,933,327
                        $1.72
                        -
  The
                  following table sets forth, as of March 1, 2006, 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, 2006, there were no issued
                  and
                  outstanding shares of any other class of the Company’s equity securities.
 
 32
 Table
                      of Contents
 
 **Name
                            and Address of Beneficial Owner**
                        **Shares
                            Beneficially Owned**
                        **Percentage
                            of Class****Officers
                            and Directors**Ronald
                            W. Pickett, President and CEO
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        2,699,699
                        5.8%Frank
                            T. Matarazzo, President and CEO, MST
                          259-263
                            Goffle Road
                          Hawthorne,
                            NJ 07506
                        400,000(1)
                        0.9%John
                            S. Cramp, Chief Operating Officer
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        75,000(2)
                        0.2%E.
                            Barry Smith, Chief Financial Officer
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        441,000(3)
                        0.9%Stephen
                            L. Sadle, Senior Vice President
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        4,389,514(4)
                        9.3%James
                            Landry, Chief Technology Officer
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        434,200(5)
                        0.9%Warren
                            V. Musser, Chairman
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        2,237,027(7)
                        4.6%David
                            Grimes, Former Director
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        1,575,405(8)
                        3.3%Thomas
                            C. Lynch, Director
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        100,000(9)
                        0.2%Dr.
                            Thomas M. Hall, Director
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        667,790(10)
                        1.4%James
                            “Lou” L. Peeler, Director
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        84,400(11)
                        0.2%Seth
                            D. Blumenfeld
                          20374
                            Seneca Meadows Parkway
                          Germantown,
                            MD 20876
                        40,000
                            (12)
                        0.1%All
                            Directors and Executive Officers as a Group
                        13,642,035
                        26.4%
 
 33
 Table
                      of Contents
 
 (1)
                        Includes
                            400,000 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 1,200,000 shares of the Company’s common stock are held in
                            escrow,issuable upon the achievement of certain performance
                            targets and
                            excluded from this table.
 (2)
                        Includes
                            options exerciseable within 60 days to purchase 75,000
                            shares of the
                            Company’s common stock at $3.04 per
                            share.
 (3)
                        Includes
                            options exerciseable within 60 days to purchase 441,000
                            shares of the
                            Company’s common stock at $1.00 per
                            share.
 (4)
                        Includes
                            options exerciseable within 60 days to purchase 900,000
                            shares of the
                            Company’s common stock at $1.00 per
                            share.
 (5)
                        Includes
                            options exerciseable within 60 days to purchase 250,000
                            and 100,000 shares
                            of the Company’s common stock at $1.00 and $3.45 per share,
                            respectively.
 (6)
                        Includes
                            options exerciseable within 60 days to purchase 500,000
                            shares of the
                            Company’s common stock at $1.00 per
                            share.
 (7)
                        Includes
                            options exerciseable within 60 days to purchase 2,000,000
                            shares of the
                            Company’s common stock at $1.00 per
                            share.
 (8)
                        Includes
                            options exerciseable within 60 days to purchase 825,000
                            shares of the
                            Company’s common stock at $1.00 per share. The remaining 75,000
                            unvested
                            options were cancelled.
 (9)
                        Includes
                            options exerciseable 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.
 (10)
                        Includes
                            options exerciseable within 60 days to purchase 80,000
                            shares of the
                            Company’s common stock at $3.45 per
                            share.
 (11)
                        Includes
                            options exerciseable within 60 days to purchase 80,000
                            shares of the
                            Company’s common stock at $3.45 per
                            share.
 (12)
                        Includes
                            10,000 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.**
 
 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 of The
                  Musser Group,
                  which is owned by Mr. Musser’s wife. For the years ended December 31, 2005, 2004
                  and 2003, the Company paid and expensed $100,000, $100,000 and
                  $33,333,
                  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.
 
 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.
 
 **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, 2005 and 2004 Additionally, the
                  Company incurred
                  approximately $200,000 associated with its Sarbanes-Oxley compliance
                  review.
 **December
                              31, 2005**
                          
                          **December
                              31, 2004**1.
                              Audit Fees
                          
                          $
                          119,090
                          
                          $
                          63,8752.
                              Audit Related Fees
                          
                          
                          62,825
                          
                          
                          23,9003.
                              Tax Fees
                          
                          
                          1,175
                          
                          
                          5,0004.
                              All Other Fees
                          
                          
                          --
                          
                          
                          --Total
                              Fees
                          
                          $
                          183,090
                          
                          $
                          92,775
 
 34
 Table
                        of Contents
 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, 2005, were approved by the Company’s audit
                    committee.
 
 **PART
                    IV**
 
 **ITEM
                    15.**  **EXHIBITS
                    AND FINANCIAL STATEMENT SCHEDULES.**
 
 The
                    following table sets forth selected unaudited quarterly information
                    for the
                    Company’s year-ended December 31, 2005 and 2004.
 **QUARTERLY
                                FINANCIAL DATA****(unaudited)**
 
 **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
                            )**March
                                31, 2004**
                            
                            
                            **June
                                30, 2004**
                            
                            
                            **September
                                30, 2004**
                            
                            
                            **December
                                31, 2004**Net
                                Revenue
                            
                            $
                            140,099
                            
                            $
                            271,903
                            
                            $
                            79,335
                            
                            $
                            207,315Gross
                                Profit
                            
                            $
                            5,695
                            
                            $
                            12,774
                            
                            $
                            10,462
                            
                            $
                            126,862Provision
                                for income taxes
                            
                            $
                            -
                            
                            $
                            -
                            
                            $
                            -
                            
                            $
                            -Net
                                loss per share -- basic
                            
                            $
                            (0.09
                            )
                            $
                            (0.11
                            )
                            $
                            (0.06
                            )
                            $
                            (0.06
                            )Net
                                loss per share -- diluted
                            
                            $
                            (0.09
                            )
                            $
                            (0.11
                            )
                            $
                            (0.06
                            )
                            $
                            (0.06
                            )
 
 
 35
 Table
                          of Contents
 The
                      following table sets forth selected unaudited valuation and
                      qualifying account
                      information for the Company’s year-ended December 31, 2005, 2004 and
                      2003.
  **SCHEDULE
                                  II- VALUATION AND QUALIFYING ACCOUNTS****(unaudited)****Balance**
                              
                              **CHARGED
                                  TO****BEGINNING
                                  OF**
                              
                              **COSTS
                                  AND**
                              
                              
                              
                              **BALANCE,
                                  END****DESCRIPTION**
                              **YEAR**
                              
                              **EXPENSES**
                              
                              **DEDUCTIONS**
                              
                              **OF
                                  YEAR****Allowance
                                  for doubtful accounts:**Year
                                  ended December 31,2005
                              $
                              13,000
                              
                              
                              $
                              39,710
                              
                              
                              $
                              (22,710)
                              
                              
                              $
                              30,0002004
                              
                              7,000
                              
                              
                              
                              30,637
                              
                              
                              
                              (24,637)
                              
                              
                              
                              13,0002003
                              
                              0
                              
                              
                              
                              7,000
                              
                              
                              
                              0
                              
                              
                              
                              7,000**Reserve
                                  for product returns**:Year
                                  ended December 31,2005
                              $
                              0
                              
                              
                              $
                              24,000
                              
                              
                              $
                              0
                              
                              
                              $
                              24,0002004
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —2003
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
    36
 Table
                            of Contents
 The
                        following exhibits are included herein or incorporated by
                        reference:
 
 **Exhibit
                                Number**
                              **Description
                                  Of Document**
 
 3.1
                              Articles
                                  of Incorporation of the Registrant (incorporated
                                  by reference to our Form
                                  8-K (No. 000-27305), filed on August 30, 2000 and
                                  our Form S-8 (No.
                                  333-47986), filed on October 16,
                                  2000)
 3.2
                              Bylaws
                                  of the Registrant (incorporated by reference to
                                  our Registration Statement
                                  on Form S-1 (No. 333-108307), filed on August 28,
                                  2003)
 4.1
                              Form
                                  of Series A Convertible Debenture (incorporated
                                  by reference to our Form
                                  10-KSB (No. 000-27305), filed on March 31, 2003)
 4.2
                              Form
                                  of Series A Non-Detachable Warrant (incorporated
                                  by reference to our Form
                                  10- KSB (No. 000-27305), filed on March 31, 2003)
 4.3
                              Form
                                  of Series B Convertible Debenture (incorporated
                                  by reference to our Form
                                  10-KSB (No. 000-27305), filed on March 31, 2003)
 4.4
                              Form
                                  of Series B Non-Detachable Warrant (incorporated
                                  by reference to our Form
                                  10- KSB (No. 000-27305), filed on March 31, 2003)
 4.5
                              Form
                                  of Senior Note (incorporated by reference to our
                                  Registration Statement on
                                  Form S-1 (No. 333-108307), filed on August 28,
                                  2003)
 4.6
                              Form
                                  of Non-Detachable Senior Note Warrant (incorporated
                                  by reference to our
                                  Registration Statement on Form S-1 (No. 333-108307),
                                  filed on August 28,
                                  2003)
 10.1
                              Amended
                                  and Restated Telkonet, Inc. Incentive Stock Option
                                  Plan (incorporated by
                                  reference to our Registration Statement on Form
                                  S-8 (No. 333-412), filed
                                  on April 17, 2002)
 10.2
                              Employment
                                  Agreement by and between Telkonet, Inc. and Stephen
                                  L. Sadle, dated as of
                                  January 18, 2003 (incorporated by reference to
                                  our Registration Statement
                                  on Form S-1 (No. 333-108307), filed on August 28,
                                  2003
 10.3
                              Employment
                                  Agreement by and between Telkonet, Inc. and Robert
                                  P. Crabb, dated as of
                                  January 18, 2003 (incorporated by reference to
                                  our Registration Statement
                                  on Form S-1 (No. 333-108307), filed on August 28,
                                  2003)
 10.4
                              Employment
                                  Agreement by and between Telkonet, Inc. and Ronald
                                  W. Pickett, dated as of
                                  January 30, 2003 (incorporated by reference to
                                  our Registration Statement
                                  on Form S-1 (No. 333-108307), filed on August 28,
                                  2003)
 10.5
                              Employment
                                  Agreement by and between Telkonet, Inc. and E.
                                  Barry Smith, dated as of
                                  February 17, 2003 (incorporated by reference to
                                  our Registration Statement
                                  on Form S-1 (No. 333-108307), filed on August 28,
                                  2003)
 10.6
                              Employment
                                  Agreement by and between Telkonet, Inc. and Frank
                                  T Matarazzo, dated as of
                                  February 1, 2006
 10.7
                              Professional
                                  Services Agreement by and between Telkonet, Inc.
                                  and Seth D. Blumethel,
                                  dated July 1, 2005 (incorporated by reference to
                                  our Form 10-Q (No.
                                  000-27305), filed on November 9,
                                  2005.
 10.8
                              MST
                                  Stock Purchase Agreement and Amendment (incorporated
                                  by reference to our
                                  8-K filed on February 2, 2006)(No.001-31972)
 14
                              Code
                                  of Ethics (incorporated by reference to our Form
                                  10-KSB (No. 001-31972),
                                  filed on March 30, 2004).
 21
                              Telkonet,
                                  Inc. Subsidiaries
 23
                              
                              Consent
                                  of Registered Independent Certified Public
                                  Accountants
 24
                              Power
                                  of Attorney (incorporated by reference to our Registration
                                  Statement on
                                  Form S-1 (No. 333-108307), filed on August 28,
                                  2003)
 31.1
                              Certification
                                  Pursuant to Section 302 of the Sarbanes-Oxley Act
                                  of 2002 of Ronald W.
                                  Pickett
 31.2
                              Certification
                                  Pursuant to Section 302 of the Sarbanes-Oxley Act
                                  of 2002 of E. Barry
                                  Smith
 32.1
                              Certification
                                  of Ronald W. Pickett pursuant to 18 U.S.C. Section
                                  1350, as adopted
                                  pursuant to Section 906 of the Sarbanes-Oxley Act
                                  of 2002
 32.2
                              Certification
                                  of E. Barry Smith pursuant to 18 U.S.C. Section
                                  1350, as adopted pursuant
                                  to Section 906 of the Sarbanes-Oxley Act of
                                  2002
 
 37
 Table
                            of Contents
 **SIGNATURES**
 
 In
                        accordance with 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. Pickett
 Ronald
                        W.
                        Pickett
 Chief
                        Executive Officer
 
 Pursuant
                        to the requirements of the Securities Exchange Act of 1934,
                        this report has been
                        signed below by the following persons on behalf of the registrant
                        and in the
                        capacities and on the dates indicated.
 
 Name
                              Position
                              Date/s/
                                  Warren V. Musser
                                Warren
                                  V. Musser
                              Chairman
                                  of the Board
                              March
                                  16, 2006/s/
                                  Ronald W. Pickett
                                Ronald
                                  W. Pickett
                              Chief
                                  Executive Officer &
                                Director
                              March
                                  16, 2006/s/
                                  E. Barry Smith
                                E.
                                  Barry Smith
                              Chief
                                  Financial Officer
                              March
                                  16, 2006/s/
                                  James Landry
                                James
                                  Landry
                              Chief
                                  Technology Officer
                              March
                                  16, 2006/s/
                                  Stephen L. Sadle
                                Stephen
                                  L. Sadle
                              Senior
                                  Vice President &
                                Director
                              March
                                  16, 2006/s/
                                  Dr. Thomas M. Hall
                                Dr.
                                  Thomas M. Hall
                              Director
                              March
                                  16, 2006/s/
                                  James L. Peeler
                                James
                                  L. Peeler
                              Director
                              March
                                  16, 2006/s/
                                  Seth D. Blumenfeld
                                Seth
                                  D. Blumenfeld
                              Director
                              March
                                  16, 2006/s/
                                  Thomas C. Lynch
                                Thomas
                                  C. Lynch
                              Director
                              March
                                  16, 2006
 
 
 
 38
 Table
                            of Contents
 **SECURITIES
                          AND EXCHANGE COMMISSION**
 
 **WASHINGTON,
                          D.C. 20549**
 
 
 
 **FINANCIAL
                          STATEMENTS AND SCHEDULES**
 
 **DECEMBER
                          31, 2005 AND 2004**
 
 
 
 **FORMING
                          A PART OF ANNUAL REPORT**
 **PURSUANT
                          TO THE SECURITIES EXCHANGE ACT OF 1934**
 
 
 **TELKONET,
                          INC.**
    F-1
 Table
                              of Contents
  **TELKONET,
                          INC.**
 
 **Index
                          to Financial Statements**
 
  Report
                                      of Independent Registered Certified Public
                                      Accounting Firm
                                  F-3Consolidated
                                      Balance Sheets at December 31, 2005 and 2004
                                  F-4Consolidated
                                      Statements of Losses for the Years ended December
                                      31, 2005, 2004 and
                                      2003
                                  F-5Consolidated
                                      Statements of Stockholders’ Equity for the Years ended December 31, 2005,
                                      2004 and 2003
                                  F-6
                                      - F-8Consolidated
                                      Statements of Cash Flows for the Years ended
                                      December 31, 2005, 2004 and
                                      2003
                                  F-9
                                      - F-10Notes
                                      to Consolidated Financial Statements
                                  F-11
                                      - F-32
   F-2
 Table
                              of Contents
  **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
                            wholly-owned subsidiary (the "Company") as of December
                            31, 2005 and 2004 and the
                            related consolidated statements of losses, stockholders'
                            equity, and cash flows
                            for each of the three years in the period ended December 31, 2005. These
                            financial statements are the responsibility of the Company's
                            management. Our
                            responsibility is to express an opinion on these financial
                            statements based upon
                            our audit.
 
