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




For the
fiscal year ended December 31, 2008





Commission
file number: 001-31972





TELKONET,
INC.


(Exact
name of registrant as specified in its charter)





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





20374
Seneca Meadows Parkway


Germantown,
MD 20876


(Address
of principal executive offices)





(240)
912-1800


(Issuer’s
telephone number)





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





Indicate
by check mark if the registrant is a well-know seasoned issuer, as defined in
Rule 405 of the Securities Act. o Yes  x No





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(b) of the Act. o Yes  x No





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. x Yes  o No





Check if
disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not
contained in this form, and no disclosure will be contained, to the best of
Registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See the definition of
“accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange
Act.




o Large
      Accelerated Filer
            o Accelerated
      Filer
            x
      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  x No





Aggregate
market value of the voting stock held by non-affiliates of the registrant as of
March 30, 2009: $11,790,502.




Number of
outstanding shares of the registrant’s par value $0.001 common stock as of March
30, 2009: 93,058,566.










TELKONET,
INC.


FORM
10-K


INDEX





PagePart
      IItem
      1.
            Description
      of Business
            1Item
      1A.
            Risk
      Factors
            13Item
      1B.
            Unresolved
      Staff Comments
            19Item
      2.
            Description
      of Property
            19Item
      3.
            Legal
      Proceedings
            19Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            19Part
      IIItem
      5.
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and
      Registrant’s Purchases of Securities
            20Item
      6.
            Selected
      Financial Data
            21Item
      7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            21Item
      7A.
            Quantitative
      and Qualitative Disclosures About Market Risk.
            33Item
      8.
            Financial
      Statements
            34Item
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
            34Item
      9A.
            Controls
      and Procedures
            34Item
      9B.
            Other
      Information
            36Part
      IIIItem
      10.
            Directors
      and Executive Officers of the Registrant
            36Item
      11.
            Executive
      Compensation
            38Item
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
            47Item
      13.
            Certain
      Relationships and Related Transactions
            49Item
      14.
            Principal
      Accounting Fees and Services
            49Part
      IVItem
      15.
            Exhibits
      and Financial Statement Schedules
            50







PART
I





ITEM
1.  DESCRIPTION OF BUSINESS.





GENERAL





Business





Telkonet,
Inc., formed in 1999 and incorporated under the laws of the state of Utah, is a
“clean technology” company that develops and manufactures proprietary energy
efficiency and smart grid networking technology.  The Company’s
patented Recovery TimeTM energy management technology and Series 5TM power grid
networking technology are innovative clean technology products that have helped
position the Company as a leading clean technology provider.





The
Telkonet SmartEnergyTM (TSE) and Networked Telkonet SmartEnergyTM (NTSE) platforms
incorporate Recovery TimeTM, an energy management technology that continuously
monitors climate conditions to automatically adjust a room’s temperature to
account for the presence or absence of an occupant in an effort to save energy
while at the same time ensuring occupant comfort.  This technology is
particularly attractive to our customers in the hospitality area and owners of
multi-dwelling units who are continually seeking ways to reduce costs without
impacting customer satisfaction.  By reducing energy usage
automatically when a space is not being utilized, our customers can realize a
significant cost savings without diminishing occupant comfort.





Telkonet's
wholly-owned subsidiary, EthoStream, LLC, operates one of the largest
hospitality high-speed Internet access (HSIA) networks in the United
States.  Although this business is successful in its own right, its
significant customer base in the hospitality industry (i.e. more than 2,500
properties that represent 210,000 rooms) has created an opportunity for Telkonet
to market its energy efficiency solutions more successfully.  It also
provides a marketing opportunity for the Company’s more traditional HSIA
offerings, including the Telkonet iWire System.  The iWire System
offers a fast and cost effective way to deliver commercial high-speed broadband
access from an IP “platform” using a building’s existing electrical
infrastructure to convert virtually every electrical outlet into a high-speed
data port without the installation of additional wiring or major disruption of
business activity.  EthoStream represents a significant portion of
Telkonet's hospitality growth and market share (described in detail in the
Segment Reporting section).





Telkonet's
Series 5 system uses powerline communications technology (PLC) to transform a
site’s existing internal electrical infrastructure into an IP network backbone.
With its powerful 200 Mbps chip, the system offers a new competitive alternative
in grid communications, enabling local area network (LAN) infrastructure for
command and control, monitoring and grid management, transforming a traditional
power management system into a “smart grid” that delivers electricity in a
manner that saves energy, reduces cost and increases reliability.  The
company’s PLC platform provides a compelling solution for substation automation,
power generation, renewable facilities, manufacturing, and research
environments, by providing a rapidly-deployed, low cost alternative to
structured cable or fiber. By leveraging the existing electrical wiring within a
facility to transport data, Telkonet’s PLC solutions enable facilities to deploy
sensing and control systems to locations without the need for new network
wiring, and without the security risks entailed with wireless.





The
Company's subsidiary MSTI Holdings, Inc. (MSTI) offers quadruple play
("Quad-Play") services to multi-tenant unit ("MTU") and multi-dwelling unit
("MDU") residential, hospitality and commercial properties. These Quad-Play
services include video, voice, high-speed Internet and wireless fidelity
("WiFi") access.





The
Company's headquarters is located at 20374 Seneca Meadows Parkway in Germantown,
Maryland 20876. Telkonet’s reports that are filed pursuant to the Securities
Exchange Act of 1934 are posted on the Company's website:
www.telkonet.com.





The
highlights and business developments for the twelve months ended December 31,
2008 include the following:





·
            Consolidated
      revenue growth of 45% driven by increased sales activity in the Clean
      Technology energy management product segment, including Telkonet
      SmartEnergyTM (TSE) and Networked Telkonet SmartEnergyTM
(NTSE).·
            Recognition
      as Top 25 in Deloitte's 2008 Nationwide Technology Fast 500
      Program.·
            Shipments
      of more than 65,000 rooms’ worth of energy management installations
      throughout 2008.




1




·
            The
      addition of over 400 new hospitality customers throughout 2008, bringing
      the total number of hotel customers supported by the EthoStream
      Hospitality Network to over 2,500 properties (representing 210,000
      rooms).·
            The
      release of Telkonet's Series 5 AV 200 Mbps-based PLC platform, targeting
      utilities and grid communications.·
            The
      introduction and initial sales of Telkonet’s next-generation energy
      management solution, NTSE.·
            The
      award of a $1.7M contract with Red Lion hotels to provide a comprehensive
      wired and wireless HSIA solution and customer support to all of the Red
      Lion corporate-owned properties, totaling 5,400-plus rooms in 30 hotels
      across the United States.·
            The
      award of a contract with New York University, the largest private
      university in the United States, to install the first phase of a networked
      energy efficiency program in two student-occupied residence
      halls.·
            The
      signing of an exclusive two-year energy management contract extension with
      West coast-based Cool Control Plus hospitality energy efficiency
      program.·
            Entered
      into a relationship with the ESCO operating Nevada’s hospitality energy
      efficiency program.·
            Transition
      of all former SSI activities from Las Vegas to Telkonet’s Milwaukee, WI
      offices.·
            Reduction
      in operating expenses of -17% on a consolidated basis in
2008.·
            Completion
      of several military base energy management installations with one of the
      largest ESCOs in the United States.·
            Completion
      of a franchise wide rollout of energy management products with the entire
      InTown Suites franchise.





Segment
Reporting





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





Telkonet
Segment (“Telkonet”)





Telkonet
provides integrated, centrally-managed energy management and SmartGrid
networking solutions that improve energy efficiency and reduce the demand for
new energy generation. The Company's energy management systems, aimed at the
hospitality, commercial, government, healthcare and education markets, are
dynamically lowering HVAC costs in over 140,000 rooms, and are an integral part
of various utilities' green energy efficiency and rebate programs.





Primarily
targeting SmartGrid and utility applications, Telkonet's patented powerline
communications (PLC) platform delivers cost-effective, robust networking, with
real-time online monitoring and maintenance capabilities, increasing the
reliability and energy efficiency across the entire utility grid.





The
Company employs direct and indirect sales channels in all areas of its business.
With a growing value-added reseller (VAR) network, Telkonet continues to broaden
its reach throughout the industry. Direct sales efforts are focused on the
hospitality industry through Telkonet's wholly-owned subsidiary, EthoStream.
With a recognized brand and strong customer loyalty, EthoStream continues to
grow its Hospitality Network and expand beyond limited and economy properties
into the full-service hospitality market.





Telkonet's
direct sales efforts target the utility, education, commercial and government
market segments. Taking advantage of legislation, including the Energy
Independence and Security Act (EISA) of 2007 and the Energy Policy Act of 2005,
Telkonet has focused its sales efforts in areas with available public funding
and incentives, such as rebate programs offered by Utilities to the hospitality
industry. Telkonet has developed a strategic growth plan to meet the needs of
this emerging industry.




2




Product
Strengths





Telkonet's
entry into the Clean Technology space has been driven by its energy efficiency
product offerings. According to the International Energy Agency, each $1
invested in energy efficiency removes the need, on average, to spend more than
$2 on creating new supply. This knowledge alone is renewing interest in energy
management and reducing the reliance on new energy generation and
consumption.





Telkonet’s
new NTSE system, which delivers intelligent energy management control with an
integrated, networked platform, has been developed in direct cooperation with
utilities and their Demand Response (DR) program interests. For example, the
Brattle Group’s recent assessment of DR, called the Power of Five Percent,
concluded that if DR could reduce peak demand by 5% it would produce a benefit
stream over twenty years with a projected present value of $66 billion. This
represents a significant increase over their previous projection of $35 billion,
based on increased peak energy costs and decreased technology
costs.





Telkonet’s
differentiated approach to energy management, with its patented Recovery TimeTM
technology, delivers significant benefits over competing technologies, including
the following:





·
            Maximum
      energy savings by evaluating each room’s environmental conditions,
      including room location, window placement, dry vs. humid climate, weather
      conditions, and condition of heating, ventilation and air conditioning
      (HVAC) equipment,·
            Longer
      life and reduced maintenance of HVAC units through effective equipment
      monitoring,·
            Increased
      occupant comfort,


·
            Speed
      and ease of installation, and·
            Wide
      range of HVAC system compatibility.




Based on
these advanced product features and capabilities, Telkonet has won significant
competitive contracts in the utility, military and educational space, including
Noresco, NYU and the Cool Control Plus Program. Forming key partnerships with
utility rebate programs has enabled Telkonet to outpace its competition in the
commercial occupancy-based energy management market.





Telkonet's
new NTSE system has evolved the Company’s strategic vision, moving past
traditional energy efficiency and energy management to bring SmartGrid controls
to the edge of the grid. Using wired and wireless technologies to network-enable
in-room energy controls provides greater granularity of control and real-time
performance monitoring. Additionally, network control maximizes energy
efficiency and savings. Finally, integrating in-room management into a Utility's
DR programs has significantly enhanced the NTSE proposition. With the first year
of sales completed, Telkonet has recognized 143% growth in its energy management
product segment and expects increased growth in 2009.





Given our
nation's population growth and the exponential increase in the number of
power-hungry digital components in our digital economy, additional
infrastructure must be built, whether it is Smart or not. According to the
Brattle Group, investments of $1.5 trillion will be required from 2010 to 2030
to pay for this infrastructure. The SmartGrid can be the most affordable
alternative to building out by building less and saving more energy. It will
clearly require investments that are not typical for utilities. However, these
investments will far outweigh the costs as some utilities are already
discovering.





There is
growing agreement among federal and state policymakers, business leaders and
other key stakeholders around the concept that a SmartGrid is not only needed
but well within reach. Short term, a smarter grid will function more
efficiently, delivering the expected level of service cost-effectively while
offering considerable societal benefits such as less impact on our environment.
Longer term, the SmartGrid will spur a transformation similar to the impact of
the Internet on how we live, work, play and learn.





Telkonet
is positioned to play a pivotal role in SmartGrid. The development of an
industrial PLC product for use within the utility space has introduced a
competitive alternative to the local area network (LAN) options. By capitalizing
on the shortcomings of previously available offerings, Telkonet has gained
traction and opened up a new market segment.




3




Telkonet's
Series 5 PLC platform includes the following key features:





·
            Multiple
      physical interfaces, including RS232, RS485 and Ethernet, enabling a wide
      range of different devices to be networked,·
            Multiple
      Utility-centric protocols supported, including DNP3, Modbus and
      IP,


·
            Granular
      QOS support over traditional communications,·
            Ability
      to withstand extended temperature ranges and harsh outdoor
      environments,·
            Stringent
      security features,·
            Support
      for both AC and DC applications,·
            Significant
      speed performance with AV chipset, and·
            Flexible
      connection technology that avoids interruption of service through
      inductive coupling.





Telkonet's
EthoStream division continues to cement its market leadership in the hospitality
HSIA space. With strong, established customer and vendor relationships,
including Choice Hotels International, Wyndham Hospitality, Destination Hotels
and Resorts, and Worldmark by Wyndham (formerly Trendwest Resorts), EthoStream
has demonstrated the continued strength of its brand through 2008. Winning
competitive bids such as the corporate rollout of the Red Lion properties,
EthoStream has expanded beyond its economy and limited service roots to enter
the more lucrative segment of full-service hospitality.





EthoStream
Gateway Servers (EGS) provide industry-leading HSIA technology to the
hospitality industry, with advanced features based on in-house product design
and development, including the following:





·
            Dual
      ISP bandwidth aggregation for faster overall speed,·
            ISP
      redundancy to eliminate network downtime,


·
            Enhanced
      Quality of Service (QoS), and·
            Real-time
      meeting room scheduling.





EthoStream's
24/7 U.S.-based Support Center employs a dedicated, in-house support team that
uses integrated, web-based centralized management tools enabling proactive
support. The Support Center has continued its growth over the last year. These
corporate strengths, along with established relationships with some of the
largest hospitality franchises, continue to set EthoStream apart.





Looking
ahead, EthoStream's core growth will come from two key areas:





·
            New
      customer growth within the full-service hospitality market and through
      additional preferred vendor agreements with franchisors, and·
            Ongoing
      sales to current customers through integration of additional in-room
      technologies such as lighting, minibars, media centers and energy
      management products.





Industry
Outlook





The
National Institute of Standards and Technology (NIST), an agency of the U.S.
Department of Commerce, has been chartered under Energy Independence and
Security Act 2007 (EISA) to identify and evaluate existing standards,
measurement methods, technologies and other support toward SmartGrid adoption.
The agency will also be preparing a report to Congress recommending areas where
standards need to be developed. These types of initiatives reinforce the need
for Telkonet's platform and technology.




4




It is
estimated that SmartGrid enhancements will ease congestion and increase
utilization, sending 50% to 300% more electricity through existing energy
corridors. Telkonet is focusing on the strength of its technology to target key
initiatives within the SmartGrid environment. Through key relationships with
original equipment manufacturers (OEMs) and Utilities, Telkonet has been
recognized as a leading technology provider.





Telkonet
is a member of Western Electricity Coordinating Council (WECC) and the North
American Electric Reliability Corporation (NERC). These industry-leading groups
are defining the standards for tomorrow's Smart Grid platforms. Comprised of
U.S. electrical grid operations and subject to oversight by the U.S. Federal
Energy Regulatory Commission and governmental authorities in Canada, the
technologies tested and approved by these groups create the foundation for
utility decisions.





Competition





Telkonet
has greatly increased its market potential by evolving its energy management
products with two significant developments:





·
            Increased
      HVAC system compatibility with the broadest range of HVAC equipment,
      and·
            Advancing
      Telkonet SmartEnergyTM to a networked energy management
      platform.





Telkonet's
products are Energy Star-certified and incorporate its patented Recovery TimeTM
technology. Although this technology provides Telkonet with significant
competitive advantage in the occupancy-based energy efficiency space, competing
technologies are available.  These technologies would include the less
automated standard available within energy management of static set point
temperature, predictive based methodologies and standard building automation
systems utilizing sensor and zone time-based architectures.  In addition to
its competitive benefits over these methodologies, Telkonet has added
functionality and techniques of these methods to its offering as well to provide
customers with more broad capabilities.





Telkonet's
Series 5 product line has targeted smart grid communications with proprietary
technological advancements. Telkonet's strengths in the grid communication space
include fast implementation, existing customer relationships and proven
performance.  Our challenges include the introduction of a new
technology into a competitive environment, entry into a fledgling market, the
significant sales cycle involved in a highly regulated environment and the
consumer education required and cultivating relationships with manufacturers and
VARs to assist Telkonet in its distribution strategy.





Management
has focused its sales and marketing efforts primarily on opportunities within
the clean technology space in the commercial and industrial, government,
education, healthcare and hospitality sectors, concentrating on markets with
public funding from government and utilities in the form of grants, loans, tax
breaks, incentives and rebates. Telkonet devotes significant resources to
establishing relationships with both value-added resellers in these markets as
well as third-party manufacturers, Utilities and energy service companies
(ESCOs). These relationships enable Telkonet to reach a larger audience, as well
as to offer increased value through complete packaged solutions. These sales and
distribution channels continue to drive Telkonet's clean technology growth,
generating greater product recognition.





Raw
Materials





Telkonet
has not experienced any significant or unusual problems in the purchase of raw
materials or commodities. While Telkonet is dependent, in certain situations, on
a limited number of vendors to provide certain raw materials and components, it
has not experienced significant problems or issues purchasing any essential
materials, parts or components. Telkonet obtains the majority of its raw
materials from the following suppliers: Arrow Electronics, Avnet Electronics
Marketing, Digi-Key Corporation, Intellon Corporation, and Versa Technology. In
addition, Superior Manufacturing Services, a U.S. based company, provides
substantially all the manufacturing and assembly requirements for Telkonet iWire
SystemTM and ATR Manufacturing, a Chinese based company, provides substantially
all the manufacturing requirements for the Telkonet SmartEnergyTM
products.




5




Customers





Telkonet
is neither limited to, nor reliant upon, a single or narrowly segmented consumer
base from which it derives its revenues. Presently, Telkonet is not dependent on
any particular customer under contract.  Telkonet’s primary focus is
in the hospitality, commercial, education, healthcare and government
markets.





Revenue
from two (2) major customer approximated $6,375,182 or 31% of total
revenues for the year ending December 31, 2008. Revenue from one (1) major
customer approximated $1,436,838 or 10% of total revenues for the year ending
December 31, 2007.




Intellectual
Property





Telkonet
has applied for patents that cover the unique technology integrated into the
Telkonet iWire SystemTM and
Series 5 product suite. Telkonet also continues to identify, design and develop
enhancements to its core technologies that will provide additional
functionality, diversification of application and desirability for current and
future users of the Telkonet iWire SystemTMand
Series 5 product suite.  Following is a description of the material
patents held by the Company:





In
December 2003, Telkonet received approval from the U.S. Patent and Trademark
Office for its “Method and Apparatus for Providing Telephonic Communication
Services” Patent No.: 6,668,058. This invention covers the utilization of an
electrical power grid, for a concentration of electrical power consumers, and
use of existing consumer power lines to provide for a worldwide voice and data
telephony exchange.





In
December 2005, the United States Patent and Trademark Office issued Patent
No: 6,975,212 titled “Method and Apparatus for Attaching Power Line
Communications to Customer Premises”. The patent covers the method and apparatus
for modifying a three-phase power distribution network in a building in order to
provide data communications by using a PLC signal to an electrical central
location point of the power distribution system. Telkonet’s Coupler technology
enables the conversion of electrical outlets into high-speed data ports without
costly installation, additional wiring, or significant disruption of business
activity. The Coupler is an integral component of the Telkonet iWire SystemTMandSeries
5 product suites.




In August
2006, the United States Patent and Trademark Office issued Patent No: 7,091,831,
titled "Method and Apparatus for Attaching Power Line Communications to Customer
Premises". The patented technology incorporates a safety disconnect circuit
breaker into the Telkonet Coupler, creating a single streamlined unit. In doing
so, installation of the Telkonet iWire System TM is faster, more efficient, and
more economical than with separate disconnect switches, delivering optimal
signal quality. The Telkonet Integrated Coupler Breaker patent covers the unique
technique used for interfacing and coupling its communication devices onto the
three-phase electrical systems that are predominant in commercial
buildings.





In
January 2007, the United States Patent and Trademark Office issued Patent No:
7,170,395 titled “Methods and Apparatus for Attaching Power Line Communications
to Customer Premises” for Delta phase power distribution system applications,
which are prevalent in the maritime industry, shipboard systems, along with that
of heavy industrial plants and facilities.





The
Company acquired certain intellectual property in the SSI acquisition,
including, but not limited to, Patent No: 5,395,042, titled “Apparatus and
Method for automatic climate control,” which was issued by the United States
Patent Trademark Office in March 1995.  This invention calculates and
records the amount of time needed for the thermostat to return the room
temperature to the occupant’s set point once a person re-enters the
room.





In
addition to the foregoing, Telkonet currently has multiple patent applications
under examination, and intends to file additional patent applications covering a
wide range of technologies, including that of improved network topologies and
techniques for imposing LANs over existing wired infrastructure.




Telkonet
has also filed multiple Patent Cooperation Treaty (PCT) patent applications,
which have been used to file national patent applications in foreign
jurisdictions including the European Union, Japan, China, Russia, India and
others.





Notwithstanding
the issuance of these patents, there can be no assurance that any of Telkonet’s
current or future patent applications will be granted, or, if granted, that such
patents will provide necessary protection for the Company’s technology or its
product offerings, or be of commercial benefit to the Company.




6




Government
Regulation





We are
subject to regulation in the United States by the Federal Communications
Commission (“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.





In
January 2003, Telkonet received FCC approval to market the Telkonet
iWire SystemTM product
suite. FCC rules permit the operation of unlicensed digital devices that radiate
radio frequency emissions if the manufacturer complies with certain equipment
authorization procedures, technical requirements, marketing restrictions and
product labeling requirements. An independent, FCC-certified testing lab has
verified the Company’s Gateway complies with the FCC technical requirements for
Class A digital devices.  No further testing of this device is
required and the device may be manufactured and marketed for commercial
use.





In
March 2005, Telkonet received final certification of its Telkonet iWire
SystemTMproduct
suite from European Union (EU) authorities, which certification was
required before Telkonet could sell and permanently install the Telkonet iWire
SystemTM
in EU countries. As a result of the certification, the Telkonet iWire
SystemTM
that will be sold and installed in EU countries will bear the Conformite
Europeene (CE) mark, a symbol that demonstrates that the product has met the
EU’s regulatory standards and is approved for sale within the EU.





In
June 2005, Telkonet received the National Institute of Standards and
Technology (NIST) Federal Information Processing Standard (FIPS) 140-2
validation for the Gateway. In July 2005, Telkonet received FIPS 140-2
validation for the eXtender and iBridge. The U.S. federal government requires,
as a condition to purchasing certain information processing applications, that
such applications receive FIPS 140-2 validation. U.S. federal agencies use FIPS
140-2 compliant products for the protection of sensitive information. As a
result of the foregoing validations, as of July 2005, all of Telkonet’s
powerline carrier products have satisfied all governmental requirements for
security certification and are eligible for purchase by the U.S. federal
government. In addition to the foregoing, Canadian provincial authorities use
FIPS 140-2 compliant products for the protection of sensitive designate
information. The Communications-Electronics Security Group (CESG) also has
stated that FIPS 140-2 compliant products meet its security criteria for use in
data traffic categorized as “Private.” CESG is part of the United Kingdom’s
National Technical Authority for Information Assurance, which is a government
agency responsible for validating the security of information processing
applications for the government of the United Kingdom, financial institutions,
healthcare organizations, and international governments, among
others.





In
November 2005, Telkonet received the Norma Official Mexicana
(NOM) certification, enabling Telkonet to sell the iWire SystemTMproduct
suite in Mexico.





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





Research
and Development





During
the years ended December 31, 2008 and 2007, Telkonet spent $2,036,129
and $2,349,690, respectively, on research and development activities. In
2008 and 2007, research and development activities were focused on the
development of Telkonet’s next generation of PLC products, and the networked
Telkonet SmartEnergyTM solution.





Long
Term Investments





Amperion,
Inc.




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




It is the
policy of Telkonet to regularly review the assumptions underlying the operating
performance and cash flow forecasts in assessing the carrying values of the
investment. Telkonet identifies and records impairment losses on investments
when events and circumstances indicate that such decline in fair value is other
than temporary. Such indicators include, but are not limited to, limited capital
resources, limited prospects of receiving additional financing, and limited
prospects for liquidity of the related securities. Telkonet determined that its
investment in Amperion was impaired based upon forecasted discounted cash flow.
Accordingly, Telkonet wrote-off $92,000 and $400,000 of the carrying value of
its investment through a charge to operations during the year-ended December 31,
2006 and 2005, respectively. The remaining value of Telkonet’s investment in
Amperion is $8,000 at December 31, 2008 and 2007.




7




BPL Global,
Ltd.




On
February 4, 2005, the Company’s Board of Directors approved an investment in BPL
Global, Ltd. (“BPL Global”), a privately held company. The Company funded an
aggregate of $131,000 as of December 31, 2005 and additional $44 during the year
of 2006. 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 did 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, Ltd. amounted $131,044 as of December
31, 2006.  On November 7, 2007, the Company completed the sale of its
investment in BPL Global, Ltd for $2,000,000 in cash to certain existing
stockholders of BPL Global.





Geeks on Call America,
Inc.





On
October 19, 2007, the Company completed the acquisition of approximately 30.0%
of the issued and outstanding shares of common stock of Geeks on Call America,
Inc. (“GOCA”), the nation's premier provider of on-site computer services. 
Under the terms of the stock purchase agreement, the Company acquired
approximately 1,160,043 shares of GOCA common stock from several GOCA
stockholders in exchange for 2,940,200 shares of the Company’s common stock for
total consideration valued at approximately $4.5 million. The number of shares
issued in connection with this transaction was determined using a per share
price equal to the average closing price of the Company’s common stock on the
American Stock Exchange (AMEX) during the ten trading days immediately preceding
the closing date. The number of shares was subject to adjustment on the date the
Company filed a registration statement for the shares issued in this
transaction, which occurred on April 25, 2008. The increase or decrease to the
number of shares issued was determined using a per share price equal to the
average closing price of the Company’s common stock on the AMEX during the ten
trading days immediately preceding the date the registration statement was
filed.  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 GOCA.  On April 30,
2008, Telkonet issued an additional 3,046,425 shares of its common stock to the
sellers of GOCA to satisfy the adjustment provision.





On
February 8 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned
subsidiary of Geeks On Call Holdings, Inc., (formerly Lightview, Inc.) merged
with GOCA. As a result of the merger, the Company’s common stock in GOCA
was exchanged for shares of common stock of Geeks on Call Holdings Inc. (“Geeks
Holdings”).  Immediately following the merger, Geeks Holdings
completed a private placement of its common stock for aggregate gross proceeds
of $3,000,000. As a result of this transaction, the Company’s 30% interest in
GOCA became an 18% interest in Geeks Holdings.  The Company
has determined that its investment in Geeks Holdings is impaired because it
believes that the fair market value of Geeks Holdings has permanently
declined.   Accordingly, the Company wrote-off $4,098,514 during
the year ended December 31 2008.   The remaining value of this
investment amounted to $367,643 as of December 31, 2008.





Multiband
Corporation





In
connection with a payment of $75,000 of accounts receivable, the Company
received 30,000 shares of common stock of Multiband Corporation, a
Minnesota-based communication services provider to multiple dwelling
units.  The Company classifies this security as available for sale,
and it is carried at fair market value.  During the year ended
December 31, 2008, the Company recorded a loss of $6,500 on the sale of 5,000
shares of its investment in Multiband.  In addition, the Company
recorded an unrealized loss of $32,750 due to a temporary decline in value of
this security.  The remaining value of this investment amounted to
$29,750 as of December 31, 2008.





Backlog





The
Telkonet Segment maintains contracts and monthly services for more than 2,500
hotels which are expected to generate approximately $3,600,000 annual recurring
support and internet advertising revenue.




8




MST Segment
(“MSTI”)





MSTI is a
communications service provider offering quadruple play (“Quad-Play”) services
to multi-tenant unit (“MTU”) and multi-dwelling unit (“MDU”) residential,
hospitality and commercial properties. These Quad-Play services include video,
voice, high-speed internet and wireless fidelity (“Wi-Fi”) access. In addition,
MSTI currently offers or plans to offer a variety of next-generation
telecommunications solutions and services including satellite installation,
video conferencing, surveillance/security and energy management, and other
complementary professional services.




NuVisionsTM




MSTI
currently offers digital television service through DISH Network, a national
satellite television provider, under its private label NuVisionsTM brand of
services. The NuVisions TV offering currently includes over 500 channels of
video and audio programming, with a large high definition (more than 40
channels) and ethnic offering (over 100 channels from 17 countries) available in
the market today. MSTI also offers its NuVisions Broadband high speed internet
service and NuVisions Digital Voice telephone service to multi-family residences
and commercial properties. MSTI delivers its broadband based services using
terrestrial fiber optic links and in February 2005, began deployment in New York
City of a proprietary wireless gigabit network that connects properties served
in a redundant gigabit ring - a virtual fiber optic network in the
air.





Wi-Fi
Network





MSTI has
constructed a large NuVisions Wi-Fi footprint in New York City intended to
create a ubiquitous citywide Wi-Fi network. NuVisions Wi-Fi offers Internet
access in the southern-half of Central Park, Riverside Park from 60th to 79th
Streets, Dag Hammarskjold Plaza, and the United Nations Plaza. In addition, MSTI
provides NuVisions Wi-Fi service in and around Trump Tower on Fifth Avenue,
Trump World Tower on First Avenue, the Trump Place properties located on
Riverside Boulevard, Trump Palace, Trump Parc, Trump Parc East as well as
portions of Roosevelt Island surrounding the Octagon residential community. MSTI
currently has plans to deploy additional Wi-Fi “Hot Zones” throughout New York
City and continue to enlarge its Wi-Fi footprint as new properties are
served.





Internet
Protocol Television (“IPTV”)





In the
fourth quarter of 2006, MSTI invested in an IPTV platform to deploy in 2008.
 IPTV is a method of distributing television content over IP that enables a
more user-defined, on-demand and interactive experience than traditional cable
or satellite television.  IPTV service delivers traditional cable TV
programming and enables subscribers to surf the Internet, receive on-demand
content, and perform a host of Internet-based functions via their TV sets. 
MSTI reassessed its plans for an IPTV service and has since suspended its
development of an IPTV service until the release of a more cost-effective third
party distribution service.





Competition




The home
entertainment and video programming industry is competitive, and MSTI expects
competition to intensify in the future. MSTI faces its most significant
competition from the franchised cable operators. In addition, MSTI’s competition
includes other satellite providers, telecom providers and off-air
broadcasters.





Hardwired
Franchised Cable System





Cable
companies currently dominate the market in terms of subscriber penetration, the
number of programming services available, audience ratings and expenditures on
programming. However, satellite services are gaining market share which MSTI
believes will provide it with the opportunity to acquire and consolidate a
subscriber base by providing a high quality signal at a comparable or reduced
price to many cable operators' current service.





Other
Operators





MSTI’s
next largest competitors are other operators who build and operate
communications systems such as satellite master antenna television systems,
commonly known as SMATV, or private cable headend systems, which generally serve
condominiums, apartment and office complexes and residential developments. MSTI
also competes with other national DBS operators such as EchoStar.




9




Off-Air
Broadcasters





A
majority of U.S. households that are not serviced by cable operators are
serviced only by broadcast networks and local television stations (“off-air
broadcasters”). Off-air broadcasters send signals through the air, which are
received by traditional television antennas. Signals are accessible to anyone
with an antenna and programming is funded by advertisers. Audio and video
quality is limited and service can be adversely affected by weather or by
buildings blocking a signal.





Traditional
Telephone Companies




Traditional
telephone companies such as Verizon and AT&T have recently diversified their
service offerings to compete with traditional franchised cable companies in a
triple-play market. Although their subscriber growth is currently smaller than
franchise cable companies, these traditional phone companies are developing
video offerings such as Verizon's FIOS product. These phone companies have in
the past also been resellers of DIRECTV and EchoStar video programming, however,
rarely in the multi-dwelling unit market. In the future, video offerings from
traditional phone companies may become a significant competitor in the MDU
market.




Customers/Strategy





MSTI’s
customer base and strategy is to target and cultivate a subscriber base that
will demand high margin products, including, video, VoIP, high-speed Internet
and Wi-Fi services.




MSTI
currently maintains service agreements with approximately 22 MDU and MTU
properties. Generally, under the terms of a service agreement, MSTI provides
either (i) “bulk services,” which may include one or all of a bundle of products
and services, at a fixed price per month to the owner of the MDU or MTU
property, and contract with individual residents for enhanced services, such as
premium cable channels, for a monthly fee or (ii) contract with individual
residents of the MDU property for one or more basic or enhanced services for a
monthly fee. These agreements typically include a revenue sharing arrangement
with property owners, whereby the property owner is entitled to a share of the
revenues derived from subscribers who reside at the MDU/MTU property.Theserevenue sharing
arrangements are either based upon a fixed amount per subscriber or based on a
percentage, typically between 7-10%, of the monthly fees MSTI charges residents
for its services. MSTI believes that its complementary products and services
allows for future growth and as such are designed and integrated with
scalability in mind.





Governmental
Regulation





Federal
Regulation




MSTI’s
systems do not use or traverse public rights-of-way and thus are exempt
from the comprehensive regulation of cable systems under the Federal
Communications Act of 1934, as amended (the “Communications Act”). Because its
systems are subject to minimal federal regulation, MSTI has greater pricing
freedom and is not required to serve any customer whom it does not choose to
serve, and management believes that MSTI has significantly more competitive
flexibility than do the franchised cable systems. Management believes that these
regulatory advantages help to make MSTIs’ private systems competitive with
larger franchised cable systems.





On
October 5, 1992, Congress enacted the Cable Consumer Protection and Competition
Act of 1992 (the “1992 Cable Act”), which imposed additional regulation on
traditional franchised cable operators and permits regulation of rates in
markets in which there is no “effective competition”, as defined in the 1992
Cable Act, and directed the FCC to adopt comprehensive new federal standards for
local regulation of certain rates charged by traditional franchised cable
operators. Conversely, the legislation also provides for deregulation of
traditional hardwire cable in a given market where effective competition is
shown to exist. Rates charged by private cable operators, typically already
lower than traditional franchise cable rates, are not subject to regulation
under the 1992 Cable Act.





In
February 1996, Congress passed the Telecommunications Act of 1996 (the “1996
Act”), which substantially amended the Communications Act. The 1996 Act contains
provisions intended to increase competition in the telephone, radio, broadcast
television, and hardwire and wireless cable television businesses. This
legislation has altered, and management believes will continue to alter,
federal, state, and local laws and regulations affecting the communications
industry, including certain of the services MSTI provides.





Under the
federal copyright laws, permission from the copyright holder generally must be
secured before a video program may be retransmitted. Section 111 of the
Copyright Act establishes the cable compulsory license pursuant to which certain
“cable systems” are entitled to engage in the secondary transmission of
broadcast programming without the prior permission of the holders of copyrights
in the programming. In order to do so, a cable system must secure a compulsory
copyright license. Such a license may be obtained upon the filing of certain
reports with and the payment of certain licensing fees to the U.S. Copyright
Office. Private cable operators, such as MSTI, may rely on the cable compulsory
license with respect to the secondary transmission of broadcast programming.
Management does not expect the licensing fees to have a material adverse effect
on MSTI’s business.