 We
                            conducted our audits in accordance with standards of
                            the Public Company
                            Accounting Oversight Board (United States of America).
                            Those standards require
                            that we plan and perform the audit to obtain reasonable
                            assurance about whether
                            the financial statements are free of material misstatements.
                            An audit includes
                            examining, on a test basis, evidence supporting the amounts
                            and disclosures in
                            the financial statements. An audit also includes assessing
                            the accounting
                            principles used and significant estimates made by management,
                            as well as
                            evaluating the overall financial statement presentation.
                            We believe our audits
                            provide a reasonable basis for our opinion.
 
 In
                            our
                            opinion, the consolidated financial statements referred
                            to above present fairly,
                            in all material respects, the financial position of Telkonet,
                            Inc. and its
                            wholly-owned subsidiary as of December 31, 2005 and 2004,
                            and the results of its
                            operations and its cash flows for each of the three years
                            in the period ended
                            December 31, 2005, in conformity with accounting principles generally
                            accepted in the United States of America.
  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, 2005, 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 February 2, 2006 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
 February
                            2, 2006
  F-3
 Table
                              of Contents
 **TELKONET,
                            INC.**
 **CONSOLIDATED
                            BALANCE SHEETS**
 **DECEMBER
                            31, 2005 AND 2004**
 **ASSETS**
                                    
                                    2005
                                    
                                    2004**Current
                                        Assets:**Cash
                                        and cash equivalents
                                    
                                    $
                                    8,422,079
                                    
                                    $
                                    11,838,702Restricted
                                        Certificate of Deposit
                                    
                                    
                                    10,000,000
                                    
                                    
                                    --Accounts
                                        receivable, net of allowance for doubtful
                                        accounts of $30,000 and $13,000
                                        at
                                      December
                                        31, 2005 and 2004, respectively
                                    
                                    
                                    119,191
                                    
                                    
                                    63,147Inventories
                                        (Note B)
                                    
                                    
                                    1,475,806
                                    
                                    
                                    1,873,718Prepaid
                                        expenses and deposits
                                    
                                    
                                    360,880
                                    
                                    
                                    124,852Total
                                        current assets
                                    
                                    
                                    20,377,956
                                    
                                    
                                    13,900,419**Property
                                        and equipment, at cost**(Note C):Furniture
                                        and equipment
                                    
                                    
                                    1,041,137
                                    
                                    
                                    704,689Less:
                                        accumulated depreciation
                                    
                                    
                                    323,667
                                    
                                    
                                    137,739Total
                                        property and equipment, net
                                    
                                    
                                    717,470
                                    
                                    
                                    566,950**Equipment
                                        under operating leases, at cost**(Note D):Telecommunications
                                        and related equipment, at cost
                                    
                                    
                                    789,099
                                    
                                    
                                    525,664Less:
                                        accumulated depreciation
                                    
                                    
                                    124,669
                                    
                                    
                                    75,329Total
                                        equipment under operating leases, net
                                    
                                    
                                    664,430
                                    
                                    
                                    450,335**Other
                                        assets:**Long-term
                                        investments (Note E)
                                    
                                    
                                    231,000
                                    
                                    
                                    500,000Financing
                                        Costs, net of accumulated amortization of
                                        $73,499 and $0 at December 31,
                                        2005
                                      and
                                        2004, respectively (Note F)
                                    
                                    
                                    1,145,911
                                    
                                    
                                    --Deposits
                                    
                                    
                                    154,216
                                    
                                    
                                    76,288Total
                                        other assets
                                    
                                    
                                    1,531,127
                                    
                                    
                                    576,288**Total
                                        Assets**
                                    
                                    $
                                    23,290,983
                                    
                                    $
                                    15,493,992**LIABILITIES
                                        AND STOCKHOLDERS' EQUITY****Current
                                        liabilities:**Accounts
                                        payable and accrued liabilities (Note M)
                                    
                                    $
                                    1,821,872
                                    
                                    $
                                    1,195,924Customer
                                        deposits held
                                    
                                    
                                    86,257
                                    
                                    
                                    32,975Senior
                                        notes payable, current portion (Note G)
                                    
                                    
                                    100,000
                                    
                                    
                                    --Convertible
                                        debentures, current portion (Note F)
                                    
                                    
                                    6,250,000
                                    
                                    
                                    --Deferred
                                        revenue
                                    
                                    
                                    59,020
                                    
                                    
                                    --Total
                                        current liabilities
                                    
                                    
                                    8,317,149
                                    
                                    
                                    1,228,899**Long-term
                                        liabilities:**Convertible
                                        debentures, net of discounts (Note F)
                                    
                                    
                                    9,616,521
                                    
                                    
                                    137,910Senior
                                        notes payable (Note G)
                                    
                                    
                                    --
                                    
                                    
                                    450,000Deferred
                                        lease liability
                                    
                                    
                                    42,317
                                    
                                    
                                    30,911Total
                                        long-term liabilities
                                    
                                    
                                    9,658,838
                                    
                                    
                                    618,821**Commitments
                                        and contingencies**(Note N)
                                    
                                    
                                    --
                                    
                                    
                                    --**Stockholders’
                                        equity**(Note H)Preferred
                                        stock, par value $.001 per share; 15,000,000
                                        shares authorized; none
                                        issued
                                      and
                                        outstanding at December 31, 2005 and 2004
                                    
                                    
                                    --
                                    
                                    
                                    --Common
                                        stock, par value $.001 per share; 100,000,000
                                        shares authorized;
                                        45,765,171
                                      and
                                        44,335,989 shares issued and outstanding
                                        at December 31, 2005 and 2004,
                                        respectively
                                    
                                    
                                    45,765
                                    
                                    
                                    44,336Additional
                                        paid-in-capital
                                    
                                    
                                    48,256,784
                                    
                                    
                                    40,811,208Accumulated
                                        deficit
                                    
                                    
                                    (42,987,553
                                    )
                                    
                                    (27,209,272
                                    )Stockholders’
                                        equity
                                    
                                    
                                    5,314,996
                                    
                                    
                                    13,646,272**Total
                                        Liabilities and Stockholders’ Equity**
                                    
                                    $
                                    23,290,983
                                    
                                    $
                                    15,493,992
  See
                              accompanying notes to consolidated financial statements
 F-4
 Table
                                of Contents
 **TELKONET,
                          INC.**
 **CONSOLIDATED
                            STATEMENTS OF LOSSES**
 **FOR
                            THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
  2005
                                    
                                    2004
                                    
                                    2003Product
                                        Revenues, net
                                    
                                    $
                                    1,769,727
                                    
                                    $
                                    477,555
                                    
                                    $
                                    88,403Rental
                                        Revenue, net
                                    
                                    
                                    718,596
                                    
                                    
                                    221,097
                                    
                                    
                                    5,257Total
                                        Revenue
                                    
                                    
                                    2,488,323
                                    
                                    
                                    698,652
                                    
                                    
                                    93,660Product
                                    
                                    
                                    1,183,574
                                    
                                    
                                    459,225
                                    
                                    
                                    101,171Rental
                                    
                                    
                                    533,605
                                    
                                    
                                    83,634
                                    
                                    
                                    3,485Total
                                        Cost of Sales
                                    
                                    
                                    1,717,179
                                    
                                    
                                    542,859
                                    
                                    
                                    104,656Gross
                                        Profit (Loss)
                                    
                                    
                                    771,144
                                    
                                    
                                    155,793
                                    
                                    
                                    (10,996
                                    )Operating
                                        Expenses:Research
                                        and Development (Note A)
                                    
                                    
                                    2,096,104
                                    
                                    
                                    1,852,309
                                    
                                    
                                    1,370,785Selling,
                                        General and Administrative
                                    
                                    
                                    12,041,661
                                    
                                    
                                    7,663,369
                                    
                                    
                                    4,089,172Consulting
                                        Fees (Note H)
                                    
                                    
                                    -
                                    
                                    
                                    2,500,000
                                    
                                    
                                    -Impairment
                                        write-down in investment in affiliate (Note
                                        E)
                                    
                                    
                                    400,000
                                    
                                    
                                    -
                                    
                                    
                                    -Non-Employee
                                        Stock Options and Warrants (Note I)
                                    
                                    
                                    1,354,219
                                    
                                    
                                    1,180,875
                                    
                                    
                                    982,390Depreciation
                                        and Amortization
                                    
                                    
                                    185,928
                                    
                                    
                                    71,514
                                    
                                    
                                    110,988Total
                                        Operating Expense
                                    
                                    
                                    16,077,912
                                    
                                    
                                    13,268,067
                                    
                                    
                                    6,553,335Loss
                                        from Operations
                                    
                                    
                                    (15,306,768
                                    )
                                    
                                    (13,112,274
                                    )
                                    
                                    (6,564,331
                                    )Other
                                        Income (Expense):Other
                                        Income (Note F)
                                    
                                    
                                    8,600
                                    
                                    
                                    --
                                    
                                    
                                    --Interest
                                        Income
                                    
                                    
                                    166,070
                                    
                                    
                                    128,938
                                    
                                    
                                    20,297Interest
                                        Expense
                                    
                                    
                                    (
                                        646,183
                                    )
                                    
                                    (109,324
                                    )
                                    
                                    (1,113,902
                                    )Total
                                        Other Income (Expenses)
                                    
                                    
                                    (471,513
                                    )
                                    
                                    19,614
                                    
                                    
                                    (1,093,605
                                    )Loss
                                        Before Provision for Income Taxes
                                    
                                    
                                    (15,778,281
                                    )
                                    
                                    (13,092,660
                                    )
                                    
                                    (7,657,936
                                    )Provision
                                        for Income Tax (Note K)
                                    
                                    
                                    --
                                    
                                    
                                    --
                                    
                                    
                                    --Net
                                        Loss
                                    
                                    $
                                    (15,778,281
                                    )
                                    $
                                    (13,092,660
                                    )
                                    $
                                    (
                                        7,657,936
                                    )Loss
                                        per common share (basic and assuming dilution)
                                        (Note L)
                                    
                                    $
                                    (0.35
                                    )
                                    $
                                    (0.32
                                    )
                                    $
                                    (0.37
                                    )Weighted
                                        average common shares outstanding
                                    
                                    
                                    44,743,223
                                    
                                    
                                    41,384,074
                                    
                                    
                                    20,702,482
  
 See
                            accompanying notes to consolidated financial statements
  F-5
 Table
                              of Contents
 **TELKONET,
                          INC.**
 **CONSOLIDATED
                          STATEMENTS OF STOCKHOLDERS’ EQUITY**
 **FOR
                          THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
  Preferred
                                      Shares
                                  
                                  Preferred
                                      Stock
                                    Amount
                                  
                                  Common
                                      Shares
                                  
                                  Common
                                      Stock Amount
                                  
                                  Additional
                                      Paid in Capital
                                  
                                  Accumulated
                                      Deficit
                                  
                                  TotalBalance
                                      at January 1, 2003
                                  
                                  
                                  **-**
                                  
                                  **$**
                                  **-**
                                  
                                  
                                  15,721,131
                                  
                                  $
                                  15,721
                                  
                                  $
                                  4,916,433
                                  
                                  $
                                  (6,458,676
                                  )
                                  $
                                  (1,526,522
                                  )Shares
                                      issued for cash at $2.00 per share, net of
                                      costs
                                    and
                                      fees
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  333
                                  
                                  
                                  -
                                  
                                  
                                  666
                                  
                                  
                                  -
                                  
                                  
                                  666Shares
                                      issued for employee stock options exercised
                                      at
                                    approximately
                                      $1.01 per share
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  109,333
                                  
                                  
                                  109
                                  
                                  
                                  110,724
                                  
                                  
                                  -
                                  
                                  
                                  110,833Shares
                                      issued to a director for employee stock options
                                    exercised
                                      at $.50 per share
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  315,000
                                  
                                  
                                  315
                                  
                                  
                                  157,185
                                  
                                  
                                  
                                  
                                  
                                  157,500Shares
                                      issued in exchange for non-employee options
                                    exercised
                                      at $1.00 per share
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  187,499
                                  
                                  
                                  189
                                  
                                  
                                  187,311
                                  
                                  
                                  -
                                  
                                  
                                  187,500Shares
                                      issued to consultants in exchange for services
                                    at
                                      approximately $2.13 per share
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  149,498
                                  
                                  
                                  150
                                  
                                  
                                  318,955
                                  
                                  
                                  -
                                  
                                  
                                  319,105Shares
                                      issued to noteholders for warrants exercised
                                    at
                                      $1.00 per share
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  3,599,250
                                  
                                  
                                  3,599
                                  
                                  
                                  3,595,651
                                  
                                  
                                  -
                                  
                                  
                                  3,599,250Shares
                                      issued to noteholders for warrants exercised
                                    at
                                      $.50 per share
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  500,000
                                  
                                  
                                  500
                                  
                                  
                                  249,500
                                  
                                  
                                  -
                                  
                                  
                                  250,000Shares
                                      issued to noteholders for cashless warrants
                                    exercised
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  317,239
                                  
                                  
                                  317
                                  
                                  
                                  (317
                                  )
                                  
                                  -
                                  
                                  
                                  -Shares
                                      issued in exchange for convertible debentures
                                    (Note
                                      F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  7,217,836
                                  
                                  
                                  7,218
                                  
                                  
                                  3,799,882
                                  
                                  
                                  -
                                  
                                  
                                  3,807,100Shares
                                      issued in exchange for accrued interest on
                                    convertible
                                      debentures (Note F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  525,403
                                  
                                  
                                  525
                                  
                                  
                                  280,209
                                  
                                  
                                  -
                                  
                                  
                                  280,734Shares
                                      issued for warrants exercised at $1.00, in
                                    exchange
                                      for Senior Notes (Note G)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  2,011,000
                                  
                                  
                                  2,011
                                  
                                  
                                  2,008,989
                                  
                                  
                                  -
                                  
                                  
                                  2,011,000Write-off
                                      of beneficial conversion features and warrants
                                    attached
                                      to convertible debentures in connection with
                                    conversion
                                      of Debenture-1 and Series B debentures (Note
                                      F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  (2,342,949
                                  )
                                  
                                  -
                                  
                                  
                                  (2,342,949
                                  )Shares
                                      issued to an employee in exchange for services
                                    at
                                      approximately $1.79 per share
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  36,000
                                  
                                  
                                  36
                                  
                                  
                                  64,433
                                  
                                  
                                  -
                                  
                                  
                                  64,469Stock
                                      options and warrants granted to consultants
                                      in
                                    exchange
                                      for services rendered (Note I)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  1,013,262
                                  
                                  
                                  -
                                  
                                  
                                  1,013,262Stock
                                      based compensation for the issuance of warrants
                                    in
                                      exchange for financing costs (Note I)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  87,217
                                  
                                  
                                  -
                                  
                                  
                                  87,217Beneficial
                                      conversion feature of convertible debentures
                                    (Note
                                      F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  1,761,675
                                  
                                  
                                  -
                                  
                                  
                                  1,761,675Value
                                      of warrants attached to convertible debentures
                                    (Note
                                      F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  265,425
                                  
                                  
                                  -
                                  
                                  
                                  265,425Net
                                      loss
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  (7,657,936
                                  )
                                  
                                  (7,657,936
                                  )****Balance
                                      at December 31, 2003****
                                  
                                  
                                  -
                                  
                                  $
                                  -
                                  
                                  
                                  30,689,522
                                  
                                  $
                                  30,690
                                  
                                  $
                                  16,474,251
                                  
                                  $
                                  (14,116,612
                                  )
                                  $
                                  2,388,329
   F-6
 Table
                              of Contents
 **TELKONET,
                            INC.**
 **CONSOLIDATED
                            STATEMENTS OF STOCKHOLDERS’ EQUITY**
 **FOR
                            THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
  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 G)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  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 (Note F)
                                  
                                  
                                  **-**
                                  
                                  
                                  -
                                  
                                  
                                  124,000
                                  
                                  
                                  124
                                  
                                  
                                  61,876
                                  
                                  
                                  -
                                  
                                  
                                  62,000Shares
                                      issued in exchange for convertible debentures
                                      at
                                    $0.55
                                      per share (Note F)
                                  
                                  
                                  **-**
                                  
                                  
                                  -
                                  
                                  
                                  200,000
                                  
                                  
                                  200
                                  
                                  
                                  109,800
                                  
                                  
                                  -
                                  
                                  
                                  110,000Shares
                                      issued in exchange for accrued interest on
                                      convertible
                                    debentures
                                      (Note F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  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 (Note
                                      F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  (134,666
                                  )
                                  
                                  -
                                  
                                  
                                  (134,666
                                  )Stock
                                      options and warrants granted to consultants
                                      in
                                    exchange
                                      for services rendered (Note I)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  1,180,875
                                  
                                  
                                  -
                                  
                                  
                                  1,180,875Net
                                      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-7
 Table
                              of Contents
 **TELKONET,
                          INC.**
 **CONSOLIDATED
                          STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)**
 **FOR
                          THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
 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 (Note F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  363,636
                                  
                                  
                                  364
                                  
                                  
                                  199,636
                                  
                                  
                                  -
                                  
                                  
                                  200,000Shares
                                      issued in exchange for interest expense on
                                      convertible
                                    debentures
                                      (Note F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  51,144
                                  
                                  
                                  51
                                  
                                  
                                  28,080
                                  
                                  
                                  -
                                  
                                  
                                  28,131Beneficial
                                      conversion feature of convertible debentures
                                      (Note F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  1,479,300
                                  
                                  
                                  -
                                  
                                  
                                  1,479,300Value
                                      of warrants attached to convertible debentures
                                      (Note F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  2,910,700
                                  
                                  
                                  -
                                  
                                  
                                  2,910,700Stock
                                      options and warrants granted to consultants
                                      in exchange
                                    for
                                      services rendered (Note I)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  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-8
 Table
                              of Contents
 **TELKONET,
                          INC.**
 **CONSOLIDATED
                            STATEMENTS OF CASH FLOWS**
 **FOR
                            THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
 2005
                                  
                                  2004
                                  
                                  2003**Increase
                                      (Decrease) In Cash and Equivalents****Cash
                                      Flows from Operating Activities:**Net
                                      loss from operating activities
                                  
                                  $
                                  (15,778,281
                                  )
                                  $
                                  (13,092,660
                                  )
                                  $
                                  (7,657,936
                                  )Adjustments
                                      to reconcile net loss from operations to cash
                                      used in operating
                                    activities:Amortization
                                      of debt discount - beneficial conversion feature
                                      of convertible
                                    debentures
                                      (Note F)
                                  
                                  
                                  138,406
                                  
                                  
                                  21,888
                                  
                                  
                                  655,261Amortization
                                      of debt discount - value of warrants attached
                                      to convertible
                                    debentures
                                      (Note F)
                                  
                                  
                                  198,805
                                  
                                  
                                  10,152
                                  
                                  
                                  89,434Amortization
                                      of financing costs
                                  
                                  
                                  73,499
                                  
                                  
                                  -
                                  
                                  
                                  -Other
                                      income in connection with derivative warrant
                                      liabilities (Note
                                      F)
                                  
                                  
                                  (8,600
                                  )
                                  
                                  -
                                  
                                  
                                  -Stock
                                      options and warrants issued in exchange for
                                      services (Note
                                      I)
                                  
                                  
                                  1,354,219
                                  
                                  
                                  1,180,875
                                  
                                  
                                  1,013,262Common
                                      stock issued in exchange for services rendered
                                      (Note H)
                                  
                                  
                                  300,117
                                  
                                  
                                  304,094
                                  
                                  
                                  383,574Common
                                      stock issued in exchange for conversion of
                                      interest (Note
                                      F)
                                  
                                  
                                  28,131
                                  
                                  
                                  23,276
                                  
                                  
                                  280,735Common
                                      stock issued in exchange for consulting fees
                                      (Note H)
                                  
                                  
                                  -
                                  
                                  
                                  2,500,000
                                  
                                  
                                  -Write-off
                                      of financing costs in connection with conversion
                                      of convertible
                                    debentures
                                      (Note F)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  204,749Depreciation,
                                      including equipment under operating leases
                                  
                                  
                                  430,104
                                  
                                  
                                  143,358
                                  
                                  
                                  110,988Impairment
                                      write-down in investment in Amperion (Note
                                      E)
                                  
                                  
                                  400,000
                                  
                                  
                                  -
                                  
                                  
                                  -Increase
                                      / decrease in:Accounts
                                      receivable, trade and other
                                  
                                  
                                  (56,044
                                  )
                                  
                                  (4,950
                                  )
                                  
                                  (56,646
                                  )Inventory
                                  
                                  
                                  397,912
                                  
                                  
                                  (1,265,202
                                  )
                                  
                                  (568,726
                                  )Prepaid
                                      expenses and deposits
                                  
                                  
                                  (313,956
                                  )
                                  
                                  (23,150
                                  )
                                  
                                  (173,366
                                  )Deferred
                                      lease liability
                                  
                                  
                                  11,406
                                  
                                  
                                  30,911
                                  
                                  
                                  -Deferred
                                      revenue
                                  
                                  
                                  59,020
                                  
                                  
                                  -
                                  
                                  
                                  -Accounts
                                      payable, accrued expenses and customer deposits,
                                      net
                                  
                                  
                                  679,230
                                  
                                  
                                  587,848
                                  
                                  
                                  122,186**Net
                                      Cash Used In Operating Activities**
                                  
                                  
                                  (12,086,032
                                  )
                                  
                                  (9,583,560
                                  )
                                  
                                  (5,596,485
                                  )**Cash
                                      Flows From Investing Activities:**Costs
                                      of equipment under operating leases
                                  
                                  
                                  (458,271
                                  )
                                  
                                  (491,776
                                  )
                                  
                                  (33,888
                                  )Purchase
                                      of property and equipment, net
                                  
                                  
                                  (336,448
                                  )
                                  
                                  (514,903
                                  )
                                  
                                  (103,033
                                  )Investment
                                      in Restricted Certificate of Deposit
                                  
                                  
                                  (10,000,000
                                  )
                                  
                                  -
                                  
                                  
                                  -Investment
                                      in Amperion and BPL Global (Note E)
                                  
                                  
                                  (131,000
                                  )
                                  
                                  (500,000
                                  )
                                  
                                  -**Net
                                      Cash Used In Investing Activities**
                                  
                                  
                                  (10,925,719
                                  )
                                  
                                  (1,506,679
                                  )
                                  
                                  (136,921
                                  )**Cash
                                      Flows From Financing Activities:**Proceeds
                                      from sale of common stock, net of costs and
                                      fees
                                  
                                  
                                  -
                                  
                                  
                                  12,726,843
                                  
                                  
                                  666Repayments
                                      of stockholder advances
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  (122,830
                                  )Proceeds
                                      from issuance of convertible debentures, net
                                      of costs and fees (Note
                                      F)
                                  
                                  
                                  18,780,590
                                  
                                  
                                  -
                                  
                                  
                                  2,027,100Repayment
                                      of convertible debenture
                                  
                                  
                                  (10,000
                                  )
                                  
                                  -
                                  
                                  
                                  -Proceeds
                                      from issuance of senior notes, net of costs
                                      and fees (Note
                                      G)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  5,000,000Repayment
                                      of senior notes
                                  
                                  
                                  (350,000
                                  )
                                  
                                  -
                                  
                                  
                                  -Proceeds
                                      from exercise of warrants (Note H)
                                  
                                  
                                  321,900
                                  
                                  
                                  4,127,950
                                  
                                  
                                  3,999,250Proceeds
                                      from exercise of employee and non-employee
                                      stock options and
                                      warrants
                                    (Note
                                      H)
                                  
                                  
                                  852,638
                                  
                                  
                                  911,230
                                  
                                  
                                  298,311Repayments
                                      of loans
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  (310,000
                                  )Repayments
                                      of capital leases
                                  
                                  
                                  -
                                  
                                  
                                  (15,000
                                  )
                                  
                                  -**Net
                                      Cash Provided By Financing Activities**
                                  
                                  
                                  19,595,128
                                  
                                  
                                  17,751,023
                                  
                                  
                                  10,892,497**Net
                                      Increase (Decrease) In Cash and Equivalents**
                                  
                                  
                                  (3,416,623
                                  )
                                  
                                  6,660,784
                                  
                                  
                                  5,159,091Cash
                                      and cash equivalents at the beginning of the
                                      year
                                  
                                  
                                  11,838,702
                                  
                                  
                                  5,177,918
                                  
                                  
                                  18,827Cash
                                      and cash equivalents at the end of the year
                                  
                                  $
                                  8,422,079
                                  
                                  $
                                  11,838,702
                                  
                                  $
                                  5,177,918
  See
                            accompanying footnotes to consolidated financial statements
 F-9
 Table
                              of Contents
 **TELKONET,
                            INC.**
 **CONSOLIDATED
                            STATEMENTS OF CASH FLOWS (Continued)**
 **FOR
                            THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
  2005
                                    
                                    2004
                                    
                                    2003Supplemental
                                        Disclosures of Cash Flow Information:Cash
                                        transactions:Cash
                                        paid during the period for interest
                                    
                                    $
                                    40,645
                                    
                                    $
                                    100,608
                                    
                                    $
                                    135,879Income
                                        taxes paid
                                    
                                    
                                    -
                                    
                                    
                                    -
                                    
                                    
                                    -Non-cash
                                        transactions:Issuance
                                        of stock options and warrants in exchange
                                        for services rendered (Note
                                        H)
                                    
                                    
                                    1,354,219
                                    
                                    
                                    1,180,875
                                    
                                    
                                    1,013,262Issuance
                                        of stock warrants in exchange for financing
                                        costs (Note I)
                                    
                                    
                                    -
                                    
                                    
                                    -
                                    
                                    
                                    87,217Common
                                        stock issued for services rendered (Note
                                        H)
                                    
                                    
                                    300,117
                                    
                                    
                                    304,094
                                    
                                    
                                    383,574Common
                                        stock issued in exchange for interest (Note
                                        F and H)
                                    
                                    
                                    28,131
                                    
                                    
                                    23,276
                                    
                                    
                                    280,735Common
                                        stock issued in exchange for consulting services
                                        (Note H)
                                    
                                    
                                    -
                                    
                                    
                                    2,500,000
                                    
                                    
                                    -Common
                                        stock issued in exchange for Senior Note
                                        (Note G and H)
                                    
                                    
                                    -
                                    
                                    
                                    2,539,000
                                    
                                    
                                    2,011,000Common
                                        stock issued in exchange for conversion of
                                        convertible debenture (Note F
                                        and H)
                                    
                                    
                                    200,000
                                    
                                    
                                    172,000
                                    
                                    
                                    3,807,100Common
                                        stock issued in exchange for notes payable
                                        (Note H)
                                    
                                    
                                    -
                                    
                                    
                                    -
                                    
                                    
                                    7,500Write-off
                                        of beneficial conversion feature for conversion
                                        of debenture (Note
                                        F)
                                    
                                    
                                    -
                                    
                                    
                                    134,135
                                    
                                    
                                    2,046,479Write-off
                                        of value of warrants attached to debenture
                                        in connection with conversion
                                        (Note F)
                                    
                                    
                                    -
                                    
                                    
                                    531
                                    
                                    
                                    296,470Notes
                                        payable issued in connection with capital
                                        lease, net of repayments (Note
                                        N)
                                    
                                    
                                    -
                                    
                                    
                                    -
                                    
                                    
                                    15,000Impairment
                                        write-down in investment in affiliate (Note
                                        E)
                                    
                                    
                                    400,000
                                    
                                    
                                    -
                                    
                                    
                                    -Beneficial
                                        conversion feature on convertible debentures
                                        (Note F)
                                    
                                    
                                    1,479,300
                                    
                                    
                                    -
                                    
                                    
                                    1,761,675Value
                                        of warrants attached to convertible debentures
                                        (Note F)
                                    
                                    
                                    2,910,700
                                    
                                    
                                    -
                                    
                                    
                                    265,425
  See
                            accompanying notes to consolidated financial statements
  F-10
 Table
                                of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          A-SUMMARY OF ACCOUNTING POLICIES**
 
 A
                          summary
                          of the significant accounting policies applied in the preparation
                          of the
                          accompanying consolidated financial statements follows.
 