10




Under the
retransmission consent provisions of the 1992 Cable Act, multichannel video
programming distributors, including, but not limited to, franchised and private
cable operators, seeking to retransmit certain commercial television broadcast
signals, notwithstanding the cable compulsory license, must first obtain the
permission of the broadcast station in order to retransmit the station’s signal.
However, private cable systems, unlike franchised cable systems, are not
required under the FCC’s “must carry” rules to retransmit local television
signals. Although there can be no assurances that MSTI will be able to obtain
requisite broadcaster consents, management believes, in most cases, MSTI will be
able to do so for little or no additional cost.





On
November 29, 1999, Congress enacted the Satellite Home Viewer Improvement Act of
1999 (“SHVIA”), which amended the Satellite Home Viewer Act. SHVIA permits DBS
operators to transmit local television signals into local markets. SHVIA
generally seeks to place satellite operators on an equal footing with cable
television operators in regards to the availability of television broadcast
programming. SHVIA amends the Copyright Act and other applicable laws and
regulations in order to clarify the terms and conditions under which a DBS
operator may retransmit local and distant broadcast television stations to
subscribers. The law was intended to promote the ability of satellite services
to compete with cable television systems and to resolve disputes that had arisen
between broadcasters and satellite carriers regarding the delivery of broadcast
television station programming to satellite service subscribers. As a result of
SHVIA, television stations are generally entitled to seek carriage on any DBS
operator's system providing local service in their respective markets. SHVIA
creates a statutory copyright license applicable to the retransmission of
broadcast television stations to DBS subscribers located in their markets.
Although there is no royalty payment obligation associated with this license,
eligibility for the license is conditioned on the satellite carrier's compliance
with applicable laws, regulations and FCC rules governing the retransmission of
such “local” broadcast television stations to satellite service subscribers.
Noncompliance with such laws, regulations and/or FCC requirements could subject
a satellite carrier to liability for copyright infringement. SHVIA was extended
and re-enacted by the Satellite Home Viewer Extension and Reauthorization Act
(“SHVERA”) in December of 2004.





MSTI is
not directly subject to rate regulation or certification requirements by the FCC
or state public utility commissions because its equipment installation and sales
agent activities do not constitute the provision of common carrier or cable
television services. As a private cable operator, MSTI is not subject to
regulation as a DBS provider, but primarily relies upon its third-party
programming aggregators to procure all necessary re-transmission consents and
other programming rights under the Communications Act and the Copyright
Act.





State
and Local Cable System Regulation




MSTI does
not anticipate that its deployment of video programming services will be subject
to state or local franchise laws primarily due to the fact that its facilities
do not use or traverse public rights-of-way. Although MSTI may be required to
comply with state and local property tax, environmental laws and local zoning
laws, management does not anticipate that compliance with these laws will have
any material adverse impact on MSTI’s business.




State
Mandatory Access Laws




A number
of states have enacted mandatory access laws that generally require, in exchange
for just compensation, the owners of rental apartments (and, in some instances,
the owners of condominiums) to allow the local franchise cable television
operator to have access to the property to install its equipment and provide
cable service to residents of the MDU. Such state mandatory access laws
effectively eliminate the ability of the property owner to enter into an
exclusive right of entry with a provider of cable or other broadcast services.
In addition, some states have anti-compensation statutes forbidding an owner of
an MDU from accepting compensation from whomever the owner permits to provide
cable or other broadcast services to the property. These statutes have been and
are being challenged on constitutional grounds in various
states.  These state access laws may provide both benefits and
detriments to our business plan should we expand significantly in any of these
states.




Preferential
Access Right




MSTI
generally negotiates exclusive rights to provide satellite services singularly
or in competition with competing cable providers, and also negotiates, where
possible, “rights-of-first-refusal” to match price and terms of third-party
offers to provide other communication services in buildings where it has
negotiated broadcast access rights. Management believes that these preferential
rights of entry are generally enforceable under applicable law. However, current
trends at the state and federal level suggest that the future enforceability of
these provisions may be uncertain. In 2001, the FCC issued an order prohibiting
telecommunications service providers from negotiating exclusive contracts with
owners of commercial MDU properties. The FCC recently extended this prior action
to prohibit carriers from entering into contracts with residential MDU owners
that grant carriers exclusive access for the provision of telecommunications
services to residents in those MDUs.  The ban applies retrospectively to
existing contracts as well as to any future agreements.  The FCC has also
banned agreements that provide exclusive access for video services to
MDUs.  The ban applies retrospectively to existing contracts as well as to
any future agreements.  The ban on exclusive video agreements does not
currently apply to non-franchised entities such as MSTI however the FCC is
currently considering extending the ban to such entities.  While
limitations on exclusivity may undermine the exclusivity provisions of MSTI’s
rights of entry on the one hand, they may also open up many other properties to
which MSTI may provide a competing service. There can be no assurance that
future state or federal laws or regulations will not restrict MSTI’s ability to
offer access payments, limit MDU owners' ability to receive access payments or e
enter into exclusive agreements, any of which could have a material adverse
effect on MSTI’s business.




11




Regulation
of the High-Speed lnternet and Wi-Fi Business




ISPs,
including Internet access providers, are largely unregulated by the FCC or state
public utility commissions at this time (apart from federal, state and local
laws and regulations applicable to business in general). However, there can be
no assurance that this business will not become subject to regulatory
restraints. Also, although the FCC has rejected proposals to impose additional
costs and regulations on ISPs to the extent they use local exchange telephone
network facilities, such change may affect demand for Internet related services.
No assurance can be given that changes in current or future regulations adopted
by the FCC or state regulators or other legislative or judicial initiatives
relating to Internet services would not have a material adverse effect on MSTI’s
business.




Regulation
of the VoIP Business




IP-based
voice services are currently exempt from the reporting and pricing restrictions
placed on common carriers by the FCC. However, there are several state and
federal regulatory proceedings further defining what specific service offerings
qualify for this exemption. Due to the growing acceptance and deployment of VoIP
services, the FCC and a number of state public service commissions are
conducting regulatory proceedings that could affect the regulatory duties and
rights of entities that provide IP-based voice applications. There is regulatory
uncertainty as to the imposition of traditional retail, common carrier
regulation on VoIP products and services.





Long
Term Investments





MSTI
maintains an investment in Interactivewifi.com, LLC a privately held company.
This investment represents an equity interest of approximately 50% at December
31, 2008. Interactivewifi.com is engaged in providing internet and related
services to customers throughout metropolitan New York, including the Nuvision's
internet services. MSTI accounted for this investment under the cost method, as
MSTI does not have the ability to exercise significant influence over operating
and financial policies of Interactivewifi.com. Telkonet reviewed the assumptions
underlying the operating performance and cash flow forecasts in assessing the
carrying values of the investment. The carrying value of the investment in
Interactivewifi.com is $55,000 at December 31, 2008 and 2007.




Backlog





The MSTI
subscriber portfolio includes approximately 22 MDU properties with bulk service
agreements and/or access licenses to service the individual subscribers in
metropolitan New York. The remaining terms of the access agreements provide MSTI
access rights from 7 to 15 years with the final agreement expiring in 2016 and
the revenues to be recognized under non-cancelable bulk agreements provide a
minimum of $2,000,000 in revenue through 2013.





Other
information





Employees





As of
March 15, 2009, the Company had 122 full time employees comprised of 100 full
time employees of Telkonet and 22 employees of MSTI. The Company intends to hire
additional personnel to meet future operating requirements.  The
Company anticipates that it may need to hire additional staff in the areas of
customer support, field services, engineering, sales and marketing, and
administration.




12




Environmental
Matters





The
Company does not anticipate any material effect on its capital expenditures,
earnings or competitive position due to compliance with government regulations
involving environmental matters.





Financial
Information About Geographic Areas





To date,
the majority of the Company’s revenue has been derived in the United States,
although the Company continues to derive a portion of our revenue from
international sales. International sales as a percentage of total revenue
represented 0.5%, 2% and 19% in 2008, 2007 and 2006, respectively. Our
international sales are concentrated in Canada, Latin America and Western Europe
and we continue to expand into other markets worldwide. The table below sets
forth our net revenue by major geographic region.





Year
      Ended December 31,2008
            
            Percentage
              Change
            
            2007
            
            Percentage
              Change
            
            2006United
      States
            
            $
            20,410,315
            
            47%
            
            $
            13,851,021
            
            207%
            
            $
            4,508,478Worldwide
            
            
            120,644
            
            -60%
            
            
            301,712
            
            -55%
            
            
            672,850Total
            
            $
            20,530,959
            
            45%
            
            $
            14,152,733
            
            173%
            
            $
            5,181,328




ITEM
1A.  RISK FACTORS.





The
Company’s results of operations, financial condition and cash flows can be
adversely affected by various risks. These risks include, but are not limited
to, the principal factors listed below and the other matters set forth in this
annual report on Form 10-K. You should carefully consider all of these
risks.





Our
independent auditors have expressed substantial doubt about our ability to
continue as a going concern, which may hinder our ability to obtain future
financing.





In their
report dated April 1, 2009, our independent auditors stated that our financial
statements for the year ended December 31, 2008 were prepared assuming that we
would continue as a going concern, and that they have substantial doubt about
our ability to continue as a going concern.  Our auditors’ doubts are
based on our net losses and deficits in cash flows from
operations.  We continue to experience net operating
losses.  Our ability to continue as a going concern is subject to our
ability to generate a profit and/or obtain necessary funding from outside
sources, including by the sale of our securities, or obtaining loans from
financial institutions, where possible.  Our continued net operating
losses and our auditors’ doubts increase the difficulty of our meeting such
goals.  If we are not successful in raising sufficient additional
capital, we may not be able to continue as a going concern and our stockholders
may lose their entire investment.





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, 2008, the Company has incurred cumulative losses
of $114,801,318 and has never generated enough funds through operations to
support its business. Additional capital may be required in order to provide
working capital requirements for the next twelve months. The Company’s losses to
date have resulted principally from:





·
            research
      and development costs relating to the development of the Telkonet
      SmartEnergyTM (TSE), Networked Telkonet SmartEnergyTM (NTSE) and the
      Telkonet Series 5TM and the Telkonet iWire SystemTM product
      suites;





·
            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 SmartEnergyTM (TSE) and Networked Telkonet
SmartEnergyTM (NTSE) product suites and the Telkonet Series 5TM grid networking
platform.  If the Company is not successful in generating sufficient
liquidity from operations or in raising sufficient capital resources on terms
acceptable to the Company, this could have a material adverse effect on the
Company’s business, results of operations, liquidity and financial
condition.




13




MSTI
is currently in default under its debentures and this indebtedness is secured by
all of MSTI’s assets.




As of
December 15, 2008, MSTI is in material default with respect to indebtedness that
is secured by substantially all of MSTI’s assets.  Although MSTI’s
lenders have not yet initiated legal action in connection with MSTI’s default,
the lenders have the right at any time to pursue any and all legal remedies
available to them, which remedies include, but are not limited to, foreclosure
on all or a portion of MSTI’s assets.  In the event such foreclosure
occurs, these assets could be liquidated by the lenders.  Although the
lenders and MSTI have agreed to pursue an orderly sale of MSTI’s assets, there
can be no assurance that a buyer will be identified or that the amount obtained
pursuant to any sale will be sufficient to satisfy MSTI’s outstanding
indebtedness.  In the event the proceeds of any such sale are less
than MSTI’s indebtedness, the value of the Company’s MSTI stock will be
significantly impaired or, in all likelihood, will become
valueless.




Our
Agreement with Frank Matarazzo, Chief Executive Officer of MSTI, obligates us to
continue to fund MSTI.
 
 Notwithstanding
that MSTI has agreed with its lenders to pursue an orderly sale of its material
assets, the Company agreed pursuant to the December 6, 2005 MST purchase
agreement, as further clarified by a May 2008 letter agreement, to fund MSTI's
business plan.  The May 2008 letter agreement confirms that the Company has
funded a majority of the business plan and provides for the final amount of the
funding obligation to be mutually agreed upon by the Company and Mr.
Matarazzo.  Since the Company's right to distributions from MSTI is
subordinate to the rights of MSTI's secured lenders, there can be no
assurance that the Company will recognize a return on this investment in the
event a sale of MSTI's assets is consummated.  The obligation to fund MSTI
will deplete the Company's available cash and could create the need to raise
additional capital.  There can be no assurance that, if additional cash is
needed, the Company will be able to consummate a capital raising transaction on
favorable terms or at all.
  Potential
fluctuations in operating results could have a negative effect on the price of
the Company’s common stock.




The
Company’s operating results may fluctuate significantly in the future as a
result of a variety of factors, most of which are outside the Company’s control,
including:





·
            the
      level of use of the Internet;





·
            the
      demand for high-tech goods;





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





·
            price
      competition or pricing changes in the
industry;





·
            technical
      difficulties or system downtime;





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





·
            general
      economic conditions.




The
Company’s quarterly results may also be significantly impacted by certain
accounting treatment of acquisitions, financing transactions or other matters.
Such accounting treatment could have a material impact on the Company’s results
of operations and have a negative impact on the price of the Company’s common
stock.




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




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





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





As of
December 31, 2008, the Company had outstanding employee options to purchase a
total of 6,993,929 shares of common stock at exercise prices ranging from $1.00
to $5.97 per share, with a weighted average exercise price of $1.82. As of
December 31, 2008, the Company had outstanding non-employee options to purchase
a total of 1,815,937 shares of common stock at an exercise price of $1.00 per
share. As of December 31, 2008, the Company had warrants outstanding to purchase
a total of 8,457,767 shares of common stock at exercise prices ranging from
$0.58 to $4.17 per share, with a weighted average exercise price of $2.19. 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.




14




The
industry within which we operate 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 the
markets within which it competes. The Company will also need to respond
effectively to new product announcements by its competitors by quickly
introducing competitive products.




Delays in
product development and introduction could result in:





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





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





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





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




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





Programming
costs have risen in past years and are expected to continue to rise, which may
adversely affect our financial results.




The cost
of acquiring programming is a significant portion of the operating costs for our
cable television business. These costs have increased each year and we expect
them to continue to increase, especially the costs associated with sports
programming. Many of our programming contracts cover multiple years and provide
for future increases in the fees we must pay. Historically, we have absorbed
increased programming costs in large part through increased prices to our
customers. However, competitive and other marketplace factors may not permit us
to continue to pass these costs through to customers. In order to minimize the
negative impact that increased programming costs may have on our margins, we may
pursue a variety of strategies, including offering some programming at premium
prices or moving some programming from our analog service to our premium digital
services. Despite our efforts to manage programming expenses and pricing, the
rising cost of programming may adversely affect our results of
operations.





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




FCC rules
permit the operation of unlicensed digital devices that radiate radio frequency
emissions if the manufacturer complies with certain equipment authorization
procedures, technical requirements, marketing restrictions and product labeling
requirements. Differing technical requirements apply to “Class A” devices
intended for use in commercial settings, and “Class B” devices intended for
residential use to which more stringent standards apply. An independent,
FCC-certified testing lab has verified that the Company’s iWire SystemTM product
suite complies with the FCC technical requirements for Class A and Class B
digital devices. No further testing of these devices is required and the devices
may be manufactured and marketed for commercial and residential use. Additional
devices designed by the Company for commercial and residential use will be
subject to the FCC rules for unlicensed digital devices. Moreover, if in the
future, the FCC changes its technical requirements for unlicensed digital
devices, further testing and/or modifications of devices may be necessary.
Failure to comply with any FCC technical requirements could impair the Company’s
ability to sell its products in certain markets and could have a negative impact
on its business and results of operations.




15




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




The
market for our products and services is highly competitive.  Some of
our competitors have longer operating histories, greater name recognition and
substantially greater financial, technical, sales, marketing and other
resources. These competitors may, among other things, undertake more extensive
marketing campaigns, adopt more aggressive pricing policies, obtain more
favorable pricing from suppliers and manufacturers and exert more influence on
the sales channel than the Company can. As a result, the Company may not be able
to compete successfully with these competitors and these 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 competitors will also
intensify their efforts to penetrate the Company’s target markets. These
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
Company may not be able to obtain patents, which could have a material adverse
effect on its business.




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




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




The
Company’s success depends partly on its ability to maintain patent and trade
secret protection, to obtain future patents and licenses, and to operate without
infringing on the proprietary rights of third parties. There can be no assurance
that the measures the Company has taken to protect its intellectual property,
including those integrated to its Telkonet iWire SystemTM product
suite, will prevent misappropriation or circumvention. In addition, there can be
no assurance that any patent application, when filed, will result in an issued
patent, or that the Company’s existing patents, or any patents that may be
issued in the future, will provide the Company with significant protection
against competitors. Moreover, there can be no assurance that any patents issued
to, or licensed by, the Company will not be infringed upon or circumvented by
others. Infringement by third parties on the Company’s proprietary technology
could negatively impact its business. Moreover, litigation to establish the
validity of patents, to assert infringement claims against others, and to defend
against patent infringement claims can be expensive and time-consuming, even if
the outcome is in the Company’s favor. The Company also relies to a lesser
extent on unpatented proprietary technology, and no assurance can be given that
others will not independently develop substantially equivalent proprietary
information, techniques or processes or that the Company can meaningfully
protect its rights to such unpatented proprietary technology. Development of
substantially equivalent technology by the Company’s competitors could
negatively impact its business.




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.




16




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




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




·
            failure
      of the acquired businesses to achieve expected
  results;





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





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





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





·
            risks
      associated with unanticipated events, liabilities or
      contingencies.





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




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




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




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





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





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





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




We are exposed to risks relating to
evaluations of controls required by section 404 of the Sarbanes-Oxley Act of
2002.
 
 We are
required to comply with Section 404 of the Sarbanes-Oxley Act of 2002. As of
December 31, 2008, we have concluded that there are material weaknesses in our
internal control over financial reporting. A material weakness is a control
deficiency, or a combination of control deficiencies, in internal control over
financial reporting, such that there is a reasonable possibility that a material
misstatement of annual or interim financial statements would not be prevented or
detected. Until this deficiency in our internal control over financial reporting
is remediated, there is reasonable possibility that a material misstatement to
our annual or interim consolidated financial statements could occur and not be
prevented or detected by our internal controls in a timely
manner.




17




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




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





A
significant portion of our total assets consists of goodwill, which is subject
to a periodic impairment analysis and a significant impairment determination in
any future period could have an adverse effect on our results of operations even
without a significant loss of revenue or increase in cash expenses attributable
to such period.




We have
goodwill totaling approximately $12.7 million at December 31, 2008 resulting
from recent and past acquisitions. We evaluate this goodwill for impairment
based on the fair value of the operating business units to which this goodwill
relates at least once a year. This estimated fair value could change if we are
unable to achieve operating results at the levels that have been forecasted, the
market valuation of those business units decreases based on transactions
involving similar companies, or there is a permanent, negative change in the
market demand for the services offered by the business units. These changes
could result in an impairment of the existing goodwill balance that could
require a material non-cash charge to our results of operations.





At
December 31, 2008, the Company performed an impairment test on the goodwill and
intangibles acquired, it was determined that there were no changes in the
carrying value of the intangibles acquired.  However, based upon
management’s assessment of operating results and forecasted discounted cash flow
the carrying value of Ethostream LLC goodwill was determined to be impaired and
therefore $2,000,000 was written off during the year ended December 31,
2008.





The
Company's indebtedness and restrictive debt covenants limit the Company's
financing options and liquidity position, which could limit the Company's
ability to grow our business.




The terms
of the Company'soutstanding debentures
put significant restrictions on the Company's ability to:





·
            pay
      cash dividends to our stockholders;·
            incur
      additional indebtedness;


·
            permit
      liens on assets or conduct sales of assets; and·
            engage
      in transactions with affiliates.




These
significant restrictions could have negative consequences, such as:




·
            the
      Company's may be unable to obtain additional financing to fund
      working capital, operating losses, capital expenditures or acquisitions on
      terms acceptable to the Company's, or at all;·
            the
      Company's may be unable to refinance its indebtedness on terms
      acceptable to the Company's, or at all; and


·
            the
      Company's may be more vulnerable to economic downturns and limit the
      Company's ability to withstand competitive
  pressures.




18




Moreover,
any additional debt financing pursued by the Company may contain terms that
include more restrictive covenants, require repayment on an accelerated schedule
or impose other obligations that limit the ability to grow the Company’s
business, acquire needed assets, or take other actions the Company might
otherwise consider appropriate or desirable.





ITEM
1B.  UNRESOLVED STAFF COMMENTS.





None.





ITEM
2.  PROPERTIES.





The
Company presently leases 16,400 square feet of commercial office space in
Germantown, Maryland for its corporate headquarters. The Germantown lease
expires in December 2015.  The Company spent approximately $61,000 in
build out costs to increase the office space of its Germantown headquarters by
approximately 6,000 square feet in April 2007.





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





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





The
Company presently leases 12,000 square feet of office space in Milwaukee, WI for
EthoStream.  The Milwaukee lease expires in February
2019.





Following
the acquisition of SSI, the Company assumed a lease on 9,000 square feet of
office and warehouse space in Las Vegas, NV on a month to month
basis.  The Las Vegas, NV office lease expired on April 30,
2008.





ITEM
3.  LEGAL PROCEEDINGS.





On July
2, 2008, EthoStream was named as a defendant in Linksmart Wireless Technology, LLC
v. T-Mobile USA, Inc., et al, filed in the Eastern District of
Texas.  The suit names 22 defendants and claims that the defendants’
services, including those of EthoStream, infringe a wireless network security
patent held by Linksmart.  Linksmart is seeking a judgment for damages
(including statutory enhanced damages), costs, expenses and prejudgment and
post-judgment interest and a permanent injunction enjoining the defendants from
infringing its patent.  In connection with a Vendor Direct Supplier
Agreement between EthoStream and WWC Supplier Services, Inc., the Company has
determined that it owes the duty to defend and indemnify Defendant Ramada
Worldwide, Inc. and it has assumed Ramada’s defense.  The Company
believes the claim is without merit and intends to vigorously defend the
allegations.





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





None.




19


PART
II
 
 ITEM
5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES.
 
 On
January 24, 2004, the Company’s common stock was listed for trading on the
American Stock Exchange (AMEX) under the ticker symbol “TKO.” Prior to January
24, 2004, the Company’s common stock was quoted on the OTC Bulletin Board under
the symbol “TLKO.OB.” As of March 15, 2009, the Company had 250 stockholders of
record and 91,365,545 shares of its common stock issued and
outstanding.
  The
following table documents the high and low sales prices for the Company’s common
stock on the AMEX for the period beginning January 1, 2007 through December 31,
2008. The information provided for the periods listed below was obtained from
the Yahoo! Finance web site.


High
            
            
            LowYear
      Ended December 31, 2008First
      Quarter
            
            $
            1.11
            
            
            $
            0.57Second
      Quarter
            
            $
            1.02
            
            
            $
            0.40Third
      Quarter
            
            $
            0.56
            
            
            $
            0.24Fourth
      Quarter
            
            $
            0.33
            
            
            $
            0.10Year
      Ended December 31, 2007First
      Quarter
            
            $
            4.00
            
            
            $
            2.50Second
      Quarter
            
            $
            2.77
            
            
            $
            1.60Third
      Quarter
            
            $
            2.01
            
            
            $
            1.20Fourth
      Quarter
            
            $
            1.84
            
            
            $
            0.75




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




Performance
Graph





Set forth
below is a line graph comparing the cumulative total return on Telkonet’s common
stock against the cumulative total return of the Market Index for the American
Stock Exchange (U.S.) and for the peer group “Communications Services, within
the Standard Industrial Classification Code category, (SIC) Code 4899”, for the
period beginning December 31, 2002 and each fiscal year ending December 31
thereafter through the fiscal year ended December 31, 2008. The total returns
assume $100 invested on December 31, 2002 with reinvestment of
dividends.





20




ITEM
6.  SELECTED FINANCIAL DATA
  The
following table sets forth selected financial data for the last 5 years. This
selected financial data should be read in conjunction with the consolidated
financial statements and related notes included in Item 15 of this Form
10-K.


Year
      Ended December 31,(in
      thousands, except per share amounts)
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004Total
      revenues
            
            $
            20,531
            
            
            $
            14,153
            
            
            $
            5,181
            
            
            $
            2,488
            
            
            $
            698Operating
      loss
            
            
            (14,836
            )
            
            
            (23,458
            )
            
            
            (17,563
            )
            
            
            (15,307
            )
            
            
            (13,112
            )Net
      loss
            
            
            (23,986
            )
            
            
            (20,391
            )
            
            
            (27,437
            )
            
            
            (15,778
            )
            
            
            (13,093
            )Loss
      per share - basic
            
            
            (0.30
            )
            
            
            (0.31
            )
            
            
            (0.54
            )
            
            
            (0.35
            )
            
            
            (0.32
            )Loss
      per share - diluted
            
            
            (0.30
            )
            
            
            (0.31
            )
            
            
            (0.54
            )
            
            
            (0.35
            )
            
            
            (0.32
            )Basic
      and diluted weighted average common shares outstanding
            
            
            79,154
            
            
            
            65,415
            
            
            
            50,824
            
            
            
            44,743
            
            
            
            41,384Working
      capital
            
            
            (15,414
            )
            
            
            (2,991
            )
            
            
            (531
            )
            
            
            12,061
            
            
            
            12,672Total
      assets
            
            
            26,508
            
            
            
            38,741
            
            
            
            12,517
            
            
            
            23,291
            
            
            
            15,493Short-term
      borrowings and current portion of long-term debt
            
            
            7,784
            
            
            
            1,471
            
            
            
            —
            
            
            
            6,350
            
            
            
            —Long-term
      debt, net of current portion
            
            
            1,311
            
            
            
            4,432
            
            
            
            —
            
            
            
            9,617
            
            
            
            588Stockholders’
      equity (deficiency)
            
            
            3,451
            
            
            
            21,268
            
            
            
            8,135
            
            
            
            5,315
            
            
            
            13,646





ITEM
7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.





The
following discussion and analysis of the Company’s financial condition and
results of operations should be read in conjunction with the accompanying
financial statements and related notes thereto.





The
Company reports financial results for the following operating business
segments:





Telkonet
Segment





Telkonet
provides integrated, centrally-managed energy management and SmartGrid
networking solutions that improve energy efficiency and reduce the demand for
new energy generation. The Company's energy management systems, aimed at the
hospitality, commercial, government, healthcare and education markets, are
dynamically lowering HVAC costs in over 140,000 rooms, and
are an integral part of various utilities' green energy efficiency and rebate
programs. The segment’s net sales in 2008 were $16,559,001, representing 81% of
the Company’s consolidated net sales.




MST
Segment





MSTI is a
communications service provider offering Quad-Play services to MTU and MDU
residential, hospitality and commercial properties. These Quad-Play services
include video, voice, high-speed internet and Wi-Fi access. In addition, MST
currently offers or plans to offer a variety of next-generation
telecommunications solutions and services, including satellite installation,
video conferencing, surveillance/security and energy management, and other
complementary professional services. The segment’s net sales in 2008 were
$3,971,958, representing 19% of the Company’s consolidated net
sales.





Critical
Accounting Policies and Estimates





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires us to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. On an ongoing basis, we evaluate significant
estimates used in preparing our financial statements, including those related to
revenue recognition, guarantees and product warranties and stock based
compensation. We base our estimates on historical experience, underlying run
rates and various other assumptions that we believe to be reasonable, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities. Actual results could differ from these estimates. The
following are critical judgments, assumptions, and estimates used in the
preparation of the consolidated financial statements.




21




Revenue
Recognition





For
revenue from product sales, the Company recognizes revenue in accordance with
Staff Accounting Bulletin No. 104, Revenue Recognition
(“SAB104”), which includes the provisionsof 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.





Revenue
from sales-type leases for EthoStream products is recognized at the time of
lessee acceptance, which follows installation. The Company recognizes revenue
from sales-type leases at the net present value of future
lease payments. Revenue from operating leases is recognized ratably over the
lease period





MSTI
accounts for the revenue, costs and expense related to residential cable
services as the related services are performed in accordance with SFAS
No. 51, Financial Reporting by Cable Television Companies. Installation
revenue for residential cable services is recognized to the extent of direct
selling costs incurred. Direct selling costs have exceeded installation revenue
in all reported periods. Generally, credit risk is managed by disconnecting
services to customers who are delinquent.





Revenue
from sales-type leases for Ethostream products is recognized at the time of
lease acceptance, which follows installation. The Company recognizes
revenue from sales-type leases at the net present value of future lease
payments. Revenue from operating leases is recognized ratably over the
lease period.





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, 2008 and 2007 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, 2008, the Company
experienced approximately 3% percent of units returned. Using this experience
factor a reserve of $146,951 was accrued.




22




Stock
Based Compensation





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





SFAS
123(R) requires companies to estimate the fair value of share-based payment
awards on the date of grant using an option-pricing model. The value of the
portion of the award that is ultimately expected to vest is recognized as
expense over the requisite service periods in the Company’s Consolidated
Statement of Operations. The Company is using the Black-Scholes option-pricing
model as its method of valuation for share-based awards. The Company’s
determination of fair value of share-based payment awards on the date of grant
using an option-pricing model is affected by the Company’s stock price as well
as assumptions regarding a number of highly complex and subjective variables.
These variables include, but are not limited to the Company’s expected stock
price volatility over the term of the awards, and certain other market variables
such as the risk free interest rate.





The
expected term of the options represents the estimated period of time until
exercise and is based on historical experience of similar awards, giving
consideration to the contractual terms, vesting schedules and expectations of
future employee behavior. For 2008 and prior years, expected stock price
volatility is based on the historical volatility of the Company’s stock for the
related vesting periods.




Stock-based
compensation expense recognized under SFAS 123(R) for the years ended December
31, 2008 and 2007 was $1,216,997 and $1,534,260, respectively, net of tax
effect.





Goodwill and Other
Intangibles





Goodwill
represents the excess of the cost of businesses acquired over fair value or net
identifiable assets at the date of acquisition. Goodwill is subject to a
periodic impairment assessment by applying a fair value test based upon a
two-step method. The first step of the process compares the fair value of the
reporting unit with the carrying value of the reporting unit, including any
goodwill. The Company utilizes a discounted cash flow valuation methodology to
determine the fair value of the reporting unit. If the fair value of the
reporting unit exceeds the carrying amount of the reporting unit, goodwill is
deemed not to be impaired in which case the second step in the process is
unnecessary. If the carrying amount exceeds fair value, the Company performs the
second step to measure the amount of impairment loss. Any impairment loss is
measured by comparing the implied fair value of goodwill, calculated per SFAS
No. 142, with the carrying amount of goodwill at the reporting unit, with
the excess of the carrying amount over the fair value recognized as an
impairment loss.





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 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.





Year
Ended December 31, 2008 Compared to Year Ended December 31,
2007





Revenues





The
Company’s revenue is derived from product sales and recurring revenue in the
commercial, government and international markets of the Telkonet Segment. MST
revenue is derived from Quad-Play services provided to a subscriber portfolio of
MDU properties with bulk service agreements and/or access licenses to service
the individual subscribers in metropolitan New York.




23




The table
below outlines product versus recurring (lease) revenues for comparable
periods:





Year
      ended December 31,2008
            
            
            2007
            
            
            VarianceProduct
            
            $
            13,690,010
            
            
            
            67%
            
            
            $
            9,168,077
            
            
            
            65%
            
            
            $
            4,521,933
            
            
            
            49%Recurring
            
            
            6,840,949
            
            
            
            33%
            
            
            
            4,984,656
            
            
            
            35%
            
            
            
            1,856,293
            
            
            
            37%Total
            
            $
            20,530,959
            
            
            
            100%
            
            
            $
            14,152,733
            
            
            
            100%
            
            
            $
            6,378,226
            
            
            
            45%




Product
revenue





The
Telkonet Segment product revenue principally arises from the sale and
installation of SmartGrid and broadband networking equipment, including Telkonet
SmartEnergyTM products, Telkonet Series 5TM products and the Telkonet iWire
SystemTM.  The Telkonet Segment markets and sells to hospitality,
education, healthcare and government markets. The Telkonet Series 5TM and the
Telkonet iWire SystemTM consist
of the Telkonet Gateways, Telkonet Extenders, the patented Telkonet Coupler, and
Telkonet iBridges.  The Telkonet SmartEnergyTM product suite consists
of thermostats, sensors and controllers.





For the
year ended December 31, 2008, product revenue in the Telkonet Segment was
approximately $13,043,000, and increased by 49% when compared to the prior
year.  Telkonet Segment product revenue for the year ended December
31, 2008 includes approximately $8,486,000 attributed to the sale of energy
management products, and approximately $4,588,000 of broadband networking
products and services to the hospitality market. The Telkonet Segment’s product
revenues in the second half of 2008 have been impacted by the difficult economic
climate, in addition to the normal season sales cycle for Telkonet’s products
and services .  However, management believes that our products and
services, specifically energy management, will provide the Company growth
opportunities despite the current US recession.  Therefore we
anticipate quarter over quarter growth in the energy management and hospitality
markets during the year ended December 31, 2009.  Additionally, we
anticipate significant opportunities for increased PLC sales in the utility and
government markets in 2009, based on the sales activities of 2008 and the
typical lead times for customers in these markets.





The MST
Segment product revenue arises from the sale of equipment, installations and
ancillary services provided to customers independent of the subscriber model.
Product revenue in this segment for the year ended December 31, 2008 was
approximately $647,000, and increased by 65% when compared to the prior
year.





Recurring
Revenue





The
recurring revenue in the Telkonet segment arises from over 2,500 hotels in our
broadband network portfolio.  We currently support over 210,000 HSIA
rooms, with over 2 million monthly users.   For the year ended
December 31, 2008, recurring revenue was approximately $3,516,000, and increased
by 30% when compared to the year ended December 31, 2007.  We
anticipate growth to our subscriber base as we deploy additional sites under
contract and increase Telkonet’s strategic franchise and group alliances through
the Ethostream brand.





For the
year ended December 31, 2008, the recurring revenue for the MST Segment
subscriber base was approximately $3,325,000, and increased by 46% when compared
to the prior year.  The MST Segment subscriber portfolio includes
approximately 22 MDU properties with bulk service agreements and/or access
licenses to service the individual subscribers in metropolitan New
York.





Cost of
Sales





Year
      ended December 31,2008
            
            
            2007
            
            
            VarianceProduct
            
            $
            8,511,196
            
            
            
            62%
            
            
            $
            7,165,120
            
            
            
            78%
            
            
            $
            1,346,076
            
            
            
            19%Recurring
            
            
            5,312,427
            
            
            
            78%
            
            
            
            4,505,476
            
            
            
            90%
            
            
            
            806,951
            
            
            
            18%Total
            
            
            13,823,623
            
            
            
            67%
            
            
            $
            11,670,596
            
            
            
            82%
            
            
            $
            2,153,027
            
            
            
            18%




24




Product
Costs





The
Telkonet Segment product costs include equipment and installation labor related
to the sale of Telkonet SmartEnergyTM products, Telkonet Series 5TM products and
the Telkonet iWire SystemTM.  For the year ended December 31, 2008,
product costs in the Telkonet Segment were approximately $8,105,000, and
increased by 18% when compared to the prior year.  Telkonet Segment
product costs have increased in connection with the increased sales to the
hospitality, energy management and government markets.