 Business
                          and Basis of Presentation
 
 Telkonet,
                          Inc. (the "Company"), formerly Comstock Coal Company, Inc.,
                          was formed on
                          November 3, 1999 under the laws of the state of Utah. The
                          Company was a
“development stage enterprise” (as defined by Statement of Financial Accounting
                          Standards No. 7) until December 31, 2003. The Company is
                          engaged in the business
                          of developing, producing and marketing proprietary equipment
                          enabling the
                          transmission of voice and data over electric utility lines.
 
 The
                          consolidated financial statements include the accounts
                          of the Company and its
                          wholly-owned subsidiary, Telkonet Communications, Inc.
                          Significant intercompany
                          transactions have been eliminated in consolidation.
 
 Concentrations
                          of Credit Risk
 
 Financial
                          instruments and related items, which potentially subject
                          the Company to
                          concentrations of credit risk, consist primarily of cash
                          and cash equivalents.
                          The Company places its cash and temporary cash investments
                          with credit quality
                          institutions. At times, such investments may be in excess
                          of the FDIC insurance
                          limit. The allowance for doubtful accounts was $30,000
                          and $13,000 at December
                          31, 2005 and December 31, 2004, 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
 
 Restricted
                          Certificate of Deposit at December 31, 2005 consists of a $10,000,000
                          certificate of deposit pledged as collateral for an irrevocable
                          letter of credit
                          agreement.  This letter of credit agreement is automatically renewable
                          annually as required in the $20,000,000 Convertible Senior
                          Notes loan
                          covenant.  (Note F).  The certificate of deposit provides for
                          approximately 4% interest payable at maturity.
 
 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 5 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. At
                          December 31, 2005, the company has determined that its
                          investment in Amperion
                          Inc. has been impaired based upon forecasted discounted
                          cash flow and has
                          written off 80%, or $400,000, of its investment based on
                          management assessment
                          (Note E).
 F-11
 Table
                              of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          A-SUMMARY OF ACCOUNTING POLICIES (Continued)**
 
 Inventories
 
 Inventories
                          consist primarily of Gateways, Extenders, iBridges and
                          Couplers which are the
                          significant components of the Telkonet solution. Cost is
                          determined by the
                          first-in, first-out method. (Note B).
 
 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 2005, 2004 and
                          2003, common stock
                          equivalents are not considered in the calculation of the
                          weighted average number
                          of common shares outstanding because they would be anti-dilutive,
                          thereby
                          decreasing the net loss per common share.
 
 Use
                          of
                          Estimates
 
 The
                          preparation of financial statements in conformity with
                          generally accepted
                          accounting principles requires management to make estimates
                          and assumptions that
                          affect certain reported amounts and disclosures. Accordingly,
                          actual results
                          could differ from those estimates.
 
 Revenue
                          Recognition
 
 For
                          revenue from product sales, the Company recognizes revenue
                          in accordance with
                          Staff Accounting Bulletin No. 104, *Revenue
                          Recognition* (“SAB104”), which superceded Staff Accounting Bulletin No. 101, *Revenue
                          Recognition in Financial Statements* (“SAB101”). SAB 101 requires that four basic criteria must be met
                          before revenue
                          can be recognized: (1) persuasive evidence of an arrangement
                          exists; (2)
                          delivery has occurred; (3) the selling price is fixed and
                          determinable; and (4)
                          collectibility is reasonably assured. Determination of
                          criteria (3) and (4) are
                          based on management’s judgments regarding the fixed nature of the selling prices
                          of the products delivered and the collectibility of those
                          amounts. Provisions
                          for discounts and rebates to customers, estimated returns
                          and allowances, and
                          other adjustments are provided for in the same period the
                          related sales are
                          recorded. The Company defers any revenue for which the
                          product has not been
                          delivered or is subject to refund until such time that
                          the Company and the
                          customer jointly determine that the product has been delivered
                          or no refund will
                          be required. SAB 104 incorporates Emerging Issues Task
                          Force 00-21 (“EITF
                          00-21”), *Multiple-Deliverable
                          Revenue Arrangements.* EITF
                          00-21 addresses accounting for arrangements that may involve
                          the delivery or
                          performance of multiple products, services and/or rights
                          to use assets.
 
 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
                          the first quarter
                          2006. The related equipment was charged to cost of sales
                          commensurate with the
                          associated revenue recognition (Note D and P).
  F-12
 Table
                              of Contents
 **TELKONET,
                            INC.**
 **NOTES
                            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                            31, 2005, 2004 AND 2003**
 
 **NOTE
                            A-SUMMARY OF ACCOUNTING POLICIES (Continued)**
 
 Guarantees
                            and Product Warranties
 
 FASB
                            Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
                            Guarantees, Including Indirect Guarantees of Indebtedness
                            of Others” (“FIN 45”),
                            requires that upon issuance of a guarantee, the guarantor
                            must disclose and
                            recognize a liability for the fair value of the obligation
                            it assumes under that
                            guarantee.
 
 The
                            Company’s guarantees issued subject to the recognition and disclosure
                            requirements of FIN 45 as of December 31, 2005 and 2004
                            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, 2005, the Company
                            experienced approximately three percent of units returned.
                            Using this experience
                            factor a reserve of $24,000 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.
 
 Advertising
 
 The
                            Company follows the policy of charging the costs of advertising
                            to expenses
                            incurred. The Company incurred $657,794, $499,874 and
                            $136,758 in advertising
                            costs during the years ended December 31, 2005, 2004
                            and 2003,
                            respectively.
 
 Liquidity
 
 As
                            shown
                            in the accompanying consolidated financial statements,
                            the Company has incurred
                            a net loss of $15,778,281, $13,092,660 and $7,657,936
                            for the year ended
                            December 31, 2005, 2004 and 2003, respectively. The Company's
                            current assets
                            exceeded its current liabilities by $12,060,807, with
                            cash and cash equivalents
                            representing $8,422,079 and Restricted Certificate of
                            Deposit representing
                            $10,000,000 of the current assets as of December 31,
                            2005.
 
 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 2005, 2004 and 2004
                            were $2,096,104,
                            $1,852,308 and $1,370,785, respectively.
 
 Comprehensive
                            Income
 
 Statement
                            of Financial Accounting Standards No. 130 ("SFAS 130"),
                            "Reporting Comprehensive
                            Income," establishes standards for reporting and displaying
                            of comprehensive
                            income, its components and accumulated balances. Comprehensive
                            income is defined
                            to include all changes in equity except those resulting
                            from investments by
                            owners and distributions to owners. Among other disclosures,
                            SFAS 130 requires
                            that all items that are required to be recognized under
                            current accounting
                            standards as components of comprehensive income be reported
                            in a financial
                            statement that is displayed with the same prominence
                            as other financial
                            statements. The Company does not have any items of comprehensive
                            income in any
                            of the periods presented.
 
 Reclassifications
 
 Certain
                            reclassifications have been made in prior year's financial
                            statements to conform
                            to classifications used in the current year.
 F-13
 Table
                                of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          A-SUMMARY OF ACCOUNTING POLICIES (Continued)**
 
 Stock
                          Based Compensation
 
 In
                          December 2002, the FASB issued SFAS No. 148, "Accounting
                          for Stock-Based
                          Compensation-Transition and Disclosure-an amendment of
                          SFAS 123." This statement
                          amends SFAS No. 123, "Accounting for Stock-Based Compensation,"
                          to provide
                          alternative methods of transition for a voluntary change
                          to the fair value based
                          method of accounting for stock-based employee compensation.
                          In addition, this
                          statement amends the disclosure requirements of SFAS No.
                          123 to require
                          prominent disclosures in both annual and interim financial
                          statements about the
                          method of accounting for stock-based employee compensation
                          and the effect of the
                          method used on reported results. The Company has chosen
                          to continue to account
                          for stock-based compensation using the intrinsic value
                          method prescribed in APB
                          Opinion No. 25 and related interpretations. Accordingly,
                          compensation expense
                          for stock options is measured as the excess, if any, of
                          the fair market value of
                          the Company's stock at the date of the grant over the exercise
                          price of the
                          related option. The Company has adopted the annual disclosure
                          provisions of SFAS
                          No. 148 in its financial reports for the years ended December
                          31, 2005, 2004 and
                          2003 and will adopt the interim disclosure provisions for
                          its financial reports
                          for the subsequent periods.
 
 Had
                          compensation costs for the Company's stock options been
                          determined based on the
                          fair value at the grant dates for the awards, the Company's
                          net loss and losses
                          per share would have been as follows (transactions involving
                          stock options
                          issued to employees and Black-Scholes model assumptions
                          are presented in Note
                          I):
 2005
                                  
                                  2004
                                  
                                  2003Net
                                      loss - as reported
                                  
                                  $
                                  (15,778,281
                                  )
                                  $
                                  (13,092,660
                                  )
                                  $
                                  (7,657,936
                                  )Add:
                                      Total stock based employee compensation expense
                                      as reported under
                                    intrinsic
                                      value method (APB. No. 25)
                                  
                                  
                                  -
                                  
                                  
                                  -
                                  
                                  
                                  -Deduct:
                                      Total stock based employee compensation expense
                                      as reported under
                                    fair
                                      value based method (SFAS No. 123)
                                  
                                  
                                  (2,440,097
                                  )
                                  
                                  (7,830,385
                                  )
                                  
                                  (5,211,112
                                  )Net
                                      loss - Pro Forma
                                  
                                  $
                                  (18,218,378
                                  
                                  $
                                  (20,923,045
                                  )
                                  $
                                  (12,869,048
                                  )Net
                                      loss attributable to common stockholders -
                                      Pro forma
                                  
                                  $
                                  (18,218,378
                                  )
                                  $
                                  (20,923,045
                                  )
                                  $
                                  (12,869,048
                                  )Basic
                                      (and assuming dilution) loss per share - as
                                      reported
                                  
                                  $
                                  (0.35
                                  )
                                  $
                                  (0.32
                                  )
                                  $
                                  (0.37
                                  )Basic
                                      (and assuming dilution) loss per share - Pro
                                      forma
                                  
                                  $
                                  (0.41
                                  )
                                  $
                                  (0.51
                                  )
                                  $
                                  (0.62
                                  )
  On
                            December 16, 2004, the Financial Accounting Standards
                            Board (FASB) issued FASB
                            Statement No. 123R (revised 2004), "Share-Based Payment"
                            which is a revision of
                            FASB Statement No. 123, "Accounting for Stock-Based Compensation".
                            Statement
                            123R supersedes APB opinion No. 25, "Accounting for Stock
                            Issued to Employees",
                            and amends FASB Statement No. 95, "Statement of Cash
                            Flows". Generally, the
                            approach in Statement 123R is similar to the approach
                            described in Statement
                            123. However, Statement 123R requires all share-based
                            payments to employees,
                            including grants of employee stock options, to be recognized
                            in the income
                            statement based on their fair values. Pro-forma disclosure
                            is no longer an
                            alternative. On April 14, 2005, the SEC amended the effective
                            date of the
                            provisions of this statement. The effect of this amendment
                            by the SEC is that
                            the Company will have to comply with Statement 123R and
                            use the Fair Value based
                            method of accounting no later than the first quarter
                            of 2006. The Company has
                            previously issued employee stock options for which no
                            expense has been
                            recognized, and which will not be fully vested as of
                            the effective date of SFAS
                            No. 123R. The Company has assessed the impact SFAS 123R and
                            believes the
                            impact of adopting SFAS No. 123R, based on our unvested options outstanding
                            at December 31, 2005, will be to increase our pre-tax
                            stock-based compensation
                            expense in 2006 by approximately $2 million.
 
 Segment
                            Information
 
 Statement
                            of Financial Accounting Standards No. 131, "Disclosures
                            about Segments of an
                            Enterprise and Related Information" ("SFAS 131") establishes
                            standards for
                            reporting information regarding operating segments in
                            annual financial
                            statements and requires selected information for those
                            segments to be presented
                            in interim financial reports issued to stockholders.
                            SFAS 131 also establishes
                            standards for related disclosures about products and
                            services and geographic
                            areas. Operating segments are identified as components
                            of an enterprise about
                            which separate discrete financial information is available
                            for evaluation by the
                            chief operating decision maker, or decision-making group,
                            in making decisions
                            how to allocate resources and assess performance. The
                            information disclosed
                            herein materially represents all of the financial information
                            related to the
                            Company's principal operating segment.
  F-14
 Table
                              of Contents
 
 **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          A-SUMMARY OF ACCOUNTING POLICIES (Continued)**
 
 New
                          Accounting Pronouncements
  In
                          March
                          2005, the FASB issued FASB Interpretation (FIN) No. 47,
“Accounting for
                          Conditional Asset Retirement Obligations, an interpretation
                          of FASB Statement
                          No. 143,” which requires an entity to recognize a liability for the
                          fair value
                          of a conditional asset retirement obligation when incurred
                          if the liability’s
                          fair value can be reasonably estimated. The Company is
                          required to adopt the
                          provisions of FIN 47 no later than the first quarter of
                          fiscal 2006. The Company
                          does not expect the adoption of this Interpretation to
                          have a material impact on
                          its consolidated financial position, results of operations
                          or cash flows.
 
 In
                          May
                          2005 the FASB issued Statement of Financial Accounting
                          Standards (SFAS) No. 154,
“Accounting Changes and Error Corrections, a replacement
                          of APB Opinion No. 20
                          and FASB Statement No. 3.” SFAS 154 requires retrospective application to prior
                          periods’ financial statements for changes in accounting principle,
                          unless it is
                          impracticable to determine either the period-specific effects
                          or the cumulative
                          effect of the change. SFAS 154 also requires that retrospective
                          application of a
                          change in accounting principle be limited to the direct
                          effects of the change.
                          Indirect effects of a change in accounting principle, such
                          as a change in
                          non-discretionary profit-sharing payments resulting from
                          an accounting change,
                          should be recognized in the period of the accounting change.
                          SFAS 154 also
                          requires that a change in depreciation, amortization, or
                          depletion method for
                          long-lived, non-financial assets be accounted for as a
                          change in accounting
                          estimate effected by a change in accounting principle.
                          SFAS 154 is effective for
                          accounting changes and corrections of errors made in fiscal
                          years beginning
                          after December 15, 2005. Early adoption is permitted for
                          accounting changes and
                          corrections of errors made in fiscal years beginning after
                          the date this
                          Statement is issued. The Company does not expect the adoption
                          of this SFAS to
                          have a material impact on its consolidated financial position,
                          results of
                          operations or cash flows.
 
 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.
 