The MST
Segment product costs primarily consist of equipment and installation labor for
installation and ancillary services provided to customers. For the year ended
December 31, 2008, product costs for the MST segment amounted to approximately
$406,000.





Recurring
Costs





For the
year ended December 31, 2008, recurring costs for the Telkonet segment were
approximately $1,681,000, and increased by 20% when compared to the prior
year.  This increase is primarily due to the increase in EthoStream’s
customer base and the related recurring revenue in the Telkonet
Segment.





The MST
Segment’s recurring costs amounted to approximately $3,632,000, for the year
ended December 31, 2008.  These costs consist of customer support,
programming and amortization of the capitalized costs to support the subscriber
revenue.  Although MST's programming fees are a significant portion of
the cost, MST continues to pursue competitive agreements and volume discounts in
conjunction with the anticipated growth of the subscriber base. The customer
support costs include build-out of the support services necessary to develop and
support the build-out of the Quad-Play subscriber base in metropolitan New York.
The capitalized costs are amortized over the lease term and include equipment
and installation labor.





Gross
Profit




Year
      ended December 31,2008
            
            
            2007
            
            
            VarianceProduct
            
            $
            5,178,814
            
            
            
            38%
            
            
            $
            2,002,957
            
            
            
            22%
            
            
            $
            3,175,857
            
            
            
            159%Recurring
            
            
            1,528,522
            
            
            
            22%
            
            
            
            479,180
            
            
            
            10%
            
            
            
            1,049,342
            
            
            
            219%Total
            
            $
            6,707,336
            
            
            
            33%
            
            
            $
            2,482,137
            
            
            
            18%
            
            
            $
            4,225,199
            
            
            
            170%





Product
Gross Profit





The gross
profit for the year ended December 31, 2008 increased compared to the prior year
period as a result of increased product sales and installations in the Telkonet
Segment and represented 38% of product revenue. We anticipate an increase in our
gross profit trend for product sales as energy management, utility and
government market opportunities expand.





Recurring
Gross Profit





The
Telkonet Segment’s gross profit associated with recurring revenue increased for
the year ended December 31, 2008, and represented approximately 52% of recurring
revenue.  The centralized remote monitoring and management platform
and internal call support center has provided the platform to continue to
increase the gross profit on the Telkonet Segment’s recurring
revenue.





The MST
Segment’s gross profit represented approximately -9% of total revenue for the
year ended December 31, 2008, compared to the prior year period, primarily due
to programming costs and the support infrastructure. MST anticipates that an
expanded subscriber base utilizing the current infrastructure and reduced
programming costs will facilitate increased gross
profit.




25




Operating
Expenses




Year
      ended December 31,2008
            
            2007
            
            VarianceTotal
            
            $
            21,543,563
            
            
            $
            25,939,690
            
            
            $
            (4,396,127
            )
            
            
            -17%





During
the year ended December 31, 2008, operating expenses for the Telkonet Segment
were approximately $14,759,172, and decreased by -19% when compared to the prior
year. The operating efficiencies achieved by the Company from the acquisitions
of SSI and EthoStream in March 2007, have been offset by a $2,000,000 write down
of Ethostream’s goodwill, resulting from the impact of the current recession on
EthoStream’s valuation.  Telkonet will continue to monitor its
operating expenses and will adjust expenses appropriately to match its
anticipated revenue opportunities.





During
the year ended December 31, 2008, operating expenses for the MST Segment were
approximately $6,784,000 and operating expenses decreased by 12% when compared
to the prior year. Despite reductions in operating expenses, the MST Segment was
impacted by non-cash charges of $1,582,033 for the impairment write-down of
MST’s fixed assets.





Research and
Development




Year
      ended December 31,2008
            
            2007
            
            VarianceTotal
            
            $
            2,036,129
            
            
            $
            2,349,690
            
            
            $
            (313,561
            )
            
            
            -13%





Telkonet’s
research and development costs related to both present and future products are
expensed in the period incurred. Total expenses decreased for the year ended
December 31, 2008 by approximately $314,000, or -13%. The Research and
Development costs are associated with the development of the Telkonet Series 5TM
product suite and the integration of new applications to the Telkonet iWire
SystemTM, and the development of next generation Telkonet SmartEnergyTM (TSE) and
Networked Telkonet SmartEnergyTM (NTSE) products. The Company does not anticipate
significant cost increases in 2009.





Selling, General and
Administrative Expenses




Year
      ended December 31,2008
            
            2007
            
            VarianceTotal
            
            $
            12,938,957
            
            
            $
            17,897,974
            
            
            $
            (4,959,017
            )
            
            
            -28%





Selling,
general and administrative expenses decreased for the year ended December 31,
2008 over the comparable prior year by approximately $4,959,000, or -28%. This
decrease is primarily the result of the efficiencies in the
organization resulting in salary and related costs reductions as well as reduced
travel costs, professional fees and rent and related costs for the Telkonet
Segment, when compared to the prior year. We do not expect to significantly
increase our selling, general and administrative expenses in 2009, when compared
to the year ended December 31, 2008.  However, due to the difficult
ecomonic climate, and the potential impact on Telkonet’s operations, if any,
these expenses will be adjusted as necessary to match our current
sales.




Liquidity
and Capital Resources
 
 Our
working capital decreased by $(12,423,227) during the year ended December 31,
2008 from a working capital deficit of $(2,990,664) at December 31, 2007 to a
working capital deficit of $(15,413,891) at December 31, 2008. The decrease in
working capital for the year ended December 31, 2008, is due to a combination of
factors, of which the significant factors are set out below:
 
 ·
              Cash
      had a net decrease from working capital by $1,347,594 for the year ended
      December 31, 2008. The most significant uses and proceeds of
      cash were:
 
 o
              Approximately
      $4,058,000 of cash consumed directly in operating
    activities





26




o
            A
      private placement from the sale of 2,500,000 shares of common stock at
      $0.60 per share provided proceeds of $1,500,000.o
            A
      repayment of a Senior Note in the amount of $1,500,000 issued to GRQ
      Consultants, Inc.o
            A
      sale of convertible debentures for proceeds of $1,000,000 and $2,500,000
      in May and July 2008, respectively.o
            Proceeds
      of approximately $574,000 from a working capital line of
      credit




Of the
total current assets of $3,445,766 as of December 31, 2008, cash represented
$281,989.  Of the total current assets of $7,004,168 as of December
31, 2007, cash represented $1,629,583.





Line
of Credit





In
September 2008, the Company entered into a two-year line of credit facility with
a third party financial institution.  The line of credit has an
aggregate principal amount of $1,000,000 and is secured by the Company’s
inventory.  The outstanding principal balance bears interest at the
greater of (i) the Wall Street Journal Prime Rate plus nine (9%) percent per
annum, adjusted on the date of any change in such prime or base rate, or (ii)
sixteen percent (16%).  Interest, computed on a 365/360 simple
interest basis, and fees on the credit facility are payable monthly in arrears
on the last day of each month and continuing on the last day of each month until
the maturity date.  The Company may prepay amounts outstanding under
the credit facility in whole or in part at any time.  In the event of
such prepayment, the lender will be entitled to receive a prepayment fee of four
percent (4.0%) of the highest aggregate loan commitment amount if prepayment
occurs before the end of the first year and three percent (3.0%) if prepayment
occurs thereafter.  The outstanding borrowing under the agreement at
December 31, 2008 was $574,005.  The Company has incurred interest
expense of $22,374 related to the line of credit for the year ended December 31,
2008. The Prime Rate was 3.25% at December 31, 2008.





On
February 19, 2009, the Company received a notice of waiver from Thermo Credit
LLC on the tangible net worth requirement, as defined item D(10)b of the line of
credit agreement.  The waiver is in effect as of December 31, 2008 and
for the 90 day period thereafter.





Convertible
Debenture





On May
30, 2008, the Company entered into a Securities Purchase Agreement with YA
Global Investments, L.P. (the “Buyer”) pursuant to which the Company agreed to
issue and sell to the Buyer up to $3,500,000 of secured convertible debentures
(the “Debentures”) and warrants to purchase (the “Warrants”) up to 2,500,000
shares of the Company’s Common Stock, par value $0.001 per share (the “Common
Stock”).  The sale of the Debentures and Warrants was effectuated in
three separate closings, the first of which occurred on May 30, 2008, and the
remainder of which occurred in July 2008.  At the May 30, 2008
closing, the Company sold Debentures having an aggregate principal value of
$1,500,000 and Warrants to purchase 2,100,000 shares of Common
Stock.  In July 2008, the Company sold the remaining Debentures having
an aggregate principal value of $2,000,000 and Warrants to purchase 400,000
shares of Common Stock.





The
Debentures accrue interest at a rate of 13% per annum and mature on May 29,
2011.  The Debentures may be redeemed at any time, in whole or in
part, by the Company upon payment by the Company of a redemption premium equal
to 15% of the principal amount of Debentures being redeemed, provided that an
Equity Conditions Failure (as defined in the Debentures) is not occurring at the
time of such redemption.  The Buyer may also convert all or a portion
of the Debentures at any time at a price equal to the lesser of (i) $0.58, or
(ii) ninety percent (90%) of the lowest volume weighted average price of the
Company’s Common Stock during the ten (10) trading days immediately preceding
the conversion date.  The Warrants expire five years from the date of
issuance and entitle the Buyers to purchase shares of the Company’s Common Stock
at a price per share of $0.61.




On March
31, 2009, the Company received a notice of waiver from YA Global Investments,
L.P. pursuant to which it agreed that, to the extent MSTI is in default of the
MSTI Debentures, such default shall not constitute an Event of Default as
defined in Section 2(a)(iii) of the May 30, 2008 Debentures the Company issued
to YA Global. The waiver is in effect as of December 31, 2008 through June 1,
2009.


Related
Party Promissory Note





On May 6,
2008, Telkonet executed a Promissory Note in the aggregate principal amount of
$400,000.  The Note was due and payable on the earlier to occur of (i)
the closing of the Company’s next financing, or (ii) November 6,
2008.  In connection with the issuance of the Note, the Company issued
warrants to purchase 800,000 shares of Telkonet common stock at $0.60 per
share.  These warrants expire five years from the date of
issuance.  The note was repaid in July 2008.





Senior
Note Payable





On July
24, 2007, Telkonet entered into a Senior Note Purchase Agreement with GRQ
Consultants, Inc. pursuant to which the Company issued to GRQ a Senior
Promissory Note in the aggregate principal amount of $1,500,000. The
Note was due and payable on the earlier to occur of (i) the closing of the
Company’s next financing, or (ii) January 28, 2008, and bore interest at a
rate of six (6%) percent per annum. The Company incurred approximately $25,000
in fees in connection with this transaction. The net proceeds from the issuance
of the Note were used for general working capital needs.  In
connection with the issuance of the Note, the Company also issued to GRQ
warrants to purchase 359,712 shares of common stock at $4.17 per share. These
warrants expire five years from the date of issuance.  On February 8,
2008, this note was repaid in full including $49,750 in interest from the
issuance date through the date of repayment.




On March
31, 2009, the Company received a notice of waiver from YA Global Investments,
L.P. pursuant to which it agreed that, to the extent MSTI is in default of the
MSTI Debentures, such default shall not constitute an Event of Default as
defined in Section 2(a)(iii) of the May 30, 2008 Debentures the Company issued
to YA Global. The waiver is in effect as of December 31, 2008 through June 1,
2009.




27




Convertible
Senior Debentures-MSTI





In May
2007, MSTI issued Debentures having a principal value of $6,576,350, plus an
original issue discount of $526,350, in exchange for $6,050,000 from investors,
exclusive of placement fees. The original issue discount to the MSTI Debentures
is amortized over 12 months. The MSTI Debentures accrue interest at 8% per annum
commencing on the first anniversary of the original issue date of the MSTI
Debentures, payable quarterly in cash or common stock, at MSTI’s option, and
mature on April 30, 2010. The MSTI Debentures are not callable and are
convertible at a conversion price of $0.65 per share into 10,117,462 shares of
MSTI common stock, subject to certain limitations.





In
connection with the placement of the MSTI Debentures, MSTI also issued to
the MSTI Debenture holders, five-year warrants to purchase an aggregate of
5,058,730 shares of MSTI common stock at an exercise price of $1.00 per share.
In connection with the issuance of the MSTI Debentures, MSTI incurred
placement fees of $423,500. Additionally, MSTI issued its placement
agents’ five-year warrants to purchase 708,222 shares of MSTI common stock
at an exercise price of $1.00 per share.  On February 11, 2008, the
MSTI Debenture holders executed a letter agreement with MSTI waiving their
rights to receive any potential liquidated damages under the registration rights
agreement executed in connection with this transaction in exchange for a
reduction in their warrant exercise price from $1.00 to $0.65.





The
purchase agreement executed in connection with the MSTI Debenture offering
prohibits MSTI from directly or indirectly, among other things, creating or
incurring any indebtedness (other than Permitted Indebtedness, as such term is
defined in the purchase agreement) without the consent of the holders of at
least 85% of the principal amount of outstanding MSTI Debentures.





Registration
Rights Liquidated Damages





On May
24, 2007, MSTI completed a private placement, pursuant to which 5,597,664
shares of common stock and five-year warrants to purchase 2,798,836 shares of
common stock were issued at an exercise price of $1.00 per share, for total
proceeds of $2,694,020.  Additionally, MSTI also sold MSTI
Debentures (as previously described) for total proceeds of
$6,050,000.   The holders of the MSTI Debentures also received
five-year warrants to purchase an aggregate of 5,058,730 shares of MSTI common
stock at an exercise price of $1.00 per share.





MSTI
agreed to file a “resale” registration statement with the SEC within 60 days
after the final closing of the private placement and the issuance of the MSTI
Debentures covering all shares of common stock sold in the private placement and
underlying the MSTI Debentures, as well as the warrants attached to the private
placement. MSTI also agreed to use its best efforts to have such
“resale” registration statement declared effective by the SEC as soon as
possible and, in any event, within 120 days after the initial closing of the
private placement and the issuance of the MSTI Debentures.




In
addition, with respect to the shares of common stock sold in the private
placement and underlying the warrants, MSTI agreed to maintain the effectiveness
of the “resale” registration statement from the effective date until the earlier
of (i) 18 months after the date of the closing of the private placement or (ii)
the date on which all securities registered under the registration statement (a)
have been sold, or (b) are otherwise able to be sold pursuant to Rule 144, at
which time exempt sales may be permitted for purchasers of the common stock in
the private placement, subject to MSTI’s right to suspend or defer the use of
the registration statement in certain events.





The
registration rights agreement required the payment of liquidated damages to the
investors of approximately 1% per month of the aggregate proceeds of $9,128,717,
or the value of the unregistered shares at the time that the liquidated damages
were assessed, until the registration statement was declared
effective.  In accordance with EITF 00-19-2, the Company evaluated the
likelihood of achieving registration statement
effectiveness.  Accordingly, the Company accrued $500,000 as
of December 31, 2007, to account for these potential liquidated damages until
the expected effectiveness of the registration statement is
achieved.





On
February 11, 2008, the investors executed a letter agreement with MSTI waiving
their rights to receive liquidated damages under the registration rights
agreement, in exchange for a reduction in their warrant exercise price from
$1.00 to $0.65.  As a result, the Company has reversed the
accrued expense for the potential liquidated damages during the year ended
December 31, 2008.


28





Additional
Debentures





As
previously described, in connection with MSTI Debentures offering, MSTI entered
into a purchase agreement with the purchasers of the MSTI Debentures, which
prohibited MSTI from, directly or indirectly, among other things, creating or
incurring any indebtedness (other than Permitted Indebtedness, as such term is
defined in the purchase agreement) without the consent of the holders of at
least 85% of the principal amount of outstanding Debentures.





On
October 16, 2008, with Alpha Capital Anstalt, Gemini Master Fund, Ltd,
Whalehaven Capital Fund Limited and Brio Capital L.P. (the “Senior Lenders”)
executed a letter agreement with MSTI pursuant to which MSTI issued $352,631 of
Additional Debentures, due December 15, 2008 (subject to extension to April 30,
2010 upon the satisfaction of certain specified conditions) that are
convertible into an aggregate of 542,509 shares of MSTI common stock at a
conversion price of $0.65 per share (subject to adjustment as provided therein).
The Additional Debentures were issued with an 8% Original Issue Discount. As a
result, MSTI received $307,500 from the issuance of the Additional Debentures.
Also, in connection with the issuance of the Additional Debentures and pursuant
to the letter agreement, MSTI issued 2 million shares of common stock to the
purchasers of such Additional Debentures and the same number of common stock
purchase warrants at a purchase price of at least $0.125 per share.





Triggering
Events that Accelerate or Increase a Direct Financial Obligation





Unless
certain conditions were satisfied the Additional Debentures were to mature on
December 15, 2008.  Upon satisfaction of such conditions, the Maturity
Date of the Additional Debentures would be automatically extended to April 30,
2010.  As a result of MSTI’s failure to satisfy the conditions for
extension of the Maturity Date, the Additional Debentures matured on December
15, 2008.  MSTI did not repay the Additional Debentures as required on
the maturity date.





As a
result of MSTI’s failure to timely pay its current obligations due to the Senior
Lenders under the Additional Debentures, certain events of default have occurred
and are continuing beyond any applicable cure or grace period with respect to
all of MSTI’s secured obligations due to the Senior Lenders and subordinate
lenders.The
aggregate amount due to these lenders is $9,448,506 ($7,010,503 in debenture
principal, $2,103,151 in default penalty and $334,852 in accrued interest) as of
December 31, 2008.  As a result of this default by MSTI, the secured
lenders have the right take all steps they deem necessary to protect their
interests, including, but not limited to, foreclosure on some or all of MSTI’s
assets, which serve as collateral for this indebtedness.




As a
result of MSTI’s default and ongoing losses, MSTI’s Board of Directors and
management has determined that it is advisable and in the best interests of the
Company and its stockholders, in cooperation with MSTI’s secured lenders, to
explore the sale of all or substantially all of the assets of Microwave
Satellite Technologies, Inc., a wholly owned subsidiary of MSTI which process is
currently ongoing.




Acquisition
of Microwave Satellite Technologies, Inc.





On
January 31, 2006, the Company acquired a 90% interest in Microwave Satellite
Technologies, Inc. (MST) from Frank Matarazzo, the sole stockholder of MST in
exchange for $1.8 million in cash and 1.6 million unregistered shares of the
Company’s common stock for an aggregate purchase price of $9,000,000. The cash
portion of the purchase price was paid in two installments, $900,000 at closing
and $900,000 in February 2007. The stock portion is payable from shares held in
escrow, 400,000 shares of which were paid at closing and the remaining 1,200,000
shares of which shall be issued based on the achievement of 3,300 “Triple Play”
subscribers over a three year period. During the year ended December 31, 2006,
the Company issued 200,000 shares of the purchase price contingency valued at
$900,000 as an adjustment to goodwill. The purchase agreement provided for an
adjustment to the number of shares owed to Mr. Matarazzo in the event the
Company’s common stock price falls below $4.50 per share upon issuance of the
shares from escrow. As of December 31, 2008, the Company’s common stock price
was below $4.50.





In April
2008, the Company released from escrow 200,000 shares of the purchase price
contingency.  In June 2008, the Company released from escrow an
additional 400,000 shares in exchange for Mr. Matarazzo’s agreement to a debt
covenant contained in the transaction documents executed in connection with the
debenture financing with YA Global Investments LP which prohibits the use of the
proceeds obtained in the debt financing to fund MST.




29




Acquisition
of Smart Systems International (SSI)





On March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $6,875,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock.





Of the
stock issued in the transaction, 1,090,909 shares were held in an escrow
account for a period of one year following the closing from which certain
potential indemnification obligations under the purchase agreement could be
satisfied. The aggregate number of shares held in escrow was subject to
adjustment upward or downward depending upon the trading price of the Company’s
common stock during the one year period following the closing
date.   On March 12, 2008, the Company released these shares from
escrow and issued an additional 1,882,225 shares on June 12, 2008 pursuant
to the adjustment provisions of the SSI asset purchase agreement.





Acquisition
of EthoStream, LLC





On March
15, 2007, the Company acquired 100% of the outstanding membership units of
EthoStream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The purchase price
of $11,756,097 was comprised of $2.0 million in cash and 3,459,609 shares of the
Company’s common stock. The entire stock portion of the purchase price was
deposited into escrow upon closing to satisfy certain potential indemnification
obligations of the sellers under the purchase agreement. The shares held in
escrow are distributable over the three years following the closing. As of March
31, 2009, 876,804 shares remain in escrow pursuant to the purchase
agreement.





Proceeds
from the issuance of common stock





During
the year ended December 31, 2008, the Company issued 2,500,000 shares of common
stock valued at $0.60 per share for an aggregate purchase price of
$1,500,000.  The proceeds of this offering were used to repay the principal
of the Senior Promissory Note to GRQ.




Cash
flow analysis





Cash
utilized in operating activities was $4,058,385 during the year ended December
31, 2008 compared to $13,989,434 and during the year ended December 31, 2007,
respectively. The primary use of cash during the twelve months ended December
31, 2008 was for operating expenses of the Company.





During
the year ended December 31, 2009, our primary capital needs are for operating
expenses, including funds to support our business strategy, which primarily
includes working capital necessary to fund inventory purchases.  We
anticipate funding our operations through working capital generated by the
following: (i) cash flow from sales of our products; (ii) reducing our
inventory levels and managing our operating expenses; (iii) maximizing our
trade payables with our domestic and international suppliers;
(iv) increasing collection efforts on existing accounts receivables; and
(v) utilizing our receivable and inventory-based agreements.





The
Company utilized cash for investing activities of $1,136,629 and $5,048,217
during the years ended December 31, 2008 and 2007,
respectively.  During the year ended December 31, 2008, these
expenditures were primarily due to the purchase of equipment under operating
lease by MSTI.  In 2007, these expenditures primarily arose
from the payment of the cash portion of the MST purchase price of $900,000,
cash payments of $875,000 and $2,000,000, for the acquisitions of SSI and
EthoStream, respectively, and $1,020,000 for the acquisition of Newport
Telecommunications in July 2007 by our MSTI subsidiary.  The proceeds
of the sale of the investment in BPL Global provided $2,000,000 in November
2007. The cost of equipment under operating leases amounted to $1,133,629
and $1,568,651 for the year ended December 31, 2008 and 2007,
respectively.  Purchases of property and equipment amounted to $9,000
and $310,715 for the year ended December 31, 2008 and 2007,
respectively.




The
Company had cash from financing activities of $3,847,420 and $19,023,197
during the year ended December 31, 2008 and 2007, respectively. The financing
activities involved the sale of 2.5 million shares of common stock at $0.60 per
share for a total of $1,500,000, in February 2008, the proceeds of which were
used to repay the outstanding principal amount on the GRQ
Note.  Additionally, the Company sold debentures for gross proceeds of
$3,500,000 in May and July 2008, and the Company received a $400,000 loan
from a private investor, which was offset by $462,511in
financing costs paid.  During the year ended December 31, 2007, the
financing activities represented proceeds of $9,610,000, net of placement fees,
from the sale of 4.0 million shares of common stock at $2.50 per share, the
issuance of a senior note payable in the principal amount of $1,500,000 and
proceeds from the exercise of stock options and warrants of
$124,460.  Through its subsidiary MSTI, the Company raised $5,303,238
through the sale of debentures, and $2,694,020 through the sale of common stock,
during the year ended December 31, 2007.




30




We have
reduced cash required for operations by reducing operating costs and reducing
staff levels. In addition, we are working to manage our current liabilities
while we continue to make changes in operations to improve our cash flow and
liquidity position.




Our
registered independent certified public accountants have stated in their report
dated March 31, 2009, that we have incurred operating losses in the past years,
and that we are dependent upon management's ability to develop profitable
operations. These factors among others may raise substantial doubt about our
ability to continue as a going concern.




While we
have raised capital in 2008 to assist in our working capital and financing
needs, additional financing is likely required in order to meet our current and
projected cashflow requirements from operations and development . Additional
investments are being sought, but we cannot guarantee that we will be able to
obtain such investments. Financing transactions may include the issuance of
equity or debt securities, obtaining credit facilities, or other financing
mechanisms. However, the trading price of our common stock and the downturn in
the U.S. stock and debt markets could make it more difficult to obtain financing
through the issuance of equity or debt securities. Even if we are able to raise
the funds required, it is possible that we could incur unexpected costs and
expenses, fail to collect significant amounts owed to us, or experience
unexpected cash requirements that would force us to seek alternative financing.
Further, if we issue additional equity or debt securities, stockholders may
experience additional dilution or the new equity securities may have rights,
preferences or privileges senior to those of existing holders of our common
stock. If additional financing is not available or is not available on
acceptable terms, we will have to curtail our operations.





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




We do not
maintain off-balance sheet arrangements nor do we participate in any
non-exchange traded contracts requiring fair value accounting
treatment.





Acquisition
or Disposition of Plant and Equipment





During
the year ended December 31, 2008, fixed assets increased approximately
$1,143,000, including $1,134,000 for the MST Segment equipment purchased for the
MST build-out. The remainder is related to computer equipment and peripherals
used in day-to-day operations. 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.  This lease terminated in March 2008.





MSTI
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.





The
Company presently leases approximately 12,000 square feet of office space in
Milwaukee, WI for EthoStream.  The Milwaukee lease expires in February
2019.





Following
the acquisition of SSI, the Company assumed a lease on 9,000 square feet of
office and warehouse space in Las Vegas, NV on a month to month
basis.  The Las Vegas, NV office lease expired on April 30,
2008.




31




New
Accounting Pronouncements





In June 2008, the FASB issued Emerging
Issues Task Force No. 07-5 (EITF 07-5),Determining Whether
an Instrument (or Embedded Feature) is Indexed to an Entity’s Own
Stock.EITF 07-5 requires
entities to evaluate whether an equity-linked financial instrument (or embedded
feature) is indexed to its own stock by assessing the instrument’s contingent
exercise provisions and settlement provisions. Instruments not indexed to their
own stock fail to meet the scope exception of Statement of Financial Accounting
Standards No. 133,Accounting for
Derivative Instruments and Hedging Activities, paragraph 11(a), and should be
classified as a liability and marked-to-market. The statement is effective for
fiscal years beginning after December 15, 2008 and is to be applied to
outstanding instruments upon adoption with the cumulative effect of the change
in accounting principle recognized as an adjustment to the opening balance of
retained earnings. The Company is currently evaluating the provisions of EITF
07-5.
 
 In
February 2007, the FASB issued Statement of Financial Accounting Standards
(“SFAS”) No. 159, The Fair
Value Option for Financial Assets and Financial Liabilities-Including an
Amendment of FASB Statement No. 115 (“SFAS 159”).  SFAS 159
permits entities to measure eligible assets and liabilities at fair
value.  Unrealized gains and losses on items for which the fair value
option has been elected are reported in earnings.  SFAS 159 is
effective for fiscal years beginning after November 15, 2007.  We
adopted SFAS 159 on January 1, 2008 and did not elect the fair value option
which did not have a material impact on our financial position and results of
operations.
 
 In
December 2007, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 141R, Business Combinations , and
Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in
Consolidated Financial Statements,   an amendment of ARB No. 51
..  These new standards significantly change the accounting for and
reporting of business combination transactions and noncontrolling interests
(previously referred to as minority interests) in consolidated financial
statements.  Both standards are effective for fiscal years beginning on or
after December 15, 2008, with early adoption prohibited. These Statements are
effective for the Company beginning on January 1, 2009.  The Company is
currently evaluating the provisions of FAS 141(R) and FAS
160.




In March
2008, the Financial Accounting Standards Board (FASB) issued Statement No. 161,
Disclosures about Derivative
Instruments and Hedging Activities - an amendment of FASB Statement No.
133 (SFAS 161).  SFAS 161 requires companies to provide
enhanced disclosures regarding derivative instruments and hedging activities and
requires companies to better convey the purpose of derivative use in terms of
the risks they intend to manage. Disclosures about (a) how and why an entity
uses derivative instruments, (b) how derivative instruments and related hedged
items are accounted for under SFAS No. 133 and its related interpretations, and
(c) how derivative instruments and related hedged items affect a company’s
financial position, financial performance, and cash flows are required. This
Statement retains the same scope as SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, and is effective for fiscal years and
interim periods beginning after November 15, 2008. We do not expect the adoption
of SFAS No. 161 to have a material impact, if any, on our consolidated financial
statements.





In
February 2008, the FASB issued a FASB Staff Position (FSP) on Accounting for Transfers of
Financial Assets and Repurchase Financing Transactions (FSP FAS 140-3).
This FSP addresses the issue of whether the transfer of financial assets and the
repurchase financing transactions should be viewed as two separate transactions
or as one linked transaction. The FSP includes a rebuttable presumption that the
two transactions are linked unless the presumption can be overcome by meeting
certain criteria. The FSP will be effective for fiscal years beginning after
November 15, 2008 and will apply only to original transfers made after that
date; early adoption will not be allowed. We do not expect the adoption of FSP
FAS 140-3 to have a material impact, if any, on our consolidated financial
statements.




In April
2008, the FASB issued FSP No. 142-3, “Determination of the Useful Life of
Intangible Assets” (“FSP 142-3”). FSP 142-3 amends the factors an entity should
consider in developing renewal or extension assumptions used in determining the
useful life of recognized intangible assets under FASB Statement No. 142,
“Goodwill and Other Intangible Assets”. This new guidance applies prospectively
to intangible assets that are acquired individually or with a group of other
assets in business combinations and asset acquisitions. FSP 142-3 is effective
for financial statements issued for fiscal years and interim periods beginning
after December 15, 2008. Early adoption is prohibited. The Company does not
expect the adoption of FSP 142-3 to have a significant impact on its
consolidated financial statements.
  32
  In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles” (“SFAS 162”). SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles (the GAAP
hierarchy). SFAS 162 will become effective 60 days following the SEC’s approval
of the Public Company Accounting Oversight Board amendments to AU Section 411,
“The Meaning of Present Fairly in Conformity With Generally Accepted Accounting
Principles.” The Company does not expect the adoption of SFAS 162 to have a
material effect on its results of operations and financial
condition.
 
 In May
2008, the FASB issued FSP Accounting Principles Board (“APB”) 14-1 “Accounting
for Convertible Debt instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement)” (“FSP APB 14-1”). FSP APB 14-1 requires the
issuer of certain convertible debt instruments that may be settled in cash (or
other assets) on conversion to separately account for the liability (debt) and
equity (conversion option) components of the instrument in a manner that
reflects the issuer’s non-convertible debt borrowing rate. FSP APB 14-1 is
effective for fiscal years beginning after December 15, 2008 on a retroactive
basis. The Company does not expect the adoption of FSP APB 14-1 will have
significant effect on its results of operations and financial
condition.




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
            
            $
            2,136,650
            
            
            
            -
            
            
            
            2,136,650
            
            
            
            -
            
            
            
            -Current
      Debt Obligations
            
            $
            7,584,508
            
            
            
            7,584,508
            
            
            
            -
            
            
            
            -
            
            
            
            -Capital
      Lease Obligations
            
            $
            204,416
            
            
            
            204,416
            
            
            
            -
            
            
            
            -
            
            
            
            -Operating
      Lease Obligations
            
            $
            2,530,955
            
            
            
            462,515
            
            
            
            740,772
            
            
            
            613,490
            
            
            
            714,178Purchase
      Obligations (1)
            
            $
            454,400
            
            
            
            454,400
            
            
            
            -
            
            
            
            -
            
            
            
            -Other
      Long-Term Liabilities Reflected on the Registrant’s Balance Sheet Under
      GAAP
            
            $
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            $
            12,910,929
            
            
            
            8,705,839
            
            
            
            2,877,422
            
            
            
            613,490
            
            
            
            714,178




(1)
            Purchase
      commitment for inventory orders of energy management
      products.  The Company has prepaid approximately $90,560 as of
      March 24, 2009.




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





Short
Term Investments





Our
excess cash is held in money market accounts in a bank and brokerage firms both
of which are nationally ranked top tier firms with an average return of
approximately 400 basis points. Due to the conservative nature of our investment
portfolio, an increase or decrease of 100 basis points in interest rates would
not have a material effect on our results of operations or the fair value of our
portfolio.





Marketable
Securities





Telkonet
maintained investments in two publicly-traded companies for the year ended
December 31, 2008.  The Company has classified these securities as
available for sale.  Such securities are carried at fair market
value.  Unrealized gains and losses on these securities, if any, are
reported as accumulated other comprehensive income (loss), which is a separate
component of stockholders’ equity.  Unrealized losses of $32,750 were
recorded for the year ended December 31, 2008 and there were no unrealized gains
or losses for the year ended December 31, 2007.  Realized gains and
losses and declines in value judged to be other than temporary on securities
available for sale, if any, are included in operations.   Realized
losses of $4,098,514 were recorded for the year ended December 31,
2008.  There were no realized gains or losses for the year ended
December 31, 2007.




33




Investments
in Privately Held Companies





We have
invested in a privately held company, which is in the startup or development
stage. This investment is inherently risky because the market for the products
of this company is developing and may never materialize. As a result, we could
lose our entire initial investment in this company. In addition, we could also
be required to hold our investment indefinitely, since there is presently no
public market in the securities of this company and none is expected to develop.
This investment is carried at cost, which as of March 1, 2009 was $8,000 and
recorded in other assets in the Consolidated Balance Sheet.




ITEM
8.    FINANCIAL STATEMENTS.





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





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





None.





ITEM
9A.  CONTROLS AND PROCEDURES.




ITEM 9A(T).        CONTROLS AND
PROCEDURES
 
 Evaluation of
Disclosure Controls and Procedures
 
 We
maintain disclosure controls and procedures that are designed to ensure that
material information required to be disclosed in our periodic reports filed
under the Securities Exchange Act of 1934, as amended, or 1934 Act, is recorded,
processed, summarized, and reported within the time periods specified in the
SEC’s rules and forms and to ensure that such information is accumulated and
communicated to our management, including our chief executive officer and chief
financial officer as appropriate, to allow timely decisions regarding required
disclosure. During the quarter ended December 31, 2008 we carried out an
evaluation, under the supervision and with the participation of our management,
including the principal executive officer and the principal financial officer,
of the effectiveness of the design and operation of our disclosure controls and
procedures, as defined in Rule 13(a)-15(e) under the 1934 Act. Based on
that evaluation and due to the lack of segregation of duties and failure to
implement accounting controls of acquired businesses, our principal executive
officer and principal financial officer concluded that our disclosure controls
and procedures were ineffective as of the end of the period covered by this
report.
 
 Management’s
Report on Internal Control over Financial Reporting
 
 Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting. The Company’s internal control over financial
reporting is designed to provide reasonable assurances regarding the reliability
of financial reporting and the preparation of the financial statements of the
Company in accordance with U.S. generally accepted accounting principles, or
GAAP. 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 or compliance with the policies or procedures may
deteriorate.






34




With the
participation of our Chief Executive Officer, our management conducted an
evaluation of the effectiveness of our internal control over financial reporting
as of December 31, 2008 based on the framework in Internal
Control—Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission ("COSO"). Based on our evaluation and the material
weaknesses described below, management concluded that the Company did not
maintain effective internal control over financial reporting as of
December 31, 2008 based on the COSO framework criteria. Management has
identified control deficiencies regarding the lack of segregation of duties and
the need for a stronger internal control environment. Management of the Company
believes that these material weaknesses are due to the small size of the
Company’s accounting staff and continued integration of the 2007 acquisitions of
Smart Systems International, EthoStream, LLC and Newport Telecommunications Co.
The small size of the Company’s accounting staff may prevent adequate controls
in the future, such as segregation of duties, due to the cost/benefit of such
remediation.  We do expect to retain additional personnel to remediate
these control deficiencies in the future.
 