 **NOTE
                          B - INVENTORIES**
 
 Inventories
                          are stated at the lower of cost or market determined by
                          the first-in, first-out
                          (FIFO) method. Inventories primarily consist of Gateways,
                          Extenders, iBridges
                          and Couplers which are the significant components of the
                          Telkonet solution.
                          Components of inventories as of December 31, 2005 and 2004
                          are as follows:
 2005
                                  
                                  2004Raw
                                      Materials
                                  
                                  $
                                  598,335
                                  
                                  $
                                  748,110Finished
                                      Goods
                                  
                                  
                                  877,471
                                  
                                  
                                  1,125,608$
                                  1,475,806
                                  
                                  $
                                  1,873,718
   F-15
 Table
                              of Contents
  **TELKONET,
                            INC.**
 **NOTES
                            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                            31, 2005, 2004 AND 2003**
 
 **NOTE
                            C - PROPERTY, PLANT AND EQUIPMENT**
 
 The
                            Company’s property and equipment at December 31, 2005 and 2004
                            consists of the
                            following:
 2005
                                  
                                  2004Development
                                      Test Equipment
                                  
                                  $
                                  96,967
                                  
                                  $
                                  74,920Computer
                                      Software
                                  
                                  
                                  142,894
                                  
                                  
                                  62,919Leasehold
                                      Improvements
                                  
                                  
                                  209,911
                                  
                                  
                                  203,948Office
                                      Equipment
                                  
                                  
                                  360,527
                                  
                                  
                                  235,114Office
                                      Fixtures and Furniture
                                  
                                  
                                  230,838
                                  
                                  
                                  127,788Total
                                  
                                  
                                  1,041,137
                                  
                                  
                                  704,689Accumulated
                                      Depreciation
                                  
                                  
                                  (323,667
                                  )
                                  
                                  (137,739
                                  )$
                                  717,470
                                  
                                  $
                                  566,950
  Depreciation
                            expense included as a charge to income was $185,928,
                            $71,514 and $35,920 for the
                            years ended December 31, 2005, 2004 and 2003, respectively.
 
 **NOTE
                            D - EQUIPMENT UNDER OPERATING LEASES**
 
 Equipment
                            leased to customers under operating leases is recorded
                            at cost and is
                            depreciated on the straight line basis to its estimated
                            residual value.
                            Estimated useful lives are two to three years. Equipment
                            under operating leases
                            at December 31, 2005 and 2004 consist of the following:
 2005
                                    
                                    2004Telecommunications
                                        and related equipment
                                    
                                    $
                                    789,099
                                    
                                    $
                                    525,664Less:
                                        accumulated depreciation
                                    
                                    
                                    (124,669
                                    )
                                    
                                    (75,329
                                    )Capitalized
                                        equipment, net of accumulated depreciation
                                    
                                    
                                    664,430
                                    
                                    
                                    450,335Less:
                                        estimated reserve for residual values
                                    
                                    
                                    --
                                    
                                    
                                    --Capitalized
                                        equipment under operating leases, net
                                    
                                    $
                                    664,430
                                    
                                    $
                                    450,335
  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 accumulated
                            depreciation, of approximately $267,000 and expensed
                            associated taxes of
                            approximately $40,000.
 The
                              following is a schedule by years of minimum future
                              rentals on non-cancellable
                              operating leases as of December 31, 2005, including
                              certain rental contract
                              agreements sold to Hospitality Leasing Corporation
                              in January 2006 (Note P):
 2006
                                      
                                      $
                                      1,416,0002007
                                      
                                      
                                      442,0002008
                                      
                                      
                                      315,0002009
                                      
                                      
                                      165,0002010
                                      
                                      
                                      73,000$
                                      2,411,000
  F-16
 Table
                              of Contents
 **TELKONET,
                            INC.**
 **NOTES
                            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                            31, 2005, 2004 AND 2003**
 
  **NOTE
                            E - 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 4.7%. 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
                            $400,000 of the
                            carrying value of its investment through a charge to
                            operations during the year
                            ended December 31, 2005. The remaining value of the Company’s investment in
                            Amperion is $100,000 at December 31, 2005.
  BPL
                            Global, Ltd.
  On
                            February 4, 2005, the Company approved its investment
                            in BPL Global, Ltd. (“BPL
                            Global”), a privately held company. During the year-end December
                            31, 2005, the
                            Company has funded an aggregate of $131,000 of this commitment.
                            This investment
                            represents an equity interest of approximately 6.21%
                            at December 31, 2005. 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. remained at $131,000 as
                            of December 31,
                            2005.
  **NOTE
                            F - CONVERTIBLE PROMISSORY NOTES PAYABLE**
 
 A
                            summary
                            of convertible promissory notes payable at December 31,
                            2005 and 2004 is as
                            follows:
 2005
                                  
                                  
                                  2004Convertible
                                      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 $5.0 per share
                                      at any time.
                                  
                                  $
                                  20,000,000
                                  
                                  $
                                  -Debt
                                      Discount - beneficial conversion feature, net
                                      of accumulated amortization
                                      of $89,163 and $0 at December 31, 2005 and
                                      2004,
                                      respectively.
                                  
                                  
                                  (1,390,137
                                  )
                                  
                                  -Debt
                                      Discount - value attributable to warrants attached
                                      to notes, net of
                                      accumulated amortization of $175,958 and $0
                                      at December 31, 2005 and 2004,
                                      respectively.
                                  
                                  
                                  (2,743,342
                                  )
                                  
                                  -$
                                  15,866,521
                                  
                                  $
                                  -Convertible
                                      notes payable (“Series B Debenture”), in quarterly installments of
                                      interest only at 8% per annum, unsecured and
                                      due three years from the date
                                      of the note with the latest maturity February
                                      2006; Noteholder has the
                                      option to convert unpaid note principal together
                                      with accrued and unpaid
                                      interest to the Company’s common stock at a rate of $.55 per share
                                      six
                                      months after issuance. All of the Series B
                                      Debenture were repaid or
                                      converted to the Company’s common stock as of December 31, 2005.
                                  
                                  
                                  -
                                  
                                  
                                  210,000Debt
                                      Discount - beneficial conversion feature, net
                                      of accumulated amortization
                                      of $49,243 and $49,249 at December 31, 2005
                                      and 2004,
                                      respectively.
                                  
                                  
                                  -
                                  
                                  
                                  (49,243
                                  )Debt
                                      Discount - value attributable to warrants attached
                                      to notes, net of
                                      accumulated amortization of $22,847 and $22,841
                                      at December 31, 2005 and
                                      2004, respectively.
                                  
                                  
                                  -
                                  
                                  
                                  (22,847
                                  )137,910Total
                                  
                                  $
                                  15,866,521
                                  
                                  $
                                  137,910Less:
                                      current portion
                                  
                                  
                                  (6,250,000
                                  )
                                  
                                  -$
                                  9,616,521
                                  
                                  $
                                  137,910
  F-17
 Table
                                  of Contents
  **TELKONET,
                                INC.**
 **NOTES
                                TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                                31, 2005, 2004 AND 2003**
 
 **NOTE
                                F - CONVERTIBLE PROMISSORY NOTES PAYABLE (Continued)**
  Aggregate
                                  maturities of long-term debt as of December 31,
                                  2005 are as
                                  follows:
  Fiscal
                                              Year
                                          
                                          Amount2006
                                          
                                          $
                                          6,250,0002007
                                          
                                          
                                          7,500,0002008
                                          
                                          
                                          6,250,000$
                                          20,000,000
 Convertible
                                Senior Notes
 
 During
                                the year ended December 31, 2005, the Company issued
                                a convertible senior debt
                                financing of $20 million (“Convertible Senior Notes”) to sophisticated investors
                                in exchange for $20,000,000. The Company received
                                proceeds of $18,780,590, net
                                of costs and fees in the amount of $1,219,410. 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 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 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 Note declines below $15 million, the balance
                                is reduced by $.50 for every $1
                                amortized. The Company also has covenants requiring
                                a minimum revenue test of $9
                                million through 2006, measured quarterly. 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 one million warrants to the Noteholders
                                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 the convertible notes issued,
                                along with the shares
                                underlying 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 the effective of the Form S-3. The
                                Company charged
                                to Other Income in the amount of $8,600 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.
 
 Convertible
                                Debentures
 
 During
                                the year ended December 31, 2001, the Company issued
                                convertible promissory
                                notes (the "Debenture-1") to Company officers, shareholders,
                                and sophisticated
                                investors in exchange for $940,000, exclusive of
                                placement costs and fees. The
                                Debenture-1 accrues interest at 8% per annum and
                                is payable and due three years
                                from the date of the note with the latest maturity
                                date of November 2004.
                                Noteholder has the option to convert any unpaid note
                                principal together with
                                accrued and unpaid interest to the Company's common
                                stock at a rate of $.50 per
                                share six months after issuance. In accordance with *Emerging
                                Issues Task Force Issue 98-5, Accounting for Convertible
                                Securities with a
                                Beneficial Conversion Features or Contingently Adjustable
                                Conversion
                                Ratios* ("EITF
                                98-5"), the Company recognized an imbedded beneficial
                                conversion feature present
                                in the Debenture-1 note.
  F-18
 Table
                                    of Contents
 **TELKONET,
                                  INC.**
 **NOTES
                                  TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                                  31, 2005, 2004 AND 2003**
 
 **NOTE
                                  F - CONVERTIBLE PROMISSORY NOTES PAYABLE (Continued)**
 
 Convertible
                                  Debentures (Continued)
 
 The
                                  Company allocated a portion of the proceeds equal
                                  to the intrinsic value of that
                                  feature to additional paid in capital. The Company
                                  recognized and measured an
                                  aggregate of $837,874 of the proceeds, which is
                                  equal to the intrinsic value of
                                  the imbedded beneficial conversion feature, to
                                  additional paid in capital and a
                                  discount against the Debenture-1 issued during
                                  the year ended December 31, 2001.
                                  The debt discount attributed to the beneficial
                                  conversion feature is amortized
                                  over the Debenture-1's maturity period (three years)
                                  as interest
                                  expense.
 
 In
                                  connection with the placement of the Debenture-1
                                  in 2001, the Company issued
                                  warrants granting the holders the right to acquire
                                  940,000 shares of the
                                  Company's common stock at $1.00 per share. In accordance
                                  with *Emerging
                                  Issues Task Force Issue 00-27, Application of Issue
                                  No. 98-5 to Certain
                                  Convertible Instruments* ("EITF -
                                  0027"), the Company recognized the value attributable
                                  to the warrants in the
                                  amount of $77,254 to additional paid in capital
                                  and a discount against the
                                  Debenture-1 issued during the year ended December
                                  31, 2001. The Company valued
                                  the warrants in accordance with EITF 00-27 using
                                  the Black-Scholes pricing model
                                  and the following assumptions: contractual terms
                                  of 3 years, an average risk
                                  free interest rate of 4.25%, a dividend yield of
                                  0%, and volatility of 21%. The
                                  debt discount attributed to the value of the warrants
                                  issued is amortized over
                                  the Debenture-1's maturity period (three years)
                                  as interest
                                  expense.
 
 During
                                  the year ended December 31, 2002, the Company issued
                                  additional convertible
                                  promissory notes (the "Debenture-1") to Company
                                  officers, shareholders, and
                                  sophisticated investors in exchange for $749,100,
                                  exclusive of placement costs
                                  and fees. The Debenture-1 accrues interest at 8%
                                  per annum and is payable and
                                  due three years from the date of the note with
                                  the latest maturity date of May
                                  2005. Noteholders have the option to convert any
                                  unpaid note principal together
                                  with accrued and unpaid interest to the Company's
                                  common stock at a rate of $.50
                                  per share six months after issuance.
 
 In
                                  accordance with *Emerging
                                  Issues Task Force Issue 98-5, Accounting for Convertible
                                  Securities with a
                                  Beneficial Conversion Features or Contingently
                                  Adjustable Conversion
                                  Ratios* ("EITF
                                  98-5"), the Company recognized an imbedded beneficial
                                  conversion feature present
                                  in the Debenture-1 note. The Company allocated
                                  a portion of the proceeds equal
                                  to the intrinsic value of that feature to additional
                                  paid in capital. The
                                  Company recognized and measured an aggregate of
                                  $693,018 of the proceeds, which
                                  is equal to the intrinsic value of the imbedded
                                  beneficial conversion feature,
                                  to additional paid-in capital and a discount against
                                  the Debenture-1 issued
                                  during the year ended December 31, 2002. The debt
                                  discount attributed to the
                                  beneficial conversion feature is amortized over
                                  the Debenture-1's maturity
                                  period (three years) as interest expense.
 
 In
                                  connection with the placement of the Debenture-1
                                  notes in 2002, the Company
                                  issued warrants granting the holders the right
                                  to acquire 749,100 shares of the
                                  Company's common stock at $1.00 per share. In accordance
                                  with *Emerging
                                  Issues Task Force Issue 00-27, Application of Issue
                                  No. 98-5 To Certain
                                  Convertible Instruments* ("EITF
                                  -0027"), the Company recognized the value attributable
                                  to the warrants in the
                                  amount of $56,082 to additional paid-in capital
                                  and a discount against the
                                  Debenture-1 issued during the year ended December
                                  31, 2002. The Company valued
                                  the warrants in accordance with EITF 00-27 using
                                  the Black-Scholes pricing model
                                  and the following assumptions: contractual terms
                                  of 3 years, an average risk
                                  free interest rate of 1.67%, a dividend yield of
                                  0%, and volatility of 26%. The
                                  debt discount attributed to the value of the warrants
                                  issued is amortized over
                                  the Debenture-1's maturity period (three years)
                                  as interest
                                  expense.
 
 Series
                                  B Debentures
 
 In
                                  October and December 2002, the Company issued convertible
                                  promissory notes (the
                                  "Series B Debenture") to Company officers, shareholders,
                                  and sophisticated
                                  investors in exchange for $472,900, exclusive of
                                  placement costs and fees. The
                                  Series B Debenture accrues interest at 8% per annum
                                  and is payable and due three
                                  years from the date of the note with the latest
                                  maturity date of December 2005.
                                  Noteholders have the option to convert any unpaid
                                  note principal together with
                                  accrued and unpaid interest to the Company's common
                                  stock at a rate of $.55 per
                                  share six months after issuance.
  F-19
 Table
                                      of Contents
 **TELKONET,
                                    INC.**
 **NOTES
                                    TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                                    31, 2005, 2004 AND 2003**
 
 **NOTE
                                    F - CONVERTIBLE PROMISSORY NOTES PAYABLE (Continued)**
 
 In
                                    accordance with *Emerging
                                    Issues Task Force Issue 98-5, Accounting For
                                    Convertible Securities With A
                                    Beneficial Conversion Features Or Contingently
                                    Adjustable Conversion
                                    Ratios* ("EITF
                                    98-5"), the Company recognized an imbedded beneficial
                                    conversion feature present
                                    in the Series B Debenture note. The Company allocated
                                    a portion of the proceeds
                                    equal to the intrinsic value of that feature
                                    to additional paid in capital. The
                                    Company recognized and measured an aggregate
                                    of $147,859 of the proceeds, which
                                    is equal to the intrinsic value of the imbedded
                                    beneficial conversion feature,
                                    to additional paid-in capital and a discount
                                    against the Series B Debenture
                                    issued during the year ended December 31, 2002.
                                    The debt discount attributed to
                                    the beneficial conversion feature is amortized
                                    over the Series B Debenture's
                                    maturity period (three years) as interest expense.
 