 These
control deficiencies could result in a misstatement of account balances that
would result in a reasonable possibility that a material misstatement to our
financial statements may not be prevented or detected on a timely basis.
Accordingly, we have determined that these control deficiencies as described
above together constitute a material weakness.
 
 In light
of this material weakness, we performed additional analyses and procedures in
order to conclude that our financial statements for the year ended
December 31, 2008 included in this Annual Report on Form 10-K were fairly
stated in accordance with US GAAP. Accordingly, management believes that despite
our material weaknesses, our financial statements for the year ended December
31, 2008 are fairly stated, in all material respects, in accordance with US
GAAP.




This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial reporting.
Management’s report was not subject to attestation by our registered public
accounting firm pursuant to temporary rules of the Securities and Exchange
Commission that permit us to provide only management’s report in this Annual
Report on Form 10-K.
 
 Changes
in Internal Controls
 
 During
the fiscal quarter ended December 31, 2008, there have been no changes in our
internal control over financial reporting that have materially affected or are
reasonably likely to materially affect our internal controls over financial
reporting.




35





ITEM
9B.  OTHER INFORMATION.





None.




PART
III





ITEM
10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.





The
following table furnishes the information concerning the Company’s directors and
officers for the fiscal year ended December 31, 2008. The directors of the
Company are elected every year and serve until their successors are duly elected
and qualified.





Name
            Age
            TitleJason
      Tienor
            34
            President
      & Chief Executive OfficerRichard
      J. Leimbach
            40
            Chief
      Financial OfficerJeffrey
      Sobieski
            33
            Chief
      Operating OfficerWarren
      V. Musser
            82
            Chairman
      of the BoardThomas
      C. Lynch
            67
            Director
      (1), (2)Dr.
      Thomas M. Hall
            57
            Director
      (1), (2)Seth
      Blumenfeld
            68
            DirectorAnthony
      J. Paoni
            64
            Director
      (1), (2)


_________________________


(1)
            Member
      of the Audit Committee(2)
            Member
      of the Compensation Committee





Jason
L. Tienor—President and Chief Executive Officer





Mr.
Tienor has served as the Company’s President and Chief Executive Officer since
December 2007 and, from August 2007 until December 2007, he served as the
Company’s Chief Operating Officer.  Mr. Tienor has also served as
Chief Executive Officer of EthoStream, LLC, a wholly-owned subsidiary of the
Company, since March 2007.  From 2002 until his employment with the
Company, Mr. Tienor served as Chief Executive Officer of EthoStream, LLC, the
company that he co-founded. Mr. Tienor received a bachelor of business
administration in management information systems and marketing from the
University of Wisconsin – Oshkosh and a masters of business
administration from Marquette University.





Richard
J. Leimbach—Chief Financial Officer




Mr.
Leimbach has served as the Company’s Chief Financial Officer since December 2007
and, from June 2006 until December 2007, he served as the Vice President of
Finance. He also served as the Company’s Controller from January 2004 until June
2006.  Mr. Leimbach is a certified public accountant with over fifteen
years of public accounting and private industry experience. Prior to joining
Telkonet, Mr. Leimbach was the Controller with Ultrabridge, Inc., an
applications solution provider. Mr. Leimbach also served as Corporate Accounting
Manager for Snyder Communications, Inc., a global provider of integrated
marketing solutions.





Jeffrey
J. Sobieski—Chief Operating Officer





Mr.
Sobieski was named the Company's Chief Operating Officer in June
2008.  Prior to this appoinment, Mr. Sobieski served as the Company’s
Executive Vice President, Energy Management since December 2007 and from March
2007 until December 2007, he served as Chief Information Officer of EthoStream,
LLC, wholly-owned subsidiary of the Company.  From 2002 until his
employment with the Company, Mr. Sobieski served as Chief Information Officer of
EthoStream, LLC, the company he co-founded.  Mr. Sobieski is also the
co-founder of Interactive Solutions, a consulting firm providing support to the
Insurance and Telecommunications Industries.




36




Warren
V. Musser—Chairman of the Board of Directors





Warren V.
“Pete” Musserjoined the Board of
Telkonet in January, 2003.  Mr. Musser is the President and Chief
Executive Officer of The Musser Group LLC, a strategy consulting firm based in
Wayne, Pennsylvania which he started in 2001.  Mr. Musser is the
founder and former Chief Executive Officer and Chairman  and current
Chairman Emeritus of Safeguard Scientifics, Inc., a company that builds
value in high-growth, revenue-stage information technology and life sciences
businesses.  He was a founding investor of QVC, Novell, Compucom
Systems and Cambridge Technology Partners, among other companies.  Mr.
Musser currently serves as Chairman of InfoLogix, Inc. and Epitome Systems,
Inc. and is on the Board of Directors of NutriSystem, Inc., Internet
Capital Group, Inc., Health Benefits Direct Corporation and Health
Advocate.  Mr. Musser serves on a variety of civic and charitable boards,
including as Co-Chairman of the Eastern Technology Council, Chairman of
Economics PA and Vice Chairman of the National Center for the American
Revolution.




Thomas
C. Lynch—Director





Mr. Lynch
is Senior Vice President 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
Chairman of Sprinturf, a synthetic turf company, and also as a Director of
Epitome Systems, Infologix Systems, Mikros Systems Corp., Economics
Pennsylvania, Armed Forces Benefit Association, Catholic Leadership Institute,
National Center for the American Revolution at Valley Forge, USO Board of
Governors and is currently a trustee of the US Naval Academy
Foundation.  Mr. Lynch has served as the President of Valley Forge
Historical Society, and Chairman of the Cradle of Liberty Council, Boy Scouts of
America.  Mr. Lynch graduated from the US Naval Academy with his
Bachelor of Science degree in 1964 and received his Master of Science degree
from the George Washington University.  Mr. Lynch has been a director
of the Company since October 2003.





Dr.
Thomas M. Hall—Director





Dr. Hall
is the Managing Director of Marrell Enterprises, LLC (a company that specializes
in international business development). 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.





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.  Mr. Blumenfeld has been a
director of the Company since 2005.





Anthony
J. Paoni - Director





Professor
Paoni has been a faculty member at Northwestern University’s Kellogg School of
Management since 1996. Previously, he spent 28 years in the information
technology industry with market leading organizations that provided computer
hardware, software and consulting services.  For the first 15 years of
his career Professor Paoni managed sales and marketing organizations and in the
later stages of his career he moved into general management positions starting
with PANSOPHIC Systems Incorporated. This Lisle, Illinois based firm was the
world’s fifth largest international software company prior to its acquisition by
Computer Associates, Incorporated. Subsequently, he became chief operating
officer of Cross Access, a venture capital funded software firm that provided
industry-leading solutions to the heterogeneous database connectivity market
segment. In addition, he has been president of two wholly-owned U.S.
subsidiaries of Ricardo Consulting, a U.K.-based international engineering
consulting firm focused on computer based automotive powertrain design. Prior to
joining the Kellogg faculty, Professor Paoni was chief executive officer of
Eolas, an Internet software company with patent pending Web technology - one of
the key technology drivers responsible for the rapid adoption of the Internet
platform.  Professor Paoni has been a director of the Company since
2007.




37




Audit
Committee





The
Company maintains an Audit Committee of the Board of Directors. For the year
ended December 31, 2008, Messrs. Hall, Lynch and Paoni served on the Audit
Committee. The Company’s Board of Directors has determined that each of Messrs.
Hall, Lynch and Paoni 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 Paoni are “independent” as such term is defined
in Section 121(A) of the AMEX Rules and Rule 10A-3 promulgated under the
Securities Exchange Act of 1934. The Board of Directors has adopted an audit
committee charter, which was ratified by the Company’s stockholders at the 2004
Annual Meeting of Stockholders.  The Audit Committee held 6 meetings
in 2008.





Compensation
Committee





The
Company maintains a Compensation Committee of the Board of Directors. For the
year ended December 31, 2008, Dr. Hall and Messrs. Lynch and Paoni served on the
Compensation Committee. The Compensation Committee held 2 meetings during
2008.




Code of
Ethics





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




SECTION
16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE





Section
16(a) of the Securities Exchange Act of 1934 requires our directors and certain
of our officers to file reports of holdings and transactions in shares of
Telkonet common stock with the Securities and Exchange Commission. Based on our
records and other information, we believe that in 2008 our directors and our
officers who are subject to Section 16 met all applicable filing
requirements.





ITEM
11.  EXECUTIVE COMPENSATION.





COMPENSATION
COMMITTEE REPORT





The
Compensation Committee of the Board of Directors has reviewed and discussed the
section of this Form 10-K entitled “Compensation Discussion and Analysis” with
management. Based on this review and discussion, the Committee has recommended
to the Board that the section entitled “Compensation Discussion and Analysis,”
be included in this Form 10-K for the year ended December 31,
2008.





Thomas M.
Hall


Thomas C.
Lynch


Anthony
J. Paoni




38




COMPENSATION
DISCUSSION AND ANALYSIS





Oversight
of Executive Compensation Program





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




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





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





·
            annually
      review and approve for the CEO and the executive officers of the Company
      the annual base salary, the annual incentive bonus, including the specific
      goals and amount, equity compensation, employment agreements, severance
      arrangements, and change in control agreements/provisions, and any other
      benefits, compensation or
arrangements.





·
            make
      recommendations to the Board with respect to incentive compensation plans,
      including reservation of shares for issuance under employee benefit
      plans.





·
            annually
      review and recommend to the Board of Directors for its approval the
      compensation, including cash, equity or other compensation, for members of
      the Board of Directors for their service as a member of the Board of
      Directors, a member of any committee of the Board of Directors, a Chair of
      any committee of the Board of Directors, and the Chairman of the Board of
      Directors.





·
            annually
      review the performance of the Company’s Chief Executive
      Officer.





·
            make
      recommendations to the Board of Directors on the Company’s executive
      compensation practices and policies, including the evaluation of
      performance by the Company’s executive officers and issues of management
      succession.





·
            review
      the Company’s compliance with employee benefit
  plans.





·
            make
      regular reports to the Board.





·
            annually
      review and reassess the adequacy of the Compensation Committee charter and
      recommend any proposed changes to the Board for
  approval.





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





Overview
of Compensation Program





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





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





·
            drive
      and reward performance which supports the Company’s core
      values;





·
            provide
      a percentage of total compensation that is “at-risk,” or variable, based
      on predetermined performance
criteria;




39




·
            design
      competitive total compensation and rewards programs to enhance the
      Company’s ability to attract and retain knowledgeable and experienced
      senior executives; and





·
            set
      compensation and incentive levels that reflect competitive market
      practices.




Compensation
Elements and Rationale





Compensation
for Named Executive Officers Other than the CEO





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





Compensation
for the Company’s CEO





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





(i)
            Performance Goals





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





(ii)
            Incentive
      Compensation





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





(iii)
            Competitive Compensation
      Program





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





Financial
Metrics Used in Compensation Programs





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





Compensation
Benchmarking Relative to Market





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




40




Review
of Senior Executive Performance





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




Components
of the Executive Compensation Program





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





·
            base
      salary;·
            stock
      incentive plan;


·
            retirement,
      health and welfare benefits;·
            perquisites
      and perquisite allowance payments;
and


·
            termination
      benefits.




Base
Salaries





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




Stock
Incentive Plan





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




The
Company practice is that the exercise price for each stock option is equal to
the fair market value on the date of grant. Under the terms of the Plan, the
option price will not be less than the fair market value of the shares on the
date of grant or, in the case of a beneficial owner of more than 5.0% of the
Company’s outstanding common stock on the date of grant, the option price will
not be less than 110% of the fair market value of the shares on the date of
grant.





There is
a limited term in which Plan participants can exercise stock options, known as
the “option term.” The option term is generally ten years from the date of
grant. At the end of the option term, the right to exercise any unexercised
options expires. Option holders generally forfeit any unvested options if their
employment with the Company terminates.




41




Certain
key executives may be a party to option agreements containing clauses that cause
their options to become immediately and fully vested and exercisable upon a
Change of Control, as defined in the Plan. Additionally, death or disability of
the executive during his or her employment period may cause certain stock
options to immediately vest and become exercisable per the terms outlined in the
stock option award agreement.





The
Compensation Committee awards options to named executive officers upon
commencement of their employment with the Company, and for successfully
achieving or exceeding predetermined individual and Company performance goals.
In determining whether to award stock options and the number of stock options
granted to a named executive officer, the Compensation Committee reviews the
compensation of executives at peer group companies to ensure that the
compensation program is competitive.




Retirement,
Health and Welfare Benefits





The
Company offers a variety of health and welfare and retirement programs to all
eligible employees. The named executive officers generally are eligible for the
same benefit programs on the same basis as the rest of the broad-based
employees. The Company’s health and welfare programs include medical, dental,
vision, life, accidental death and disability, and short and long-term
disability insurance. In addition to the foregoing, the named executive officers
are eligible to participate in the Company’s 401(k) Profit Sharing
Plan.





401(k) Profit
Sharing Plan





Telkonet
maintains a defined contribution profit sharing plan for employees (the
“Telkonet 401(k)”) that is administered by a committee of trustees appointed by
the Company. All Company employees are eligible to participate upon the
completion of six months of employment, subject to minimum age
requirements. Contributions by employees under the Telkonet 401(k) are
immediately vested and each employee is eligible for distributions upon
retirement, death or disability or termination of employment. Depending upon the
circumstances, these payments may be made in installments or in a single lump
sum.





MSTI
maintains a defined contribution profit sharing plan for employees (the “MSTI
401(k)”) that is administered by a committee of trustees appointed by the
Company. All Company employees are eligible to participate upon the completion
of three months of employment, subject to minimum age requirements. Each
year the Company makes a contribution to the MSTI 401(k) without regard to
current or accumulated net profits of the Company. These contributions are
allocated to participants in amounts of 100% of the participants’ contributions
up to 1% of each participant’s gross pay, then 10% of the next 5% of each
participant’s gross pay (a higher contribution percentage may be determined at
the Company’s discretion). In addition, the Company makes a one-time, annual
contribution of 3% of each participant’s gross pay to each participant’s
contribution account in the MSTI 401(k) plan. Participants become vested in
equal portions of their Company contribution account for each year of service
until full vesting occurs upon the completion of six years of service.
Distributions are made upon retirement, death or disability in a lump sum or in
installments.




Perquisites





The
Company leased a vehicle for the use of Telkonet's former CEO, which
expired in September 2008. Additionally, in the first quarter of 2007 the
Company began providing monthly car allowance stipends to certain executives of
Telkonet and MSTI.





42


EXECUTIVE
COMPENSATION
  The
following table sets forth certain information with respect to compensation for
services in all capacities for the years ended December 31, 2008, 2007 and
2006 paid to our Chief Executive Officer (principal executive officer), Chief
Financial Officer (principal financial officer) and the three other most highly
compensated executive officers who were serving as such as of December 31,
2008.


Summary
Compensation Table





Name
      and Principal Position
            Year
            
            Salary
              ($)
            
            
            Bonus
              ($)
            
            
            Stock
              Awards
              ($)
            
            
            Option
              Awards
              ($)
              (1)(2)
            
            
            Non-Equity
              Incentive
      Plan
              Compensation
              ($)
            
            
            Change
      in
              Pension
      Value
              and
              Nonqualified
              Deferred
              Compensation
              Earnings
              ($)
            
            
            All
      Other
              Compen-sation
              ($)
            
            
            Total
              ($)Jason
      L. Tienor
            2008
            
            $
            194,421
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            7,431
            
            
            $
            201,852President
      and Chief
            2007
            
            $
            133,022
            
            
            $
            0
            
            
            $
            0
            
            
            $
            111,230
            
            
            $
            0
            
            
            $
            0
            
            
            $
            6,139
            
            
            $
            250,391Executive
      Officer
            2006
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0Richard
      J. Leimbach
            2008
            
            $
            180,039
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            180,039Chief
      Financial
            2007
            
            $
            133,491
            
            
            $
            25,000
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            158,491Officer
            2006
            
            $
            111,231
            
            
            $
            5,000
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            116,231Jeffrey
      J. Sobieski
            2008
            
            $
            186,421
            
            
            $
            0
            
            
            $
            0
            
            
            $
            31,180
            
            
            $
            0
            
            
            $
            0
            
            
            $
            7,431
            
            
            $
            225,032Chief
      Operating
            2007
            
            $
            122,003
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            6,139
            
            
            $
            128,142Officer
            2006
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0





(1)
            In
      2007 the following assumptions were used to determine the fair value of
      stock option awards granted: historical volatility of 70%, expected option
      life of 5.0 years and a risk-free interest rate of
4.8%.(2)
            In
      2008 the following assumptions were used to determine the fair value of
      stock option awards granted: historical volatility of 74%, expected option
      life of 5.0 years and a risk-free interest rate of
  3.0%.




Employment
Agreements





Jason
Tienor, President and Chief Executive Officer, is employed pursuant to an
employment agreement dated March 15, 2007.  Mr. Tienor’s employment
agreement has a term of three years, which may be extended by mutual agreement
of the parties thereto, and provides for an annual base salary of $148,000 per
year and bonuses and benefits based on Telkonet’s internal
policies.  On August 20, 2007, Mr. Tienor’s annual salary was
increased to $200,000 and he remains eligible to participate in the incentive
and benefit plans pursuant to his existing employment agreement and Telkonet’s
internal policies.





Richard
J. Leimbach, Chief Financial Officer, has been employed by the Company since
January 26, 2004.  Mr. Leimbach’s annual salary was increased from
$130,000 to $190,000 in December 2007 in connection with his appointment as
Chief Financial Officer.  He is also eligible to receive bonuses and
benefits based upon Telkonet’s internal policies.  Mr. Leimbach does
not have a written employment agreement.





Jeff
Sobieski, Chief Operating Officer, is employed pursuant to an employment
agreement, dated March 15, 2007. Mr. Sobieski’s employment agreement has a term
of three years, which may be extended by mutual agreement of the parties
thereto, and provides for a base salary of $148,000 per year and bonuses and
benefits based upon Telkonet’s internal policies.  On December 11,
2007, Mr. Sobieski’s salary was increased to $190,000  and he remains
eligible to participate in the incentive and benefit plans pursuant to his
existing employment agreement and Telkonet’s internal policies.





In
addition, to the foregoing, stock options are periodically granted to employees
under the Company’s Plan 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.




43


GRANT
OF PLAN BASED AWARDS
 
 The
following table sets forth information concerning stock options granted in the
fiscal year ended December 31, 2008, to the persons listed on the Summary
Compensation Table.


Name
            Grant
      Date
            All
      Other
              Option
      Awards:
              Number
      of
              Securities
      Underlying
              Options
      Granted
              (#)
            Exercise
      Price or
              Base
      Price of
              Option
      Awards
              ($/sh)
            Grant
      Date
              Fair
      Value of Stock
              and
      Option AwardsJason
      Tienor
            n/a
            n/a
            n/a
            n/aRichard
      J. Leimbach
            n/a
            n/a
            n/a
            n/aJeffrey
      Sobieski
            02/19/2008
            50,000
            $1.00
            $31,180





OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END TABLE





The
following table shows outstanding stock option awards classified as exercisable
and unexercisable as of December 31, 2008 for the named executive
officers.





OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END




Option
      Awards
            
            Stock
      AwardsName
            
            Number
      of
              Securities
              Underlying
              Unexercised
              Options
              (#)
              Exerciseable
            
            
            Number
      of
              Securities
              Underlying
              Unexercised
              Options
              (#)
              Unexerciseable
            
            
            Equity
              Incentive
              Plan
      Awards:
              Number
      of
              Securities
              Underlying
              Unexercised
              Unearned
              Options
              (#)
            
            
            Option
              Exercise
              Price
              ($)
            
            Option
              Expiration
              Date
            
            Number
      of
              Shares
      or
              Units
      of
              Stock
              That
      Have
              Not
      Vested
              (#)
            
            
            Market
              Value
      of
              Shares
      or
              Units
      of
              Stock
      That
              Have
      Not
              Vested
              ($)
            
            
            Equity
              Incentive
              Plan
      Awards:
              Number
      of
              Unearned
      Shares, Units
              or
      Other
              Rights
      That
              Have
      Not
              Vested
              (#)
            
            
            Equity
              Incentive
              Plan
      Awards:
              Market
      or Payout
              Value
      of Unearned Shares, Units
              or
      Other
              Rights
      That
              Have
      Not
              Vested
              ($)Jason
      L. Tienor
            
            
            30,000
            
            
            
            70,000
            
            
            
            -
            
            
            $
            1.80
            
            4/24/2012
      (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Richard
      J. Leimbach
            
            
            77,500
            
            
            
            10,000
            
            
            
            -
            
            
            
            (1
            )
            4/24/2012
      (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Jeffrey
      J. Sobieski
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            $
            1.00
            
            4/24/2012
      (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -





(1)
            Includes
      35,000 and 2,500 vested and unvested options, respectively, exerciseable
      at $2.59, and 42,500 and 7,500 vested and unvested options, respectively,
      exerciseable at $5.08 per share.(2)
            All
      options granted in accordance with the Telkonet Amended and Restated Stock
      Incentive Plan (the “Plan”) have an outstanding term equal to the shorter
      of ten years, or the expiration of the Plan.  The Plan expires
      on April 24, 2012.




44




OPTION
EXERCISES AND STOCK VESTED





There
were no options exercised by, or stock awards vested for the account of, the
named executive officers during 2008.




POTENTIAL
PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL




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




In the
event Telkonet fails to renew the employment agreements upon expiration of the
term, then Telkonet shall continue to pay the executive's base salary and
provide the executive with continued participation in each employee benefit plan
in which the executive participated immediately prior to expiration of the term
for a period of three months following expiration of the term. Each of Messrs.
Tienor and Sobieski have agreed to not to compete with the Company or solicit
any Company employees for a period of one year following expiration or earlier
termination of the employment agreements.  Assuming Mr. Tienor’s and
Mr. Sobieski’s employment agreements were terminated as of December 31, 2008,
the total estimated compensation that would have been paid under these
agreements would be $468,000 in the aggregate.





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 $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.




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 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 are made to The Musser Group pursuant to a consulting agreement
described below under the heading “Certain Relationships and Related
Transactions.”




On July
1, 2005, the Company executed a consulting agreement with Mr. Blumenfeld
pursuant to which Mr. Blumenfeld was issued 10,000 shares of Company common
stock upon execution of the agreement, 10,000 shares of Company common 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.  Under the terms
of the consulting agreement Mr. Blumenfeld was also entitled to receive a
commission equal to 5% on all international sales generated by him having gross
margins of 50% or more.  This commission was payable in cash or common
stock, at Mr. Blumenfeld’s option.  The agreement had a one year term,
and was renewable annually upon both parties’ agreement. The consulting
agreement expired on June 20, 2006 and was not renewed. On March 16, 2007, the
Board of Directors authorized a payment to Mr. Blumenfeld of $24,000 for Board
service between July 1, 2006, and December 31, 2006, which payments were
commensurate with the payments made to the other directors for Board service
during that time period.  Effective January 1, 2007, Mr. Blumenfeld
began receiving compensation in accordance with the non-management director
compensation plan.


45
  The
following table summarizes all compensation paid to the Company’s directors in
the year ended December 31, 2008.





Name
            
            Fees
              Earned
      or
              Paid
      in
              Cash
              ($)
            
            
            Stock
              Awards
              ($)
            
            
            Option
              Awards
              ($)
            
            
            Non-Equity
              Incentive
      Plan Compensation
              ($)
            
            
            Change
      in
              Pension
      Value
              and
              Nonqualified
              Deferred
      Compensation Earnings
            
            
            All
      Other Compensation
              ($)
            
            
            Total
              ($)Warren
      V. Musser
            
            $
            48,000
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            52,000
            (1)
            
            $
            100,000Thomas
      M. Hall
            
            
            48,000
            
            
            
            -
            
            
            
            12,196
            (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            60,196Thomas
      C. Lynch
            
            
            48,000
            
            
            
            -
            
            
            
            12,196
            (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            60,196James
      L. Peeler (3)
            
            
            12,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            12,000Seth
      D. Blumenfeld
            
            
            48,000
            
            
            
            -
            
            
            
            12,196
            (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            60,196Anthony
      J. Paoni
            
            
            48,000
            
            
            
            -
            
            
            
            12,196
            (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            60,196


(1)
              Fees
      for director services performed by Mr. Musser and paid to the Musser Group
      pursuant to a September 2003 consulting
  agreement.
 (2)
              Stock
      options granted pursuant to the 2008 non-management director compensation
      plan.  The following assumptions were used to determine the fair
      value of stock option awards: historical volatility of 81%, expected
      option life of 5.0 years and a risk-free interest rate of
      3.5%.
 (3)
              Mr.
      Peeler resigned from the Board of Directors on April 7,
    2008.


COMPENSATION
COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
 
 During
the year ended December 31, 2008, Messrs, Hall, Lynch and Paoni served as
members of the Company’s Compensation Committee. No member of the Compensation
Committee is, or was during the fiscal year ended December 31, 2008, an officer
or employee of the Company or any of its subsidiaries, or a person having a
relationship requiring disclosure by the Company pursuant to Item 404 of
Regulation S-K.  During 2008, no executive officer of the Company
served as a member of (i) the compensation committee of another entity of which
one of the executive officers of such entity served on the Compensation
Committee or Board of Directors; or (ii) the board of directors of another
entity of which one of the executive officers of such entity served on the
Company’s Compensation Committee.
 
 46




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, 2008.





Number
      of securities tobe
      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
            
            
            8,309,866
            
            
            $
            1.71
            
            
            
            2,951,012Equity
      compensation plans not approved by security holders
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            
            8,309,866
            
            
            $
            1.71
            
            
            
            2,951,012




47


The
following table sets forth, as of March 30, 2009, 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 30, 2009, there were no issued and
outstanding shares of any other class of the Company’s equity
securities.


Name
      and Address of Beneficial Owner
            Amount
      and Nature of Beneficial Ownership
            Percentage
      of ClassOfficers
      and DirectorsJason
      Tienor, President and Chief Executive Officer
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            736,803(1)
            0.8%Richard
      Leimbach, Chief Financial Officer
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            431,000(2)
            0.5%Jeffrey
      Sobieski, Executive Vice President
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            714,303(3)
            0.8%Warren
      V. Musser, Chairman
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            2,000,000(4)
            2.1%Thomas
      C. Lynch, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            210,000(5)
            0.2%Dr.
      Thomas M. Hall, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            747,790(6)
            0.8%Seth
      D. Blumenfeld, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            130,000(7)
            0.1%Anthony
      J. Paoni, Director
              20374
      Seneca Meadows Parkway
              Germantown,
      MD 20876
            80,000(8)
            0.1%All
      Directors and Executive Officers as a Group
            5,049,896
            5.3%





(1)
            Includes
      701,803 shares of the Company’s common stock and options exercisable
      within 60 days to purchase 35,000 shares of the Company’s common stock at
      $1.80 per share.(2)
            Includes
      351,000 shares of the Company’s common stock and options exercisable
      within 60 days to purchase 37,500 and 42,500 shares of the Company’s
      common stock at $2.59 and $5.08 per share,
respectively.(3)
            Includes
      701,803 shares of the Company’s common stock and options exercisable
      within 60 days to purchase 12,500 shares of the Company’s common stock at
      $1.00 per share.(4)
            Includes
      options exercisable within 60 days to purchase 2,000,000 shares of the
      Company’s common stock at $1.00 per share.(5)
            Includes
      options exercisable within 60 days to purchase 40,000, 20,000, 70,000 and
      80,000 shares of the Company’s common stock at $1.00, $2.00, $2.66 and
      $3.45 per share, respectively.(6)
            Includes
      557,790 shares of the Company’s common stock and options exercisable
      within 60 days to purchase 40,000, 70,000 and 80,000 shares of the
      Company’s common stock at $1.00, $2.66 and $3.45 per share,
      respectively.(7)
            Includes
      50,000 shares of the Company’s common stock and options exercisable within
      60 days to purchase 40,000 and 40,000 shares of the Company’s common stock
      at $1.00 and $2.66 per share.(8)
            Includes
      options exercisable within 60 days to purchase 40,000 and 40,000 shares of
      the Company’s common stock at $1.00 and $2.30 per
  share.




48




ITEM 13.  CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE




Description
of Related Party Transactions





In
February 2006, MSTI entered into a one-year professional services agreement with
Global Transport Logistics, Inc. (“GTI”), for consulting services for which GTI
is paid a fee of $10,000 per month. GTI is 100% owned by Eileen Matarazzo, the
sister-in-law of MSTI’s Chief Executive Officer. The agreement has been extended
through February 2009. For the years ended December 31, 2008 and 2007, MSTI paid
and expensed $6,869 and $110,000, respectively.





The Chief
Administrative Officer at MSTI, Laura Matarazzo, is the sister of the Chief
Executive Officer of MSTI and receives an annual base salary of approximately
$134,000 with bonuses and benefits based upon the Company’s internal
policies.





Company’s
Policies on Related Party Transactions





Under the
Company’s policies and procedures, related-party transactions that must be
publicly disclosed under the federal securities laws require prior approval
of the Company’s independent directors without the participation of
any director who may have a direct or indirect interest in the transaction in
question. Related parties include directors, nominees for director, principal
shareholders, executive officers and members of their immediate families. For
these purposes, a “transaction” includes all financial transactions,
arrangements or relationships, ranging from extending credit to the provision of
goods and services for value and includes any transaction with a company in
which a director, executive officer immediate family member of a director or
executive officer, or principal shareholder (that is, any person who
beneficially owns five percent or more of any class of the Company’s voting
securities) has an interest by virtue of a 10-percent-or-greater equity
interest. The Company’s policies and procedures regarding related-party
transactions are not a part of a formal written policy, but rather, represent
the Company’s historical course of practice with respect to approval of
related-party transactions.





Director
Independence





The Board
of Directors has determined that Dr. Hall and Messrs. Lynch and  Paoni
are “independent” under the listing standards of the American Stock Exchange
(AMEX). Each of Dr. Hall, Mr. Lynch and Mr. Paoni serve on, and are the only
members of, the Company’s Audit Committee and Compensation Committee. Although
Telkonet does not maintain a standing Nominating Committee, nominees for
election as directors are considered and nominated by a majority of Telkonet’s
independent directors in accordance with the AMEX listing standards.
“Independence” for these purposes is determined in accordance with
Section 121(A) of the AMEX Rules and Rule 10A-3 under the Securities
Exchange Act of 1934.





ITEM
14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES.





The
following table sets forth fees billed to the Company by our auditors during the
fiscal years ended December 31, 2008 and 2007.




December
      31,
              2008
            
            December
      31,
              20071.
      Audit Fees
            $
            309,755
            
            $
            379,8282.
      Audit Related Fees
            
            46,262
            
            
            136,5253.
      Tax Fees
            
            --
            
            
            --4.
      All Other Fees
            
            --
            
            
            --Total
      Fees
            $
            356,017
            
            $
            516,353





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 RBSM 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
consist 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.




49




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, 2008, 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, 2008 and 2007.