 In
                                    connection with the placement of the Series B
                                    Debenture notes in 2002, the
                                    Company issued warrants granting the holders
                                    the right to acquire 472,900 shares
                                    of the Company's common stock at $1.00 per share.
                                    In accordance with *Emerging
                                    Issues Task Force Issue 00-27, Application Of
                                    Issue No. 98-5 To Certain
                                    Convertible Instruments* ("EITF
                                    -0027"), the Company recognized the value attributable
                                    to the warrants in the
                                    amount of $68,595 to additional paid-in capital
                                    and a discount against the
                                    Series B Debenture issued during the year ended
                                    December 31, 2002. The Company
                                    valued the warrants in accordance with EITF 00-27
                                    using the Black-Scholes
                                    pricing model and the following assumptions:
                                    contractual terms of 3 years, an
                                    average risk free interest rate of 1.67%, a dividend
                                    yield of 0%, and volatility
                                    of 26%. The debt discount attributed to the value
                                    of the warrants issued is
                                    amortized over the Series B Debenture's maturity
                                    period (three years) as
                                    interest expense.
 
 In
                                    January and February 2003, the Company issued
                                    convertible Series B Debentures to
                                    Company officers, shareholders, and sophisticated
                                    investors in exchange for
                                    $2,027,100, exclusive of placement costs and
                                    fees. The Series B Debentures
                                    accrue interest at 8% per annum and are payable
                                    and due three years from the
                                    date of the note with the latest maturity date
                                    of February 2006. Noteholders
                                    have the option to convert any unpaid note principal
                                    together with accrued and
                                    unpaid interest to the Company's common stock
                                    at a rate of $.55 per share six
                                    months after issuance.
 
 In
                                    accordance with *Emerging
                                    Issues Task Force Issue 98-5, Accounting For
                                    Convertible Securities With A
                                    Beneficial Conversion Features Or Contingently
                                    Adjustable Conversion
                                    Ratios* ("EITF
                                    98-5"), the Company recognized an imbedded beneficial
                                    conversion feature present
                                    in the Series B Debenture note. The Company allocated
                                    a portion of the proceeds
                                    equal to the intrinsic value of that feature
                                    to additional paid in capital. The
                                    Company recognized and measured an aggregate
                                    of $1,761,675 of the proceeds,
                                    which is equal to the intrinsic value of the
                                    imbedded beneficial conversion
                                    feature, to additional paid-in capital and a
                                    discount against the Series B
                                    Debentures issued during the year ended December
                                    31, 2003. The debt discount
                                    attributed to the beneficial conversion feature
                                    is amortized over the Series B
                                    Debentures maturity period (three years) as interest
                                    expense.
 
 In
                                    connection with the placement of the Series B
                                    Debenture notes in January and
                                    February 2003, the Company issued warrants granting
                                    the holders the right to
                                    acquire 2,027,100 shares of the Company's common
                                    stock at $1.00 per share. In
                                    accordance with *Emerging
                                    Issues Task Force Issue 00-27, Application Of
                                    Issue No. 98-5 To Certain
                                    Convertible Instruments* ("EITF
                                    -0027"), the Company recognized the value attributable
                                    to the warrants in the
                                    amount of $265,425 to additional paid-in capital
                                    and a discount against the
                                    Series B Debentures issued during the year ended
                                    December 31, 2003. The Company
                                    valued the warrants in accordance with EITF 00-27
                                    using the Black-Scholes
                                    pricing model and the following assumptions:
                                    contractual terms of 3 years, an
                                    average risk free interest rate of 1.25%, a dividend
                                    yield of 0%, and volatility
                                    of 26%. The debt discount attributed to the value
                                    of the warrants issued is
                                    amortized over the Series B Debentures maturity
                                    period (three years) as interest
                                    expense.
  F-20
 Table
                                        of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          F - CONVERTIBLE PROMISSORY NOTES PAYABLE (Continued)**
 
 During
                          the year ended December 31, 2003, the Debenture-1 noteholders
                          demanded
                          registration of that number of common shares of the Company
                          sufficient to cover
                          the conversion of their debentures and exercise of the
                          attached warrants.
                          Accordingly, the Company notified the Series B Debenture
                          noteholders, Senior
                          noteholders (Note G) and warrant holders with piggy-back
                          registration rights of
                          their right to participate in the registration. During
                          the year ended December
                          31, 2003, the Company issued an aggregate of 7,217,836
                          shares of common stock in
                          connection with the conversion of $1,627,100 aggregate
                          principal amount of the
                          Debenture-1 and $2,180,000 aggregate principal amount of
                          the Series B
                          Debentures. The Company also issued an aggregate of 525,403
                          shares of common
                          stock in exchange for accrued interest of $195,148 and
                          $85,586 for Debenture-1
                          and Series B debenture, respectively. (Note H).
 
 During
                          the year ended December 31, 2004, the Company issued additional
                          324,000 shares
                          of its common stock in connection with the conversion of
                          $62,000 aggregate
                          principal amount of the Debenture-1 and $110,000 aggregate
                          principal amount of
                          the Series B Debentures. The Company also issued an aggregate
                          of 42,999 shares
                          of common stock in exchange for accrued interest of $23,276
                          for Debenture 1 and
                          Series B Debentures. (Note H). All of the Debenture-1 were
                          converted to the
                          Company’s common stock as of December 31, 2004. During the year
                          ended December
                          31, 2005, the Company issued an aggregate of 363,636 shares
                          of common stock and
                          $10,000 of cash to its Series B Debenture holders in exchange
                          for $200,000 and
                          $10,000 of debt, respectively. The Company also issued
                          an aggregate of 51,114
                          shares of common stock in exchange for accrued interest
                          of $28,131 for the
                          Series B Debentures. All of the Series B Debentures were
                          repaid or converted to
                          the Company’s common stock as of December 31, 2005.
 
 In
                          connection with the conversion of Debenture-1 and Series
                          B Debentures, the
                          Company wrote off the unamortized debt discount attributed
                          to the beneficial
                          conversion feature and the value of the attached warrants
                          in the amount of
                          $134,135 and $531, respectively, during the year ended
                          December 31, 2004 and an
                          additional $2,046,479 and $296,470, respectively, during
                          the year ended December
                          31, 2003.
 
 The
                          Company amortized the Convertible Senior Notes, Debenture-1
                          and the Series B
                          Debenture debt discount attributed to the beneficial conversion
                          feature and the
                          value of the attached warrants, and recorded non-cash interest
                          expense in the
                          amount of $337,211, $32,040 and $744,695 for the years
                          ended December 31, 2005,
                          2004 and 2003, respectively.
 
 **NOTE
                          G - SENIOR NOTES PAYABLE**
 
 In
                          the
                          second quarter of 2003, the Company issued Senior Notes
                          to Company officers,
                          shareholders, and sophisticated investors in exchange for
                          $5,000,000, exclusive
                          of placement costs and fees. The Senior Notes are denominated
                          in units of
                          $100,000, accrue interest at 8% per annum and are due three
                          years from the date
                          of issuance with the latest maturity date of June 2006.
                          Attached to each Senior
                          Note are warrants to purchase 125,000 shares of common
                          stock. The warrants have
                          a three-year contractual life and are exercisable immediately
                          after the issuance
                          of the Senior Note at exercise price of $1.00 per share.
                          The Senior Notes are
                          secured by a first priority security interest in all intellectual
                          property
                          assets of the Company. The Company plans to use the Senior
                          Note proceeds for
                          expansion of sales, marketing and strategic partnership
                          programs, building
                          required infrastructure and for working capital.
 
 In
                          September 2003, certain Senior noteholders elected to surrender
                          their Senior
                          Notes as consideration for the exercise of warrants to
                          purchase shares of common
                          stock of the Company. The Company issued an aggregate of
                          2,011,000 restricted
                          shares of common stock for warrants exercised at $1.00
                          per share, in exchange
                          for $2,011,000 of Senior Notes. In January 2004, certain
                          senior note holders
                          elected to convert $2,539,000 of their senior notes into
                          1,209,038 shares of
                          common stock of the Company, at a conversion price of $2.10
                          per share (Note H).
                          During the year ended December 31, 2005, the Company repaid
                          $350,000 of Senior
                          Notes in cash. The remaining outstanding balance of senior
                          notes as of December
                          31, 2005 and 2004 was $100,000 and $450,000, respectively.
 
 **NOTE
                          H - CAPITAL STOCK**
 
 The
                          Company has authorized 15,000,000 shares of preferred stock,
                          with a par value of
                          $.001 per share. As of December 31, 2005, 2004 and 2003,
                          the Company has no
                          preferred stock issued and outstanding. The company has
                          authorized 100,000,000
                          shares of common stock, with a par value of $.001 per share.
                          As of December 31,
                          2005, 2004 and 2003, the Company has 45,765,171, 44,335,989
                          and 30,689,522
                          shares, respectively, of common stock issued and outstanding.
  F-21
 Table
                              of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          H - CAPITAL STOCK (Continued)**
 
 During
                          the year ended December 31, 2003, the Company issued 109,333
                          shares of common
                          stock for an aggregate purchase price of $110,833 to certain
                          employees upon
                          exercise of employee stock options at approximately $1.01
                          per share.
                          Additionally, the Company issued 187,499 shares of common
                          stock for an aggregate
                          purchase price of $187,500 to consultants upon exercise
                          of non-employee stock
                          options at approximately $1.00 per share. The Company also
                          issued 333 shares of
                          common stock for $666 of cash, net of costs and fees.
 
 During
                          the year ended December 31, 2003, the Company issued 315,000
                          shares of common
                          stock for an aggregate purchase price of $157,500 to one
                          of the Company's
                          directors upon exercise of employee stock options exercised
                          at $0.50 per
                          share
 
 During
                          the year ended December 31, 2003, the Company issued an
                          aggregate of 149,498
                          shares of common stock, having an aggregate fair market
                          value of $319,105, to
                          consultants in exchange for services rendered, which approximated
                          the fair value
                          of the shares issued during the period services were completed
                          and rendered.
 
 During
                          the year ended December 31, 2003, the Company issued an
                          aggregate of 7,217,836
                          shares of common stock to its convertible debenture holders
                          in exchange for
                          $3,807,100 of debt (Note F). The Company also issued an
                          aggregate of 525,403
                          shares of common stock in exchange for accrued interest
                          of $280,734 for
                          Debenture 1 and Series B Debentures (Note F).
 
 During
                          the year ended December 31, 2003, the Company issued an
                          aggregate of 3,599,250
                          and 500,000 shares of common stock for warrants exercised
                          at $1.00 and $0.50 per
                          share, respectively.
 
 During
                          the year ended December 31, 2003, the Company issued an
                          aggregate of 2,011,000
                          restricted shares of common stock for warrants exercised
                          at $1.00 per share, in
                          exchange for $2,011,000 of Senior Notes (see Note G).
 
 During
                          the year ended December 31, 2003, the Company issued an
                          aggregate of 36,000
                          shares of common stock to an employee in exchange for $64,469
                          of services
                          rendered, which approximated the fair value of the shares
                          issued during the
                          period services were completed and rendered. Compensation
                          costs of $64,469 were
                          charged to operations.
 
 During
                          the year ended December 31, 2004, the Company issued 540,399
                          shares of common
                          stock for an aggregate purchase price of $582,898 to certain
                          employees upon
                          exercise of employee stock options at approximately $1.08
                          per share.
                          Additionally, the Company issued 328,333 shares of common
                          stock for an aggregate
                          purchase price of $328,333 to consultants upon exercise
                          of non-employee stock
                          options at approximately $1.00 per share.
 
 During
                          the year ended December 31, 2004, the Company issued an
                          aggregate of 63,566
                          shares of common stock, having an aggregate fair market
                          value of $196,315, to
                          consultants in exchange for services rendered, which approximated
                          the fair value
                          of the shares issued during the period services were completed
                          and rendered.
 
 During
                          the year ended December 31, 2004, the Company issued an
                          aggregate of 1,209,038
                          of restricted shares of common stock upon the election
                          of certain senior note
                          holders to convert their senior notes into equity at a
                          conversion price of $2.10
                          per share (Note G).
 
 During
                          the year ended December 31, 2004, the Company issued 6,387,600
                          shares of its
                          common stock for an aggregate purchase price of $12,726,843,
                          net of costs and
                          fees.
 
 During
                          the year ended December 31, 2004, the Company issued an
                          aggregate of 4,000,950
                          shares of common stock upon the exercise of warrants at
                          approximately $1.00 per
                          share and an aggregate of 368,867 shares of common stock
                          in exchange for 448,407
                          outstanding warrants.
 
 During
                          the year ended December 31, 2004, the Company issued an
                          aggregate of 50,000
                          shares of common stock to consultants pursuant to warrants
                          exercised at $2.54
                          per share.
  F-22
 Table
                              of Contents
 **TELKONET,
                            INC.**
 **NOTES
                            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                            31, 2005, 2004 AND 2003**
 
 **NOTE
                            H - CAPITAL STOCK (Continued)**
 
 During
                            the year ended December 31, 2004, the Company issued
                            an aggregate of 324,000
                            shares of common stock in connection with the conversion
                            of $62,000 aggregate
                            principal amount of the Debenture-1 and $110,000 aggregate
                            principal amount of
                            the Series B Debentures. The Company also issued an aggregate
                            of 42,999 shares
                            of common stock in exchange for accrued interest of $23,276
                            for Debenture 1 and
                            Series B Debentures (Note F).
 
 During
                            the year ended December 31, 2004, the Company issued
                            an aggregate of 36,000
                            shares of common stock to an employee in exchange for
                            $107,779 of services
                            rendered, which approximated the fair value of the shares
                            issued during the
                            period services were completed and rendered. Compensation
                            costs of $107,779 were
                            charged to operations.
 
 In
                            March
                            2004, the Company entered into consulting agreements
                            (the “Agreements”) with
                            Aware Capital Consultants, Inc. and Scarborough, Ltd.
                            (“Consultants”). Pursuant
                            to the Agreements, the Company issued an aggregate of
                            1,000,000 shares of its
                            restricted common stock to Consultants in exchange for
                            professional services
                            rendered and to be rendered. In
                            accordance with Emerging
                            Issues Task Force Issue 96-18, Accounting for Equity
                            Instruments That Are Issued
                            to Other Than Employees for Acquiring, or in Conjunction
                            with Selling, Goods or
                            Services (“EITF 96-18”) ,
                            the
                            measurement date to determine fair value was the date
                            at which a commitment for
                            performance by the counter party to earn the equity instrument
                            was reached. The
                            Company valued the shares issued for consulting services
                            at the rate which
                            represents the fair value of the services received which
                            did not differ
                            materially from the value of the stock issued. Compensation cost of $2,500,000 was charged to operations
                            during the year ended
                            December 31, 2004.
  The
                            Company reorganized its capital structure in January
                            2002 whereby the Company
                            agreed to repurchase common stock held by the founders
                            of the Company. All
                            founders shares were returned and canceled in March 2002,
                            except for 705,285
                            shares which remained outstanding, but were subject to
                            repurchase by the Company
                            pending receipt of the share certificate evidencing those
                            shares. During the
                            year ended December 31, 2004, the remaining 705,285 shares
                            of founder’s stock
                            were returned to and canceled by the Company.
 
 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 (Note I).
  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 (Note F and J).
  F-23
 Table
                                of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          I - STOCK OPTIONS AND WARRANTS**
 
 Employee
                          Stock Options
 
 The
                          following table summarizes the changes in options outstanding
                          and the related
                          prices for the shares of the Company’s common stock issued to employees of the
                          Company under a non-qualified employee stock option plan.
 Options
                                      Outstanding
                                  
                                  Options
                                      ExercisableExercise
                                      Prices
                                  
                                  Number
                                    Outstanding
                                  
                                  Weighted
                                      Average
                                    Remaining
                                      Contractual
                                    Life
                                      (Years)
                                  
                                  Weighted
                                      AverageExercise
                                      Price
                                  
                                  Number
                                    Exercisable
                                  
                                  Weighted
                                      AverageExercise
                                      Price$
                                      1.00 - $1.99
                                  
                                  5,813,578
                                  
                                  6.96
                                  
                                  $
                                      1.00
                                  
                                  5,751,078
                                  
                                  $
                                      1.00$
                                      2.00 - $2.99
                                  
                                  2,136,000
                                  
                                  7.76
                                  
                                  $
                                      2.28
                                  
                                  1,044,250
                                  
                                  $
                                      2.25$
                                      3.00 - $3.99
                                  
                                  1,716,500
                                  
                                  8.76
                                  
                                  $
                                      3.31
                                  
                                  502,083
                                  
                                  $
                                      3.44$
                                      4.00 - $4.99
                                  
                                  185,000
                                  
                                  9.20
                                  
                                  $
                                      4.45
                                  
                                  14,250
                                  
                                  $
                                      4.51$
                                      5.00 - $5.99
                                  
                                  300,000
                                  
                                  9.07
                                  
                                  $
                                      5.22
                                  
                                  35,750
                                  
                                  $
                                      5.1410,151,078
                                  
                                  7.54
                                  
                                  $
                                      1.85
                                  
                                  7,347,411
                                  
                                  $
                                      1.37
  Transactions
                            involving stock options issued to employees are summarized
                            as
                            follows:
 Number
                                      of Shares
                                  
                                  Weighted
                                      Average
                                    Price
                                      Per ShareOutstanding
                                      at January 1, 2003
                                  
                                  
                                  1,950,000
                                  
                                  $
                                  1.00Granted
                                  
                                  
                                  7,202,333
                                  
                                  
                                  1.22Exercised
                                      (Note H)
                                  
                                  
                                  (109,333
                                  )
                                  
                                  1.01Cancelled
                                      or expired
                                  
                                  
                                  (750,000
                                  )
                                  
                                  1.00Outstanding
                                      at December 31, 2003
                                  
                                  
                                  8,293,000
                                  
                                  $
                                  1.19Granted
                                  
                                  
                                  2,108,000
                                  
                                  
                                  3.06Exercised
                                      (Note H)
                                  
                                  
                                  (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 H)
                                  
                                  
                                  (415,989
                                  )
                                  
                                  1.18Cancelled
                                      or expired
                                  
                                  
                                  (372,700
                                  )
                                  
                                  3.74Outstanding
                                      at December 31, 2005
                                  
                                  
                                  10,151,078
                                  
                                  $
                                  1.85
  The
                              weighted-average fair value of stock options granted
                              to employees during the
                              years ended December 31, 2005, 2004 and 2003 and the
                              weighted-average
                              significant assumptions used to determine those fair
                              values, using a
                              Black-Scholes option pricing model are as follows:
 2005
                                    
                                    2004
                                    
                                    2003Significant
                                        assumptions (weighted-average):Risk-free
                                        interest rate at grant date
                                    
                                    
                                    4.50%
                                    
                                    
                                    1.35%
                                    
                                    
                                    1.13%Expected
                                        stock price volatility
                                    
                                    
                                    71%
                                    
                                    
                                    76%
                                    
                                    
                                    118%Expected
                                        dividend payout
                                    
                                    
                                    -
                                    
                                    
                                    -
                                    
                                    
                                    -Expected
                                        option life (in years)
                                    
                                    
                                    5.0
                                    
                                    
                                    5.0
                                    
                                    
                                    10.0
  If
                              the
                              Company recognized compensation cost for the non-qualified
                              employee stock option
                              plan in accordance with SFAS No. 123, the Company’s pro forma net loss and net
                              loss per share would have been $(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 and $(12,869,048)
                              and $(0.62), respectively,
                              for the year ended December 31, 2003.
 F-24
 Table
                                  of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          I - STOCK OPTIONS AND WARRANTS (Continued)**
 
 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
                                      Price
                                  
                                  Number
                                    Outstanding
                                  
                                  Weighted
                                      Average Remaining ContractualLife
                                      (Years)
                                  
                                  Weighed
                                      AverageExercise
                                      Price
                                  
                                  Number
                                    Exercisable
                                  
                                  Weighted
                                      AverageExercise
                                      Price$
                                      1.00
                                  
                                  1,841,774
                                  
                                  6.34
                                  
                                  $
                                      1.00
                                  
                                  1,758,441
                                  
                                  $
                                      1.00
  Transactions
                              involving options issued to non-employees are summarized
                              as
                              follows:
 Number
                                          of Shares
                                      
                                      Weighted
                                          Average
                                        Price
                                          Per ShareOutstanding
                                          at January 1, 2003
                                      
                                      
                                      1,555,000
                                      
                                      $
                                      1.00Granted
                                      
                                      
                                      1,900,000
                                      
                                      
                                      1.00Exercised
                                          (Note H)
                                      
                                      
                                      (187,500
                                      )
                                      
                                      0.96Canceled
                                          or expired
                                      
                                      
                                      -
                                      
                                      
                                      -Outstanding
                                          at December 31, 2003
                                      
                                      
                                      3,267,500
                                      
                                      $
                                      1.00Granted
                                      
                                      
                                      60,000
                                      
                                      
                                      3.45Exercised
                                          (Note H)
                                      
                                      
                                      (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 H)
                                      
                                      
                                      (172,395
                                      )
                                      
                                      2.07Canceled
                                          or expired
                                      
                                      
                                      -
                                      
                                      
                                      -Outstanding
                                          at December 31, 2005
                                      
                                      
                                      1,841,774
                                      
                                      $
                                      1.00
  The
                                  estimated value of the non-employee stock options
                                  vested during the year ended
                                  December 31, 2005 was determined using the Black-Scholes
                                  option pricing model
                                  and the following assumptions: expected option
                                  life of 4 years, a risk free
                                  interest rate of 4.35%, a dividend yield of 0%
                                  and volatility of 71%. The amount
                                  of the expense charged to operations in connection
                                  with granting the options was
                                  $1,191,767, $1,130,780 and $982,390 during the
                                  year ended December 31, 2005,
                                  2004 and 2003, respectively.
 
 Warrants
 
 The
                                  following table summarizes the changes in warrants
                                  outstanding and the related
                                  prices for the shares of the Company’s common stock issued to non-employees of
                                  the Company. These warrants were granted in lieu
                                  of cash compensation for
                                  services performed or financing expenses and in
                                  connection with placement of
                                  convertible debentures.
 Warrants
                                              Outstanding
                                          
                                          Warrants
                                              ExercisableExercise
                                              Prices
                                          
                                          Number
                                            Outstanding
                                          
                                          Weighted
                                              Average
                                            Remaining
                                              Contractual
                                            Life
                                              (Years)
                                          
                                          Weighed
                                              Average
                                            Exercise
                                              Price
                                          
                                          Number
                                            Exercisable
                                          
                                          Weighted
                                              AverageExercise
                                              Price$
                                              1.00
                                          
                                          195,000
                                          
                                          0.35
                                          
                                          $
                                              1.00
                                          
                                          195,000
                                          
                                          $
                                              1.00$
                                              2.97
                                          
                                          35,000
                                          
                                          0.38
                                          
                                          $
                                              2.97
                                          
                                          35,000
                                          
                                          $
                                              2.97$
                                              5.00
                                          
                                          1,000,000
                                          
                                          2.82
                                          
                                          $
                                              5.00
                                          
                                          1,000,000
                                          
                                          $
                                              5.001,230,000
                                          
                                          2.36
                                          
                                          $
                                              4.31
                                          
                                          1,230,000
                                          
                                          $
                                              4.31
   F-25
 Table
                                        of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          I - STOCK OPTIONS AND WARRANTS (Continued)**
 
 Warrants
                          (Continued)
 
 Transactions
                          involving warrants are summarized as follows:
 Number
                                      of Shares
                                  
                                  Weighted
                                      Average
                                    Price
                                      Per ShareOutstanding
                                      at January 1, 2003
                                  
                                  3,531,460
                                  
                                  $
                                      0.84Granted
                                  
                                  
                                  8,591,800
                                  
                                  
                                  1.01Exercised
                                      (Note H)
                                  
                                  
                                  (6,963,770
                                  )
                                  
                                  0.92Canceled
                                      or expired
                                  
                                  
                                  -
                                  
                                  
                                  -Outstanding
                                      at December 31, 2003
                                  
                                  
                                  5,159,490
                                  
                                  $
                                  1.01Granted
                                  
                                  
                                  -
                                  
                                  
                                  -Exercised
                                      (Note H)
                                  
                                  
                                  (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 H)
                                  
                                  
                                  (371,900
                                  )
                                  
                                  1.00Canceled
                                      or expired
                                  
                                  
                                  (14,000
                                  )
                                  
                                  1.00Outstanding
                                      at December 31, 2005
                                  
                                  
                                  1,230,000
                                  
                                  $
                                  4.31
  The
                              Company capitalized financing costs of $87,217 for
                              compensatory warrants granted
                              in connection with placement of convertible debentures
                              during the year ended
                              December 31, 2003. The financing cost was amortized
                              over the life of the
                              convertible debentures and all unamortized financing
                              cost was expensed upon the
                              conversion of the convertible debentures during the
                              year ended December 31,
                              2003. The Company did not granted any warrants during
                              the year ended December
                              31, 2004. The Company granted 1,000,000 warrants to
                              Convertible Senior Notes
                              holders (Note F) and 40,000 compensatory warrants to
                              non-employees during the
                              year ended December 31, 2005. The estimated value of
                              compensatory warrants
                              granted and previously granted warrants vested during
                              the period ended December
                              31, 2005 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 $162,453, $50,096 and $30,872 was charged
                              to operations for the year
                              ended December 31, 2005, 2004 and 2003, respectively.
 
 **NOTE
                              J - RELATED PARTY TRANSACTIONS**
 
 In
                              January 2003, the Company entered into an informal
                              agreement with Warren V.
                              Musser, Chairman of the Board of Directors, pursuant
                              to which the Company agreed
                              to pay Mr. Musser a commission equal to 8.0% of the
                              aggregate value of Series B
                              Debentures purchased by persons referred to Telkonet,
                              Inc. by Mr. Musser.
                              Pursuant to this agreement, Mr. Musser received $8,000
                              during the year ended
                              December 31, 2003.
 
 In
                              January 2003, the Company entered into an informal
                              agreement with Howard Lubert,
                              Telkonet's formed Chief Executive Officer, pursuant
                              to which the Company agreed
                              to pay Mr. Lubert a commission equal to 8.0% of the
                              aggregate value of the
                              Series B Debentures purchased by persons referred to
                              Telkonet, Inc. by Mr.
                              Lubert. Pursuant to this agreement, Mr. Lubert received
                              $12,000 during the year
                              ended December 31, 2003.
  F-26
 Table
                                  of Contents
 **TELKONET,
                                INC.**
 **NOTES
                                TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                                31, 2005, 2004 AND 2003**
 
 **NOTE
                                J - RELATED PARTY TRANSACTIONS (Continued)**
 
 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, 2005, 2004 and 2003, the Company has
                                provided for the issuance of
                                36,000 shares of its common stock to Mr. Pickett
                                each year (Note H).
 
 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, 2005, 2004 and
                                2003, an aggregate of
                                $100,000, $100,000 and $33,333 of consulting fees
                                was charged to income pursuant
                                to the agreement, respectively.
 
 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. As of
                                December 31, 2005, the Company issued 30,000 common
                                shares and an aggregate of
                                $127,766 was charged to operations.
 
 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. (Note F
                                and H).
 
 **NOTE
                                K - INCOME TAXES**
 
 The
                                Company has adopted Financial Accounting Standard
                                No. 109 which requires the
                                recognition of deferred tax liabilities and assets
                                for the expected future tax
                                consequences of events that have been included in
                                the financial statement or tax
                                returns. Under this method, deferred tax liabilities
                                and assets are determined
                                based on the difference between financial statements
                                and tax bases of assets and
                                liabilities using enacted tax rates in effect for
                                the year in which the
                                differences are expected to reverse.
 
 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:
 2005
                                        
                                        2004
                                        
                                        2003Tax
                                            provision computed at the statutory rate
                                        
                                        $
                                        (5,522,000
                                        )
                                        $
                                        (4,583,000
                                        )
                                        $
                                        (2,680,000
                                        )Deferred
                                            state income taxes, net of federal income
                                            tax benefit
                                        
                                        
                                        (525,000
                                        )
                                        
                                        -
                                        
                                        
                                        -Book
                                            expenses not deductible for tax purposes
                                        
                                        
                                        19,000
                                        
                                        
                                        15,000
                                        
                                        
                                        5,000U.S.
                                            NOL created from stock option exercise
                                        
                                        
                                        (463,000
                                        )
                                        
                                        (404,000
                                        )
                                        
                                        -U.S.
                                            deferred tax liability for beneficial
                                            conversion feature
                                        
                                        
                                        518,000
                                        
                                        
                                        -
                                        
                                        
                                        617,000Change
                                            in valuation allowance for deferred tax
                                            assets
                                        
                                        
                                        5,973,000
                                        
                                        
                                        4,972,000
                                        
                                        
                                        2,058,000Income
                                            tax expense
                                        
                                        $
                                        --
                                        
                                        $
                                        --
                                        
                                        $
                                        --
   F-27
 Table
                                    of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          K - INCOME TAXES (Continued)**
 
 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. Approximately
                          $877,000 of
                          the valuation allowance relates to stock option expense
                          for which subsequently
                          recognized tax benefits will be allocated to Additional
                          Paid in
                          Capital.
 