QUARTERLY
FINANCIAL DATA


(unaudited)





March
      31,
              2008
            
            
            June
      30,
              2008
            
            
            September
      30,
              2008
            
            
            December
      31,
              2008Net
      Revenue
            
            $
            4,959,021
            
            
            $
            5,624,537
            
            
            $
            5,727,815
            
            
            $
            4,219,586Gross
      Profit
            
            $
            1,116,818
            
            
            $
            1,887,760
            
            
            $
            2,206,451
            
            
            $
            1,496,307Provision
      for income taxes
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Net
      loss per share -- basic
            
            $
            (0.07
            )
            
            $
            (0.05
            )
            
            $
            (0.04
            )
            
            $
            (0.14
            )Net
      loss per share -- diluted
            
            $
            (0.07
            )
            
            $
            (0.05
            )
            
            $
            (0.04
            )
            
            $
            (0.14
            )March
      31,
              2007
            
            
            June
      30,
              2007
            
            
            September
      30,
              2007
            
            
            December
      31,
              2007Net
      Revenue
            
            $
            1,246,269
            
            
            $
            3,666,607
            
            
            $
            4,588,777
            
            
            $
            4,651,081Gross
      Profit
            
            $
            (70,192
            )
            
            $
            670,718
            
            
            $
            1,219,758
            
            
            $
            661,854Provision
      for income taxes
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Net
      loss per share -- basic
            
            $
            (0.09
            )
            
            $
            (0.07
            )
            
            $
            (0.07
            )
            
            $
            (0.08
            )Net
      loss per share -- diluted
            
            $
            (0.09
            )
            
            $
            (0.07
            )
            
            $
            (0.07
            )
            
            $
            (0.08
            )








50





The
following exhibits are included herein or incorporated by
reference:





Exhibit
              Number
            Description
      Of Document2.1
            MST
      Stock Purchase Agreement and Amendment (incorporated by reference to our
      8-K filed on February 2, 2006)2.2
            Asset
      Purchase Agreement by and between Telkonet, Inc. and Smart Systems
      International, dated as of February 23, 2007 (incorporated by reference to
      our Form 8-K filed on March 2, 2007)2.3
            Unit
      Purchase Agreement by and among Telkonet, Inc., EthoStream, LLC and the
      members of EthoStream, LLC dated as of March 15, 2007 (incorporated by
      reference to our Form 8-K filed on March 16, 2007)3.1
            Articles
      of Incorporation of the Registrant (incorporated by reference to our Form
      8-K (No. 000-27305), filed on August 30, 2000 and our Form S-8 (No.
      333-47986), filed on October 16, 2000)3.2
            Bylaws
      of the Registrant (incorporated by reference to our Registration Statement
      on Form S-1 (No. 333-108307), filed on August 28, 2003)3.3
            Amendment
      to Articles of Incorporation (incorporated by reference to our Form 10-Q
      (No. 001-31972), filed August 11, 2008)4.1
            Form
      of Series A Convertible Debenture (incorporated by reference to our Form
      10-KSB (No. 000-27305), filed on March 31, 2003)4.2
            Form
      of Series A Non-Detachable Warrant (incorporated by reference to our Form
      10- KSB (No. 000-27305), filed on March 31, 2003)4.3
            Form
      of Series B Convertible Debenture (incorporated by reference to our Form
      10-KSB (No. 000-27305), filed on March 31, 2003)4.4
            Form
      of Series B Non-Detachable Warrant (incorporated by reference to our Form
      10-KSB (No. 000-27305), filed on March 31, 2003)4.5
            Form
      of Senior Note (incorporated by reference to our Registration Statement on
      Form S-1 (No. 333-108307), filed on August 28, 2003)4.6
            Form
      of Non-Detachable Senior Note Warrant (incorporated by reference to our
      Registration Statement on Form S-1 (No. 333-108307), filed on August 28,
      2003)4.7
            Senior
      Convertible Note by Telkonet, Inc. in favor of Portside Growth &
      Opportunity Fund (incorporated by reference to our Form 8-K (No.
      001-31972), filed on October 31, 2005)4.8
            Senior
      Convertible Note by Telkonet, Inc. in favor of Kings Road Investments Ltd.
      (incorporated by reference to our Form 8-K (No. 001-31972), filed on
      October 31, 2005)4.11
            Warrant
      to Purchase Common Stock by Telkonet, Inc. in favor of Portside Growth
      & Opportunity Fund (incorporated by reference to our Form 8-K (No.
      001-31972), filed on October 31, 2005)4.12
            Warrant
      to Purchase Common Stock by Telkonet, Inc. in favor of Kings Road
      Investments Ltd. (incorporated by reference to our Form 8-K (No.
      001-31972), filed on October 31, 2005)4.13
            Form
      of Warrant to Purchase Common Stock (incorporated by reference to our
      Current Report on Form 8-K (No. 001-31972), filed on September 6,
      2006)4.14
            Form
      of Accelerated Payment Option Warrant to Purchase Common Stock
      (incorporated by reference to our Registration Statement on Form S-3 (No.
      333-137703), filed on September 29, 2006.4.15
            Form
      of Warrant to Purchase Common Stock (incorporated by reference to our
      Current Report on Form 8-K filed on February 5,
  2007)4.16
            Senior
      Note by Telkonet, Inc. in favor of GRQ Consultants, Inc. (incorporated by
      reference to our Form 10-Q (No. 001-31972), filed November 9,
      2007)4.17
            Warrant
      to Purchase Common Stock by Telkonet, Inc in favor of GRQ Consultants,
      Inc. (incorporated by reference to our Form 10-Q (No. 001-31972), filed
      November 9, 2007)4.18
            Form
      of Promissory Note (incorporated by reference to our Form 8-K (No.
      001-31972) filed on May 12, 2008)




51




4.19
            Form
      of Warrant to Purchase Common Stock (incorporated by reference to our Form
      8-K (No. 001-31972) filed on May 12, 2008)4.20
            Form
      of Convertible Debenture (incorporated by reference to our Form 8-K (No.
      001-31972) filed on June 5, 2008)4.21
            Form
      of Warrant to Purchase Common Stock (incorporated by reference to our Form
      8-K (No. 001-31972) filed on June 5, 2008)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 Frank T. Matarazzo, dated as
      of February 1, 2006 (incorporated by reference to our Form 10-K (No.
      001-31972), filed March 16, 2006)10.3
            Settlement
      Agreement by and among Telkonet, Inc. and Kings Road Investments Ltd.,
      dated as of August 14, 2006 (incorporated by reference to our Form 8-K
      (No. 001-31972), filed on August 16, 2006)10.4
            Settlement
      Agreement by and among Telkonet, Inc. and Portside Growth &
      Opportunity Fund, dated as of August 14, 2006 (incorporated by reference
      to our Form 8-K (No. 001-31972), filed on August 16,
  2006)10.5
            Securities
      Purchase Agreement, dated August 31, 2006, by and among Telkonet, Inc.,
      Enable Growth Partners LP, Enable Opportunity Partners LP and Pierce
      Diversified Strategy Master Fund LLC, Ena (incorporated by reference to
      our Form 8-K (No. 001-31972), filed on September 6,
    2006)10.6
            Registration
      Rights Agreement, dated August 31, 2006, by and among Telkonet, Inc.,
      Enable Growth Partners LP, Enable Opportunity Partners LP and Pierce
      Diversified Strategy Master Fund LLC, Ena (incorporated by reference to
      our Form 8-K (No. 001-31972), filed on September 6,
    2006)10.7
            Securities
      Purchase Agreement, dated February 1, 2007, by and among Telkonet, Inc.,
      Enable Growth Partners LP, Enable Opportunity Partners LP, Pierce
      Diversified Strategy Master Fund LLC, Ena, Hudson Bay Fund LP and Hudson
      Bay Overseas Fund, Ltd. (incorporated by reference to our Current Report
      on Form 8-K filed on February 5, 2007)10.8
            Registration
      Rights Agreement, dated February 1, 2007, by and among Telkonet, Inc.,
      Enable Growth Partners LP, Enable Opportunity Partners LP and Pierce
      Diversified Strategy Master Fund LLC, Ena, Hudson Bay Fund LP and Hudson
      Bay Overseas Fund, Ltd. (incorporated by reference to our Current Report
      on Form 8-K filed on February 5, 2007)10.9
            Employment
      Agreement by and between Telkonet, Inc. and Jason Tienor, dated as of
      March 15, 2007 (incorporated by reference to our Form 10-K (No.
      001-31972), filed March 16, 2007)10.10
            Employment
      Agreement by and between Telkonet, Inc. and Jeff Sobieski, dated as of
      March 15, 2007 (incorporated by reference to our Form 10-K (No.
      001-31972), filed March 16, 2007)10.11
            Securities
      Purchase Agreement, dated May 30, 2008, by and between Telkonet, Inc. and
      YA Global Investments LP (incorporated by reference to our Current Report
      on Form 8-K filed on June 5, 2008)10.12
            Registration
      Rights Agreement, dated May 30, 2008, by and between Telkonet, Inc. and YA
      Global Investments LP (incorporated by reference to our Current Report on
      Form 8-K filed on June 5, 2008)10.13
            Security
      Agreement, dated May 30, 2008, by and between Telkonet, Inc. and YA Global
      Investments LP (incorporated by reference to our Current Report on Form
      8-K filed on June 5, 2008)14
            Code
      of Ethics (incorporated by reference to our Form 10-KSB (No. 001-31972),
      filed on March 30, 2004).21
            Telkonet,
      Inc. Subsidiaries23.1
            Consent
      of RBSM LLP , Independent Registered Certified Public Accounting Firm,
      filed herewith24
            Power
      of Attorney (incorporated by reference to our Registration Statement on
      Form S-1 (No. 333-108307), filed on August 28, 2003)31.1
            Certification
      Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Jason
      Tienor31.2
            Certification
      Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Richard J.
      Leimbach32.1
            Certification
      of Jason L. Tienor pursuant to 18 U.S.C. Section 1350, as adopted pursuant
      to Section 906 of the Sarbanes-Oxley Act of 200232.2
            Certification
      of Richard J. Leimbach pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002




52





SIGNATURES





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




TELKONET,
      INC./s/ Jason L. TienorJason
      L. Tienor

              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/ Jason L. Tienor
            
            Chief
      Executive Officer
            April
      1, 2009Jason
      Tienor
            
            (principal
      executive officer)/s/ Richard J. Leimbach
            
            Chief
      Financial Officer
            April
      1, 2009Richard
      J. Leimbach
            
            (principal
      financial officer)

              (principal
      accounting officer)/s/ Warren V. Musser
            
            Chairman
      of the Board
            April
      1, 2009Warren
      V. Musser/s/ Thomas C. Lynch
            
            Director
            April
      1, 2009Thomas
      C. Lynch/s/ Dr. Thomas M. Hall
            
            Director
            April
      1, 2009Dr.
      Thomas M. Hall/s/ Seth D. Blumenfeld
            
            Director
            April
      1, 2009Seth
      D. Blumenfeld/s/ Anthony J. Paoni
            
            Director
            April
      1, 2009Anthony
      J. Paoni




55











SECURITIES
AND EXCHANGE COMMISSION





WASHINGTON,
D.C. 20549






FINANCIAL
STATEMENTS AND SCHEDULES





DECEMBER
31, 2008 AND 2007







FORMING
A PART OF ANNUAL REPORT


PURSUANT
TO THE SECURITIES EXCHANGE ACT OF 1934








TELKONET,
INC.










F-1




TELKONET,
INC.





Index
to Financial Statements




Report
      of Independent Registered Certified Public Accounting Firm
            F-3Consolidated
      Balance Sheets at December 31, 2008 and 2007
            F-4Consolidated
      Statements of Operations and Comprehensive Losses for the Years ended
      December 31, 2008 and 2007
            F-5Consolidated
      Statements of Stockholders’ Equity for the Years ended December 31, 2008
      and 2007
            F-6Consolidated
      Statements of Cash Flows for the Years ended December 31, 2008 and
      2007
            F-8Notes
      to Consolidated Financial Statements
            F-10










F-2




RBSM
LLP


CERTIFIED
PUBLIC ACCOUNTANTS





REPORT OF INDEPENDENT
REGISTERED CERTIFIED PUBLIC ACCOUNTING FIRM





Board of
Directors


Telkonet,
Inc.


Germantown,
MD




We have
audited the accompanying consolidated balance sheets of Telkonet, Inc. and its
subsidiaries (the "Company") as of December 31, 2008 and 2007 and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the two years in the period ended December 31, 2008. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based upon
our audit.




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





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Telkonet, Inc. and its
subsidiaries as of December 31, 2008 and 2007, and the results of its operations
and its cash flows for each of the two years in the period ended
December 31, 2008, in conformity with accounting principles generally
accepted in the United States of America.




The
accompanying consolidated financial statements have been prepared assuming the
Company will continue as a going concern. As discussed in the Note A to the
accompanying financial statements, the Company has incurred significant
operating losses in current year and also in the past. These factors, among
others, raise substantial doubt about the Company's ability to continue as a
going concern. The financial statements do not include any adjustments that
might result from the outcome of this uncertainty.






/s/ RBSM LLPCertified Public
      Accountants


New York,
New York


April 1,
2009


F-3





TELKONET,
INC.


CONSOLIDATED
BALANCE SHEETS


DECEMBER 31, 2008 AND
2007






ASSETS
            2008
            
            
            2007Current
      assets:Cash
      and cash equivalents
            
            $
            281,989
            
            
            $
            1,629,583Accounts
      receivable, net
            
            
            1,024,909
            
            
            
            2,134,978Inventories
            
            
            1,733,940
            
            
            
            2,578,084Other
      current assets
            
            
            404,928
            
            
            
            661,523Total
      current assets
            
            
            3,445,766
            
            
            
            7,004,168Property
      and equipment, net
            
            
            3,744,525
            
            
            
            5,147,408Other
      assets:Marketable
      securities
            
            
            397,403
            
            
            
            4,541,167Deferred
      financing costs, net
            
            
            432,136
            
            
            
            697,461Goodwill
      and other Intangible assets, net
            
            
            18,322,303
            
            
            
            21,119,484Other
      long term assets
            
            
            166,210
            
            
            
            231,657Total
      other assets
            
            
            19,318,052
            
            
            
            26,589,769Total
      Assets
            
            $
            26,508,343
            
            
            $
            38,741,345LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable and accrued liabilities
            
            $
            10,328,255
            
            
            $
            7,847,051Line
      of credit
            
            
            574,005
            
            
            
            -Capital
      lease payable - current
            
            
            204,416
            
            
            
            7,128Related
      party advances
            
            
            285,784
            
            
            
            291,000Convertible
      debentures of subsidiary - current
            
            
            7,010,503
            
            
            
            -Senior
      note payable, net of debt discounts of $29,180
            
            
            -
            
            
            
            1,470,820


Other
      current liabilities
            
            
            456,694
            
            
            
            378,833Total
      current liabilities
            
            
            18,859,657
            
            
            
            9,994,832Long-term
      liabilities:Convertible
      debentures, net of debt discounts of $825,585 – non
current
            
            
            1,311,065
            
            
            
            -Convertible
      debentures of subsidiary, net of debt discounts of $2,144,010 – non
      current
            
            
            -
            
            
            
            4,432,342Derivative
      liability
            
            
            2,573,126
            
            
            
            -Deferred
      lease liability and other
            
            
            50,791
            
            
            
            67,112Total
      long-term liabilities
            
            
            3,934,982
            
            
            
            4,499,454Commitments and
      contingenciesMinority
      interest
            
            
            262,795
            
            
            
            2,978,918Stockholders’
      equityPreferred
      stock, par value $.001 per share; 15,000,000 shares
      authorized;
              none issued and outstanding at December 31, 2008 and 2007
            
            
            -
            
            
            
            -Common
      stock, par value $.001 per share; 130,000,000 shares authorized;
      87,525,495 and
              70,826,544
      shares issued and outstanding at December 31, 2008 and 2007,
      respectively
            
            
            87,526
            
            
            
            70,827Additional
      paid-in-capital
            
            
            118,197,450
            
            
            
            112,013,093Accumulated
      deficit
            
            
            (114,801,318
            )
            
            
            (90,815,779
            )Accumulated
      comprehensive loss
            
            
            (32,750
            )
            
            
            -Stockholders’
      equity
            
            
            3,450,908
            
            
            
            21,268,141Total
      Liabilities and Stockholders’ Equity
            
            $
            26,508,343
            
            
            $
            38,741,345




See
accompanying notes to consolidated financial statements


F-4





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSSES


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007






2008
            
            
            2007Revenues,
      net:Product
            
            $
            13,690,010
            
            
            $
            9,168,077Rental
            
            
            6,840,949
            
            
            
            4,984,656Total
      Revenue
            
            
            20,530,959
            
            
            
            14,152,733Cost
      of Sales:Product
            
            
            8,511,197
            
            
            
            7,165,120Rental
            
            
            5,312,427
            
            
            
            4,505,476Total
      Cost of Sales
            
            
            13,823,624
            
            
            
            11,670,596Gross
      Profit
            
            
            6,707,336
            
            
            
            2,482,137Operating
      Expenses:Research
      and Development
            
            
            2,036,129
            
            
            
            2,349,690Selling,
      General and Administrative
            
            
            12,938,957
            
            
            
            17,897,974Impairment
      of Goodwill and Long Lived Assets
            
            
            3,962,033
            
            
            
            2,471,280Stock
      Based Compensation
            
            
            699,639
            
            
            
            1,655,346Stock
      Based Compensation of Subsidiary
            
            
            923,857
            
            
            
            686,634Depreciation
      and Amortization
            
            
            982,948
            
            
            
            878,766Total
      Operating Expenses
            
            
            21,543,563
            
            
            
            25,939,690Loss
      from Operations
            
            
            (14,836,227
            )
            
            
            (23,457,553
            )Other
      Income (Expenses):Interest
      Income
            
            
            9,961
            
            
            
            116,043Financing
      Expense
            
            
            (9,088,561
            )
            
            
            (1,828,624
            )(Loss)
      on Derivative Liability
            
            
            (1,174,121
            )
            
            
            -Gain
      (Loss) on Sale of Investments
            
            
            (6,500
            )
            
            
            1,868,956Impairment
      of Investment in Marketable Securities
            
            
            (4,098,514
            )
            
            
            -Other
      Income
            
            
            270,950
            
            
            
            -Total
      Other Income (Expenses)
            
            
            (14,086,785
            )
            
            
            156,375Loss
      Before Provision for Income Taxes
            
            
            (28,923,012
            )
            
            
            (23,301,178
            )Minority
      interest
            
            
            4,937,473
            
            
            
            2,910,068Provision
      for Income Tax
            
            
            -
            
            
            
            -Net
      (Loss)
            
            $
            (23,985,539
            )
            
            $
            (20,391,110
            )Loss
      per common share (basic and assuming dilution)
            
            $
            (0.30
            )
            
            $
            (0.31
            )Weighted
      average common shares outstanding
            
            
            79,153,788
            
            
            
            65,414,875Comprehensive
      Loss:Net
      Loss
            
            $
            (23,985,539
            )
            
            $
            (20,391,110
            )Unrealized
      loss on investment
            
            
            (32,750
            )
            
            
            -Comprehensive
      Loss
            
            $
            (24,018,289
            )
            
            $
            (20,391,110
            )




See
accompanying notes to consolidated financial statements


F-5




TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007







Preferred
      Shares
            
            Preferred
              Stock
              Amount
            
            Common
      Shares
            
            Common
              Stock
              Amount
            
            Additional
              Paid
      in
              Capital
            
            Accumulated
      Deficit
            
            TotalBalance
      at January 1, 2007
            
            
            -
            
            
            -
            
            
            56,992,301
            
            $
            56,992
            
            $
            78,502,900
            
            $
            (70,424,669
            )
            $
            8,135,223Shares
      issued for employee stock options exercised at approximately $1.05 per
      share
            
            
            -
            
            
            -
            
            
            118,500
            
            
            119
            
            
            124,342
            
            
            -
            
            
            124,460Shares
      issued in exchange for services rendered at approximately $2.63 per
      share
            
            
            -
            
            
            -
            
            
            21,803
            
            
            22
            
            
            57,320
            
            
            -
            
            
            57,342Shares
      issued in exchange for services at $1.36 per share
            
            
            -
            
            
            -
            
            
            200,000
            
            
            200
            
            
            271,300
            
            
            -
            
            
            271,500Issuance
      of shares for purchase of subsidiary
            
            
            -
            
            
            -
            
            
            2,227,273
            
            
            2,227
            
            
            5,997,773
            
            
            -
            
            
            6,000,000Issuance
      of shares for purchase of subsidiary
            
            
            -
            
            
            -
            
            
            3,459,609
            
            
            3,460
            
            
            9,752,637
            
            
            -
            
            
            9,756,097Issuance
      of shares for acquisition by subsidiary
            
            
            -
            
            
            -
            
            
            866,856
            
            
            867
            
            
            1,529,133
            
            
            -
            
            
            1,530,000Shares
      Issued in connection with Private Placement
            
            
            -
            
            
            -
            
            
            4,000,000
            
            
            4,000
            
            
            9,606,000
            
            
            -
            
            
            9,610,000Issuance
      of shares for investment in affiliate
            
            
            -
            
            
            -
            
            
            2,940,202
            
            
            2,940
            
            
            4,463,227
            
            
            -
            
            
            4,466,167Value
      of additional warrants issued in conjunction with exchange of convertible
      debentures
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            132,949
            
            
            -
            
            
            132,949Debt
      discount attributable to warrants attached to Note
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            195,924
            
            
            -
            
            
            195,924Stock-based
      compensation expense related to employee stock options
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,225,626
            
            
            -
            
            
            1,225,626Stock-based
      compensation related to Stock option expenses accrued in prior
      period
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            153,963
            
            
            -
            
            
            153,963Net
      Loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (20,391,110
            )
            
            (20,391,110
            )Balance
      at December 31, 2007
            
            
            -
            
            $
            -
            
            
            70,826,544
            
            $
            70,827
            
            $
            112,013,093
            
            $
            (90,815,779
            )
            $
            21,268,141





See
accompanying footnotes to consolidated financial statements


F-6




TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





Preferred
      Shares
            
            Preferred
              Stock
      Amount
            
            Common
              Shares
            
            Common
              Stock
              Amount
            
            Additional
              Paid
      in
              Capital
            
            Accumulated
      Deficit
            
            Comprehensive
      Income (Loss)
            
            TotalBalance
      at January 1, 2008
            -
            
            
            -
            
            
            70,826,544
            
            $
            70,827
            
            $
            112,013,093
            
            $
            (90,815,779
            )
            $
            -
            
            $
            21,268,141Shares
      issued in exchange for services rendered  and accrued at
      approximately $1.00 per share
            -
            
            
            -
            
            
            346,244
            
            
            346
            
            
            345,060
            
            
            -
            
            
            -
            
            
            345,407Shares
      issued for cashless warrants exercised
            -
            
            
            -
            
            
            1,000,000
            
            
            1,000
            
            
            (1,000
            )
            
            -
            
            
            -
            
            
            -Shares
      issued in connection with Private Placement
            -
            
            
            -
            
            
            2,500,000
            
            
            2,500
            
            
            1,497,500
            
            
            -
            
            
            -
            
            
            1,500,000Adjustment
      shares issued for investment in affiliate
            -
            
            
            -
            
            
            3,046,425
            
            
            3,046
            
            
            (3,046
            )
            
            -
            
            
            -
            
            
            -Adjustment
      shares issued for purchase of subsidiary
            -
            
            
            -
            
            
            1,882,225
            
            
            1,882
            
            
            (1,882
            )
            
            -
            
            
            -
            
            
            -Shares
      issued from escrow contingency in purchase of subsidiary
            -
            
            
            -
            
            
            600,000
            
            
            600
            
            
            379,400
            
            
            -
            
            
            -
            
            
            380,000Shares
      issued in exchange for convertible debentures
            -
            
            
            -
            
            
            7,324,057
            
            
            7,324
            
            
            1,356,026
            
            
            -
            
            
            -
            
            
            1,363,350Value
      of additional warrants issued in conjunction with anti-dilution
      provision
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            200,459
            
            
            -
            
            
            -
            
            
            200,459Stock-based
      compensation expense related to the re-pricing of investor
      warrants
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,598,203
            
            
            -
            
            
            -
            
            
            1,598,203Stock-based
      compensation expense related to employee stock options
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            559,478
            
            
            -
            
            
            -
            
            
            559,478Value
      of warrants attached to note payable
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            254,160
            
            
            -
            
            
            -
            
            
            254,160Holding
      loss on available for sale securities
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (32,750
            )
            
            (32,750
            )Net
      Loss
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (23,985,539
            )
            
            -
            
            
            (23,985,539
            )Balance
      at December 31, 2008
            -
            
            
            -
            
            
            87,525,495
            
            $
            87,526
            
            $
            118,197,450
            
            $
            (114,801,318
            )
            $
            (32,750
            )
            $
            3,450,908




See
accompanying notes to consolidated financial statements


F-7





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR THE YEARS ENDED DECEMBER 31,
2008, 2007 AND 2006




2008
            
            
            2007Increase
      (Decrease) In Cash and EquivalentsCash
      Flows from Operating Activities:Net
      loss
            
            $
            (23,985,539
            )
            
            $
            (20,391,110
            )Adjustments
      to reconcile net loss from operations to cash used in operating
      activities:Minority
      interest
            
            
            (4,937,473
            )
            
            
            (2,910,068
            )Registration
      rights liquidated damages of subsidiary (financing
expense)
            
            
            (500,000
            )
            
            
            500,000Debenture
      default penalty of subsidiary (financing expense)
            
            
            2,103,151
            
            
            
            -Amortization
      of debt discounts and financing costs
            
            
            1,713,818
            
            
            
            475,391Impairment
      of goodwill and long-lived assets
            
            
            3,962,033
            
            
            
            2,471,280Impairment
      of investment in affiliate
            
            
            4,098,514
            
            
            
            -(Gain)
      loss on sale of investment
            
            
            6,500
            
            
            
            (1,868,956
            )Loss
      on derivative liability
            
            
            1,174,121
            
            
            
            -Stock
      based compensation
            
            
            1,623,496
            
            
            
            2,241,102Fair
      value of issuance of warrants and re-pricing  (financing
      expense)
            
            
            5,304,502
            
            
            
            764,279Inventory
      Allowance
            
            
            200,000
            
            
            
            -Depreciation
      and Amortization
            
            
            1,910,106
            
            
            
            1,785,832Increase
      / decrease in:Accounts
      receivable, trade and other
            
            
            1,089,898
            
            
            
            (1,466,682
            )Inventories
            
            
            671,349
            
            
            
            251,185Prepaid
      expenses and deposits
            
            
            476,219
            
            
            
            (106,661
            )Deferred
      revenue
            
            
            29,425
            
            
            
            (88,857
            )Other
      Assets
            
            
            104,163
            
            
            
            3,257Accounts
      payable, accrued expenses, net
            
            
            897,332
            
            
            
            4,350,590Net
      Cash Used In Operating Activities
            
            
            (4,058,385
            )
            
            
            (13,989,434
            )Cash
      Flows From Investing Activities:Purchase
      of cable and related equipment
            
            
            (1,133,629
            )
            
            
            (1,568,651
            )Purchase
      of property and equipment
            
            
            (9,000
            )
            
            
            (310,715
            )Investment
      in subsidiaries
            
            
            -
            
            
            
            (5,168,851
            )Proceeds
      from sale of investment
            
            
            6,000
            
            
            
            -Proceeds
      from BPL Global
            
            
            -
            
            
            
            2,000,000Net
      Cash Used In Investing Activities
            
            
            (1,136,629
            )
            
            
            (5,048,217
            )Cash
      Flows From Financing Activities:Proceeds
      from sale of common stock, net of costs and fees
            
            
            1,500,000
            
            
            
            9,610,000Proceeds
      from issuance of note payable
            
            
            409,000
            
            
            
            1,500,000Proceeds
      from subsidiaries’ sale of common stock, net of costs
            
            
            -
            
            
            
            2,694,023Proceeds
      from issuance of convertible debentures, net of costs
            
            
            3,037,434
            
            
            
            -Proceeds
      from subsidiaries’ issuance of convertible debentures, net
            
            
            382,500
            
            
            
            5,303,238Proceeds
      from line of credit
            
            
            574,005
            
            
            
            -Financing
      fees for line of credit and factoring agreement
            
            
            (112,361
            )
            
            
            -Repayment
      of notes payable
            
            
            (1,900,000
            )
            
            
            -Proceeds
      from exercise of stock options and warrants
            
            
            -
            
            
            
            124,460Repayment
      of capital lease and other
            
            
            (34,158
            )
            
            
            -Repayments
      of subsidiary loans
            
            
            -
            
            
            
            (208,524
            )Net
      Cash Provided By Financing Activities
            
            
            3,847,420
            
            
            
            19,023,197Net (Decrease) In Cash
      and Equivalents
            
            
            (1,347,594
            )
            
            
            (14,454
            )Cash
      and cash equivalents at the beginning of the year
            
            
            1,629,583
            
            
            
            1,644,037Cash
      and cash equivalents at the end of the year
            
            $
            281,989
            
            
            $
            1,629,583




See
accompanying notes to consolidated financial statements


F-8





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS (Continued)


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





2008
            
            2007Supplemental
      Disclosures of Cash Flow Information:Cash
      transactions:Cash
      paid during the period for financing expenses
            
            $
            333,435
            
            
            $
            4,521Income
      taxes paid
            
            
            -
            
            
            
            -Non-cash
      transactions:Stock
      options and warrants issued in exchange for services
            
            
            1,216,996
            
            
            
            1,534,260Common
      stock issued in exchange for services rendered
            
            
            406,500
            
            
            
            706,842Value
      of warrant repricing and additional warrants issued
            
            
            5,304,502
            
            
            
            764,279Registration
      rights liquidated damages
            
            
            (500,000
            )
            
            
            500,000Issuance
      of shares for purchase of subsidiary (below)
            
            
            -
            
            
            
            17,286,097Issuance
      of shares for investment in affiliate
            
            
            -
            
            
            
            4,466,167Impairment
      write-down of goodwill
            
            
            2,380,000
            
            
            
            1,977,768Impairment
      write-down of long-lived assets
            
            
            1,582,033
            
            
            
            493,512Impairment
      write-down in investment in affiliate
            
            
            4,098,514
            
            
            
            -Loss
      on derivative liability
            
            
            1,174,121
            
            
            
            -Debenture
      default penalty of subsidiary
            
            
            2,103,151
            
            
            
            -Beneficial
      conversion feature on convertible debentures
            
            
            720,966
            
            
            
            1,457,815Value
      of warrants attached to convertible debentures
            
            
            678,041
            
            
            
            931,465Value
      of warrants attached to senior note
            
            
            254,160
            
            
            
            359,712Value
      of common stock received for outstanding accounts
      receivable
            
            
            -
            
            
            
            75,000Equipment
      purchased under capital lease obligations
            
            
            226,185
            
            
            
            -Acquisition
      of Subsidiaries:Assets
      acquired
            
            
            -
            
            
            
            3,052,880Subscriber
      lists
            
            
            -
            
            
            
            4,781,893Goodwill
      (including purchase price contingency)
            
            
            -
            
            
            
            15,096,922Liabilities
      assumed
            
            
            -
            
            
            
            (1,356,415
            )Common
      stock issued
            
            
            -
            
            
            
            (17,286,097
            )Direct
      acquisition costs
            
            
            -
            
            
            
            (394,183
            )Cash
      paid for acquisition
            
            
            -
            
            
            
            3,895,000





See
accompanying notes to consolidated financial statements


F-9





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007




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., formed in 1999 and incorporated under the laws of the state of Utah, has
evolved into a Clean Technology company that develops and manufactures
proprietary energy efficiency and SmartGrid networking technology. Prior to
January 1, 2007, the Company was primarily engaged in the business of
developing, producing and marketing proprietary equipment enabling the
transmission of voice and data communications over electric utility
lines.





In
January 2006, following the acquisition of Microwave Satellite Technologies
(MST), the Company began offering complete sales, installation, and service
of VSAT and business television networks, and became a full-service
national Internet Service Provider (ISP). The MST solution offers a complete
“Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
broadbandinternet access and wireless fidelity (“Wi-Fi”) access, to commercial
multi-dwelling units and hotels.





In March
2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada.





In March
2007, the Company acquired 100% of the outstanding membership units of
EthoStream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The EthoStream
acquisition will enable Telkonet to provide installation and support for PLC
products and third party applications to customers across North
America.





In May
2007, Microwave Acquisition Corp., a newly formed, wholly-owned subsidiary of
MSTI Holdings Inc. (formerly Fitness Xpress-Software Inc.) merged with MST.
As a result of the merger, the Company’s common stock in MST was exchanged for
shares of common stock of MSTI Holdings Inc. Immediately following the merger,
MSTI Holdings Inc. completed a private placement of its common stock for
aggregate gross proceeds of $3,078,716 and sold senior convertible debentures in
the aggregate principal amount of $6,050,000 (plus an 8% original issue discount
added to such principal amount). As a result of these transactions, the
Company’s 90% interest in MST became a 63% interest in MSTI Holdings
Inc.





In July
2007, Microwave Satellite Technologies, Inc., the wholly-owned subsidiary of the
Company’s majority owned subsidiary MSTI Holdings Inc., acquired substantially
all of the assets of Newport Telecommunications Co., a New Jersey general
partnership. Pursuant to the terms of the acquisition, the total consideration
paid was $2,550,000, consisting of unregistered shares of the Company’s common
stock, equal to $1,530,000, and (ii) $1,020,000 in cash, subject to adjustments.
The total consideration will be increased or decreased depending on the number
of subscriber accounts acquired in the acquisition that were in good standing at
that time.





The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries, Telkonet Communications, Inc. and EthoStream, LLC and
58%-owned subsidiary MSTI Holdings Inc. (reported as the Company’s MSTI
segment). Significant intercompany transactions have been eliminated in
consolidation.





Investments
in entities over which the Company has significant influence, typically those
entities that are 20 to 50 percent owned by the Company, are accounted for
using the equity method of accounting, whereby the investment
is carried at cost of acquisition, plus the Company’s equity in undistributed
earnings or losses since acquisition.





Going
Concern





The   accompanying   consolidated   financial   statements
have been prepared in conformity with accounting principles generally
accepted in the United States of
America, which contemplate continuation of the Company as a going
concern. However, the Company has reported a net loss of $23,985,539 for
the year ended December 31, 2008, accumulated deficit of $114,801,318 and a
working capital deficit of $15,413,891 as of December 31, 2008.





F-10


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007


The
Company believes that anticipated revenues from operations will be insufficient
to satisfy its ongoing capital requirements for at least the next 12
months.  If the Company’s financial resources from
operationsare insufficient, the Company will
require additional financing in order to execute its operating plan
and continue as a going concern. The Company cannot predict whether
this additional financing will be in the form of equity or debt, or be
in another form. The Company may not be able to obtain the
necessary additional capital on a
timely basis, on acceptable terms, or at
all.  In any of these events, the Company may be unable to
implement its current plans for expansion,
repay its debt obligations as they become due,
or respond to competitive pressures, any of
which circumstances would have a material adverse effect on its
business, prospects, financial condition and results of operations.





Management intends
to raise capital through asset-based financing and/or the sale of its stock in
private placements.  Management believes that with this financing, the
Company will be able to generate additional revenues that will allow the Company
to continue as a going concern. There can be no assurance that the Company
will be successful in obtaining additional funding.





Concentrations of Credit
Risk





Financial
instruments and related items, which potentially subject the Company to
concentrations of credit risk, consist primarily of cash, cash equivalents and
trade recievables. 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 $186,400 and
$111,957 at December 31, 2008 and December 31, 2007, respectively.




Management
identifies a delinquent customer based upon the delinquent payment status of an
outstanding invoice, generally greater than 30 days past due
date.  The delinquent account designation does not trigger an
accounting transaction until such time the account is deemed uncollectible. The
allowance for doubtful accounts is determined by examining the reserve history
and any outstanding invoices that are over 30 days past due as of the end of the
reporting period.  Accounts are deemed uncollectible on a case-by-case
basis, at management’s discretion based upon an examination of the communication
with the delinquent customer and payment history.  Typically, accounts
are only escalated to “uncollectible” status after multiple attempts have been
made to communicate with the customer.


Cash and Cash
Equivalents





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





Property and
Equipment





Property
and equipment is stated at cost. Depreciation is calculated using the
straight-line method over the estimated useful lives of the assets. The
estimated useful life ranges from 2 to 10 years.





Goodwill and Other
Intangibles





Goodwill
represents the excess of the cost of businesses acquired over fair value or net
identifiable assets at the date of acquisition. Goodwill is subject to a
periodic impairment assessment by applying a fair value test based upon a
two-step method. The first step of the process compares the fair value of the
reporting unit with the carrying value of the reporting unit, including any
goodwill. The Company utilizes a discounted cash flow valuation methodology to
determine the fair value of the reporting unit. If the fair value of the
reporting unit exceeds the carrying amount of the reporting unit, goodwill is
deemed not to be impaired in which case the second step in the process is
unnecessary. If the carrying amount exceeds fair value, the Company performs the
second step to measure the amount of impairment loss. Any impairment loss is
measured by comparing the implied fair value of goodwill, calculated per SFAS
No. 142, with the carrying amount of goodwill at the reporting unit, with
the excess of the carrying amount over the fair value recognized as an
impairment loss.





Fair
Value of Financial Instruments.




In
January 2008, the Company adopted the provisions of SFAS No. 157, “Fair Value
Measurements”, (“FAS157”) which
defines fair value for accounting purposes, establishes a framework for
measuring fair value and expands disclosure requirements regarding fair value
measurements. The Company’s adoption of FAS 157 did not have a material impact
on its consolidated financial statements. Fair value is defined as an exit
price, which is the price that would be received upon sale of an asset or paid
upon transfer of a liability in an orderly transaction between market
participants at the measurement date. The degree of judgment utilized in
measuring the fair value of assets and liabilities generally correlates to the
level of pricing observability. Financial assets and liabilities with readily
available, actively quoted prices or for which fair value can be measured from
actively quoted prices in active markets generally have more pricing
observability and require less judgment in measuring fair value. Conversely,
financial assets and liabilities that are rarely traded or not quoted have less
price observability and are generally measured at fair value using valuation
models that require more judgment. These valuation techniques involve some level
of management estimation and judgment, the degree of which is dependent on the
price transparency of the asset, liability or market and the nature of the asset
or liability. The Company has categorized its financial assets and liabilities
measured at fair value into a three-level hierarchy in accordance withFAS 157.




F-11


TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007




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 impairment in value be indicated, the
carrying value of intangible assets will be adjusted, based on estimates of
future discounted cash flows resulting from the use and ultimate disposition of
the asset. SFAS No. 144 also requires assets to be disposed of be reported at
the lower of the carrying amount or the fair value less costs to
sell.





Inventories





Inventories
consist of Telkonet Series 5TM products and the Telkonet iWire SystemTM, which the
primary components are Gateways, Extenders, iBridges and Couplers, and the
primary components of the Telkonet SmartEnergyTM (TSE) and the Networked Telkonet
SmartEnergyTM (NTSE) product suites, which are thermostats, sensors and
controllers.  Inventories are stated at
the lower of cost or market determined by the first in, first out (FIFO)
method.