 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:
 2005
                                  
                                  2004**Deferred
                                      Tax Assets:**Net
                                      operating loss carryforwards
                                  
                                  $
                                  15,015,000
                                  
                                  $
                                  8,983,000Warrants
                                      and non-employee stock options
                                  
                                  
                                  684,000
                                  
                                  
                                  379,000Investment
                                      in Amperion
                                  
                                  
                                  152,000
                                  
                                  
                                  -Other
                                  
                                  
                                  487,000
                                  
                                  
                                  459,000Total
                                      deferred tax assets
                                  
                                  
                                  16,338,000
                                  
                                  
                                  9,821,000**Deferred
                                      Tax Liabilities:**Beneficial
                                      Conversion Feature of Convertible Debentures
                                  
                                  
                                  (527,000
                                  )
                                  
                                  (17,000
                                  )Property
                                      and equipment, principally due to differences
                                      in
                                      depreciation
                                  
                                  
                                  (66,000
                                  )
                                  
                                  (32,000
                                  )Total
                                      deferred tax liabilities
                                  
                                  
                                  (593,000
                                  )
                                  
                                  (49,000
                                  )Valuation
                                      allowance
                                  
                                  
                                  (15,745,000
                                  )
                                  
                                  (9,772,000
                                  )Net
                                      deferred tax assets
                                  
                                  $
                                  --
                                  
                                  $
                                  --
  At
                            December 31, 2005, the Company has net operating loss
                            carryforwards of
                            approximately $39,100,000 for federal income tax purposes
                            which will expire at
                            various dates from 2020 through 2025.
  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. Thus, the resolution
                            of this matter would
                            have no effect on the reported assets, liabilities, revenues
                            and expenses for
                            the periods presented.
  F-28
 Table
                              of Contents
  **TELKONET,
                              INC.**
 **NOTES
                              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                              31, 2005, 2004 AND 2003**
 
 **NOTE
                              L - LOSSES PER COMMON SHARE**
 
 The
                              following table presents the computations of basic
                              and dilutive loss per
                              share:
 2005
                                      
                                      2004
                                      
                                      2003Net
                                          loss available to common shareholders
                                      
                                      $
                                      (15,778,281
                                      )
                                      $
                                      (13,092,660
                                      )
                                      $
                                      (
                                          7,657,936
                                      )Basic
                                          and fully diluted loss per share
                                      
                                      $
                                      (0.35
                                      )
                                      $
                                      (0.32
                                      )
                                      $
                                      (0.37
                                      )Weighted
                                          average common shares outstanding
                                      
                                      
                                      44,743,223
                                      
                                      
                                      41,384,074
                                      
                                      
                                      20,702,482
  For
                                the
                                years ended December 31, 2005, 2004 and 2003, 7,577,208, 9,198,646
                                and 10,984,201 potential shares, respectively were excluded
                                from shares
                                used to calculate diluted losses per share as their
                                inclusion would reduce net
                                losses per share.
 **NOTE
                                  M - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES**
 
 Accounts
                                  payable and accrued liabilities at December 31,
                                  2005 and 2004 are as
                                  follows:
 2005
                                          
                                          2004Accounts
                                              payable
                                          
                                          $
                                          880,802
                                          
                                          $
                                          812,602Accrued
                                              interest
                                          
                                          
                                          263,806
                                          
                                          
                                          21,611Accrued
                                              payroll and payroll taxes
                                          
                                          
                                          594,401
                                          
                                          
                                          348,471Warranty
                                          
                                          
                                          24,000
                                          
                                          
                                          -Other
                                          
                                          
                                          58,863
                                          
                                          
                                          13,240Total
                                          
                                          $
                                          1,821,872
                                          
                                          $
                                          1,195,924
  **NOTE
                                      N - COMMITMENTS AND CONTINGENCIES**
 
 Office
                                      Leases
 
 The
                                      Company leases office space under a sub-lease
                                      agreement through November 2010
                                      for office space which occupies approximately
                                      11,600 square feet in Germantown,
                                      MD. 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. Commitments
                                      for minimum rentals under non cancelable leases
                                      at December 31, 2005 are as
                                      follows:
 2006
                                              
                                              $
                                              428,9072007
                                              
                                              
                                              404,6672008
                                              
                                              
                                              217,4792009
                                              
                                              
                                              161,1952010
                                                  and thereafter
                                              
                                              
                                              150,918$
                                              1,363,166
  Rental
                                          expenses charged to operations for the
                                          year ended December 31, 2005, 2004 and
                                          2003 are $389,935, $165,249 and $74,777,
                                          respectively.
  F-29
 Table
                                              of
                                              Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          N - COMMITMENTS AND CONTINGENCIES (Continued)**
 
 Capital
                          Lease Obligations
 
 Development
                          test equipment (Note C) includes the following amounts
                          for capitalized leases at
                          December 31, 2005 and 2004:
 2005
                                  
                                  2004Computer
                                      equipment and software
                                  
                                  $
                                  52,000
                                  
                                  $
                                  52,000Less:
                                      accumulated depreciation and amortization
                                  
                                  
                                  (26,000
                                  )
                                  
                                  (15,600
                                  )$
                                  26,000
                                  
                                  $
                                  36,400
  The
                              Company has computer equipment and software purchased
                              under non-cancelable
                              leases with an original cost of $52,000. As of December
                              31, 2005, the Company
                              has paid in full the lease obligation. Depreciation
                              expense of $10,400, $10,400
                              and $5,200 in connection with the capital leased equipment
                              was charged to
                              operations during the year ended December 31, 2005,
                              2004 and 2003,
                              respectively.
 
 Employment
                              and Consulting Agreements
 
 The
                              Company has employment agreements with certain of its
                              key employees which
                              include non-disclosure and confidentiality provisions
                              for protection of the
                              Company’s proprietary information.
 
 The
                              Company has consulting agreements with outside contractors
                              to provide marketing
                              and financial advisory services. The Agreements are
                              generally for a term of 12
                              months from inception and renewable automatically from
                              year to year unless
                              either the Company or Consultant terminates such engagement
                              by written
                              notice.
 
 Litigation
 
 The
                              Company is subject to legal proceedings and claims
                              which arise in the ordinary
                              course of its business. Although occasional adverse
                              decisions or settlements may
                              occur, the Company believes that the final disposition
                              of such matters should
                              not have a material adverse effect on its financial
                              position, results of
                              operations or liquidity.
  **NOTE
                              O - BUSINESS CONCENTRATION**
 
 The
                              sale
                              of certain rental contract agreements and the related capitalized equipment
                              to Hospitality Leasing Corporation in December 2005
                              represented $439,074 or
                              approximately 18% of the 2005 revenues (Note D). Revenue from one major
                              customer represented $136,166 or approximately 19% of 2004
                              revenues. In 2003, two customers represented $32,762 or approximately
                              35% of total 2003 revenues. There were no other customers
                              which represented more
                              than 10% of total revenues in the three years ended
                              December 31, 2005. There
                              were no outstanding accounts receivable from these
                              major customers as of the
                              December 31, 2005 and 2004.
  Purchases
                              from three (3) major suppliers approximated $598,000
                              or 48% of purchases,
                              $885,568 or 40% of purchases and $354,149 or 47% of
                              purchases for the years
                              ended December 31, 2005, 2004 and 2003, respectively.
                              Total accounts payable of
                              approximately $3,000 or 0.4% of total accounts payable
                              was due to these three
                              suppliers as of December 31, 2005 and approximately
                              $105,000 or 13% of total
                              accounts payable was due to these three suppliers as
                              of December 31,
                              2004.
 
 **NOTE
                              P - SUBSEQUENT EVENTS**
 
 Sale
                              of Rental Contracts
 
 In
                              January 2006, the Company consummated a non-recourse
                              sale of certain rental
                              contract agreements which were previously accounted
                              for as operating leases and
                              the related capitalized equipment with Hospitality
                              Leasing Corporation. The
                              remaining rental income payments of the contracts were
                              valued at approximately
                              $918,000, excluding the customer support component
                              of approximately $250,000
                              which the Company will retain and continue to receive
                              monthly customer support
                              payments over the remaining average unexpired lease
                              term of 25 months. The
                              Company recognized revenue of approximately $464,000
                              for the sale, calculated
                              based on the present value of total unpaid rental payments,
                              and expensed the
                              associated capitalized equipment cost, net of accumulated
                              depreciation, of
                              approximately $210,000 and expensed associated taxes
                              of approximately
                              $45,000.
  F-30
 Table
                                  of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          P - SUBSEQUENT EVENTS (Continued)**
 
 Acquisition
                          of Microwave Satellite Technologies, Inc.
 
 In
                          January 2006, the Company acquired a 90% interest in Microwave
                          Satellite
                          Technologies (MST), a
                          communications technology company that
                          offers complete sales, installation, and service of VSAT
                          and business television
                          networks, and is a full-service national Internet Service
                          Provider (ISP). The $9
                          million cash and stock acquisition will provide the Company
                          a “triple-play”
solution to subscribers of HDTV, VoIP telephony and Internet
                          access. The
                          purchase price is payable $1.8 million in cash and 1.6
                          million unregistered
                          shares of the Company’s common stock. The cash portion of the purchase price
                          is
                          payable $900,000 at closing and $900,000 payable in January
                          2007. The stock
                          portion is payable from shares held in escrow 400,000 shares
                          at closing and the
                          remaining 1,200,000 shares issued based on the achievement
                          of 3,300 “Triple
                          Play” subscribers over a three year period.
 
 The
                          Company plans to expand the existing operations concentrated
                          in Manhattan
                          throughout New York and to increase its presence in other
                          major metropolitan
                          cities using the New York system as a template. This acquisition
                          will enable the
                          Company to establish a subscriber base with recurring revenues.
                          A substantial
                          portion of the purchase price will be allocated to intangible
                          assets and
                          amortized over the estimated useful life. Intangible assets
                          consist primarily of
                          subscriber rights, property access rights and network infrastructure. The
                          acquisition was accounted for using the purchase method
                          of accounting under SFAS
                          No. 141.
 
 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
                          the acquisition of MST. The components of the purchase
                          price were as
                          follows:
 
 Cash
                                
                                $
                                1,800,000Common
                                    stock
                                
                                
                                7,200,000Direct
                                    acquisition costs
                                
                                
                                62,000Total
                                    purchase price
                                
                                $
                                9,062,000
  The
                            following table presents the purchase price allocation,
                            including professional
                            fees and other related acquisition costs, to the assets
                            acquired and liabilities
                            assumed, based on their fair values at the date of acquisition:
 Current
                                      assets
                                  
                                  $
                                  400,548Fixed
                                      and other assets
                                  
                                  
                                  1,396,190Intangible
                                      assets
                                  
                                  
                                  2,737,697Goodwill
                                  
                                  
                                  5,334,249Total
                                      liabilities assumed
                                  
                                  
                                  (868,684
                                  )Acquisition
                                      costs
                                  
                                  
                                  62,000Total
                                      purchase price
                                  
                                  $
                                  9,062,000
  Due
                              to
                              its recent date of acquisition, the purchase price
                              allocation to Intangibles and
                              Goodwill is based upon preliminary data that is subject
                              to adjustment and could
                              change significantly pending the completion of an independent
                              appraisal to
                              accurately evaluate this allocation. The Company recognizes
                              goodwill in
                              connection with this acquisition as a result of MST’s historical development of
                              its subscriber base, high profile customer acquisition,
                              its unique “Triple Play”
solution and strategic industry position. All of the
                              intangible assets, which
                              consist of subscriber
                              rights, property access rights and network infrastructure ,
                              are
                              subject to amortization and have a weighted-average
                              useful life of 10 years. The
                              results of the acquisition will be included within
                              the consolidated financial
                              statements from its date of acquisition as of January
                              31, 2006.
   F-31
 Table
                                  of Contents
  **TELKONET,
                          INC.**
 **NOTES
                          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
                          31, 2005, 2004 AND 2003**
 
 **NOTE
                          P - SUBSEQUENT EVENTS (Continued)**
 
 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
                          acquisitions discussed above, had occurred on January 1,
                          2004. 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 these acquisitions
                          at the beginning of the
                          periods shown below or the results that will be attained
                          in the future.
                          Additionally, the Pro forma results for MST does not include
                          the results
                          associated with the analog subscriber base sold to Cablevision
                          in
                          2004:
 **Year
                                      Ended December 31, 2005****As
                                      Reported**
                                  
                                  **Pro
                                      Forma Adjustments**
                                  
                                  **Pro
                                      Forma**Revenues
                                  
                                  $
                                  2,488,323
                                  
                                  $
                                  1,795,658
                                  
                                  
                                  4,283,981Net
                                      loss
                                  
                                  $
                                  (15,919,778)
                                  
                                  $
                                  (1,132,722)
                                  
                                  
                                  (17,052,500)Net
                                      loss per common share outstanding - basic & diluted
                                  
                                  $
                                  (.36)
                                  
                                  $
                                  (.01)
                                  
                                  
                                  (.37)Weighted
                                      average common shares outstanding - basic & diluted
                                  
                                  
                                  44,743,223
                                  
                                  
                                  
                                  
                                  
                                  46,343,223
  Acquisition
                          of Microwave Satellite Technologies, Inc. (Continued)
 **Year
                                      Ended December 31, 2004****As
                                      Reported**
                                  
                                  **Pro
                                      Forma Adjustments**
                                  
                                  **Pro
                                      Forma**Revenues
                                  
                                  $
                                  698,652
                                  
                                  $
                                  2,766,372
                                  
                                  $
                                  3,465,024Net
                                      loss
                                  
                                  $
                                  (13,092,660)
                                  
                                  $
                                  (558,299)
                                  
                                  $
                                  (13,650,959)Net
                                      loss per common share outstanding - basic & diluted
                                  
                                  $
                                  (.32)
                                  
                                  $
                                  .00
                                  
                                  $
                                  (.32)Weighted
                                      average common shares outstanding - basic & diluted
                                  
                                  
                                  41,384,074
                                  
                                  
                                  
                                  
                                  
                                  42,984,074
     F-32