Investments





Telkonet
maintained investments in two publicly-traded companies for the year ended
December 31, 2008.  The Company has classified these securities as
available for sale.  Such securities are carried at fair market
value.  Unrealized gains and losses on these securities, if any, are
reported as accumulated other comprehensive income (loss), which is a separate
component of stockholders’ equity.  Unrealized losses of $32,750 were
recorded for the year ended December 31, 2008 and there were no unrealized gains
or losses for the year ended December 31, 2007.  Realized gains and
losses and declines in value judged to be other than temporary on securities
available for sale, if any, are included in operations.   Realized
losses of $4,098,514 were recorded for the year ended December 31,
2008.  There were no realized gains or losses for the year ended
December 31, 2007.




Deferred Financing
Costs




Deferred
financing costs are being amortized under the straight-line method over the
terms of the related indebtedness, which approximates the effective interest
method and is included in interest expense in the accompanying consolidated
statements of operations.




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.




In June
2006, the FASB issued FASB Interpretation No. 48,Accounting for Uncertainty in
Income Taxes-an interpretation of FASB Statement No. 109 ("FIN 48").
FIN 48 prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. FIN 48 also provides guidance on
derecognition, classification, treatment of interest and penalties, and
disclosure of such positions. Effective January 1, 2007, the Company
adopted the provisions of FIN 48, as required. As a result of implementing FIN
48, there has been no adjustment to the Company’s financial statements and the
adoption of FIN 48 did not have a material effect on the Company’s consolidated
financial statements for the year ending December 31, 2008.





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 2008 and 2007 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.




F-12


TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007




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 includes the provisions ofStaff Accounting Bulletin No. 101, Revenue Recognition in Financial
Statements (“SAB101”). SAB 101 requires that four basic criteria must be
met before revenue can be recognized: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred; (3) the selling price is fixed and
determinable; and (4) collectibility is reasonably assured. Determination of
criteria (3) and (4) are based on management’s judgments regarding the fixed
nature of the selling prices of the products delivered and the collectibility of
those amounts. Provisions for discounts and rebates to customers, estimated
returns and allowances, and other adjustments are provided for in the same
period the related sales are recorded. The Company defers any revenue for which
the product has not been delivered or is subject to refund until such time that
the Company and the customer jointly determine that the product has been
delivered or no refund will be required. SAB 104 incorporates Emerging Issues
Task Force 00-21 (“EITF 00-21”), Multiple-Deliverable Revenue
Arrangements.EITF 00-21 addresses accounting for arrangements that may
involve the delivery or performance of multiple products, services and/or rights
to use assets.





For
equipment under lease, revenue is recognized over the lease term for operating
lease and rental contracts. All of the Company’s leases are accounted for as
operating leases. At the inception of the lease, no lease revenue is recognized
and the leased equipment and installation costs are capitalized and appear on
the balance sheet as “Equipment Under Operating Leases.” The capitalized cost of
this equipment is depreciated from two to three years, on a straight-line basis
down to the Company’s original estimate of the projected value of the equipment
at the end of the scheduled lease term. Monthly lease payments are recognized as
rental income. The Company has sold a portion of its lease portfolio in December
2005 and substantially all the remaining portfolio during 2006. The related
equipment was charged to cost of sales commensurate with the associated revenue
recognition (Note F).





MST
accounts for the revenue, costs and expense related to residential cable
services as the related services are performed in accordance with SFAS
No. 51, Financial
Reporting by Cable Television Companies. Installation revenue for
residential cable services is recognized to the extent of direct selling costs
incurred. Direct selling costs have exceeded installation revenue in all
reported periods. Generally, credit risk is managed by disconnecting services to
customers who are delinquent.




Revenue
from sales-type leases for EthoStream products is recognized at the time of
lessee acceptance, which follows installation. The Company recognizes revenue
from sales-type leases at the net present value of future lease payments.
Revenue from operating leases is recognized ratably over the lease
period





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.




F-13


TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007




The
Company’s guarantees were issued subject to the recognition and disclosure
requirements of FIN 45 as of December 31, 2008 and 2007. 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, 2008 and 2007, the Company
experienced approximately three percent of units returned. As of December 31,
2008 and 2007, the Company recorded warranty liabilities in the amount of
$146,951 and $102,534, respectively, using this experience factor.





Advertising





The
Company follows the policy of charging the costs of advertising to expenses
incurred. The Company incurred $92,410 and $592,313 in advertising costs during
the years ended December 31, 2008 and 2007, respectively.





Research and
Development





The
Company accounts for research and development costs in accordance with the
Financial Accounting Standards Board's Statement of Financial Accounting
Standards No. 2 ("SFAS 2"), "Accounting for Research and Development Costs.”
Under SFAS 2, all research and development costs must be charged to expense as
incurred. Accordingly, internal research and development costs are expensed as
incurred. Third-party research and developments costs are expensed when the
contracted work has been performed or as milestone results have been achieved.
Company-sponsored research and development costs related to both present and
future products are expensed in the period incurred. Total expenditures on
research and product development for 2008 and 2007 were $2,036,129 and
$2,349,690, 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.




Stock Based
Compensation





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





SFAS
123(R) requires companies to estimate the fair value of share-based payment
awards on the date of grant using an option-pricing model. The value of the
portion of the award that is ultimately expected to vest is recognized as
expense over the requisite service periods in the Company’s Consolidated
Statement of Operations. The Company is using the Black-Scholes option-pricing
model as its method of valuation for share-based awards. The Company’s
determination of fair value of share-based payment awards on the date of grant
using an option-pricing model is affected by the Company’s stock price as well
as assumptions regarding a number of highly complex and subjective variables.
These variables include, but are not limited to the Company’s expected stock
price volatility over the term of the awards, and certain other market variables
such as the risk free interest rate.





The
expected term of the options represents the estimated period of time until
exercise and is based on historical experience of similar awards, giving
consideration to the contractual terms, vesting schedules and expectations of
future employee behavior. For 2008 and prior years, expected stock price
volatility is based on the historical volatility of the Company’s stock for the
related vesting periods.




Stock-based
compensation expense recognized under SFAS 123(R) for the years ended December
31, 2008 and 2007 was $1,216,997 and $1,534,260, respectively, net of tax
effect.




F-14


TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007




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.





Registration Payment
Arrangements





The
Company accounts for registration payment arrangements under Financial
Accounting Standards board (FASB) Staff Position EITF 00-19-2, “Accounting for
Registration Payment Arrangements” (FSP EITF 00-19-2). FSP EITF 00-19-2
specifies that the contingent obligation to make future payments under a
registration payment arrangement should be separately recognized and measured in
accordance with SFAS No. 5, Accounting for Contingencies. FSP EITF 00-19-2 was
issued in December, 2006.  As of December 31, 2007, the Company had
accrued an estimated penalty of $500,000.





On
February 11, 2008, the investors in MSTI Holdings Inc. executed a letter
agreement with MSTI Holdings, Inc. waiving their rights to receive liquidated
damages under the registration rights agreement, in exchange for a reduction in
their warrant exercise price from $1.00 to $0.65.  Therefore the
Company has reversed the accrued expense for the potential liquidated damages
during the year ended December 31, 2008.





Reclassifications





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





New Accounting
Pronouncements





In June 2008, the FASB issued Emerging
Issues Task Force No. 07-5 (EITF 07-5),Determining Whether
an Instrument (or Embedded Feature) is Indexed to an Entity’s Own
Stock.EITF 07-5 requires
entities to evaluate whether an equity-linked financial instrument (or embedded
feature) is indexed to its own stock by assessing the instrument’s contingent
exercise provisions and settlement provisions. Instruments not indexed to their
own stock fail to meet the scope exception of Statement of Financial Accounting
Standards No. 133,Accounting for
Derivative Instruments and Hedging Activities, paragraph 11(a), and should be
classified as a liability and marked-to-market. The statement is effective for
fiscal years beginning after December 15, 2008 and is to be applied to
outstanding instruments upon adoption with the cumulative effect of the change
in accounting principle recognized as an adjustment to the opening balance of
retained earnings. The Company is currently evaluating the provisions of EITF
07-5.





In
February 2007, the FASB issued Statement of Financial Accounting Standards
(“SFAS”) No. 159, The Fair
Value Option for Financial Assets and Financial Liabilities-Including an
Amendment of FASB Statement No. 115 (“SFAS 159”).  SFAS 159
permits entities to measure eligible assets and liabilities at fair
value.  Unrealized gains and losses on items for which the fair value
option has been elected are reported in earnings.  SFAS 159 is
effective for fiscal years beginning after November 15, 2007.  We
adopted SFAS 159 on January 1, 2008 and did not elect the fair value option
which did not have a material impact on our financial position and results of
operations.





In
December 2007, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 141R, Business Combinations , and
Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in
Consolidated Financial Statements,   an amendment of ARB No. 51
..  These new standards significantly change the accounting for and
reporting of business combination transactions and noncontrolling interests
(previously referred to as minority interests) in consolidated financial
statements.  Both standards are effective for fiscal years beginning on or
after December 15, 2008, with early adoption prohibited. These Statements are
effective for the Company beginning on January 1, 2009.  The Company is
currently evaluating the provisions of FAS 141(R) and FAS 160.




F-15


TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007




In March 2008, the Financial Accounting Standards Board
(FASB) issued Statement No. 161, Disclosures about Derivative
Instruments and Hedging Activities - an amendment of FASB Statement No.
133 (SFAS 161).  SFAS 161 requires companies to provide
enhanced disclosures regarding derivative instruments and hedging activities and
requires companies to better convey the purpose of derivative use in terms of
the risks they intend to manage. Disclosures about (a) how and why an entity
uses derivative instruments, (b) how derivative instruments and related hedged
items are accounted for under SFAS No. 133 and its related interpretations, and
(c) how derivative instruments and related hedged items affect a company’s
financial position, financial performance, and cash flows are required. This
Statement retains the same scope as SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, and is effective for fiscal years and
interim periods beginning after November 15, 2008. We do not expect the adoption
of SFAS No. 161 to have a material impact, if any, on our consolidated financial
statements.





In
February 2008, the FASB issued a FASB Staff Position (FSP) on Accounting for Transfers of
Financial Assets and Repurchase Financing Transactions (FSP FAS 140-3).
This FSP addresses the issue of whether the transfer of financial assets and the
repurchase financing transactions should be viewed as two separate transactions
or as one linked transaction. The FSP includes a rebuttable presumption that the
two transactions are linked unless the presumption can be overcome by meeting
certain criteria. The FSP will be effective for fiscal years beginning after
November 15, 2008 and will apply only to original transfers made after that
date; early adoption will not be allowed. We do not expect the adoption of FSP
FAS 140-3 to have a material impact, if any, on our consolidated financial
statements.




In April
2008, the FASB issued FSP No. 142-3, “Determination of the Useful Life of
Intangible Assets” (“FSP 142-3”). FSP 142-3 amends the factors an entity should
consider in developing renewal or extension assumptions used in determining the
useful life of recognized intangible assets under FASB Statement No. 142,
“Goodwill and Other Intangible Assets”. This new guidance applies prospectively
to intangible assets that are acquired individually or with a group of other
assets in business combinations and asset acquisitions. FSP 142-3 is effective
for financial statements issued for fiscal years and interim periods beginning
after December 15, 2008. Early adoption is prohibited. The Company does not
expect the adoption of FSP 142-3 to have a significant impact on its
consolidated financial statements.
 
 In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles” (“SFAS 162”). SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles (the GAAP
hierarchy). SFAS 162 will become effective 60 days following the SEC’s approval
of the Public Company Accounting Oversight Board amendments to AU Section 411,
“The Meaning of Present Fairly in Conformity With Generally Accepted Accounting
Principles.” The Company does not expect the adoption of SFAS 162 to have a
material effect on its results of operations and financial
condition.
 
 In May
2008, the FASB issued FSP Accounting Principles Board (“APB”) 14-1 “Accounting
for Convertible Debt instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement)” (“FSP APB 14-1”). FSP APB 14-1 requires the
issuer of certain convertible debt instruments that may be settled in cash (or
other assets) on conversion to separately account for the liability (debt) and
equity (conversion option) components of the instrument in a manner that
reflects the issuer’s non-convertible debt borrowing rate. FSP APB 14-1 is
effective for fiscal years beginning after December 15, 2008 on a retroactive
basis. The Company does not expect the adoption of FSP APB 14-1 will have
significant effect on its results of operations and financial
condition.




NOTE
B - ACQUISITION OF SUBSIDIARY




Acquisition of Smart Systems
International, Inc.





On March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $6,875,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. The Company is obligated to register the stock portion of the purchase
price on or before May 15, 2007 and on March 14, 2008, this registration
statement was declared effective.  Additionally, 1,090,909 of these
shares were held in an escrow account for a period of one year following the
closing from which certain potential indemnification obligations under the
purchase agreement could be satisfied. The aggregate number of shares held in
escrow was subject to adjustment upward or downward depending upon the trading
price of the Company’s common stock during the one year period following the
closing date.   On March 12, 2008, the Company released these
shares from escrow and issued an additional 1,882,225 shares on June 12,
2008 pursuant to the adjustment provision in the SSI asset purchase
agreement.




The
acquisition of SSI was accounted for using the purchase method in accordance
with SFAS 141, “Business Combinations.” The value of the Company’s common stock
issued as a part of the acquisition was determined based on the most recent
price of the Company's common stock on the day immediately preceding the
acquisition date. The results of operations for SSI have been included in the
Consolidated Statements of Operations since the date of acquisition.  The
components of the purchase price were as follows:





As
              ReportedCommon
      stock
            
            $
            6,000,000Cash
            
            
            875,000Direct
      acquisition costs
            
            
            131,543Total
      Purchase Price
            
            $
            7,006,543




F-16


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007
  In
accordance with Financial Accounting Standard (SFAS) No. 141, Business
Combinations, the total purchase price was allocated to the estimated fair value
of assets acquired and liabilities assumed. The fair value of the assets
acquired was based on management’s best estimates. The purchase price was
allocated to the fair value of assets acquired and liabilities assumed as
follows:


Current
      assets
            
            $
            1,646,054Property,
      plant and equipment
            
            
            36,020Other
      assets
            
            
            8,237Goodwill
            
            
            5,874,016Total
      assets acquired
            
            
            7,564,327Accounts
      payable and accrued liabilities
            
            
            (557,784
            )Total
      liabilities assumed
            
            
            (557,784
            )Net
      assets acquired
            
            $
            7,006,543




Goodwill
represents the excess of the purchase price over the fair value of the net
tangible assets acquired.  In accordance with SFAS 142, goodwill is
not amortized and will be tested for impairment at least annually.  We
completed our annual impairment testing during the fourth quarter of 2008, and
determined that there was no impairment to the carrying value of
goodwill.





Acquisition of EthoStream
LLC





On March
15, 2007, the Company acquired 100% of the outstanding membership units of
EthoStream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The EthoStream
acquisition will enable Telkonet to provide installation and support for PLC
products and third party applications to customers across North America. The
purchase price of $11,756,097 was comprised of $2.0 million in cash and
3,459,609 shares of the Company’s common stock. The entire stock portion of the
purchase price is being held in escrow to satisfy certain potential
indemnification obligations of the sellers under the purchase agreement. The
shares held in escrow are distributable over the three years following the
closing.  If during the twelve months following the Closing, the common
stock has a volume-weighted average trading price of at least $4.50, as reported
on the American Stock Exchange, for twenty (20) consecutive trading days, the
aggregate number of shares of common stock issuable to the sellers shall be
adjusted such that the number of shares of common stock issuable as the stock
consideration shall be determined assuming a per share price equal to
$4.50.





The
acquisition of EthoStream was accounted for using the purchase method in
accordance with SFAS 141, “Business Combinations.” The value of the Company’s
common stock issued as a part of the acquisition was determined based on the
most recent price of the Company's common stock prior to the acquisition date.
The results of operations for EthoStream have been included in the Consolidated
Statements of Operations since the date of acquisition.  The components of
the purchase price were as follows:




As
      ReportedCommon
      stock
            
            $
            9,756,097Cash
            
            
            2,000,000Direct
      acquisition costs
            
            
            164,346Total
      Purchase Price
            
            $
            11,920,443





In
accordance with Financial Accounting Standard (SFAS) No. 141, Business
Combinations, the total purchase price was allocated to the estimated fair value
of assets acquired and liabilities assumed. The fair value of the assets
acquired was based on management’s best estimates. The purchase price was
allocated to the fair value of assets acquired and liabilities assumed as
follows:





Current
      assets
            
            $
            949,308Property,
      plant and equipment
            
            
            51,724Other
      assets
            
            
            21,603Subscriber
      lists
            
            
            2,900,000Goodwill
            
            
            8,796,439Total
      assets acquired
            
            
            12,719,074Accounts
      payable and accrued liabilities
            
            
            (798,631
            )Total
      liabilities assumed
            
            
            (798,631
            )Net
      assets acquired
            
            $
            11,920,443




F-17


TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007




Goodwill
and other intangible assets represent the excess of the purchase price over the
fair value of the net tangible assets acquired. The Company used a discounted
cash flow model to determine the value of the intangible assets and to allocate
the excess purchase price to the intangible assets and goodwill as appropriate.
In this model, expected cash flows from subscribers were discounted to their
present value at a rate of return of 20% (incorporating the risk-free rate,
expected inflation, and related business risks) over a period of twelve years.
Expected costs such as income taxes and cost of sales were deducted from
expected revenues to arrive at after tax cash flows. In accordance with SFAS
142, goodwill is not amortized and will be tested for impairment at least
annually.









In
accordance with SFAS 142, goodwill is not amortized and will be tested for
impairment at least annually.  At December 31, 2008, the Company
performed an impairment test on the goodwill. Based upon management’s assessment
of operating results and forecasted discounted cash flow, the carrying value of
goodwill was determined to be impaired and therefore $2,000,000 was written off
during the year ended December 31, 2008.





Acquisition of Newport
Telecommunications Co. by Subsidiary





On July
18, 2007, Microwave Satellite Technologies, Inc., the wholly-owned subsidiary of
the Company’s majority owned subsidiary MSTI Holdings Inc., acquired
substantially all of the assets of Newport Telecommunications Co., a New Jersey
general partnership (“NTC”), relating to NTC’s business of providing broadband
internet and telephone services at certain residential and commercial properties
in the development known as Newport in Jersey City, New Jersey. Pursuant to the
terms of the NTC acquisition, the total consideration paid was $2,550,000,
consisting of (i) 866,856 unregistered shares of the Company’s common stock,
equal to $1,530,000 (which is based on the average closing prices for the
Company common stock for the ten trading days immediately prior to the closing
date), and (ii) $1,020,000 in cash.





The
acquisition of Newport was accounted for using the purchase method in accordance
with SFAS 141, “Business Combinations.” The value of the Company’s common stock
issued as a part of the acquisition was determined based on the average closing
prices for the Company common stock for the ten trading days immediately prior
to the closing date. The results of operations for Newport have been included in
the Consolidated Statements of Operations since the date of acquisition. 
The components of the purchase price were as follows:




As
      ReportedCommon
      stock
            
            $
            1,530,000Cash
            
            
            1,020,000Direct
      acquisition costs
            
            
            98,294Total
      Purchase Price
            
            $
            2,648,294





In
accordance with Financial Accounting Standard (SFAS) No. 141, Business
Combinations, the total purchase price was allocated to the estimated fair value
of assets acquired and liabilities assumed. The fair value of the assets
acquired was based on management’s best estimates. The purchase price was
allocated to the fair value of assets acquired and liabilities assumed as
follows:





Current
      assets
            
            $
            -Property,
      plant and equipment
            
            
            668,107Subscriber
      lists
            
            
            1,980,187Total
      assets acquired
            
            
            2,648,294Accounts
      payable and accrued liabilities
            
            
            -Total
      liabilities assumed
            
            
            -Net
      assets acquired
            
            $
            2,648,294





Goodwill
and other intangible assets represent the excess of the purchase price over the
fair value of the net tangible assets acquired. The subscriber list was valued
at $1,980,187 with an estimated useful life of eight years.




F-18


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007
  The
following unaudited condensed combined pro forma results of operations reflect
the pro forma combination of SSI, EthoStream and Newport businesses as if the
combination had occurred at the beginning of the periods presented compared with
the actual results of operations of Telkonet for the same period. The unaudited
pro forma condensed combined results of operations do not purport to represent
what the companies’ combined results of operations would have been if such
transaction had occurred at the beginning of the periods presented, and are not
necessarily indicative of Telkonet’s future results.




Year
      Ended December 31, 2007As
      Reported
            
            
            Pro
      Forma Adjustments
            
            
            Pro
      FormaRevenues
            
            $
            14,152,733
            
            
            $
            2,423,320
            
            
            $
            16,576,053Net
      profit (loss)
            
            $
            (20,391,110
            )
            
            $
            511,538
            
            
            $
            (19,879,572
            )Net
      (loss) per common share outstanding - basic
            
            $
            (0.31
            )
            
            $
            0.02
            
            
            $
            (0.29
            )Weighted
      average common shares outstanding - basic
            
            
            65,414,875
            
            
            
            2,588,959
            
            
            
            68,003,834




NOTE C - INTANGIBLE ASSETS AND
GOODWILL





As a
result of the MSTI acquisition at January 31, 2006 and the EthoStream
acquisition on March 15, 2007 and MSTI Holdings, Inc.’s acquisition of Newport
on July 18, 2007, the Company had intangibles totaling $7,344,114 at December
31, 2008 (Note B).





We used a
discounted cash flow model to determine the value of the intangible assets and
to allocate the excess purchase price to the intangible assets and goodwill as
appropriate. In this model, expected cash flows from subscribers were discounted
to their present value at a rate of return of 20% (incorporating the risk-free
rate, expected inflation, and related business risks) over a determined length
of life year. Expected costs such as income taxes and cost of sales were
deducted from expected revenues to arrive at after tax cash flows.





We have
applied the same discounted cash flow methodology to the assessment of value of
the intangible assets of EthoStream, LLC, during the acquisition completed on
March 15, 2007, for purposes of determining the purchase price.





The MSTI
subscriber list was determined to have an eight-year life. This intangible was
amortized using that life and amortization from the date of the acquisition
through December 31, 2008 was taken as a charge against income in the
consolidated statement of operations.




Total
identifiable intangible assets acquired and their carrying values at December
31, 2007 are:





Gross
              Carrying
              Amount
            
            
            Accumulated
      Amortization
            
            
            Net
            
            
            Residual
              Value
            
            
            Weighted
      Average Amortization Period (Years)Amortized
      Identifiable Intangible Assets:Subscriber
      lists – MSTI
            
            $
            4,444,114
            
            
            $
            (703,766
            )
            
            $
            3,740,348
            
            
            $          
                  -
            
            
            
            8.0Subscriber
      lists - EthoStream
            
            
            2,900,000
            
            
            
            (191,320
            )
            
            
            2,708,680
            
            
            
            -
            
            
            
            12.0Total
      Amortized Identifiable Intangible Assets
            
            
            7,344,114
            
            
            
            (895,085
            )
            
            
            6,449,029
            
            
            
            -
            
            
            
            9.6Goodwill
      - MSTI
            
            1,997,768
            
            
            
            (1,997,768
            )
            
            
            -Goodwill
      - EthoStream
            
            8,796,440
            
            
            
            -
            
            
            
            8,796,440
            
            
            
            -Goodwill
      - SSI
            
            5,874,015
            
            
            
            -
            
            
            
            5,874,015
            
            
            
            -Total
            
            $
            24,012,337
            
            
            $
            (2,892,853
            )
            
            $
            21,119,484
            
            
            $
            -




F-19


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007





Total
identifiable intangible assets acquired and their carrying values at December
31, 2008 are:





Gross
              Carrying
              Amount
            
            
            Accumulated
      Amortization
            
            
            Net
            
            
            Residual
              Value
            
            
            Weighted
      Average Amortization Period (Years)Amortized
      Identifiable Intangible Assets:Subscriber
      lists – MSTI
            
            $
            4,444,114
            
            
            $
            (1,259,281
            )
            
            $
            3,184,833
            
            
            $                -
            
            
            
            8.0Subscriber
      lists - EthoStream
            
            
            2,900,000
            
            
            
            (432,985
            )
            
            
            2,467,015
            
            
            
            -
            
            
            
            12.0Total
      Amortized Identifiable Intangible Assets
            
            
            7,344,114
            
            
            
            (1,692,266
            )
            
            
            5,651,848
            
            
            
            -
            
            
            
            9.6Goodwill
      - MSTI
            
            2,377,768
            
            
            
            (2,377,768
            )
            
            
            -Goodwill
      - EthoStream
            
            8,796,439
            
            
            
            (2,000,000
            )
            
            
            6,796,439
            
            
            
            -Goodwill
      - SSI
            
            5,874,016
            
            
            
            -
            
            
            
            5,874,016
            
            
            
            -Total
            
            $
            24,392,337
            
            
            $
            (6,070,034
            )
            
            $
            18,322,303
            
            
            $
            -





Total
amortization expense charged to operations for the year ended December 31,
2008 and 2007 was $797,179 and $612,760, respectively. Estimated amortization
expense as of December 31, 2008 is as follows:





Years
      Ended December 31,2009
            
            $
            797,1812010
            
            
            797,1812011
            
            
            797,1812012
            
            
            797,1812013
      and after
            
            
            2,463,123Total
            
            $
            5,651,847




The
Company does not amortize goodwill. The Company recorded goodwill in the amount
of $1,977,768 as a result of the acquisition of MSTI during the year ended
December 31, 2006, and additional $14,670,455 as a result of the acquisition of
EthoStream and SSI during the year ended December 31, 2007.  At
December 31, 2007, the Company has determined that the value of MSTI’s goodwill
has been impaired based upon managements assessment of operating results and
forecasted discounted cash flow and has written off the entire $1,977,768 of its
value.  At December 31, 2008, the Company has determined that a
portion of the value of EthoStream’s goodwill has been impaired based upon
management’s assessment of operating results and forecasted discounted cash flow
and has written off $2,000,000 of its value.  During the year ended
December 31, 2008, the Company recorded a goodwill impairment charge of $380,000
related to the additional shares issued upon the release of the purchase price
contingency escrow with the MSTI acquisition.





NOTE
D – ACCOUNTS RECEIVABLE





Components
of accounts receivable as of December 31, 2008 and 2007 are as
follows:





2008
            
            
            2007Accounts
      receivable  (factored)
            
            $
            1,961,535
            
            
            $
            -Advances
      from factor
            
            
            (1,075,879
            )
            
            
            -Due
      from factor
            
            
            885,656
            
            
            
            -Accounts
      receivable  (non-factored)
            
            
            325,653
            
            
            
            2,246,935Allowance
      for doubtful accounts
            
            
            (186,400
            )
            
            
            (111,957)Total
            
            $
            1,024,909
            
            
            $
            2,134,978




In
February 2008, the Company entered into a factoring agreement to sell, without
recourse, certain receivables to an unrelated third party financial institution
in an effort to accelerate cash flow.  Under the terms of the
factoring agreement the maximum amount of outstanding receivables at any one
time is $2.5 million.  Proceeds on the transfer reflect the face value
of the account less a discount.  The discount is recorded as interest
expense in the Consolidated Statement of Operations in the period of the
sale.  Net funds received reduced accounts receivable outstanding
while increasing cash.  Fees paid pursuant to this arrangement are
included in “Financing expense” in the Consolidated Statement of Operations and
amounted to $237,813 for the year ended December 31, 2008. The amounts borrowed
are collateralized by the outstanding accounts receivable, and are reflected as
a reduction to accounts receivable in the accompanying consolidated balance
sheets.





F-20


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007





NOTE
E - INVENTORIES




Components
of inventories as of December 31, 2008 and 2007 are as follows:





2008
            
            
            2007Raw
      Materials
            
            $
            843,978
            
            
            $
            928,739Finished
      Goods
            
            
            1,089,962
            
            
            
            1,649,345Reserve
      for Obsolescence
            
            
            (200,000
            )
            
            
            -Total
            
            $
            1,733,940
            
            
            $
            2,578,084





NOTE F
– OTHER CURRENT ASSETS





Components
of other current assets as of December 31, 2008 and 2007 are as
follows:





2008
            
            
            2007Investment
      in sales-type lease - current
            
            $
            10,270
            
            
            $
            16,501Prepaid
      expenses and deposits
            
            
            394,658
            
            
            
            645,022Total
            
            $
            404,928
            
            
            $
            661,523




EthoStream,
LLC’s net investment in sales-type leases, included in other assets, as of
December 31, 2008 and 2007 consists of the following:





2008
            
            
            2007Total
      Minimum Lease Payments to be Received
            
            $
            11,709
            
            
            $
            30,000Less:
      Unearned Interest Income
            
            
            (540
            )
            
            
            (2,330
            )Net
      Investment in Sales-Type Leases
            
            
            11,169
            
            
            
            27,670Less:
      Current Maturities
            
            
            (10,270
            )
            
            
            (16,501
            )Non-Current
      Portion
            
            $
            899
            
            
            $
            11,169





Aggregate
future minimum lease payments to be received under the above leases are as
follows as of December 31, 2008:





2009
            
            
            10,7972010
            
            
            9122011
            
            
            -$
            11,709




NOTE G
- PROPERTY AND EQUIPMENT





The
Company’s property and equipment at December 31, 2008 and 2007 consists of the
following:





2008
            
            
            2007Cable
      equipment and installations of subsidiary
            
            $
            4,879,799
            
            
            $
            5,764,645Telecommunications
      and related equipment
            
            
            117,493
            
            
            
            313,941Development
      Test Equipment
            
            
            153,487
            
            
            
            153,487Computer
      Software
            
            
            160,894
            
            
            
            160,894Leasehold
      Improvements
            
            
            512,947
            
            
            
            512,947Office
      Equipment
            
            
            382,851
            
            
            
            426,813Office
      Fixtures and Furniture
            
            
            383,361
            
            
            
            406,352Total
            
            
            6,590,831
            
            
            
            7,739,079Accumulated
      Depreciation
            
            
            (2,846,306
            )
            
            
            (2,591,671
            )$
            3,744,525
            
            
            $
            5,147,408




F-21


TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007






MSTI
currently maintains service agreements with approximately 22 MDU and MTU
properties and the equipment is capitalized under Cable equipment and
installations.  Generally, under the terms of a service agreement,
MSTI provides either (i) “bulk services,” which may include one or all of a
bundle of products and services, at a fixed price per month to the owner of the
MDU or MTU property, and contract with individual residents for enhanced
services, such as premium cable channels, for a monthly fee or
(ii) contract with individual residents of the MDU property for one or more
basic or enhanced services for a monthly fee.





Telecommunication,
cable and installations equipment maintained for customers is recorded at cost
and is depreciated on the straight line basis to its estimated residual value.
Estimated useful lives are two to ten years.  The majority of the
equipment is leased to customers under operating leases.





The
following is a schedule by years of minimum future rentals under bulk services
of non-cancelable operating agreements as of December 31, 2008:





2009
            
            $
            589,3722010
            
            
            484,9142011
            
            
            456,9722012
            
            
            315,9342013
            
            
            200,446Total
            
            $
            2,047,638





The
Company has determined that the value of MSTI’s capitalized equipment maintained
at certain properties has been impaired based upon management’s assessment of
the discounted cash flows from subscriber revenues. During the years ended
December 31, 2008 and 2007, the Company recorded an impairment of long lived
assets totaling $1,582,033 and $493,512, respectively.





Depreciation
expense included as a charge to income was $1,112,923 and $1,173,072 for the
years ended December 31, 2008 and 2007, respectively.





NOTE H
– MARKETABLE SECURITIES





Geeks on Call America,
Inc.





On
October 19, 2007, the Company completed the acquisition of approximately 30.0%
of the issued and outstanding shares of common stock of Geeks on Call America,
Inc. (“GOCA”), the nation's premier provider of on-site computer services. 
Under the terms of the stock purchase agreement, the Company acquired
approximately 1,160,043 shares of GOCA common stock from several GOCA
stockholders in exchange for 2,940,200 shares of the Company’s common stock for
total consideration valued at approximately $4.5 million. The number of shares
issued in connection with this transaction was determined using a per share
price equal to the average closing price of the Company’s common stock on the
American Stock Exchange (AMEX) during the ten trading days immediately preceding
the closing date. The number of shares was subject to adjustment on the date the
Company filed a registration statement for the shares issued in this
transaction, which occurred on April 25, 2008. The increase or decrease to the
number of shares issued was determined using a per share price equal to the
average closing price of the Company’s common stock on the AMEX during the ten
trading days immediately preceding the date the registration statement was
filed.  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 GOCA.  On April 30,
2008, Telkonet issued an additional 3,046,425 shares of its common stock to the
sellers of GOCA to satisfy the adjustment provision.




F-22


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




On
February 8 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned
subsidiary of Geeks On Call Holdings, Inc., (formerly Lightview, Inc.) merged
with Geeks on Call America, Inc (“GOCA”). As a result of the merger, the
Company’s common stock in GOCA was exchanged for shares of common stock of Geeks
on Call Holdings Inc.  Immediately following the merger, Geeks on Call
Holdings Inc. completed a private placement of its common stock for aggregate
gross proceeds of $3,000,000. As a result of this transaction, the Company’s 30%
interest in GOCA became an 18% interest in Geeks on Call Holdings
Inc.  The Company has determined that its investment in GOCA is
impaired because it believes that the fair market value of GOCA has permanently
declined.   Accordingly, the Company wrote-off $4,098,514 during
the year ended December 31 2008.   The remaining value of this
investment amounted to $367,643 as of December 31, 2008.




Multiband
Corporation





In
connection with a payment of $75,000 of accounts receivable, the company
received 30,000 shares of common stock of Multiband Corporation, a
Minnesota-based communication services provider to multiple dwelling
units.  The Company classifies this security as available for sale,
and is carried at fair market value.  During the year ended December
31, 2008, the Company recorded a loss of $6,500 on the sale of 5,000 shares of
its investment in Multiband.  In addition, the Company recorded an
unrealized loss of $32,750 due to a temporary decline in value of this
security.  The remaining value of this investment amounted to $29,750
as of December 31, 2008.





NOTE I
– OTHER LONG TERM ASSETS





Components
of other long term assets as of December 31, 2008 and 2007 are as
follows:





2008
            
            
            2007Long-term
      investments
            
            $
            62,803
            
            
            $
            62,803Investments
      in sales-type leases – non current
            
            
            899
            
            
            
            11,179Deposits
      and other
            
            
            102,508
            
            
            
            157,675Total
            
            $
            166,210
            
            
            $
            231,657





Long-term
investments held during the years ended December 31, 2008 and 2007 included the
following:





Amperion,
Inc.




On
November 30, 2004, the Company entered into a Stock Purchase Agreement
(“Agreement”) with Amperion, Inc. ("Amperion"), a privately held company.
Amperion is engaged in the business of developing networking hardware and
software that enables the delivery of high-speed broadband data over
medium-voltage power lines. Pursuant to the Agreement, the Company invested
$500,000 in Amperion in exchange for 11,013,215 shares of Series A Preferred
Stock for an equity interest of approximately 0.8%. The Company has the right to
appoint one person to Amperion’s seven-person board of directors. The Company
accounted for this investment under the cost method, as the Company does not
have the ability to exercise significant influence over operating and financial
policies of the investee. The carrying value of the Company’s investment in
Amperion is $8,000 at December 31, 2008 and 2007.





BPL
Global, Ltd.




On
February 4, 2005, the Company’s Board of Directors approved an investment in BPL
Global, Ltd. (“BPL Global”), a privately held company. The Company funded an
aggregate of $131,000 as of December 31, 2005 and additional $44 during the year
of 2006. This investment represents an equity interest of approximately 4.67% at
December 31, 2006. The fair value of the Company's investment in BPL Global,
Ltd. amounted $131,044 as of December 31, 2006.  On November 7, 2007,
the Company completed the sale of its investment in BPL Global, Ltd for
$2,000,000 in cash to certain existing stockholders of BPL Global. The Company
recorded $1,868,956 of gain on sale of the investment.





Interactivewifi.com,
LLC




MST
maintains an investment in Interactivewifi.com, LLC a privately held company.
This investment represents an equity interest of approximately 50% at December
31, 2007. Interactivewifi.com is engaged in providing internet and related
services to customers throughout metropolitan New York, including the Nuvisions
internet services. MST accounted for this investment under the cost method, as
MST does not have the ability to exercise significant influence over operating
and financial policies of the investee. Telkonet reviewed the assumptions
underlying the operating performance and cash flow forecasts in assessing the
carrying values of the investment. The carrying value of the
investment in Interactivewifi.com is $55,000 at December 31, 2008 and
2007.





F-23


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




NOTE J
- ACCOUNTS PAYABLE AND ACCRUED LIABILITIES





Accounts
payable and accrued liabilities at December 31, 2008 and 2007 are as
follows:





2008
            
            
            2007Accounts
      payable
            
            $
            5,169,087
            
            
            $
            4,240,654Accrued
      expenses and liabilities
            
            
            3,654,548
            
            
            
            692,692Accrued
      payroll and payroll taxes
            
            
            832,593
            
            
            
            913,962Accrued
      interest
            
            
            525,076
            
            
            
            40,000Accrued
      purchase price contingency
            
            
            -
            
            
            
            400,000Registration
      rights liability
            
            
            
            
            
            
            500,000Warranty
            
            
            146,951
            
            
            
            102,534Other
      accrued expenses
            
            
            -
            
            
            
            957,209Total
            
            $
            10,328,255
            
            
            $
            7,847,051





NOTE K
– LINE OF CREDIT





In
September 2008, the Company entered into a two-year line of credit facility with
a third party financial institution.  The line of credit has an
aggregate principal amount of $1,000,000 and is secured by the Company’s
inventory.  The outstanding principal balance bears interest at the
greater of (i) the Wall Street Journal Prime Rate plus nine (9%) percent per
annum, adjusted on the date of any change in such prime or base rate, or (ii)
Sixteen percent (16%).  Interest, computed on a 365/360 simple
interest basis, and fees on the credit facility are payable monthly in arrears
on the last day of each month and continuing on the last day of each month until
the maturity date.  The Company may prepay amounts outstanding under
the credit facility in whole or in part at any time.  In the event of
such prepayment, the lender will be entitled to receive a prepayment fee of four
percent (4.0%) of the highest aggregate loan commitment amount if prepayment
occurs before the end of the first year and three percent (3.0%) if prepayment
occurs thereafter.  The outstanding borrowing under the agreement at
December 31, 2008 was $574,005.  The Company has incurred interest
expense of $22,374 related to the line of credit for the year ended December 31,
2008. The Prime Rate was 3.25% at December 31, 2008.





On
February 19, 2009, the Company received a notice of waiver from Thermo Credit
LLC on the tangible net worth requirement, as defined item D(10)b of the line of
credit agreement.  The waiver is in effect as of December 31, 2008 and
for the 90 day period thereafter.





NOTE L
- SENIOR CONVERTIBLE DEBENTURES AND SENIOR NOTES PAYABLE





Senior Convertible
Debenture





A summary
of convertible debentures payable at December 31, 2008 and December 31, 2007 is
as follows:





December
      31,
              2008
            
            
            December
      31, 2007Senior
      Convertible Debentures, accrue interest at 13% per annum and mature on May
      29, 2011
            
            $
            2,136,650
            
            
            $
            -Debt
      Discount - beneficial conversion feature, net of accumulated amortization
      of $295,508 and $0 at December 31, 2008 and December 31, 2007,
      respectively.
            
            
            (425,458
            )
            
            
            -Debt
      Discount - value attributable to warrants attached to notes, net of
      accumulated amortization of $277,913 and $0 at December 31, 2008 and
      December 31, 2007, respectively.
            
            
            (400,127
            )
            
            
            -Total
            
            $
            1,311,065
            
            
            $
            -Less:
      current portion
            
            
            -
            
            
            
            -$
            1,311,065
            
            
            $
            -




F-24


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




On May
30, 2008, the Company entered into a Securities Purchase Agreement with YA
Global Investments, L.P. (the “Buyer”) pursuant to which the Company agreed to
issue and sell to the Buyer up to $3,500,000 of secured convertible debentures
(the “Debentures”) and warrants to purchase (the “Warrants”) up to 2,500,000
shares of the Company’s Common Stock, par value $0.001 per share (the “Common
Stock”).  The sale of the Debentures and Warrants was effectuated in
three separate closings, the first of which occurred on May 30, 2008, and the
remainder of which occurred in June 2008.  At the May 30, 2008
closing, the Company sold Debentures having an aggregate principal value of
$1,500,000 and Warrants to purchase 2,100,000 shares of Common
Stock.  In July 2008, the Company sold the remaining Debentures having
an aggregate principal value of $2,000,000 and Warrants to purchase 400,000
shares of Common Stock.





During
the year ended December 31, 2008, $1,363,350 of the debt has been converted to
equity.  Accordingly, as of December 31, 2008, the Company has
$2,136,650 outstanding in convertible debentures. During the year ended December
31, 2008, the $1,363,350 of convertible debentures was converted into 7,324,057
shares of common stock.





The
Debentures accrue interest at a rate of 13% per annum and mature on May 29,
2011.  The Debentures may be redeemed at any time, in whole or in
part, by the Company upon payment by the Company of a redemption premium equal
to 15% of the principal amount of Debentures being redeemed, provided that an
Equity Conditions Failure (as defined in the Debentures) is not occurring at the
time of such redemption.  The Buyer may also convert all or a portion
of the Debentures at any time at a price equal to the lesser of (i) $0.58, or
(ii) ninety percent (90%) of the lowest volume weighted average price of the
Company’s Common Stock during the ten (10) trading days immediately preceding
the conversion date.  The Warrants expire five years from the date of
issuance and entitle the Buyers to purchase shares of the Company’s Common Stock
at a price per share of $0.61.





The
Debenture meets the definition of a hybrid instrument, as defined in SFAS
133,Accounting for Derivative
Instruments and Hedging Activities (SFAS No. 133). The hybrid instrument
is comprised of a i) a debt instrument, as the host contract and ii) an option
to convert the debentures into common stock of the Company, as an embedded
derivative. The embedded derivative derives its value based on the underlying
fair value of the Company’s common stock. The Embedded Derivative is not clearly
and closely related to the underlying host debt instrument since the economic
characteristics and risk associated with this derivative are based on the common
stock fair value.




The
embedded derivative does not qualify as a fair value or cash flow hedge under
SFAS No. 133. Accordingly, changes in the fair value of the embedded derivative
are immediately recognized in earnings and classified as a gain or loss on the
embedded derivative financial instrument in the accompanying statements of
operations. There was a loss of $1,174,121 recognized for the year ended
December 31, 2008.





The
Company determines the fair value of the embedded derivatives and records them
as a discount to the debt and a derivative liability on the date of issue. The
Company recognizes an immediate financing expense for any excess in the fair
value of the derivatives over the debt amount.  Upon conversion of the
debt to equity, any remaining unamortized discount is charged to financing
expense.





The
Company amortized the beneficial conversion feature and the value of the
attached warrants, and recorded non-cash interest expense in the amount of
$295,508, and $277,913, respectively, for the year ended December 31,
2008.




At
December 31, 2008, the Senior Convertible Debenture had an estimated fair value
of $1.9 million.




On March
31, 2009, the Company received a notice of waiver from YA Global Investments,
L.P. pursuant to which it agreed that, to the extent MSTI is in default of the
MSTI Debentures, such default shall not constitute an Event of Default as
defined in Section 2(a)(iii) of the May 30, 2008 Debentures the Company issued
to YA Global. The waiver is in effect as of December 31, 2008 through June 1,
2009.


Senior Convertible
Debentures - MST





A summary
of convertible promissory notes payable at December 31, 2008 and December 31,
2007 is as follows:





December
      31,
              2008
            
            
            December
      31,
              2007Senior
      Convertible Debentures, accrue interest at 8% per annum commencing on the
      first anniversary of the original issue date of the debentures, payable
      quarterly in cash or common stock, at MSTI Holdings Inc.’s option, and
      mature on April 30, 2010
            
            $
            6,657,872
            
            
            $
            6,576,350Senior
      Convertible Debentures, accrue interest at 8% per annum commencing on the
      first anniversary of the original issue date of the debentures, payable
      quarterly in cash or common stock, at MSTI Holdings Inc.’s option, and
      mature on December 15, 2008
            
            
            352,631Original
      Issue Discount - net of accumulated amortization of $550,503 and $307,038
      at December 31, 2008 and December 31, 2007, respectively.
            
            
            -
            
            
            
            (219,312
            )Debt
      Discount - beneficial conversion feature, net of accumulated amortization
      of $1,591,697and $283,464 at December 31, 2008 and December 31, 2007,
      respectively.
            
            
            -
            
            
            
            (1,174,351
            )Debt
      Discount - value attributable to warrants attached to notes, net of
      accumulated amortization of $2,124,569 and $181,118 at December 31, 2008
      and December 31, 2007, respectively.
            
            
            -
            
            
            
            (750,347
            )Total
            
            $
            7,010,503
            
            
            $
            4,432,342Less:
      current portion
            
            
            7,010,503
            
            
            
            -$
            -
            
            
            $
            4,432,342




F-25


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




During
the year ended December 31, 2007, MSTI Holdings Inc., issued senior convertible
debentures (the "Debentures") having a principal value of $6,576,350 to
investors, including an original issue discount of $526,350, in exchange for
$6,050,000 from investors, exclusive of placement fees. The original issue
discount to the MSTI Debentures is amortized over 12 months. The MSTI Debentures
accrue interest at 8% per annum commencing on the first anniversary of the
original issue date of the MSTI Debentures, payable quarterly in cash or common
stock, at MSTI Holdings Inc.’s option, and mature on April 30, 2010. The MSTI
Debentures are not callable and are convertible at a conversion price of $0.65
per share into 10,117,462 shares of MSTI Holdings Inc. common stock, subject to
certain limitations.  The MSTI Debenture holders are subject
to a “Beneficial Ownership Limitation” pursuant to which the number of shares of
common stock of MSTI Holdings, Inc. held by such debenture holders immediately
following conversion of the MSTI Debenture shall not exceed 4.99% of all of the
issued and outstanding common stock of MSTI Holdings, Inc.  The MSTI
Debentures are senior indebtedness and the holders of the MSTI Debentures have a
security interest in all of MSTI Holdings, Inc.’s assets.




In
accordance with Emerging Issues Task Force Issue 98-5, Accounting for
Convertible Securities with Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios ("EITF 98-5"), MST recognized an imbedded
beneficial conversion feature present in the MSTI Debentures. The Company
allocated a portion of the proceeds equal to the intrinsic value of that feature
to the MST additional paid in capital included in the Company’s minority
interest. The Company recognized and measured an aggregate of $1,457,815 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 MSTI Debentures issued during the year ended December 31, 2007. The
debt discount attributed to the beneficial conversion feature is amortized over
the MSTI Debentures maturity period (three years) as interest
expense.  On February 11, 2008, the MSTI Debenture holders executed a
letter agreement with MSTI Holdings, Inc. waiving their rights to receive
liquidated damages under the registration rights agreement, in exchange for a
reduction in their warrant exercise price from $1.00 to $0.65.  In
connection with this waiver, the Company has recognized an additional $641,294
of debt discount attributed to the beneficial conversion feature for the nine
months ended September 30, 2008.





In
connection with the placement of the MSTI Debentures, MSTI Holdings,
Inc. also issued to the MSTI Debenture holders, five-year warrants to
purchase an aggregate of 5,058,730 shares of MSTI Holdings, Inc. common stock at
an exercise price of $1.00 per share. MSTI Holdings Inc. 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 5.00%, a dividend yield of 0%, and volatility of 54%. The
$931,465 of debt discount attributed to the value of the warrants issued is
amortized over the MSTI Debentures maturity period (three years) as
interest expense.  On February 11, 2008, the Debenture holders
executed a letter agreement with MSTI Holdings, Inc. waiving their rights to
receive liquidated damages under the registration rights agreement, in exchange
for a reduction in their warrant exercise price from $1.00 to
$0.65.  In connection with this waiver, the Company has recognized an
additional $641,294 of debt discount attributed to the value of the warrants
issued for the year ended December 31, 2008.





In
connection with the issuance of the MSTI Debentures, MSTI Holdings Inc. incurred
placement fees of $423,500. Additionally, MSTI Holdings Inc. issued such agents
five-year warrants to purchase 708,222 shares of MSTI Holdings Inc. common stock
at an exercise price of $1.00.





During
the year ended December 31, 2008, MSTI Holdings Inc. issued additional
convertible debentures with a principal value of $81,522 to existing note
holders with a maturity date of April 30, 2010.  In connection with
this debenture, the Company has recognized an additional $6,522, $25,460 and
$18,938 of debt discount attributed to the original issue discount, the
beneficial conversion feature and the value of the attached warrants for the
year ended December 31, 2008.




F-26


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




The
Company amortized the original issue discount, the beneficial conversion feature
and the value of the attached warrants, and recorded non-cash interest expense
in the amount of $243,465, $1,841,105, and $1,410,575, respectively, for the
year ended December 31, 2008.





Registration
Rights Liquidated Damages





On May
24, 2007, MSTI Holdings, Inc. completed a private placement, pursuant to
which 5,597,664 shares of common stock and five-year warrants to purchase
2,798,836 shares of common stock were issued at an exercise price of $1.00 per
share, for total proceeds of $2,694,020.  Additionally, MSTI Holdings,
Inc. also sold MSTI Debentures (as previously described) for total proceeds
of $6,050,000.  The MSTI Debentures bear interest at a rate of 8% per
annum, commencing on the first anniversary of the original issue date of the
MSTI Debentures, payable quarterly in cash or common stock, at MSTI Holdings,
Inc. option, and mature on April 30, 2010. The MSTI Debentures are not callable
and are convertible at a price of $0.65 per share into 10,117,462 shares of MSTI
Holdings, Inc. common stock.  In addition, holders of the MSTI
Debentures received five-year warrants to purchase an aggregate of 5,058,730
shares of MSTI Holdings, Inc. common stock at an exercise price of $1.00 per
share.





MSTI
Holdings, Inc. agreed to file a “resale” registration statement with the SEC
within 60 days after the final closing of the private placement and the issuance
of the MSTI Debentures covering all shares of common stock sold in the private
placement and underlying the MSTI Debentures, as well as the warrants attached
to the private placement. MSTI Holdings, Inc. also agreed to use
its best efforts to have such “resale” registration statement declared
effective by the SEC as soon as possible and, in any event, within 120 days
after the initial closing of the private placement and the issuance of the MSTI
Debentures.




In
addition, with respect to the shares of common stock sold in the private
placement and underlying the warrants, MSTI Holdings, Inc. agreed to maintain
the effectiveness of the “resale” registration statement from the effective date
until the earlier of (i) 18 months after the date of the closing of the private
placement or (ii) the date on which all securities registered under the
registration statement (a) have been sold, or (b) are otherwise able to be sold
pursuant to Rule 144, at which time exempt sales may be permitted for purchasers
of the common stock in the private placement, subject to MSTI Holdings right to
suspend or defer the use of the registration statement in certain
events.





The
registration rights agreement requires the payment of liquidated damages to the
investors of approximately 1% per month of the aggregate proceeds of $9,128,717,
or the value of the unregistered shares at the time that the liquidated damages
are assessed, until the registration statement is declared
effective.  In accordance with EITF 00-19-2, the Company evaluated the
likelihood of achieving registration statement
effectiveness.  Accordingly, the Company accrued $500,000 as
of December 31, 2007, to account for these potential liquidated damages until
the expected effectiveness of the registration statement is
achieved.





On
February 11, 2008, the investors executed a letter agreement with MSTI Holdings,
Inc. waiving their rights to receive liquidated damages under the registration
rights agreement, in exchange for a reduction in their warrant exercise price
from $1.00 to $0.65.  As a result, the Company has reversed the
accrued expense for the potential liquidated damages during the year ended
December 31, 2008.





Additional
Debentures





In
connection with MSTI Holdings, Inc. (“MSTI”) May 2007 private offering of
convertible debentures (the “Debentures”) and warrants to purchase common stock
(the “Warrants”), MSTI entered into a Securities Purchase Agreement (the
“Purchase Agreement”) with the purchasers of the Debentures and Warrants (the
“Purchasers”), which prohibited MSTI from, directly or indirectly, among other
things, creating or incurring any indebtedness (other than Permitted
Indebtedness, as such term is defined in the Purchase Agreement) without the
consent of the holders of at least 85% of the principal amount of outstanding
Debentures.





On
October 16, 2008, Alpha Capital Anstalt, Gemini Master Fund, Ltd, Whalehaven
Capital Fund Limited and Brio Capital L.P.(the “Senior Lenders”) executed a
letter agreement (the “Letter Agreement”) with MSTI pursuant to which MSTI
issued $352,631 of Additional Debentures, due December 15, 2008, subject to
being extended to April 30, 2010 upon the satisfaction of certain specified
conditions, that are convertible into an aggregate of 542,509 shares of
MSTI common stock at a conversion price of $0.65 per share (subject to
adjustment as provided therein). The Additional Debentures were issued with an
8% Original Issue Discount. As a result, MSTI received $307,500 from the
issuance of the Additional Debentures. Also, in connection with the issuance of
the Additional debentures and pursuant to the letter agreement, MSTI issued 2
million shares of common stock to the purchasers of such Additional Debentures
and the same number of common stock purchase warrants at a purchase price of at
least $0.125 per share (the “Equity Raise”);.




F-27


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




In
connection with these debentures, MSTI has recognized an additional $17,631 of
debt discount attributed to the original issue discount for the year ended
December 31, 2008.





Triggering
Events that Accelerate or Increase a Direct Financial Obligation





As
previously described, MSTI entered into an October 16, 2008 letter agreement
with the Senior Lenders pursuant to which each of the Senior Lenders agreed to
purchase from MSTI, and MSTI agreed to sell to such Senior lenders, additional
Debentures in the aggregate principal amount of $352,631 (the “Additional
Debentures”).  Unless certain conditions were satisfied the
Additional Debentures were to mature on December 15, 2008.  Upon
satisfaction of such conditions, the Maturity Date of the Additional Debentures
would be automatically extended to April 30, 2010.  As a result of
MSTI’s failure to satisfy the conditions for extension of the Maturity Date, the
Additional Debentures matured on December 15, 2008.





As a
result of MSTI’s failure to timely pay its current obligations due to the Senior
Lenders under the Additional Debentures in the amount of $352,631, certain
events of default have occurred and are continuing beyond any applicable cure or
grace period with respect to all of MSTI’s secured obligations due to the Senior
Lenders and subordinate lenders.The total amounts due is
$9,448,506 ($7,010,503 in debenture principal, $2,103,151 in default penalty and
$334,852 in accrued interest).  MSTI did not make such payments, and,
accordingly, the Senior Lenders may take all steps they deem necessary to
protect the Senior Lenders’ interests, including the enforcement and exercise of
any and all of its rights, remedies, liens and security interests available to
them.





As
discussed previously, the MSTI Debentures are senior indebtedness and the
holders of the MSTI Debentures have a security interest in all of MSTI Holdings,
Inc.’s assets.  As a consequence of MSTI’s default, the Senior Lenders
have the right to pursue any of the remedies set forth in the security
agreements.




As a
result of MSTI’s default and ongoing losses, MSTI’s Board and management has
determined that it is advisable and in the best interests of the Company and its
stockholders, in cooperation with the Senior Lenders to explore the sale of all
or substantially all of the assets of Microwave Satellite Technologies, Inc., a
wholly owned subsidiary of MSTI which process is currently ongoing.




At
December 31, 2008, the carrying amounts of the Senior Convertible Debenture of
MST approximate fair value because the entire note had been classified to
current maturity.





Senior Note
Payable





A summary
of the senior notes payable at December 31, 2008 and December 31, 2007 is as
follows:





December
      31,
              2008
            
            
            December
      31,
              2007Senior
      Note Payable, accrues interest at 6% per annum, and matures on the earlier
      to occur of (i) the closing of the Company’s next financing, or (ii)
      January 28, 2008.
            
            $
            -
            
            
            $
            1,500,000Debt
      Discount - value attributable to warrants attached to notes, net of
      accumulated amortization of $195,924 and $166,744 at December 31, 2008 and
      December 31, 2007, respectively.
            
            
            -
            
            
            
            (29,180
            )Total
            
            $
            -
            
            
            $
            1,470,820Less:
      current portion
            
            
            -
            
            
            
            1,470,820$
            -
            
            
            $
            -





On July
24, 2007, Telkonet entered into a Senior Note Purchase Agreement with GRQ
Consultants, Inc. (“GRQ”) pursuant to which the Company issued to GRQ a Senior
Promissory Note (the “Note”) in the aggregate principal amount of $1,500,000.
The Note was due and payable on the earlier to occur of (i) the closing of
the Company’s next financing, or (ii) January 28, 2008, and bore interest
at a rate of nine (6%) percent per annum. The Company incurred
approximately $25,000 in fees in connection with this transaction. The net
proceeds from the issuance of the Note were for general working capital
needs.  On February 8, 2008, this note was repaid in full including
$49,750 in accrued but unpaid interest from the issuance date through the date
of repayment.




F-28


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




In
connection with the issuance of the Note, the Company also issued to GRQ
warrants to purchase 359,712 shares of common stock at $4.17 per share. These
warrants expire five years from the date of issuance. 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
$195,924 of debt discount attributed to the value of the warrants issued is
amortized over the note maturity period (six months) as non-cash interest
expense. The Company amortized the value of the attached warrants, and recorded
non-cash interest expense in the amount of $29,180, respectively, during the
year ended December 31, 2008.





Aggregate
maturities of long-term debt as of December 31, 2008 are as
follows:





For the twelve months
      ended December 31,
            
            Amount2009
            
            $
            7,010,5032010
            
            
            -2011
            
            
            2,136,650$
            9,147,153





Note
Payable





On May 6,
2008, Telkonet executed a Promissory Note (the “Note”) in favor of Ralph W.
Hooper (the “Note”) in the aggregate principal amount of Four Hundred Thousand
Dollars ($400,000). The Note was due and payable on the earlier to occur of (i)
the closing of the Company’s next financing, or (ii) November 6, 2008. As of
December 31, 2008, there was no outstanding liability.





In
connection with the issuance of the Note, the Company also issued to Mr. Hooper
warrants to purchase 800,000 shares of common stock at $0.60 per share. These
warrants expire five years from the date of issuance. The Company valued the
warrants using the Black-Scholes pricing model and the following assumptions:
contractual terms of 5 years, an average risk free interest rate of 3.2%, a
dividend yield of 0%, and volatility of 82%. The Company recorded non-cash
interest expense in the amount of $254,160 for the value of the attached
warrants during the year ended December 31, 2008.





NOTE M
– CAPITAL LEASE OBLIGATIONS





Capital
lease obligations consists of the following as of December 31 2008 and
2007:





December
      31, 2008
            
            
            December
      31, 2007Capital
      lease of subsidiary
            
            $
            199,702
            
            
            $
            -Capital
      lease
            
            
            4,714
            
            
            
            11,842Total
            
            
            204,416
            
            
            
            11,842Less:
      Current Maturities
            
            
            (204,416
            )
            
            
            (7,128
            )Balance*
            
            $
            -
            
            
            $
            4,714





*Balance
includes net assets under capital leases of approximately $195,160 and $10,270
in 2008 and 2007, respectively.





The
following is a schedule of future minimum lease payments under capital leases
and the present value of such payments as of December 31, 2008:





2009
                
                $
                279,9932010
                
                
                -2011
                
                
                -Total
      minimum payments
                
                
                279,993Less:
      amount representing interest
                
                
                (75,577
                )Present
      value of net minimum payments
                
                $
                204,416




F-29


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




NOTE N
- 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, 2008 and 2007, the Company has no
preferred stock issued and outstanding. The company has authorized 130,000,000
shares of common stock, with a par value of $.001 per share. As of December 31,
2008 and 2007, the Company has 87,525,495 and 70,826,544, respectively, of
shares of common stock issued and outstanding.





During
the year ended December 31, 2007, the Company issued an aggregate of 118,500
shares of common stock for an aggregate purchase price of $124,460 to certain
employees upon exercise of employee stock options at approximately $1.05 per
share. (Note N).





During
the year ended December 31, 2007, the Company issued an aggregate of 21,803
shares of common stock, valued at $57,342, to a consultant and an employee in
exchange for services, which approximated the fair value of the shares issued
during the period services were completed and rendered.





During
the year ended December 31, 2007, the Company issued 200,000 shares of common
stock pursuant to a consulting agreement.  These shares were valued at
$271,500, which approximated the fair value of the shares issued during the
period services were completed and rendered (Note T).




On March
9, 2007, the Company entered into an Asset Purchase Agreement (“Agreement”) with
Smart Systems International, a privately held company. Pursuant to the
Agreement, the Company issued 2,227,273 shares of Common Stock at approximately
$2.69 per share (Note B).





On March
15, 2007, the Company entered into a Purchase Agreement (“Agreement”) with
EthoStream, LLC, a privately held company. Pursuant to the Agreement, the
Company issued 3,459,609 shares of Common Stock at approximately $2.82 per share
(Note B).





On July
18, 2007, Telkonet issued 866,856 unregistered shares of common stock of
Telkonet, Inc. in connection with the acquisition of substantially all of the
assets of Newport Telecommunications Co. by the Telkonet majority-owned
subsidiary, Microwave Satellite Holdings, Inc.   The Common Stock
issued by Telkonet represented $1,530,000 of the total consideration
of $2,550,000 paid in the asset purchase (Note B).





In
February 2007, the Company issued 4,000,000 shares of Common Stock valued at
$2.50 per share for an aggregate purchase price of $9,610,000, net of placement
fees. The Company also issued to this investor warrants to purchase 2.6 million
shares of its common stock at an exercise price of $4.17 per share in this
private placement transaction. A registration statement covering the shares
underlying the warrants was filed with the Securities and Exchange Commission on
Form S-3 on March 5, 2007 and was declared effective on March 20,
2007.  In accordance with EITF 00-19-02, “Accounting for Registration
Payment Arrangements”, at the time of the issuance of the equity for
registration the Company deemed it probable that a registration of shares would
be deemed effective therefore a loss contingency would not be necessary and the
equity was recorded at fair value on the date of issuance.




On
October 19, 2007, the Company completed the acquisition of approximately 30.0%
of the issued and outstanding shares of common stock of Geeks on Call America,
Inc. (“GOCA”), the nation's premier provider of on-site computer services. 
Under the terms of the stock purchase agreement, the Company acquired
approximately 1,160,043 shares of GOCA common stock from several GOCA
stockholders in exchange for 2,940,202 shares of the Company’s common stock for
total consideration valued at approximately $4.5 million (Note I).  On
February 8 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned
subsidiary of Geeks On Call Holdings, Inc., (formerly Lightview, Inc.) merged
with Geeks on Call America, Inc (“GOCA”). As a result of the merger, the
Company’s common stock in GOCA was exchanged for shares of common stock of Geeks
on Call Holdings Inc.  Immediately following the merger, Geeks on Call
Holdings Inc. completed a private placement of its common stock for aggregate
gross proceeds of $3,000,000. As a result of this transaction, the Company’s 30%
interest in GOCA became an 18% interest in Geeks on Call Holdings
Inc.





In
February 2008, the Company amended certain stock purchase warrants held by
private placement investors to reduce the exercise price under such warrants
from $4.17 per share to $0.6978258 per share.  The warrants entitled
the holders to purchase an aggregate of up to 3,380,000 shares of Telkonet
common stock.   Subsequently, these private placement investors
exercised all of their warrants on a cashless basis using the five day volume
average weighted price (VWAP) as of January 31, 2008 of $.99 resulting in the
issuance of 1,000,000 shares of Company common stock.




F-30


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




During
the year ended December 31, 2008, the Company issued 346,244 shares of common
stock to consultants for services performed and services accrued in fiscal
2007.  These shares were valued at $345,407, which approximated the
fair value of the shares issued during the period services were completed and
rendered.





In
February 2008, Telkonet completed a private placement with one investor for
aggregate gross proceeds of $1.5 million.  Pursuant to this private
placement, the Company issued 2,500,000 shares of common stock valued at $0.60
per share.





In April
2008, Telkonet issued an additional 3,046,425 shares of its common stock to the
sellers of Geeks on Call America, Inc. to satisfy the adjustment provision in
the stock purchase agreement dated October 19, 2007 (Note T).





In June
2008, Telkonet issued an additional 1,882,225 shares of its common stock to the
sellers of Smart Systems International (SSI), to satisfy the adjustment
provision in the purchase agreement dated March 9, 2007 (Note B).





During
the year ended December 31, 2008, Telkonet issued an aggregate of 600,000 shares
of its common stock to Frank T. Matarazzo pursuant to the stock purchase
agreement between Telkonet and MST, dated January 31, 2006.  These
shares were valued at $380,000, which approximated the fair value of the shares
on the date the shares were issued (Note B).





During
the year ended December 31, 2008, Telkonet issued 7,324,057 shares of common
stock at approximately $0.19 per shares to its senior convertible debenture
holders in exchange for $1,363,350 of debentures.





NOTE O
- STOCK OPTIONS AND WARRANTS





Employee Stock
Options




The
following table summarizes the changes in options outstanding and the related
prices for the shares of the Company’s common stock issued to employees of the
Company under a non-qualified employee stock option plan.





Options
      Outstanding
            
            
            Options
      ExercisableExercise
      Prices
            
            
            Number
              Outstanding
            
            
            Weighted
              Average
              Remaining
              Contractual
              Life
              (Years)
            
            
            Weighted
              Average
              Exercise
              Price
            
            
            Number
              Exercisable
            
            
            Weighted
              Average
              Exercise
              Price$
            1.00
      - $1.99
            
            
            
            4,263,429
            
            
            
            4.30
            
            
            $
            1.02
            
            
            
            4,049,679
            
            
            $
            1.01$
            2.00
      - $2.99
            
            
            
            1,232,500
            
            
            
            5.80
            
            
            $
            2.48
            
            
            
            1,213,500
            
            
            $
            2.48$
            3.00
      - $3.99
            
            
            
            1,272,000
            
            
            
            6.21
            
            
            $
            3.32
            
            
            
            1,074,500
            
            
            $
            3.35$
            4.00
      - $4.99
            
            
            
            100,000
            
            
            
            6.18
            
            
            $
            4.32
            
            
            
            72,000
            
            
            $
            4.31$
            5.00
      - $5.99
            
            
            
            126,000
            
            
            
            6.11
            
            
            $
            5.22
            
            
            
            97,000
            
            
            $
            5.236,993,929
            
            
            
            4.98
            
            
            $
            1.82
            
            
            
            6,506,679
            
            
            $
            1.77





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





Number
      of
              Shares
            
            
            Weighted
              Average
              Price
              Per
      ShareOutstanding
      at January 1, 2007
            
            
            8,520,929
            
            
            $
            2.06Granted
            
            
            935,000
            
            
            
            2.55Exercised
      (Note M)
            
            
            (118,500
            )
            
            
            1.05Cancelled
      or expired
            
            
            (1,232,000
            )
            
            
            3.00Outstanding
      at December 31, 2007
            
            
            8,105,429
            
            
            $
            1.98Granted
            
            
            185,000
            
            
            
            1.00Exercised
      (Note M)
            
            
            -
            
            
            
            -Cancelled
      or expired
            
            
            (1,296,500
            )
            
            
            2.71Outstanding
      at December 31, 2008
            
            
            6,993,929
            
            
            $
            1.82




F-31


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




The
weighted-average fair value of stock options granted to employees during the
years ended December 31, 2008 and 2007 and the weighted-average significant
assumptions used to determine those fair values, using a Black-Scholes option
pricing model are as follows:





2008
            
            
            2007Significant
      assumptions (weighted-average):Risk-free
      interest rate at grant date
            
            
            2.9%
            
            
            
            4.8%Expected
      stock price volatility
            
            
            78%
            
            
            
            70%Expected
      dividend payout
            
            
            -
            
            
            
            -Expected
      option life (in years)
            
            
            5.0
            
            
            
            5.0Fair
      value per share of options granted
            
            $
            0.55
            
            
            $
            1.57





The
expected life of awards granted represents the period of time that they are
expected to be outstanding. We determine the expected life based on historical
experience with similar awards, giving consideration to the contractual terms,
vesting schedules, exercise patterns and pre-vesting and post-vesting
forfeitures. We estimate the volatility of our common stock based on the
calculated historical volatility of our own common stock using the trailing 24
months of share price data prior to the date of the award. We base the risk-free
interest rate used in the Black-Scholes-Merton option valuation model on the
implied yield currently available on U.S. Treasury zero-coupon issues with an
equivalent remaining term equal to the expected life of the award. We have not
paid any cash dividends on our common stock and do not anticipate paying any
cash dividends in the foreseeable future. Consequently, we use an expected
dividend yield of zero in the Black-Scholes-Merton option valuation model. We
use historical data to estimate pre-vesting option forfeitures and record
share-based compensation for those awards that are expected to vest. In
accordance with SFAS No. 123R, we adjust share-based compensation for changes to
the estimate of expected equity award forfeitures based on actual forfeiture
experience.




The total
intrinsic value of the options exercised for the year ended December 31, 2007
was $137,666. There were no options exercised during the year ended December 31,
2008.  Additionally, the total fair value of shares vested during the
year ended December 31, 2008 and 2007 was $613,139 and $1,225,626,
respectively.





Total
stock-based compensation expense recognized in the consolidated statement of
earnings for the year ended December 31, 2008 and 2007 was $1,216,997 and
$1,534,560, respectively, net of tax effect. Additionally, the aggregate
intrinsic value of options outstanding and unvested as of December 31, 2008 is
$0.





Non-Employee Stock
Options





The
following table summarizes the changes in options outstanding and the related
prices for the shares of the Company’s common stock issued to the Company
consultants. These options were granted in lieu of cash compensation for
services performed.





Options
      Outstanding
            
            Options
      ExercisableExercise
      Prices
            
            
            Number
              Outstanding
            
            
            Weighted
              Average
              Remaining
              Contractual
              Life
      (Years)
            
            
            Weighted
              Average
              Exercise
      Price
            
            Number
              Exercisable
            
            
            Weighted
              Average
              Exercise
      Price$
            1.00
            
            
            
            1,815,937
            
            
            
            3.33
            
            
            $
            1.00
            
            
            1,815,937
            
            
            $
            1.00




F-32


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




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





Number
      of
              Shares
            
            
            Weighted
              Average
      Price
              Per
      ShareOutstanding
      at January 1, 2007
            
            
            1,815,937
            
            
            $
            1.00Granted
            
            
            -
            
            
            
            -Exercised
            
            
            -
            
            
            
            -Canceled
      or expired
            
            
            -
            
            
            
            -Outstanding
      at December 31, 2007
            
            
            1,815,937
            
            
            $
            1.00Granted
            
            
            -
            
            
            
            -Exercised
            
            
            -
            
            
            
            -Canceled
      or expired
            
            
            -
            
            
            
            -Outstanding
      at December 31, 2008
            
            
            1,815,937
            
            
            $
            1.00





There
were no non-employee stock options vested during the years ended December
31, 2008 and 2007, respectively.





Warrants





The
following table summarizes the changes in warrants outstanding and the related
prices for the shares of the Company’s common stock issued to non-employees of
the Company. These warrants were granted in lieu of cash compensation for
services performed or financing expenses and in connection with placement of
convertible debentures.




Warrants
      Outstanding
            
            
            
            
            
            Warrants
      ExercisableExercise
      Prices
            
            
            Number
              Outstanding
            
            
            Weighted
      Average
              Remaining
      Contractual
              Life
      (Years)
            
            
            Weighed
              Average
              Exercise
      Price
            
            
            Number
              Exercisable
            
            
            Weighted
              Average
              Exercise
      Price$
            0.58
            
            
            
            856,739
            
            
            
            3.08
            
            
            $
            0.58
            
            
            
            856,739
            
            
            $
            0.58$
            0.60
            
            
            
            800,000
            
            
            
            4.35
            
            
            $
            0.60
            
            
            
            800,000
            
            
            $
            0.60$
            0.61
            
            
            
            2,500,000
            
            
            
            4.41
            
            
            $
            0.61
            
            
            
            2,500,000
            
            
            $
            0.61$
            2.59
            
            
            
            862,452
            
            
            
            2.62
            
            
            $
            2.59
            
            
            
            862,452
            
            
            $
            2.59$
            3.98
            
            
            
            3,078,864
            
            
            
            3.56
            
            
            $
            3.98
            
            
            
            3,078,864
            
            
            $
            3.98$
            4.17
            
            
            
            359,712
            
            
            
            2.79
            
            
            $
            4.17
            
            
            
            359,712
            
            
            $
            4.178,457,767
            
            
            
            3.46
            
            
            $
            2.19
            
            
            
            8,457,767
            
            
            $
            2.19





Transactions
involving warrants are summarized as follows:





Number
      of
              Shares
            
            
            Weighted
              Average
      Price
              Per
      ShareOutstanding
      at January 1, 2007
            
            
            4,557,850
            
            
            $
            4.20Granted
            
            
            3,115,777
            
            
            
            4.18Exercised
      (Note M)
            
            
            -
            
            
            
            -Canceled
      or expired
            
            
            -
            
            
            
            -Outstanding
      at December 31, 2007
            
            
            7,673,627
            
            
            $
            4.15Granted
            
            
            4,164,140
            
            
            
            1.31Exercised
      (Note M)
            
            
            (3,380,000
            )
            
            
            0.70
            *Canceled
      or expired
            
            
            -
            
            
            
            -Outstanding
      at December 31, 2008
            
            
            8,457,767
            
            
            $
            2.19


______________


*The
warrants were issued to Enable Capital and originally priced at $4.17 per
share.  In February 2008, these warrants were re-priced to $0.6978258
per share and the holders exercised the warrants on a cashless basis and
received 1,000,000 shares




F-33


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




The
Company granted 864,140 and 79,326 warrants to Convertible Senior Notes holders,
0 and 2,600,000 warrants to private placement investors (Note M), 2,500,000 and
0 to a Convertible Debenture holder, 800,000 and 0 to a Note holder,
and  0 and 76,739 compensatory warrants to non-employees during the
year ended December 31, 2008 and 2007, respectively.  There was no
compensatory warrant expense recorded for the year ended December 31,
2008.  The estimated value of compensatory warrants granted during the
year ended December 31, 2007 was determined using the Black-Scholes option
pricing model and the following assumptions: contractual term of 5 years, a risk
free interest rate of approximately 4.75%, a dividend yield of 0% and volatility
of 70%. Compensation expense of $139,112 was charged to operations for the year
ended December 31, 2007.





The
purchase price of the warrants issued to Convertible Senior Note holders was
adjusted from $4.70 to $3.98 per share during the year ended December 31, 2008
in accordance with the anti-dilution protection provision of the Convertible
Senior Notes Payable Agreement (“the Agreement”) dated October 27, 2005, upon
the occurrence of certain events as defined in the Agreement.





In
February 2008, the Company amended certain stock purchase warrants held by
private placement investors to reduce the exercise price under such warrants
from $4.17 per share to $0.6978258 per share.  The warrants entitled
the holders to purchase an aggregate of up to 3,380,000 shares of Telkonet’s
common stock.   Subsequently, these private placement investors
exercised all of their warrants on a cashless basis using the five day volume
average weighted price (VWAP) as of January 31, 2008 of $.99 resulting in the
issuance of 1,000,000 shares of Company common stock.  The Company has
accounted for the amended warrants issued, valued at $1,224,236, as other
expense using the Black-Scholes pricing model and the following assumptions:
contractual term of 5 years, an average risk-free interest rate of 3.5% a
dividend yield of 0% and volatility of 70%.  In addition, during the
year ended December 31, 2008, the Company recorded non-cash expenses of $574,426
for issuing additional warrants and the re-pricing of outstanding warrants in
accordance with the anti-dilution provision of the warrant
agreements.





NOTE P
- RELATED PARTY TRANSACTIONS





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, 2007, an aggregate of $100,000 of
consulting fees was charged to income each year pursuant to the
agreement.





On
July 1, 2005, the Company and Mr. Blumenfeld executed a consulting
agreement pursuant to which Mr. Blumenfeld agreed to act as a consultant with
respect to international sales.  Pursuant to the terms of the
agreement, Mr. Blumenfeld received 10,000 shares of Telkonet stock upon
execution of the agreement, 10,000 shares of Telkonet stock per quarter for the
first year (for a total 50,000 shares in the first year) and 5,000 shares of
Telkonet stock per quarter thereafter plus a five percent (5%) commission
(payable in cash or Telkonet stock at the Consultant’s option) 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.  The agreement was not renewed and therefore expired
effective June 30, 2006.  On March 16, 2007, the Board of Directors
approved the payment of compensation to Mr. Blumenfeld in the amount of $24,000
for his service as a director during the period of July 1, 2006 through December
31, 2006, which payment is commensurate with the payments made to the other
directors for their board service.   In addition, effective
January 1, 2007, Mr. Blumenfeld is being compensated according to the
non-management compensation plan.





In
conjunction with the acquisition of MST on January 31, 2006, the Company assumed
a non-interest bearing demand promissory note in the amount of $80,444 due to
Frank Matarazzo, MST President. Additionally, an estimated $285,784 income tax
receivable due to the Company for certain carryback tax losses of MST for the
period prior to the Company’s acquisition is payable to Frank
Matarazzo.





In
February 2006, MST entered into a one-year professional services agreement with
Global Transport Logistics, Inc. (“GTI”), for consulting services for which GTI
is paid a fee of $10,000 per month. GTI is 100% owned by Eileen Matarazzo, the
sister-in-law of MST’s Chief Executive Officer. The agreement has been extended
through February 2009. For the years ended December 31, 2008 and 2007, MST paid
and expensed $6,869 and $110,000, respectively.





The Chief
Administrative Officer at MST, Laura Matarazzo, is the sister of the Chief
Executive Officer of MST and receives an annual base salary of approximately
$134,000 with bonuses and benefits based upon the Company’s internal
policies.




F-34


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




From time
to time the Company may receive advances from certain of its officers to meet
short term working capital needs.  These advances may not have formal
repayment terms or arrangements.  As of December 31, 2008, there were
no amounts due to officers of the Company.




NOTE Q
- 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:





2008
            
            2007Tax
      provision computed at the statutory rate
            $
            (8,677,000
            )
            $
            (7,137,000
            )Stock-based
      compensation
            
            390,000
            
            
            563,000Goodwill
      impairment
            
            950,000
            
            
            692,000Book
      expenses not deductible for tax purposes
            
            200,000
            
            
            135,000Minority
      Interest
            
            (1,728,000
            )
            
            (1,019,000
            )Change
      in valuation allowance for deferred tax assets
            
            8,865,000
            
            
            6,766,000Income
      tax expense
            $
            --
            
            $
            --





Deferred
income taxes include the net tax effects of net operating loss (NOL)
carryforwards and the temporary differences between the carrying amounts of
assets and liabilities for financial reporting purposes and the amounts used for
income tax purposes. Significant components of the Company's deferred tax assets
are as follows:





2008
              
              2007Deferred
      Tax Assets:Net
      operating loss carryforwards
              $
              40,076,000
              
              $
              32,231,000Property
      and equipment, principally due to differences in
    depreciation
              
              638,000
              
              
              259,000Warrants
      and non-employee stock options
              
              1,421,000
              
              
              1,031,000Investment
      in Amperion
              
              188,000
              
              
              188,000Other
              
              915,000
              
              
              915,000Total
      deferred tax assets
              
              43,238,000
              
              
              34,624,000Deferred
      Tax Liabilities:Beneficial
      Conversion Feature of Convertible Debentures
              
              (247,000
              )
              
              (513,000
              )Acquired
      Intangibles
              
              (984,000
              )
              
              (984,000
              )Other
              
              (850,000
              )
              
              (825,000
              )Total
      deferred tax liabilities
              
              (2,081,000
              )
              
              (2,332,000
              )Valuation
      allowance
              
              (41,157,000
              )
              
              (32,292,000
              )Net
      deferred tax assets
              $
              --
              
              $
              --




F-35


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




The
Company has provided a valuation reserve against the full amount of the net
deferred tax assets, because in the opinion of management, it is more likely
than not that these tax assets will not be realized.





At
December 31, 2008 and 2007, the Company has net operating loss carryforwards of
approximately $116 million and $87 million, respectively, for federal income tax
purposes which will expire at various dates from 2020 through 2028.





With the
implementation of FAS123R, the amount of the NOL carryforward related to stock
based compensation expense is not recognized until the stock-based compensation
tax deductions reduce taxes payable. Accordingly, the NOL's reported in the
deferred tax asset that were generated in the current year do not include the
component of the NOL related to excess tax deductions over book compensation
cost related to stock based compensation.. The NOL deferred tax asset does
include pre-implementation excess tax deductions over book compensation cost
related to stock based compensation. The NOL related to excess tax deductions
will be recorded directly into Additional Paid-in-Capital at the time they
produce a future current tax benefit.





During
2007, the Company acquired SSI and EthoStream.  As part of the
purchase accounting for these acquisitions, deferred tax assets in the amount of
$3.8 million and $74,000, respectively, were established.  A valuation
allowance against these deferred assets was established as part of purchase
accounting and was recorded to goodwill.




SFAS 109
requires recognition of a deferred tax liability for outside basis differences
arising in fiscal years beginning after December 15, 1992.  An outside
basis difference represents the amount by which the basis of an investment in a
domestic subsidiary for financial reporting purposes exceeds the tax basis in
such asset.  If under applicable tax law, the outside basis difference in a
domestic subsidiary can be recovered tax-free and the Company expects to avail
itsself of such law, the outside basis difference is not a temporary difference
since no taxes are expected to result upon its reversal.  Subsequent to the
transaction in May 2007 discussed previously, Telkonet's ownership in Microwave
Satellite Technologies, Inc. is only 58%.  As such, it can no longer
recover the outside tax basis in a tax-free manner and Telkonet does not intend
to modify its ownership to avail itself of a tax-free recovery
alternative.  As such, a deferred liability was established in 2007 for the
outside basis difference in Telkonet's ownership of Microwave Satellite
Technologies, Inc.




The
Company’s NOL and tax credit carryovers may be significantly limited under
Section 382 of the Internal Revenue Code (IRC). NOL and tax credit carryovers
are limited under Section 382 when there is a significant “ownership change” as
defined in the IRC. During 2005 and in prior years, the Company may have
experienced such ownership changes.




The
limitation imposed by Section 382 would place an annual limitation on the amount
of NOL and tax credit carryovers that can be utilized. When the Company
completes the necessary studies, the amount of NOL carryovers available may be
reduced significantly. However, since the valuation allowance fully reserves for
all available carryovers, the effect of the reduction would be offset by a
reduction in the valuation allowance.





NOTE R
- LOSSES PER COMMON SHARE





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





2008
            
            
            2007Net
      loss available to common shareholders
            
            $
            (23,985,539
            )
            
            $
            (20,391,110
            )Basic
      and fully diluted loss per share
            
            $
            (0.30
            )
            
            $
            (0.31
            )Weighted
      average common shares outstanding
            
            
            79,153,788
            
            
            
            65,414,875




F-36


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




For the
year ended December 31, 2008, no potential shares were excluded from shares used
to calculate diluted losses per share.  For the year ended December
31, 2007, 2,800,950 potential shares were excluded from shares used to calculate
diluted losses per share as their inclusion would reduce net losses per
share.





NOTE
S- COMMITMENTS AND CONTINGENCIES





Office Leases
Obligations





The
Company presently leases 16,400 square feet of commercial office space in
Germantown, Maryland for its corporate headquarters. The Germantown lease
expires in December 2015. The Company spent approximately $61,000 in build-out
costs to increase the office space of its Germantown headquarters by
approximately 6,000 square feet in April 2007.





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





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





The
Company presently leases approximately 12,000 square feet of office space in
Milwaukee, WI for EthoStream.  The Milwaukee lease expires in February
2019.





Following
the acquisition of SSI, the Company assumed a lease on 9,000 square feet of
office and warehouse space in Las Vegas, NV on a month to month
basis.  The Las Vegas, NV office lease expired on April 30,
2008.





In
September 2006, the Company leased a vehicle for the then Chief Executive
Officer of Telkonet, Inc. This lease expired in September 2008.




Commitments
for minimum rentals under non cancelable leases at December 31, 2008 are as
follows:




2009
              
              $
              462,5152010
              
              
              469,4182011
              
              
              292,8922012
              
              
              294,9322013
      and thereafter
              
              
              1,011,198Total
              
              $
              2,530,955





Rental
expenses charged to operations for the years ended December 31, 2008
and 2007 are $613,663 and $825,785, respectively.




Employment and Consulting
Agreements





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





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




The
Company entered into an exclusive financial advisor and consulting agreement in
January 2007. The agreement provides a minimum consideration fee, not less than
$250,000, in the event of an equity or financing transaction where the advisor
is engaged. The agreement may be terminated with sixty days notification by
either party.





On August
1, 2007, the Company entered into an agreement with Barry Honig, President of
GRQ Consultants, Inc. (“GRQ”). Telkonet has agreed to pay Mr. Honig 50,000
shares of common stock per month for six (6) months, to provide the Company with
transaction advisory services. As of December 31, 2007, GRQ held a Senior
Promissory Note issued by Telkonet on July 24, 2007, in the principal amount of
$1,500,000 (Note J).  On February 8, 2008, this note was repaid in
full including $49,750 in accrued but unpaid interest from the issuance date
through the date of repayment.




F-37


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




Jason
Tienor, President and Chief Executive Officer, is employed pursuant to an
employment agreement dated March 15, 2007.  Mr. Tienor’s employment
agreement has a term of three years and provides for a base salary of $200,000
per year.





Jeff
Sobieski, Executive Vice President, Energy Management, is employed pursuant to
an employment agreement, dated March 15, 2007. Mr. Sobieski’s employment
agreement has a term of three years for a base salary of $190,000 per
year.





Frank T.
Matarazzo, Chief Executive Officer, MSTI Holdings, Inc, is employed pursuant to
an employment agreement that provides for an annual salary of $300,000 and
expires December 31, 2011.




Litigation





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





Senior Convertible
Noteholder Claim





The
August 14, 2006 Settlement Agreement with the Senior Convertible Debenture
Noteholders provided that the number of shares issued to the Noteholders shall
be adjusted based upon the arithmetic average of the weighted average price of
the Company’s common stock on the American Stock Exchange for the twenty trading
days immediately following the settlement date.  The Company has
concluded that, based upon the weighted average of the Company's common stock
between August 16, 2006 and September 13, 2006, the Company is entitled to a
refund from the two Noteholders.  One of the Noteholders has informed
the Company that it does not believe such a refund is required.  As a
result, the Company has declined to deliver to the Noteholders certain stock
purchase warrants issued to them pursuant to the Settlement Agreement pending
resolution of this disagreement. The Noteholder has alleged that the Company has
failed to satisfy its obligations under the Settlement Agreement by failing to
deliver the warrants. In addition, the Noteholder maintains that the Company has
breached certain provisions of the Registration Rights Agreement and, as a
result of such breach, such Noteholder claims that it is entitled to receive
liquidated damages from the Company. In the Company’s opinion, the ultimate
disposition of these matters will not have a material adverse effect on the
Company’s results of operations or financial position.





Purchase Price
Contingency





In
conjunction with the acquisition of MST on January 31, 2006, the purchase price
contingency shares are price protected for the benefit of the former owner of
MST. In the event the Company’s common stock price is below $4.50 per share upon
the achievement of thirty three hundred (3,300) subscribers a pro rata
adjustment in the number of shares will be required to support the aggregate
consideration of $5.4 million. The price protection provision provides a cash
benefit to the former owner of MST if the as-defined market price of the
Company’s common stock is less than $4.50 per share at the time of issuance from
the escrow on or before January 31, 2009. The issuance of additional shares or
distribution of other consideration upon resolution of the contingency based on
the Company’s common stock prices will not affect the cost of the acquisition.
When the contingency is resolved or settled, and additional consideration is
distributable, the Company will record the current fair value of the additional
consideration and the amount previously recorded for the common stock issued
will be simultaneously reduced to the lower current value of the Company’s
common stock. In addition, the Company agreed to fully fund the MST three year
business plan, established on January 31, 2006, to satisfy the benchmarks
established to achieve 3,300 subscribers. In the event, for any reason, the
Company materially fails to satisfy its obligations under the acquisition
agreement, then the former owners of MST shall be entitled to the release of any
and all consideration held in reserve. In May 2008, the Company executed an
agreement for a minimum commitment of $2.3 million to fund MST's business plan
in accordance with Section 11.1 of the Purchase Agreement between Telkonet and
Frank T. Matarazzo. In addition, the adjustment date for the achievement of
MST's 3,300 subscribers has been extended an additional six months from January
31, 2009 to July 31, 2009. Additionally, in April 2008 the Company issued from
escrow 200,000 shares of the purchase price contingency and advanced 400,000
shares in June 2008 in exchange for Mr. Matarazzo’s agreement to a debt covenant
restricting the use of proceeds in the Company’s debenture financing with YA
Global Investments LP.




On March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $6,875,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. The Company was obligated to register the stock portion of the purchase
price on or before May 15, 2007. Pursuant to the registration rights agreement,
the registration statement was required to be effective no later than July 14,
2007.  The registration rights agreement does not expressly provide
for penalties in the event this deadline is not met.  This
registration statement was declared effective on March 14, 2008.




F-38


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




Of the
stock issued in the SSI acquisition, 1,090,909 shares were being held in an
escrow account for a period of one year following the closing from which certain
potential indemnification obligations under the purchase agreement could be
satisfied. The aggregate number of shares held in escrow was subject to
adjustment upward or downward depending upon the trading price of the Company’s
common stock during the one year period following the closing
date.  On March 12, 2008, the Company released these shares from
escrow and issued an additional 1,882,225 shares on June 12, 2008 pursuant
to the adjustment provision in the SSI asset purchase agreement.





On
October 19, 2007, the Company completed the acquisition of approximately 30.0%
of the issued and outstanding shares of common stock of Geeks on Call America,
Inc. (“GOCA”), the nation's premier provider of on-site computer services. 
Under the terms of the stock purchase agreement, the Company acquired
approximately 1,160,043 shares of GOCA common stock from several GOCA
stockholders in exchange for 2,940,200 shares of the Company’s common stock for
total consideration valued at approximately $4.5 million. The number of shares
issued in connection with this transaction was determined using a per share
price equal to the average closing price of the Company’s common stock on the
American Stock Exchange (AMEX) during the ten trading days immediately preceding
the closing date. The number of shares was subject to adjustment on the date the
Company filed a registration statement for the shares issued in this
transaction, which occurred on April 25, 2008. The increase or decrease to the
number of shares issued was determined using a per share price equal to the
average closing price of the Company’s common stock on the AMEX during the ten
trading days immediately preceding the date the registration statement was
filed.  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 GOCA.  On April 30,
2008, Telkonet issued an additional 3,046,425 shares of its common stock to the
sellers of GOCA to satisfy the adjustment provision.





Senior Convertible
Debentures





On
February 11, 2008, purchasers of MSTI Holdings, Inc.
Debentures executed a letter agreement with MSTI Holdings, Inc. providing
that, among other things, in the event Frank Matarazzo ceases being Chief
Executive Officer of MSTI Holdings, Inc., MSTI Holdings, Inc. will be in default
under the Debentures.





NOTE T
- MINORITY INTEREST IN SUBSIDIARY




Minority
interest in results of operations of consolidated subsidiaries represents the
minority shareholders' share of the income or loss of the consolidated
subsidiary MST. The minority interest in the consolidated balance sheet reflects
the original investment by these minority shareholders in the consolidated
subsidiaries, along with their proportional share of the earnings or losses of
the subsidiaries.




On
January 31, 2006, the Company acquired a 90% interest in Microwave Satellite
Technologies, Inc. (“MST”) from Frank Matarazzo, the sole stockholder of MST in
exchange for $1.8 million in cash and 1.6 million unregistered shares of the
Company’s common stock for an aggregate purchase price of $9,000,000 (See Note
B). This transaction resulted in a minority interest of $19,569, which reflects
the original investment by the minority shareholder of MST.




On May
24, 2007, MST merged with a wholly-owned subsidiary of MSTI Holdings, Inc.
(formerly Fitness Xpress, Inc. ("FXS")). Immediately following the merger, MSTI
Holdings Inc. completed an equity financing of approximately $3.1 million
through the private placement of common stock and warrants and a debt financing
of approximately $6 million through the private placement of debentures and
warrants. These transactions resulted in additional minority interest of
$4,576,740 and increased the minority interest from 10% to 37% of MSTI Holding,
Inc. outstanding common shares.




For
the twelve months ended ended December 31, 2008 and 2007, the minority
shareholder's share of the loss of MST was limited to $4,937,473 and $2,910,068,
respectively. The minority interest in MST through May 24, 2007 was a deficit
and, in accordance with Accounting Research Bulletin No. 51, subsidiary losses
should not be charged against the minority interest to the extent of reducing it
to a negative amount. As such, any losses will be charged against the Company's
operations, as majority owner. However, if future earnings do materialize, the
majority owner should be credited to the extent of such losses previously
absorbed in the amount of $545,745.





Minority
interest at December 31, 2008 and December 31, 2007 amounted to $262,795 and
$2,978,918, respectively.




F-39


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




NOTE U
- BUSINESS CONCENTRATION





Revenue
from two (2) major customer approximated $6,375,182 or 31% of total
revenues for the year ending December 31, 2008. Revenue from one (1) major
customer approximated $1,436,838 or 10% of total revenues for the year ending
December 31, 2007. Total accounts receivable of $486,906, or 22% of total
accounts receivable, was due from these customers as of December 31,
2008.  Total accounts receivable of $290,990, or 10% of total accounts
receivable, was due from these customers as of December 31, 2007.




Purchases
from two (2) major suppliers approximated $3,243,691 or 57% of
purchases and $2,126,137 or 36% of purchases for the years ended December 31,
2008 and 2007, respectively. Total accounts payable of approximately $309,620 or
6% was due to these suppliers as of December 31, 2008, and $761,033 or 19% of
total accounts payable was due to these suppliers as of December 31,
2007.





NOTE V
- FAIR VALUE MEASUREMENTS





The
financial assets of the Company measured at fair value on a recurring basis are
cash equivalents, and long-term marketable securities. The Company’s cash
equivalents and long term marketable securities are generally classified within
Level 1 of the fair value hierarchy because they are valued using quoted
market prices, broker or dealer quotations, or alternative pricing sources with
reasonable levels of price transparency. The Company’s long-term investments are
classified within Level 3 of the fair value hierarchy because they are valued
using unobservable inputs, due to the fact that observable inputs are not
available, or situations in which there is little, if any, market activity for
the asset or liability at the measurement date.  The Company’s
derivative liabilities are classified within Level 2 of the fair value hierarchy
because they are valued using inputs which are not actively observable, either
directly or indirectly.




•
            
            Level
      1: Unadjusted quoted prices in active markets that are accessible at the
      measurement date for identical, unrestricted assets or
      liabilities;




•
            
            Level
      2: Quoted prices in markets that are not active, or inputs which are
      observable, either directly or indirectly, for substantially the full term
      of the asset or liability; or




•
            
            Level
      3: Prices or valuation techniques that require inputs that are both
      significant to the fair value measurement and are
      unobservable.




The following table sets forth the
Company’s short- and long-term investments as of December 31,
2008 which are measured at fair value on a recurring basis by level within
the fair value hierarchy. As required by SFAS No. 157, these are
classified based on the lowest level of input that is significant to the fair
value measurement, (in thousands):





(in
      thousands)
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3
            
            
            Assets
      at fair valueCash
      and cash equivalents
            
            $
            282
            
            
            $
            -
            
            
            $
            -
            
            
            $
            282Marketable
      securities
            
            
            397
            
            
            
            -
            
            
            
            -
            
            
            
            397Long-term
      investments
            
            
            -
            
            
            
            -
            
            
            
            63
            
            
            
            63Derivative
      liabilities
            
            
            -
            
            
            
            2,573
            
            
            
            -
            
            
            
            2,573Long-term
      debt
            
            
            -
            
            
            
            -
            
            
            $
            1,311
            
            
            
            1,311Total
            
            $
            679
            
            
            $
            2,573
            
            
            $
            1,374
            
            
            $
            4,626





NOTE W
- EMPLOYEE BENEFIT PLAN





MSTI
maintains a defined contribution profit sharing plan for employees (the
“401(k)”), that is administered by a committee of trustees appointed by MSTI.
All MSTI employees are eligible to participate upon the completion of
three months of employment, subject to minimum age requirements. Each year
MSTI makes a contribution to the 401(k) without regard to current or
accumulated net profits of MSTI. These contributions are allocated to
participants in amounts of  100% of the participants’ contributions up
to 1% of each participant’s gross pay, then 10% of the next 5% of each
participant’s gross pay (a higher contribution percentage may be determined at
MSTI’s discretion).  In addition, MSTI makes a one-time, annual
contribution of 3% of each participant’s gross pay to each participant’s
contribution account in the 401(k) plan.  Participants become vested
in equal portions of their MSTI contribution account for each year of service
until full vesting occurs upon the completion of six years of service.
Distributions are made upon retirement, death or disability in a lump sum or in
installments. The
expense for these benefits was $9,076 and $65,812 for the years ended December
31, 2008 and 2007, respectively.




F-40


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




NOTE X
- SUBSEQUENT EVENTS





Senior Convertible
Debenture





In 2009,
the Company has issued 5,449,738 shares of its common stock for the repayment of
$500,000 of additional principal value of the outstanding convertible debentures
issued to YA Global Investments LP.





Sale of MSTI Holdings, Inc.
common stock





On
February 26, 2009, Telkonet, Inc. (the “Company”) executed and completed a Stock
Purchase Agreement (the “Agreement”) with William Davis pursuant to which the
Company sold, and Mr. Davis purchased, 2,800,000 shares of MSTI Holdings, Inc.
common stock (the “MSTI Shares”)  for consideration in the aggregate
principal amount of $10,000.





In a
related transaction, the Company entered into a Partial Release of Lien with YA
Global Investments, L.P. (“YA Global”), pursuant to which, in consideration of
YA Global’s agreement to release its lien and security interest on the MSTI
Shares, the Company paid a commitment fee to YA Global in MSTI Holdings, Inc.
common stock equal to one percent (1%) of MSTI Holdings, Inc. common stock owned
by the Company following the sale of the MSTI Shares (157,000
Shares).   Prior to the transaction, the Company held 18,500,000
Shares of MSTI Holdings, Inc. common stock.





With the
reduction in holdings, the Company now holds 15,543,000 of MSTI Holdings,
Inc. common stock reducing its percentage holdings in MSTI Holdings, Inc. common
stock to forty nine percent (49%).





Amendment to Senior
Convertible Debenture Agreement





On
February 20, 2009, the Company and YA Global Investments, L.P. entered into an
Agreement of Clarification pursuant to which the parties agreed upon the
following clarifications to the Securities Purchase Agreement and the Debenture
Agreement, dated May 30, 2008:





·
            The
      parties agree that the term Equity Conditions shall be clarified such that
      if the Company’s Common Stock has not been suspended from trading and the
      Company has not been notified in writing that a delisting or suspension
      from trading is threatened or pending, the Company shall be deemed to have
      satisfied the conditions in clause (B) requiring that the Company be in
      compliance with the then effective minimum listing maintenance
      requirements of the exchange on which the Common Stock is
      listed.·
            Section
      1(b) of the Debenture requires, among other things, that interest shall be
      paid quarterly, in arrears.  The Debentures do not indicate when
      such quarterly interest payments begin.  The parties agreed to
      clarify that the quarterly interest payments shall be paid on the first
      Business Day of each calendar quarter beginning on April 1,
      2009.  The parties further agreed to clarify that quarterly
      interest accrued to date shall be added to the principal amount
      outstanding under the Debentures and that each Debenture be amended to
      reflect the applicable increase in principal amount.  The
      parties further agreed that the Company is not in breach of Section 2(a)
      of the Debentures for not making any interest payments during calendar
      year 2008 or the first quarter of calendar year
  2009.


·
            The
      conversion provisions contained in Section 4 of the Debentures and the
      exercise provisions contained in Section 2 of the Warrants do not cap such
      conversion or exercise provisions, as applicable, to the 19.99%
      Limitation.  The Principal Market requires such a cap absent
      stockholder approval.  To date the Company has not sought, nor
      has YA Global requested, stockholder approval for issuances of common
      stock in excess of the 19.99% Limitation.  Accordingly, the
      parties agree that the 19.99% Limitation is applicable for conversion of
      the Debentures and exercises of the Warrants, in the aggregate and that
      the Company shall not be obligated to issue such shares of common stock in
      excess of the 19.99% Limitation unless and until the Company obtains
      stockholder approval in accordance with applicable Principal Market rules
      and regulations.  Further, the Company agreed to seek
      stockholder approval to remove the 19.99% Limitation at its next annual
      meeting, to be held on or before May 31,
2009.





NOTE Y
- BUSINESS SEGMENTS AND GEOGRAPHIC INFORMATION




The
Company's reportable operating segments are strategic businesses differentiated
by the nature of their products, activities and customers and are described as
follows:




F-41


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




Telkonet
is a “clean technology” company that develops and manufactures proprietary
energy efficiency and smart grid networking technology.  Through the
Company’s wholly owned subsidiary, EthoStream, LLC, the Company also operates
one of the largest hospitality high-speed internet access (HSIA) networks in the
United States.





Microwave
Satellite Technologies (MST) (Note B), offers complete sales, installation,
and service of VSAT and business television networks, and became a
full-service national Internet Service Provider (ISP). The MST solution offers a
complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
Broadband Internet access and wireless fidelity (“Wi-Fi”) access, to commercial
multi-dwelling units and hotels.





The
measurement of losses and assets of the reportable segments is based on the same
accounting principles applied in the consolidated financial
statements.





Financial
data relating to reportable operating segments is as follows:





2008
              
              
              2007TKO
              
              
              MST
              
              
              TKO
              
              
              MSTCurrent
      assets, excluding intercompany
              
              $
              2,915,859
              
              
              $
              529,907
              
              
              $
              5,516,844
              
              
              $
              1,487,324Property
      and equipment, net
              
              
              274,403
              
              
              
              3,470,122
              
              
              
              491,606
              
              
              
              4,655,802Other
      assets
              
              
              16,065,815
              
              
              
              3,252,237
              
              
              
              22,084,555
              
              
              
              4,505,214Due
      from MST (intercompany)
              
              
              2,181,793
              
              
              
              -
              
              
              
              1,270,287
              
              
              
              -Total
      assets
              
              $
              21,437,870
              
              
              $
              7,252,266
              
              
              $
              29,363,292
              
              
              $
              10,648,340Current
      liabilities, excluding intercompany
              
              
              5,371,645
              
              
              
              13,488,012
              
              
              
              7,223,514
              
              
              
              2,771,318Long
      term liabilities
              
              
              3,934,982
              
              
              
              -
              
              
              
              67,112
              
              
              
              4,432,342Due
      to TKO (intercompany)
              
              
              -
              
              
              
              2,181,793
              
              
              
              -
              
              
              
              1,270,287Total
      liabilities
              
              $
              9,306,627
              
              
              $
              15,669,805
              
              
              $
              7,290,656
              
              
              $
              8,473,947Capital
      expenditures
              
              $
              9,000
              
              
              $
              1,133,629
              
              
              $
              224,175
              
              
              $
              1,655,191Revenues
              
              $
              16,559,001
              
              
              $
              3,971,958
              
              
              $
              11,476,983
              
              
              $
              2,675,750Gross
      profit (loss)
              
              
              6,772,865
              
              
              
              (65,529
              )
              
              
              3,211,989
              
              
              
              (729,849
              )Research
      and development
              
              
              2,036,129
              
              
              
              -
              
              
              
              2,349,690
              
              
              
              -Selling,
      general and administrative
              
              
              9,252,381
              
              
              
              3,686,576
              
              
              
              13,789,897
              
              
              
              4,108,077Impairment
      of goodwill and long lived assets
              
              
              2,380,000
              
              
              
              1,582,033
              
              
              
              -
              
              
              
              2,471,280Depreciation
      and amortization
              
              
              391,023
              
              
              
              591925
              
              
              
              412,624
              
              
              
              466,142


Stock
      based compensation
            
            
            699,639
            
            
            
            923,857
            
            
            
            1,655,346
            
            
            
            686,634Total
      operating expenses
            
            
            14,759,172
            
            
            
            6,784,391
            
            
            
            18,207,560
            
            
            
            7,732,133Loss
      from operations
            
            
            (7,986,307
            )
            
            
            (6,849,920
            )
            
            
            (14,995,571
            )
            
            
            (8,461,982
            )Other
      income (expenses)
            
            
            (8,093,930
            )
            
            
            (5,992,855
            )
            
            
            1,724,847
            
            
            
            (1,568,472
            )Loss
      before minority interest and provision for income taxes
            
            $
            (16,080,237
            )
            
            $
            (12,842,775
            )
            
            $
            (13,270,724
            )
            
            $
            (10,030,454
            )




All of
the Company’s assets as of December 31, 2008 and 2007 were attributable to U.S.
operations.




F-42


TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




The
following is a summary of operations within geographic areas, classified by the
Company's country of domicile and by foreign countries:




Year
      ended December 31,2008
            
            
            2007(In
      thousands of U.S. $)Revenues
      from sales to unaffiliatedcustomers
      from continuing operationsin
      Telkonet and MST segments:United
      States
            
            
            20,410
            
            
            
            13,851Worldwide
            
            
            121
            
            
            
            302$
            20,531
            
            
            $
            14,153




Revenues
to major customers in the Telkonet segments out of total revenues are as
follows:




Year ended December
      31,2008
                  
                  
                  2007In
      Town Suites
                  
                  
                  20%
                  
                  
                  
                  -Honeywell
      Utility Solutions
                  
                  
                  11%
                  
                  
                  
                  10%





For the
years ended December 31, 2008 and 2007, there were no major customers in the MST
Segment.








F-43